Day: August 5, 2024

Shiloh:

Hi, I’m Shiloh Bates and welcome to the CLO Investor
Podcast. CLO stands for Collateralized Loan Obligations, which are securities backed by pools of leveraged loans. In this podcast, we discuss current news in the CLO industry, and I interview key market players. Today I’m speaking with Drew Sweeney, the broadly syndicated CLO portfolio manager at TCW. In a
previous life, Drew and I went to rival high schools in Arlington, Virginia, and we worked together as credit analysts at Four Corners Capital. Now Flat Rock invests in some of the CLOs that he manages. I asked Drew to come on the podcast to discuss his perspective on the quality of loan documentation in the broadly syndicated loan market, and to discuss examples of when loan investors were not as senior and secured as they might’ve liked to be. It’s a bit of a technical podcast, but that’s the only way to adequately treat the subject. If you are enjoying the podcast, please remember to share, like, and follow. And now my conversation with Drew Sweeney.

Drew, thanks so much for coming on the podcast.

 

Drew:

Thanks for having me. It’s good to be here.

 

Shiloh:

So I’d like to start off the podcast by just asking your
background story and how you became a CLO manager.

 

Drew:

Well, as you know, many, many years ago we worked together in investment banking and I was syndicating bank loans at the time, and I liked the idea of being an investor as opposed to a banker. So I moved from First Union, which was a bank many years ago to the buy side and began working there. And we worked together again at a place called Four Corners, which I focused on managing bank loans in market value CLOs, and some closed-end funds, and a variety other products. And then just my path led me eventually to TCW, but I think it’s the natural progression of do you like to be an investor?

 

And then the most common vehicle with investing in loans are CLOs. And so it’s just a natural pairing.

 

Shiloh:

And what do you find interesting about bank loans in particular?

 

Drew:

I like bank loans because they’re not always efficient. So you can outwork competitors, you can meet with management teams on a regular basis. You can apply a level of discipline to and process. And over years, I’ve been doing this over 25 years. When you apply a level of discipline and a process, you can just see what works and doesn’t then you iterate on that. But I like investing in general and then you combine that with the inefficiencies of the bank loan market and I think it makes for great opportunity.

 

Shiloh:

So I think the attraction for me in coming over from the investment banking side was that in investment banking you work on a lot of deals that never really come to fruition, and that can be quite frustrating.

 

Whereas on the buy side, if you’re investing in bank loans, there’s in an active market, you’re a credit analyst, you cover an industry or two, and a lot of times there’s just a lot of activity. So you work on a loan opportunity, you might want to do it or not, but even if you don’t, it’s good to understand more of the companies in your space. So I just felt the amount of work that you do versus the product and how interesting it is really skewed very favorably to working on the buy side.

 

Drew:

Yeah, makes sense. It’s been a long time since I’ve been in banking, but you’re right, the number of deals that do not go through that you spend your weekend modeling is remarkable.

 

Shiloh:

Now you’re at TCW. Why don’t you tell us a little bit about the loan platform in particular?

 

Drew:

We have roughly six and a half billion dollars of loan AUM today. We manage 12 CLOs as part of that. And I think the idea of TCW Bank loans is really, we are a bank loan team that is sitting in a very large asset manager and we try to leverage all the things about being a large asset manager and get the benefits of being something more nimble. On the bank loan side, I think we offer a pretty differentiated product. There are three or four things that distinguish us from others. We have an integrated bank loan team, which means basically our analysts are looking at bank loans, high yield and investment grade. And simply put, we always say competition doesn’t stop at capital structure. So if you’re in technology or if you’re in telecom or if you’re in cable or a variety of industries and you’re only looking at non-investment grade borrowers, you don’t really know where CapEx dollars are coming from, or trends, and you really don’t know all your competitors.

And then outside of that, I think we’ve built, probably from investing in the product, one of the most robust databases that exist. We have information on roughly 850 loan borrowers in the loan universe. And if you think about the CS index, that was 1600 borrowers.

 

Shiloh:

So that’s the Credit Suisse loan index.

Drew:

Yes. And then if you say of those 1600, maybe 1200 are liquid, and we have three quarters of those mapped. So not only do we see how our borrowers perform each quarter, then we see how the borrowers’ competitors perform each quarter. And it allows us to use these as building blocks in exchange. If our chemical companies are doing not what we think and these chemical companies are, we can swap.

 

Shiloh:

If it’s a private market though, how are you tracking loans that you aren’t participating in in the primary?

 

Drew:

This is what it gets back to the disciplined and outworking competitors.

 

We have a whole team of research associates that work along with the senior analysts and they spend a lot of time getting access, keeping access,  and adding that information on a quarterly basis.

 

Shiloh:

Interesting. So the theme for today’s podcast is weak loan documentation. So the idea of being a first lien lender is that in a bankruptcy, if the business doesn’t perform as expected, if you end up in a bankruptcy, I think it happens to about 3% of borrowers each year. But in the restructuring process as a first lien lender, you’re secured by all the collateral and you’re first in line for any proceeds. So that’s conceptually how a restructuring should work. But I guess what actually happens in reality doesn’t always conform to the description I just gave. Once you make a first lien loan, some things should be prohibited. So one is the payment of dividends to the company’s owners.

The first lien lenders are not signing up for that. Again, they want to be first in line. They’d rather see that cash go to repay the loan. In most cases, you’re secured by the collateral of the company. So you want to make sure that none of that collateral can leak away from you over time or through malfeasance by the owner. So then one exception though is if you do end up in a bankruptcy, oftentimes there’s a debtor in possession loan. So that comes in when the company is out of cash and somebody’s got to put up some additional dollars so that the company can pay its workforce, for example. And then in that case, the debtor end possession financing does come in senior to the first lien term loan. When you’re committing to a new loan in the primary market, it’s the sketch, if you will, of how the loan documentation is going to read.

That comes from the term sheet. We’ll see a term sheet first. And then what’s some of the important things that you would look for in the term sheet?

 

 Drew:

You’re looking at all the basics of what you would expect or the price talk would be, what the maturity is, what your assets, so what the collateral is, and then whether or not what’s permitted in terms of repayment of debt for IPO proceeds, what’s permitted for dividends, whether or not any bonds or loans mature inside your borrower. So you’re going through a checklist of things to make sure that in essence, exactly what you described, a first lien senior secured loan is in actuality a first lien senior secured loan. Who the borrower is too, whether it’s at the Op-co or the Hold-Co, is something else you’ll see in the term sheet.

 

Shiloh:

So a company may have a number of different subsidiaries in your terminology.

The Op-co actually does have some business operations that it’s doing. And then the holding company in the organizational chart, that’s just basically the owner of the different op-cos. So then the idea of the first lien loan is that all the subsidiaries, all the different parts of a company, are borrowers under the credit agreement. There’s different assets of the different subsidiaries. The idea anyway is that all of that is pledged as collateral for the first lien loan.

 

Drew:

That’s the idea. And in reality, back from my days in investment banking, one of the first things I was taught is you want to be as close to the assets as you can, so as close to the collateral as you can. So in a perfect world, there’s one op-co and you’re lending against that. That’s not in reality what a company with 300 million to $2 billion of EBITDA has.

The org chart’s much more complicated than that. You want to have as many of those subsidiaries as your guarantors of the loan, and then you want to make sure that the subsidiaries stay your guarantor.

 

Shiloh:

So what are some reasons that a subsidiary would not be a party to the credit agreement?

 

Drew:

Some of those borrowers aren’t part of our guarantor package just because sponsors or the companies feel they don’t need to do that to get the loan done. So there’s some optionality in it. There’s some tax consequence to it when it comes to foreign subs. And then there’s some just natural evolution where there are times when the loan market is easily accessible and there are times when the loan market is not. So a company might do an acquisition in 2018 and follow that up with another acquisition in 2021, but they don’t want to pay down the debt of the 2018 facility.

 

So they might finance that separately, and it might be part of our box, but not our explicit guarantor. So there’s a variety of reasons it ends up there.

 

Shiloh:

But the general idea is that the material subsidiaries are guarantors of the term loan. So something foreign subsidiaries, like you mentioned, may not be guarantors. Maybe they’ve pledged their equity but are not specific guarantor. Maybe a subsidiary with an immaterial amount of revenue or EBITDA could also not be pledged. Maybe they just didn’t want to go through the hassle or the paperwork to do that. So some of these subsidiaries just end up outside of the borrower group and are not considered guarantors of the first lien loan.

 

Drew:

That’s right. And the last item you mentioned is something that happens quite a bit, I think in certain segments more than others, but some businesses will have an immaterial amount of EBITDA and it won’t be required that they’re pledged as a guarantor, that those assets are part of our collateral.

And in technology, those may be the fastest growing assets. So they may not be at the time you do the loan, but three years from now it could be driving the business. So there’s always that risk.

 

Shiloh:

Then what’s the difference between a subsidiary that’s a guarantor of the loan versus an unrestricted subsidiary?

 

Drew:

So we have a guarantor that is a guarantor in our collateral agreement, and we have a non guarantor that has to live by the credit agreement, but it lives by the credit agreement however, and it’s part of our restricted group. And then we have an unrestricted sub that’s actually outside of our borrower group entirely and not bound by the same obligations as the collateral agreement.

 

Shiloh:

Got it. So then it sounds like the primary market, you’re looking at a term sheet which is going to sketch out these terms, the terms that make it into the credit agreement, which is the legally binding doc once the loan closes.

So it sounds like the credit agreement is designed to give you the first lien that you want, but also some flexibility to the borrower. And so not every single asset makes it into the restricted group or the guarantors. There is some flexibility there and it probably should be warranted. You don’t really need to take every asset. So another concept I wanted to just chat through before we maybe get into some historical cases is just the concept of baskets. What’s a basket in a credit agreement?

 

Drew:

A basket is going to be a carve out of some amount. So most of our covenants today are in currents-based covenants. So you’re going to have a basket for permitted liens, a basket for dividends, and that’s saying you’re allowed to dividend out a certain amount per year. You’re allowed to invest in this non guarantor restricted subsidiary a certain amount per year.

 

And in the example that we talked about earlier where there’s a tech business that might be fast growing but not part of a collateral, the management and the owner and the sponsor will want to be able to invest in that technology. It may be part of the future of their business.

So they create these carve outs and they create these baskets. And essentially those baskets, many of them have the right to build over time based on the growth of the overall company based on a leverage ratio or a variety of other things. So those baskets are also a natural part of credit agreements.

 

Shiloh:

So the basket is a function of EBITDA. So if you have a hundred million of EBITDA, a for example, then the credit agreement might give you some percent of that to invest in unrestricted sub, for example, or to pay a dividend. That’s how to think about it.

 

Drew:

Yes.

 

Shiloh:

And then as EBITDA grows over time, is it warranted that the owners of the company should have more flexibility?

 

Drew:

I think to some degree it is. Flexibility is warranted when the company is growing, and the issue is it’s just whenever things are manipulated. So we’ve had borrowers go grow EBITDA nicely. It could be a cyclical business, it could be a business that has competition on the horizon that maybe the broader market doesn’t appreciate. Then they’ve maybe grown through debt financed acquisition, but they’ve realized synergies and they’ve maintained add-backs at the same time. So EBITDA appears to be growing rapidly, while it’s growing, but it’s growing mostly through acquisition. And then because they’ve built this basket, they take large dividend out because the market will be hot periodically, and you go back to the market, you dividend it out, people are in need of paper, and then within six to 12 months, all of a sudden EBITDA is not growing the way you thought it was because it’s either a cyclical business, like I said, or other competition has come online and you’re realizing those adjustments are not going to be realized. And then at that point, you’ve just added a layer of debt.

 

Shiloh:

So I think there’s three cases in the loan market, and I’d like to talk through all three of ’em where lenders made a first lien loan and it turned out that there were some loopholes in the credit agreements where they weren’t as senior and secured as they would’ve liked to be. So one is J Crew. Why don’t we start there? What happened at J Crew?

 

Drew:

I think J Crew was particularly interesting for a lot of investors because it was litigated and the litigation allowed us to see what baskets a sponsor was using or company was using in order to drop collateral out. So this is really about leakage from your borrower group. So where you lose collateral, you think you have intellectual property, it doesn’t have EBITDA associated with it. So they valued it, and they valued it at $250 million. And they happened to have some basket flexibility between their investment covenant and their general basket that allowed them to dividend out 250 million dollars worth of collateral. And in this case, they dividend out from the guarantor to a non guarantor. So once it was in that non guarantor box, they had something that allowed them to pass through from a non guarantor box out to an unrestricted sub. So essentially they dropped collateral in the value of $250 million, which you can easily argue was an underestimated number. They dropped it out of the borrower box, and they did this to facilitate an exchange of notes at the whole-co.

 

Shiloh:

Okay, so the intellectual property was collateral for the first lien lenders, and then they are able to move that collateral out through baskets, the baskets you mentioned, and then they start sitting in a subsidiary where they’re no longer guarantors of the first lien loan. And then didn’t they also raise new debt against that intellectual property?

 

Drew:

They did.

 

Shiloh:

So even if they would’ve dividend the IP to the unrestricted sub, it could have stayed in the sub and that would’ve been a subsidiary owned by the borrower under the credit agreement. So that would really not have at the end of the day hurt your position, but it was the fact that at the unrestricted subsidiary, they actually raised more debt that effectively was jumping the line, if you will, in terms of the priority of payments that was really expected when the term loan was put in place.

 

Drew:

You’ve had collateral that you thought was yours that doesn’t have EBITDA associated with it, leak out of the borrower. So by default, you’ve essentially been primed. You’re not at the Op-co where this collateral is now held. You’re at a Op-co, but you’re at an Op-co that doesn’t have IP.

 

Shiloh:

Is the market response to this that the market saw the weakness in loan documentation and for future loans, this is something that’s tied up and shouldn’t be a worry? Or is that too optimistic way to think about it?

 

Drew:

Yeah, it is addressed in many credit agreements. It’s usually tied to very specific collateral. However, in the market, it’s referred to as the J Crew trap door. So essentially on every one of our credit writeups, we have whether or not the J Crew Trap door exists or it doesn’t exist, but it does exist in credit agreements today. And in fact, in many, many deals when we receive the first term sheet, it exists there and then it’s very common for it to be pushed back on. But the reality is, is people are still trying to get it in. The reality is there are weaknesses in all these documents that you can say there’s no trap door in this deal, but it doesn’t mean you have all the collateral, and it doesn’t mean there aren’t baskets that they won’t be able to provision out.

 

Shiloh:

So that’s J Crew. Another big case in the market was Serta. Serta is a mattress company, And what happened there?

 

Drew:

Serta is a story about priming. So there’s a sacred right in terms of your priority of a lien, priority of payment, or that’s thought to be a sacred right. And you had mentioned at the outset about dips. So when a company needs to file for bankruptcy and they raise a dip, that dip goes in front of the existing first lien. It provides liquidity and it’s agreed to essentially by all parties in the bankruptcy. But a bankruptcy, when you file for chapter 11, it’s a complete restructuring. You lower the quantum of debt and you also provide for the company’s liquidity via the dip, and you can restrike all your liens and get rid of things that you don’t want, close EBITDA-negative stores. There’s a lot of things that can be done. With Serta, essentially what happened is they voted, and with a simple majority, roughly about 55% majority in a 45% minority group, they were able to contribute $200 million of new capital to help Serta with their liquidity issuance just like a dip. And then as opposed to the benefit being pro rata to all lenders, getting the benefit of participating in the DIP, and then participating in what the other debts exchanged for, the majority component was able to exchange into a second out. And then there was also a third out provided for future exchanges.

 

Shiloh:

So a second out and a third out, it’s a secure term loan, but the second out only gets paid after the first out is paid.

 

Drew:

So the new money becomes the first out. The majority holders that are in the first lien, and some of the majority holders that are in the second lien, they move into the second out. And then the minority holders within the first lien actually exchange into what would be a fourth out behind because they preserved a small amount of third out for future exchanges. But the reality is that they became third or fourth out, so they dropped from being a first lien senior secured lender with the right of payment from first to then essentially fourth.

 

Shiloh:

So Serta is a story about some lenders voting to give themselves the ability to prime or step ahead of other first lien lenders. Is, again the same question as related to J Crew, is that loophole that was found in the docks and now the loophole is largely closed, or is this a continuing risk in loan documentation?

 

Drew:

This exists in most deals today. A term sheet can say it’s cured or not cured, but in reality, when I talked about the evolution of credit agreement before and you had expanding allowances and then you had removing restrictions by increasing baskets and doing those things, the third evolution is essentially when you can make changes to the priority of payment by a simple majority. So changing the voting rights within credit agreements and those voting rights are pretty pervasive within credit agreements today, meaning simple majority voting rights.

 

Shiloh:

So then I think the third case that was very prominent in the market was Chewy. So can you tell us what did it do and why has it become a case study in the loan market?

 

Drew:

Well, PetSmart acquired Chewy, which was an online pet retailer, and they acquired it for roughly $3 billion. And the thing that makes it notable is that Chewy was a wholly owned subsidiary at the time of the acquisition and as a wholly owned subsidiary, it was a guarantor of our credit agreement. It was in our restricted box and a guarantor. And in fact, they raised term loan money around this acquisition. So the catch is, it’s only a guarantor if it’s wholly owned. So if you sell 1% of a business in this credit agreement and it’s no longer wholly owned, then it’s not a guarantor. So that’s what made it unique. So essentially what PetSmart and Chewy did, or what PetSmart did is they used investment capacity to transfer out 16.5% of the Chewy equity, and then they used a dividend to dividend out another 20% to a whole-co of the Chewy equity. So essentially 37% of this 3 billion asset got out of our borrower, and then it was no longer a guarantor of our credit agreement.

 

Shiloh:

So because Chewy was not a wholly owned subsidiary, they were able to send dividends up to the parent and get the capital to the business’ owners. How did Chewy end up not being a wholly owned subsidiary of PetSmart?

 

Drew:

It’s not uncommon for a company or a business to co own something, have joint ventures and not own a hundred percent of a subsidiary. So the idea that a wholly owned sub, and you can only guarantee the collateral of what you own wholly, so that makes sense. So it’s relatively a benign characteristic within the credit agreement to say it has to be a wholly owned sub to guarantee this debt. So the difference is the sponsor and the company use that relatively benign clause to be able to use baskets that were permissive where they could dividend out large portions of the borrower and essentially have value escape and also make it a non guarantor of our credit agreement, which the loan traded into the seventies at the time because it was thought to be pretty horrific. I think the thing that worked out well about it is they essentially ended up IPOing Cewy for a much greater dollar amount than the value of the entire term loan, despite the fact that lenders were in a bad position as a result of the weak credit docs, it turned out that Chewy was worth far in excess of the amount that they had paid for it, and they valued it at, and as a result, the term loan lenders got out whole.

 

Shiloh:

So in that case, the credit agreement had this loophole in it, but the business ended up performing well and the first lien got repaid. So that’s the punchline there. But it sounds like it gave the lenders a good scare. In all these case studies, is it that the weakness in the loan doc was put in intentionally, the private equity firm that owns the company was thinking that this is something that they might have wanted to do to lenders in the future? Or is it that the docs were just drafted this way and later only after the business had some operational difficulties did somebody at the company or the private equity sponsor figure out that there was some optionality for them and that the first lien lenders were not as secured as they might’ve thought they were?

 

Drew:

I think, this is my opinion, but what started as — we’ll talk to certain sponsors and they won’t even know the loopholes in these credit agreements. So I think what started as attorneys feeling like they wanted to build as much flexibility into these documents, and they were essentially showing their ability to work around the credit agreement and create loopholes, and then some sponsors took advantage of some of those loopholes. But generally speaking, a lot of documents have weakness in them, a lot of documents, and we track every sponsor. One of the things we do within our database is we track every sponsor. We know what the average price of every sponsor’s deal is, if they have 64 deals in the market or if they have 12 deals in the market.

 

Shiloh:

And a sponsor, by the way, that’s the private equity firm that bought the company.

 

Drew:

That’s right. So while many of these documents, we have one favored private equity sponsor that we have the most exposure to any private equity sponsor, and they’ve never had a US borrower lose a dollar of debt, they don’t use these loopholes. And guess what? These loopholes exist in their credit agreements too. So I think it’s two things. One is you have some sponsors who have been aggressive with it. All these sponsors have a capital markets person who’s focused on the docs.

 

Shiloh:

This is the broadly syndicated loan market.

 

Drew:

Yeah, the broadly syndicated loan market is this broad array of investors that could be in a variety of different investment vehicles and they’re investing in many, many deals. So for every new loan that gets syndicated, you may have 130 borrowers in it, but you only have one private equity sponsor. So that control pivot and having a single point person allows them to focus  and push on docs in a different way than having a confederation of investors together. So I think yes, there’s an effort by private equity to make sure these loopholes exist. A lot of times they exist with private equity firms that don’t focus on them, and I think once they existed or once some of this stuff was developed, then essentially lawyers that developed these docs have looked to make them standardized and weaker across the board.

 

Shiloh:

So is it then to find yourself in a situation where you’re being harmed by loose loan documentation, business really needs to underperform? First off, the business is performing well and the loan doc is weak, you’re probably fine. You also need a private equity firm or sponsor that’s going to want to do something that’s not creditor friendly and risk the wrath of the loan market. From the perspective of a private equity firm, if they do this, if they screw over one group of lenders, I would assume people have somewhat long memories in the loan market.

 

Drew:

I think it does influence company’s ability to borrow, and we’ve seen that before. I don’t know how long the memory is, but I think you’re right. I think generally three things are present.

 

Shiloh:

You need a loose stock.

 

Drew:

financial stress.

 

Shiloh:

Financial stress, and a private equity firm owner who decides that they’re going to put it to the lenders and bear the reputational risk for them that might come along with that. And it may affect the borrowing costs of companies in the future who are owned by that private equity firm.

 

Drew:

I don’t know the memory that the collective investment world in loans has, but what we’ve been screaming from our little mountaintop is that we track, as I just said, every single financial sponsor. We know  how many deals they have in the market, we know how many liability management exercises they performed, which we can get to, but we also know what the average price of their loans are. So when a sponsor is a bad actor on a repeated basis, we’re no longer lending to them. If they’re a bad investor and all their loans traded 80, we’re not lending to them. So that essentially means I think some of the sponsors you see in the market today are going to be cut out of the BSL market.

 

Shiloh:

Interesting. So it sounds like when you’re evaluating a loan opportunity, it’s not just the fundamentals of the business that you care about, but it’s actually the ownership team, the private equity firm, and how they’ve treated lenders in the past. That’s an important variable in your credit selection process.

 

Drew:

And we meet with sponsors on a regular basis. We go into offices, we have conversations and we have relationships. And I would say it’s really clear when you talk to some of the sponsors, some of the sponsors are very operations focused. They have teams of people that help drive synergies between businesses. Some of the sponsors are very legal based and they’re looking to have a way out in the event that things don’t work well. So we try to focus on that component.

 

Shiloh:

Okay. What’s an LME and why is that important today?

 

Drew:

An LME is a liability management exercise, much like what we discussed with Serta, and it is essentially an out of court bankruptcy. It’s not as clean as a chapter 11. You don’t restate your leases, you don’t close doors. You usually don’t get rid of the quantum of debt you have outstanding, but it does restrike a lot of the borrower’s debt, and it does usually come with a component of liquidity where the lenders are inserting some liquidity into the borrower.

 

Shiloh:

So we’ve seen an uptick in LME activity over the last two years. What do you think is driving these out of court restructurings?

 

Drew:

For context, we’ve had roughly 60 LMEs since 2014 through the first quarter of 2024, and then we had 25 LMEs in 2023 and eight in the first quarter of this year. So clearly the ramp has been significant in the last two years relative to what we’ve seen historically. And I think at the end of the day we’ve seen the things that are driving that are high rates is the first and most prevalent thing. A component of high rates is every credit agreement prior to 2008 used to require hedging. It no longer does in post 2008, credit agreements really didn’t include mandatory hedging.

 

Shiloh:

So the hedging would be you’re taking on this debt on a floating rate basis, so the business was required to hedge that floating rate risk or exposure in the derivatives market.

Drew:

And you hedge it out from floating to fixed for half the term loan and then fast forward to today, and that wasn’t required. So two things happen as rates spike so quickly that companies were not able to get hedges on, and then when they did get them on, they were considerably higher than if they’re putting them on at three or four percent SOFR/LIBOR, whatever measurement versus essentially a zero-rate interest rate environment. Well, you’ve already missed the benefit of the real hedge. So high rates, lack of hedging, and then I think sponsors, because it’s been such a competitive market where they’ve raised so much money, there’s just been a lot of high purchase price multiples made over the last five years. So all those things together mean you’ve got a higher quantum of debt, and you have higher interest rates, and it’s very hard for some of these companies to bridge some of the last couple of years.

Shiloh:

The LME that’s tied to the specific case that we talked about was Serta. LMEs are tied to Serta where one lender group is trying to prime another, and this is the description of lender-on-lender violence. That’s
where that comes in.

Drew:

We’ve seen LMEs performed on a prorata basis, meaning lenders aren’t harmed if they’re not in the existing group. And we’ve seen LMEs come in a non-pro rata manner, just like Serta, where the majority holders are favored and the minority holders do worse.

Shiloh:

So the LMEs have resulted in some pretty low loan recoveries. Is that a function of rapid business, fundamental deterioration, or the lender-on-lender violence?

Drew:

It’s a bit of all of that. So we’re in 2024, and it sounds crazy to say, but 2020, 21, 22, 23, and part of 24 for many industries, were dictated by still emerging from COVID. It sounds silly, but we lived through a period of zero revenue for some of these businesses. They had to take on more debt to bridge that gap. And then we had inventory management issues. We had logistical issues where you weren’t able to get supplies in and then you had inflation and then you had to pass along those costs. And then we’ve had destocking. So whether it’s packaging or whether it’s chemicals, some of these companies had quite a volatile performance over the last two, three years, or a travel business. They might’ve been dealing with the legacy of COVID and how much debt they took on during that period of time. Some of the businesses are just failing, and they’re zombies, and this has forced its hand.

So there’s a variety of reasons why a company might’ve gotten here.

Shiloh:

So how do you protect yourself from lower loan recoveries?

Drew:

This is part of this sponsor outreach and having those relationships. We have somebody who’s full-time in charge of reaching out to advisors and attorneys and came from an advisor background. So when you see a company with weakness, you need to get your hands around, “Is there a group forming?” “Is there a cooperative?” The very first step is cooperative groups started to form to prevent this lender-on-lender violence that took place in the market. So I don’t know if it was a year or a year and a half ago, we started seeing cooperative agreements among lenders, formed on a lot of stressed borrowers, and the idea was in the event something happens, we
are prepared to act as a united front, and that was the first step.

So we try to make sure that where there’s stress in a
borrower, that we’re going to get involved in being part of that group and being part of driving the solution.

Shiloh:

How do you think a CLO equity investor should think about the lower loan recoveries and potential risks in the loan documentation in the broadly syndicated loan market?

Drew:

I think you have to look at the adjusted default rate. So if you look at default rates today, its loan defaults are below 2% the adjusted default rate, if you take in LMEs, it’s around four and a half percent, somewhere around that. So there’s about a two and a half percent difference between the actual default rate in LMEs. And some of the LMEs, it’s deceiving, because you’ll get 85% of your debt restated, you’ll get 90 cents on the dollar restated. The problem is in a bankruptcy, you are getting rid of a lot of debt, you are getting rid of leases, you’re getting rid of EBITDA negative stores, and in LME, it only is a cure if the business improves on the back end of it because you’re really not getting rid of the quantum of debt.

You’re only providing for liquidity. So obviously we’re in the weeds on all these names. So there are some borrowers where you see an LME exercise done, and it might be in healthcare services, and we have one borrower that’s in healthcare services. Well, if you think about the consequence of COVID for anybody who’s in healthcare services is they had a tremendous amount of inflation within labor. So first you had wages go up, then you had a lot of nurses leave the entire system. So then that spike wages higher. So if you only have a reimbursement rate that’s set by a government entity and your primary costs are wages and you’ve been having inflation in wages for three years, it takes a long time to get through that. It takes years to get through that curve. So we had one deal where an LME was completed and it was done on a pro-rata basis. So everyone ended up at the same spot and the lenders injected additional liquidity, essentially primed ourselves, but then all got

ratable treatment. And in my opinion, as that loan trades close to 90 today, is the best decision we could have made because fundamental performance is
improving for the last several quarters. It’s improving because wage inflation’s decelerating, and they’re finally able to pass on the costs of all that labor. So every situation’s different. So I’m curious because you have more than one manager in general, what you’re hearing and what your thoughts are on potentially lower recoveries

.

Shiloh:

I definitely think that for the broadly syndicated loan
market, lower loan recoveries has been the risk. So a lot of times an investor will throw a stat at me, okay, here’s some low loan recoveries in the index. But really the question for me is, well, are those loans in CLOs and then even more important, are they in my CLOs? So my view is that if you’re working with the right managers in broadly syndicated that a lot of these lower loan recoveries and loose stocks can be avoided. I also think that this year, we didn’t really talk about it during this podcast, but refinancings and resets or CLO extensions have the ability to materially increase CLO equity returns. So on the one hand, we do have these low loan recoveries. On the other hand, the upside from refis and resets is significant, and then you’re a broadly syndicated CLO manager, but the majority of our equity positions are in middle market CLOs. I’ll give you an example. A few years ago we had a new VP who was trying to understand better middle market loan credit agreement, and we had a lawyer on the phone and we were going through the specifics of the doc, and this VP that we had was asking all these questions around J Crew around Serta trap doors, add backs, and the lawyers like, “no, no. In the middle market, there’s none of that. There’s no unrestricted subs, there’s no non guarantors or no baskets, there’s no dividends”

Disclosure AI:

Note, this is one example of a middle market credit
agreement. Other credit agreements may vary.

Shiloh:

So I think for somebody investing in middle market loans or middle market CLOs, I think that recoveries there are going to track more to the historical norm of the last 30 years. So I don’t see it as big of a risk in the middle market CLOs.

Drew:

Yeah, I think there’s one other big factor out there. I think most of this financial stress is coming from higher rates, which 60% of our borrowers are sponsor driven. So if a sponsor bought a company, they’ve
owned it for five or six years and they want to sell it, they can’t get the multiple they want today. If we fast forward, I’m not talking about rates going to zero, but if SOFR comes down to 3% and now all of a sudden you start seeing these assets trade again and LDOs increase again, I think it goes a long way to ease a lot of the stress and the interest stress that our borrowers are feeling today. So I think we’re in the eye of the storm in the BSL market today. Rates will go lower at some point, and that will ease a lot. The other thing in the BSL market, we don’t have a lot of nearing maturities. There’s very little still to mature in 25, and there’s very little to mature in 26. So if you have several years to wait this out, it doesn’t really matter the vol that you had along the way, as long as you can get to the point of being able to refinance your debt.

Shiloh:

These loans have initially a loan a value of 45 or 50% or something like that. So there’s a lot of cushion in there. A lot of things can go wrong in the business, and as a first lien lender, as long as the wheels don’t fully come off the cart, we should be money good at the end of the day.

Drew:

Agreed.

Shiloh:

Well, Drew, thanks so much for coming on the podcast. Really enjoyed our conversation.

Drew:

Thank you. Thanks for having me.

Disclosure AI:

The content here is for informational purposes only and should not be taken as legal, business, tax, or investment advice or be used to evaluate any investment or security. This podcast is not directed at any investment or potential investors in any Flat Rock Global Fund.

 

Definition Section

AUM refers to assets under management.

LMT or liability management transactions are an out of court modification of a company’s debt.

Layering refers to placing additional debt with a priority above the first lien term loan.

The secured overnight financing rate, SOFR, is a broad measure of the cost of borrowing cash overnight, collateralized by Treasury securities.

The global financial crisis, GFC, was a period of extreme stress in global financial markets and banking systems between mid 2007 and early 2009.

Credit ratings are opinions about credit risk for long-term issues or instruments,. The ratings lie on a spectrum ranging from the highest credit quality on one end to default or junk on the other.

A AAA is the highest credit quality. A C or D, depending on the agency issuing the rating, is the lowest or junk quality.

Leveraged loans are corporate loans to companies that are not rated investment grade.

Broadly syndicated loans are underwritten by banks, rated by nationally recognized statistical ratings organizations and often traded by market participants.

Middle market loans are usually underwritten by several lenders with the intention of holding the investment through its maturity.

Spread is the percentage difference in current yields of various classes of fixed income securities versus treasury bonds or another benchmark bond measure.

ETFs are exchange traded funds.

A reset is a refinancing and extension of A CLO investment period.

EBITDA is earnings before interest, taxes, depreciation, and amortization.

An add back would attempt to adjust EBITDA for non-recurring items.

The Credit Suisse Leveraged Loan Index measures the performance of the broadly syndicated loan market.

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