Brian Nolan, Head of European CLO Structuring at PGIM, joins The CLO Investor podcast to discuss European CLOs and how they differ from U.S. CLOs.
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TRANSCRIPT
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 Brian Nolan, Head of European CLO structuring at PGIM. This spring I saw Brian present at the Creditflux conference in London and thought he’d be a good guest to have on to discuss European CLOs and how they’re different from US CLOs. At Flat Rock we invest in US CLOs so this podcast was a learning experience for me.
If you’re enjoying the podcast, please remember to share, like and follow. And now my conversation with Brian Nolan.
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Brian Nolan:
Thanks so much for having me. It’s a pleasure.
Shiloh Bates:
So why don’t we start off with your origin story and how you ended up in the European CLO market?
Brian Nolan:
So I went to school in Ireland where I’m from and I moved to London in 2010. So my first three years is not worth speaking about because it wasn’t CLO related, but that was in Bank of Ireland and then I moved to Fitch Ratings. So my background before I joined PGIM is in rating agencies. I spent two and a half years at Fitch in the CLO team, two and a half years in S&P in the CLO team. And now I’ve been at PGIM for about seven years in the structuring team here.
Shiloh Bates:
And what’s one thing that you find interesting about CLOs?
Brian Nolan:
So, I think my original three years I was in a Corporate Banking type role and I think what some people might find interesting, but what frustrated me was the difficulty in finding information. So you spend so much of your time on various websites trying to get reports. The thing that I loved about CLOs, and this is probably a boring answer, is you have such a complete set of data that you can interpret and use and whether that’s in the rating agencies when you’re trying to stress a portfolio or when you’re structuring a portfolio on the issuer side, I just get a lot of comfort from having a lot of certainty in the numbers that we’re using.
Shiloh Bates:
Okay. So, at PGIM, is your role more structuring CLOs or are you also playing a role in the loans that go into these vehicles?
Brian Nolan:
Predominantly it’s on the structuring side. So, we’re one of the biggest CLO managers both in Europe and the US and with that comes quite frequent access to the market. So, whether it’s resets, refis or new issues. So my team is responsible for structuring the cadence of those deals and when they’re going to market and being as efficient as possible in terms of getting in and out of the market. Then when the transaction starts, we’re responsible for making sure the bank is doing a good structuring job and then a lot of the back and forth with investors on the CLO documents. So we have full-time analysts that do that. I think the thinking being that because of the volume expecting the portfolio managers to do that on top of their day job is probably stretching them too thin. So, it’s very much making sure the structures make sense for the platform and then keeping the machine consistently going.
Shiloh Bates:
Okay. So, are you working on structuring deals in the US and Europe or just Europe?
Brian Nolan:
No, I personally work just in Europe. So, we have an equivalent team in the US that would do it for our US deals and we’re in constant communication to understand the differences between the markets and usually it’s the way that the US innovates in something first and then they’re explaining it to me so that we can try and do it in Europe as well. But occasionally maybe it goes the other way.
Shiloh Bates:
As a CLO manager, how does PGIM differentiate itself?
Brian Nolan:
I’m sure most people have interesting answers to this. I think certainly the first one is quite a difference between Europe and the US. So, in Europe PGIM manages loans and bonds from the same team out of our portfolio management team. So, if you look at our CLOs versus some of our competitors here in Europe, you will see a much larger proportion of fixed rate bonds in our deals versus others. So, I think that’s probably the most obvious difference between US and others in Europe. In the US that’s less so I think up until a few years ago, Volker restricted any bonds at all going into the CLOs and I think even now most managers just have a small 5% bucket, so it’s less of a thing in the US but in Europe that’s a big distinguishing factor. I would say generally, and this applies to both sides is we’ve got a very active management style, so we have a high churn rate. We have deep resources. So, I think across the US and Europe we’ve got 35 credit analysts and 15 people on the desk between portfolio management and traders. So that is to allow us to analyze things quickly, take a view quickly, and churn the portfolio – mostly through primary. So, replacing assets that are less good relative value with the primary assets that come in. So, I think that is something we would say over and above what most people do in our DNA.
Shiloh Bates:
So how big is the European CLO market?
Brian Nolan:
I don’t have the number in front of me, but I think it’s about a quarter to a third of the size of the US market. So it’s materially smaller. I think it’s really since 2013 when 2.0s started going. I can tell you a busy year for us in Europe is maybe 9 or 10 deals in a year where our US colleagues are in the twenties and thirties number.
Shiloh Bates:
So that’d be about 300 billion or so euros I guess.
Brian Nolan :
Yes.
Shiloh Bates:
And then in Europe, are CLO securities only denominated in euros or are there other currencies that you guys are dealing with?
Brian Nolan:
The vast majority is in euros. Within the CLOs or you mean the liability structure?
Shiloh Bates:
I’ll take both.
Brian Nolan:
So within the CLOs we have a construct here in Europe called a perfect asset swap, which is a derivative that you sign with one or two banks that offer it here where it basically hedges your FX and is also linked to the underlying assets such that if the asset prepays you or if it defaults, the swap is linked to that so you don’t end up with a big mark to market payment that you need to make.
Shiloh Bates:
Interesting.
Brian Nolan:
It is, it’s quite bespoke, which makes it quite expensive. So for instance, you could have a sterling asset that pays you 500 over and the cost of the swap might be a hundred or 150 basis points of that. So the actual real term, what you’re comparing it to on the Euro side, it has to be something compelling for it to make sense for the costs that’s involved. So, I would say in Europe I suspect if you looked originally back in 2013, 2014 when the loan market was much smaller, you probably did have some of this happening as people were stretching to get diversity. As the European market has matured, I think you have a lot more options in Euro loans now that it would be a small minority of managers that still use that flexibility. On the liability side, it’s interesting because the vast majority of CLOs are issued in Euro. We actually issued the only GBP Sterling CLO, so that was back probably about seven or eight years ago now. That was just before Brexit. It was a very distinctive trade and that was called a couple of years ago, so it doesn’t exist anymore. That’s the only non-euro deals that I’m aware of up until I think there was a mid-market CLO that was done quite recently, which was GBP Sterling as well. So 99% of it will be in euros.
Shiloh Bates:
How many CLO managers do you have in Europe?
Brian Nolan:
So this is an ever-increasing number as a lot of US platforms are moving over to Europe. I think if you look at people that have actively issued a deal in the last year or two, you’re probably talking about 50 to 60 managers. If you actually look at every manager that has a deal outstanding, it’s probably more like 70 80, but a large chunk of those have not been active for a long time and I think that’s grown significantly. You probably add high single digits of managers over the last four or five years. In terms of new entrants to the market
Shiloh Bates:
Geographically, are most of the managers in London or spread around Europe?
Brian Nolan:
The vast majority will be in London. You have three or four in Dublin, in Ireland, I’m aware of a couple in Scandinavia and maybe one in Spain and then a few France maybe. But I would say probably 80% plus based in London.
Shiloh Bates:
So then talking about getting into the assets in the European CLOs and how they’re different from the US, the loans that go into CLOs often are created in leveraged buyouts. Is the continent, is Europe as friendly to private equity activity as we are here in the US?
Brian Nolan:
I think that depends on whether you’re looking at creation or other things that happen along the lines. So, I think one thing Europe has – can be seen as a positive or a negative – you have a lot of regional diversity, so you have different domiciles but different regulations and different laws. So, I don’t think anything could be as friendly as the US because obviously it’s very uniform there and very business friendly. That leads to potentially less efficiency on the LBO side, what it does potentially benefit you on the other side of things is if things go wrong, what you can see is the different regulatory regimes in Europe that are maybe not as sponsor friendly as the US would be do mean that you see things like less LME activity, you see a bit more of a relationship based interaction between sponsor and CLO managers versus a transactional one, which maybe you might see more in the US. That’s very much looking for the positives. I mean up until the last few years when LMEs started to come through in the US I think in Europe there was a lot of frustration with how long things took and the various hoops you had to jump through in various jurisdictions.
Shiloh Bates:
So in a European CLO, is it easy to come up with enough underlying loans so that you have the diversity that the CLO requires?
Brian Nolan:
Ultimately I think that is becoming more difficult as the years go by and more managers come to the market. So LBO activity in Europe, since the interest rate spikes in ’22 has really slowed down, whereas issuance on the CLO side has not really. So, you’re definitely seeing significant demand for loans where the supply is not necessarily coming through on LBOs. So I think you definitely can struggle to do it in a fast way and I think a good example of this is maybe print and sprint transactions. So I think these happen quite frequently in the US and I know obviously the most about our platform versus our US colleagues and how easy it can be for them to do a print and sprint transaction. Whereas in Europe, while there have been some done, and we did one, our original deal in the 2.0 era was a print and sprint, it definitely is more difficult to get that many assets very quickly.
Shiloh Bates:
So the print and sprint in case people don’t know is just a CLO is forming without really any assets in a warehouse or a very small warehouse if there is one and the CLOs come into life and all the assets are just being bought in the secondary market.
Brian Nolan:
Yes, in a very short period of time. Whereas I think the typical warehousing period here in Europe is you generally ramp up those assets over a three-to-six-month period before you issue the CLO. And to your point around diversity, I guess this is one key difference between the markets, so defining what’s an acceptable level of diversity is quite different between the European and the US markets. So I think your typical US transaction is going to have somewhere between 250 to 350 individual obligors, whereas a European deal is probably half of that. And I think that’s a function of the smaller market and I would say that diversity amount has increased in Europe over time. If you go back to when the market opened in 2013, it would not be uncommon to see less than a hundred obligors in a portfolio, whereas now it’s probably around the 150 number.
Shiloh Bates:
Does that tie to your earlier comment about putting bonds in your portfolios that it’s easier to get the diversity you need if you’re also looking at senior secured bonds?
Brian Nolan:
That was absolutely one of the key drivers when we originally issued our first European CLO 2.0. So I think as the loan market has matured, it’s become less necessary, but we still think that your top 10 bond ideas are going to be better than your worst 10 loan ideas. So even though it might not change the number of obligor, it should give you access to a better quality of obligor.
Shiloh Bates:
So the base rate in your market is euribor, am I pronouncing it correctly?
Brian Nolan:
Correct.
Shiloh Bates:
So the loans are floating on euribor and are they paying 300 over like in the US?
Brian Nolan:
No. Typically if you look back on the long-term averages, I would say the European market generally is at a premium to, on a spread basis. A portfolio today is probably somewhere between 340 and 380 depending on the style of the manager. Whereas I think in the US as you said, it’s closer to 300.
Shiloh Bates:
And so what accounts for that premium over the US does that reflect liquidity or potentially higher loan losses that you need to be compensated for?
Brian Nolan:
I think primarily it’s driven by CLOs. So in Europe the CLO buyer is in excess of 80% of the loan market, so we wouldn’t have the alternatives to CLOs that the US would have. And on the other side of the equation, CLO liabilities generally price at a premium to the US. So in order for the arbitrage to work, the CLOs are floored at a certain level and because they make up so much of the market that technical can sometimes put a floor on where spreads can go until liabilities come in tighter. Equally, you could argue the loan market is definitely less liquid in Europe we would still consider it a liquid market, but it wouldn’t be the same as the US. So you could also imply that there is some illiquidity premium there versus the European equivalents.
Shiloh Bates:
So then SOFR, the secured overnight financing rate is the base rate for US CLOs. So that’s roughly four and a quarter. Where’s euribor? I know that’s been coming down. Where does that sit today?
Brian Nolan:
Probably date myself here. I haven’t checked it recently. It’s somewhere in the two and a half percent area, I think
Shiloh Bates:
Two and a half. So the ECB has been cutting.
Brian Nolan:
Yeah, I don’t think went as high as you guys, but then we’ve been cutting as well.
Shiloh Bates:
So then the underlying loans geographically, is it mostly the UK, Germany, France, and maybe Spain or what’s the country mix there?
Brian Nolan:
I mean the ones you’ve named are generally the top. I would say the largest countries would probably be still below 20%. So it would have a regional diversity there, the UK, France and Germany would be the largest. Then you would have Spanish, Italian, Scandinavians as well as some more peripheral countries. So that is one thing I think a US CLO will have more obligor diversity, but a European CLO will have that regional diversity where you do have some diversity benefits from having exposure to multiple geographies.
Shiloh Bates:
So in the US I think that investors in CLO equity for example are assuming a loan loss reserve, which is a 2% default rate and a 70 cent recovery rate. In prior podcasts I’ve talked about that being maybe a little bit antiquated or a little bit too beneficial for the CLO equity investor. How do those compare to what’s happened in Europe and what investors should expect maybe going forward?
Brian Nolan :
See, I think the one thing we always say in relation to this is that A CLO is an actively managed portfolio. So when we look back across all of our portfolios over the last 10 years we’ve done this analysis and the vast majority of our deals actually have a positive annual trading. So when you take away the losses versus the positives, depending on certain vintages for instance, if you go out of reinvestment period just before there’s a downturn and you lose the flexibility, those vintages can be the most difficult. But I would say the headline numbers in Europe, the default rate has been materially below that over the course of the 10 year average. Obviously that will differ year to year and the recovery rate is, again, this is very idiosyncratic because you’re going to have one that’s 20 and another one that’s a hundred.
I think the average is in the 60 to 70 range across those defaults that have happened. So I think the recovery rate is 1 – Obviously as the market has gone cov-lite, there was a lot of discussion around whether recoveries were going to be later or worse than long-term averages. I don’t think there’s been enough defaults in Europe ready to get a meaningful amount of data on that, but what we have seen so far is obviously on a case by case it can be wildly different, but if you look at the average across a bigger data set, we don’t see a huge difference in the long-term average.
Shiloh Bate:
So are the assets leveraged on assets four and a half to five and a half times EBITDA with interest coverage around three times?
Brian Nolan:
That depends on whose numbers you use. If you use the company numbers, that probably sounds about right. I think it differs per industry, but I think certainly on our numbers we obviously do our own internal forecasts and look at add-backs and what ones are realistic In terms of one-offs, we would see it probably slightly ahead of that. I don’t work on the portfolio management side of the team, I wouldn’t be as close to that data as those guys would. I think your numbers sound like company projections in line with what we’re typically seeing
Shiloh Bates:
Is the reinvestment period in Europe, is it typically five years like the US?
Brian Nolan:
I would say the average is probably four and a half. And I would say five years ago it was probably four years. So it’s slowly migrating and we have seen deals that have done at five as well, but my understanding of the US market is it’s much more standard to be five in most deals.
Shiloh Bates:
And so what’s a good AAA spread over euribor if you’re issuing a deal today?
Brian Nolan:
So today I think the European market is potentially starting to distinguish between new issue and reset and also between managers. So I know you’ve seen tiering in the US market for a long time and I think it’s probably a sign of the European market maturing more that we’re starting to see that. I would say for a new issue deal today you’re probably looking at 130 or low 130s. For a reset, you’re probably looking at mid 130s and then yeah, you could see certain deals in the high 130s depending on if it’s a reset, the quality of the portfolio and the manager and things like that.
Shiloh Bates:
So the spread for European AAAs is pretty comparable to what you find in the US then
Brian Nolan:
Today, I think so, yes. I think that has diverged over time, but as of today it’s actually remarkably close.
Shiloh Bates:
So then for the equity tranche, is that much more profitable in Europe given the numbers you went through? I mean if the AAA financing cost is the same as the US but the spread is 50 to 80 bps more on the assets, that should be pretty lucrative for the equity tranche?
Brian Nolan:
Yes, so I think down the structure you probably are a little bit wider in Europe. So when you’re looking at the weighted average cost, you should be wider in Europe than you would be in the US. But we’ve done some analysis looking back since 2018 we’ve done the high-level arbitrage calculation, which is the spread on the assets minus the cost of debt times the leverage. We would typically see Europe being somewhere between, and this is proportional, not eight points higher, but about 8%. So if it’s 15% in US, the equivalent would be about 16 or 17 in Europe. So I think it’s generally looked a little bit higher. The other thing in Europe is we issue a single B tranche in almost every transaction, whereas I think that’s quite rare in the US.
Shiloh Bates:
It is, yeah,
Brian Nolan:
Which means you get more leverage, but obviously it’s more expensive leverage, but overall in Europe it’s accretive to the returns.
Shiloh Bates:
So at Flat Rock we also invest in BBs. What’s the spread over euribor for BB these days?
Brian Nolan:
So the spread, I think it’s probably in the low 600s right now. I think that can be a bit volatile per manager and I think it’s demand and supply and technicals can have a big impact on that market. If you have a lot of deals all come at the same time, that can suddenly blow out to 650, 700 pretty quickly. And equally in a very strong market it could be as tight as 500, but I think in today’s market you’re probably looking at high five hundreds, low six hundreds.
Shiloh Bates:
Then does the lack of diversity when compared to the US, does that mean that the CLO needs some additional equity capital to support the BB?
Brian Nolan:
Yes. For instance, AAA, your typical subordination in the US is somewhere between 35 and 36%. The equivalent in Europe would be more like 38 to 39%. So, you are going to have less leverage across your structure if you just go down to BBs, you will have to issue more equity in Europe. But typically what happens is they issue single Bs as well. So actually if you look for the same size deal in Europe, you would generally have a smaller equity ticket, but because you’re getting less efficient leverage, you’re going to have a more expensive leverage than you would in the us.
Shiloh Bates:
So what are the economics then of the single B?
Brian Nolan:
The single B can be volatile. So right now it’s probably high eight hundreds, low nine hundreds, DM probably at a price of 98 or 97.
Shiloh Bates:
And then once you issue the BB and the single B, how much equity is left in the deal? Is it 7% or 6% or something?
Brian Nolan:
So the enhancement on the junior note is 6.5%. So for say a 400 million transaction you could do 30 million or 31 million of equity.
Shiloh Bates:
And then is the equity in Europe, is it typically bought by third parties like a Flat Rock, or is the manager putting the CLO equity into their own funds?
Brian Nolan:
So, this has evolved considerably over the last four or five years I would say. So PGIM is now one of the minority of CLO managers that is 100% third party equity. So in our transactions, 95% is sold to third parties. I think if you look at the rest of the top 10 managers, they all have captive equity funds. So it’s effectively the managers managing that money instead of each individual deal having an individual third party. If I was to talk about percentages of the market, it’s not all published anywhere, but I think you’re probably out of the 50 managers that are currently active, you’re probably talking somewhere between five and 10 of them are third party equity guys. The rest would be captive fund guys and I would say five, six years ago that was probably closer to 60/40.
Shiloh Bates:
So then are people investing in Euro CLO securities? I mean these are investors that their assets are in euros as well, or do you think people are like myself, I’m a US dollar funder if you will, so people give me their US dollars, they want to return in dollars. Are you seeing people like me come across the pond looking at European CLOs and just maybe taking the currency risk or trying to hedge it? Or are these more European asset managers who already fund in euros and the risk return of CLO equity or BBs or up the stack?
Brian Nolan:
See, I would say certainly on the equity tranche, if look at our equity investors, you’re pretty close to 50/50 I would say between the US and Europe. So we do have a lot of US investors that relative value between the US and the European market at any given time and any hedging that they’re doing is happening away from the CLO. So I don’t see what that looks like, but presumably they are hedging it somehow. And I think similar to the US, I mean when you go into the debt of the structure, certainly on the AAA level, a large portion is coming out of Asia, in particular Japan, but you would have some US banks there as well.
Shiloh Bates:
So the AAA through maybe single A that comes out of Japan. I mean those are banks that are buying Euro CLOs and then they have some hedging program that converts those euros back to yen at some point.
Brian Nolan:
Yes. So these are quite established buyers. They’re buying big size. So I think this happens between the bank and them, so we’re not party to exactly what it looks like, but that would all be 100% hedged on their side. I think it’s a lot easier to hedge AAAs where you know the cash flows versus equity, which can be a lot more variable.
Shiloh Bates:
Then if somebody is doing relative value, let’s just stay with equity for a second amongst the two different markets, I guess it’s easy to run your scenarios through Intex and presumably the US CLO equity tranche and a European would spit out different projected IRRs. Would in general that potential investor, would they see the European collateral pool as a more safe and stable one?
Brian Nolan:
I think that’s changed over time. I would say historically US pools were always viewed as lower risk and more diversified and better quality, especially with the LME activity we’re seeing in the US. I think a lot of people are starting to question that. Additionally, I mean certainly the course of this year, I was just at the global ABS conference in Barcelona where we met a lot of international investors and there’s definitely a tone of people that were historically all in on US maybe thinking that diversity away from the US is maybe the thing to do right now. So I think that historically it’s always been viewed the US is the superior market and you don’t get many European investors that don’t do US, but you get a lot of US investors that don’t do Europe. But I think there may be a bit of a change given the recent macro events.
Shiloh Bates:
So, if somebody were to begin investing in European CLO securities, my understanding of the market is that it’s pretty clubby. Whereas in the US CLO market, it’s a lot of people with sharp elbows I think and relationships matter, but the economics of trades is really the key driver. Is it possible, I guess people are doing it, but you see a lot of investors come over there and have success in navigating a market that’s more relationship based?
Brian Nolan:
I think so, and I think you probably distinguish at this point between taking majority equity and being involved in the warehouse versus when the deal is brought to market and maybe a minority is sold at that point. I think the relationship aspect in Europe is huge in terms of deciding to do a transaction together and being involved right from the warehouse stage through to the CLO. Where it gets maybe a bit more transactional is if you want to sell some equity at the time of your CLO pricing, I think runs will be sent out to everyone and everyone will put their bids in. That will be a lot more transactional. So I haven’t been involved in the US market to know if that follows the same dynamics, but I think in Europe, and I think this is what most people do, it’s you go to some of these conferences and all of the managers are there, and if you sit down with a manager and you express an interest in getting involved in equity, I think most of them will go out of their way to help educate and get anyone up the curve and explain to them how things work.
And you probably do that with multiple managers, so you don’t have a single guy, but I don’t think it’s a difficult club to penetrate, especially if most European managers will have a US affiliate and if there’s a relationship existing on that side of things, it obviously makes things a lot more easy as well. But I think it’s a fairly open community and I think the problem certainly from an equity perspective is the amount of captive funds that are in the European market means that with those funds, minority equity is the only piece that’s sold and that is usually sold in the transactional way on the day of pricing, whereas the 95% third party guys is still very relationship based.
Shiloh Bates:
In the US we have around 100 active managers, and I think if you’re willing to invest in one of their warehouses, be that equity and participate in the takeout, I think it’s probably not too hard to find many who will take you up on that.
Brian Nolan:
I would say that historically was the case in Europe you had a big pipeline and the successful managers generally had, and this is a European perspective, quite a lot of warehouses, but you might have three or four open at a given time, which is probably about a year’s worth of issuance. So, getting in the pipeline was generally a year in advance. I would say with the amount of new entrance to the European market as well as the amount of secondary or in minority equity that’s available at primary from the retention fund type vehicles, we’ve seen that lower down a bit because I think there’s more supply than there used to be, and I don’t think the equity base has materially increased. So, I think it used to be, as you describe in Europe as well, probably less so in the last couple of years.
Shiloh Bates:
So one of the big changes to the US market over the last two or three years is just the rise of ETFs, the exchange traded funds, where lots of retail investors now own CLO securities. Is that something that is beginning in Europe?
Brian Nolan:
I think it’s beginning. So I think we’ve got three or four that have launched in the last year or so. None of them to the scale of what we’ve seen in the US yet. I’m not an expert on the regulations behind it, but my high-level understanding is the retail investor is a lot harder to access in Europe, whereas in the US you can go onto your personal trading app and access a bunch of these things. In Europe to get it to show up on your list, you’ve got to qualify as a certain type of investor, which means going out of your way to answer some questions and get signed off. So I think the barriers to investing are a bit higher in Europe, but I think if you look at generally how things go, if it works in the US with a lag effect, it’s likely to come to Europe as well. We’re just a little bit behind you guys.
Shiloh Bates:
Are there any other big differences between European and US CLOs that we haven’t covered?
Brian Nolan:
One thing that is present in European CLOs that is probably viewed as a negative in US CLOs is maybe the ESG elements. So, in European CLOs it’s become fairly standard to have an exclusion list in your CLOs and you’ve got a lot of European managers and a lot of this is coming from the European investor base that is very ESG focused.
Shiloh Bates:
ESG is the inclusion of environmental, social and governance factors in investment decisions.
Brian Nolan:
And a lot of managers are doing a lot of ESG work on their non-CLO funds. So you’ll see a lot of managers including us, will put additional ESG information in their reports as well as having quite a conclusive ESG exclusion list.
Shiloh Bates:
Okay, so ESG exclusion would, so we’re talking about dirty coal and what other industries can be excluded or would be commonly excluded?
Brian Nolan:
You can have stuff like gambling, tobacco, alcohol, anything. This can differ a lot between transactions, but I think in a typical European transaction you probably have somewhere between 20 and 30 exclusions and it would be a lot of the energy ones, a lot to do with weapons and ammunition, anything that someone somewhere has thought that that could be viewed as an ESG point. So you probably have, I’m not an expert on US documentation, I think there are some exclusions that go into US documents, but I think they existed for a long time. I would say that it’s significantly more comprehensive in European transactions.
Shiloh Bates:
In the US I hear very little talk of ESG and I think it’s partially because of the difficulty in quantifying the criteria. Any other key differences, Brian?
Brian Nolan:
Maybe the risk retention as well. So obviously historically this was present in the US as well, but I don’t know how long ago, seven, eight years ago, it was repelled in the US so it’s not a thing anymore unless you have a manager that wants to do it for accessing European investors. But obviously every deal in Europe is risk retention compliant, which is a 5% co-investment in the vehicle by the sponsor or the originator, which in the vast majority of circumstances is the manager or a manager entity. Or you can have some people use a third party originator where I think it’s a skin in the game thing. So to qualify, you basically have to take underlying risk on the assets that are going into the CLO. So I think you, depending on who you talk to, I mean I think a lot of European managers would say it’s not needed, but from an investor perspective, I think it’s probably only a good thing if the manager is required to put skin in the game as well.
You have two ways of solving for this, which is either a vertical retention where you take 5% of every tranche or you take it horizontal, which is you take 5% of the transaction size in the equity tranche. So I think historically we call them captive funds, but most of them in Europe started out as retention funds where managers would go out and raise enough capital to do the next seven, eight deals and be the retention provider. I think that’s evolved a little bit in Europe that people are doing it over and above just for retention purposes. But I think that’s a key difference. And again, this is maybe a European perspective, but I think when the manager has a requirement to put 5% of the capital into the structure, it does maybe raise the barrier of entry in Europe from a manager perspective. And also I guess over time this may be compresses, but I think historically European management fees have been higher than the US and I think generally what we’ve always said is that capital requirement is potentially part of that as well, that in order for it to be economic for the manager to put 5% into every transaction, it does have that impact in terms of the hurdle rate on the fee side.
So I think that the retention is quite a big difference and it probably has a couple of knock-on effects.
Shiloh Bates:
So European risk retention is something I come across quite a bit just because in our US CLOs there is not the requirement, at least for broadly syndicated, there is not the requirement for the manager to own the 5% vertical strip or half the equity roughly. But when you’re selling CLO securities, there’s a lot of investors in Europe who if you want to market the CLOs, AAA or whatever to them, the CLO needs to be risk retention compliant. So even if you’re not bound to those rules in the US, the manager or some affiliated vehicle needs to buy the CLO securities so that you can gather up European investors if you want to go that route.
Brian Nolan:
Yeah, I think you’ll know better than me, but anecdotally, I think someone told me it’s somewhere around the 1 in 10 transactions is risk retention compliance in the US. So yeah, obviously that’s 100% in Europe
Shiloh Bates:
I do a lot of middle market CLOs and those are actually still on the European standard. So there’s still the risk retention capital is required here in the US.
Brian Nolan:
As an investor, do you see that as a positive, negative or neutral
Shiloh Bates:
If a manager, let’s say they own a 5% vertical strip, do I really care? Not that much. I mean imagine, so 65% of what they are committing to is AAA. They’re comfortable owning the AAA in their own deal. It’s not a huge vote of confidence for me. And then 5% of the equity and the other more junior securities, I think it’s helpful. I mean I would take it if offered. I think for a lot of CLO management platforms, they do a lot of deals and to put up 5% of the capital on each one, I think that’s really quite a burden on their platform. I think probably the ultimate alignment is we’ve been in some deals where the CLO equity is also going into the personal PAs, the personal accounts of the CLO managers so directly in, and that is I think a very strong alignment.
Let’s say a manager hasn’t invested in any of the CLO securities that I’m in. So what’s the alignment? Well, I think it’s still pretty strong because 1 – there’s an incentive fee that could be material for the manager if they really perform. 2 – CLO management is a competitive business and if a CLO manager doesn’t do a great job with the assets, then they’re going to struggle to find new investors. So I don’t think there’s a risk that there’s some orphan CLO at the manager where they didn’t invest in it and don’t prioritize it like the others. I just don’t see that as a risk.
Brian Nolan:
No, I think a lot of CLO managers would agree with you on that one. Certainly from the capital requirements of building a large platform point of view.
Shiloh Bates:
How easy is it to get allocations of new loans in Europe?
Brian Nolan:
Relationships still play a key part. I mean a typical loan that comes to market that is well liked by CLOs can be quite easily six to seven times oversubscribed. So the relationships do become a big part of it. And obviously, yeah, the bigger you are, the more important you are to the bank. Typically that would lead to better allocations. So you could say that maybe the managers that don’t have those relationships are potentially taking all the stuff that the other guys don’t want. But I think even as one of the biggest managers, while we might get an oversized allocation, we still on a deal like that, it’s not like you’re getting anywhere close to a hundred percent fill. So if you look at the amount of managers across the market and the amount of assets in their deals, I think it’s probably gotten a little better than it used to be in terms of new managers getting allocation and all the different term loans. My time from banking, all I know is A and B where A was amortizing and B was a bullet. And that’s actually one difference I think actually with US and Europe that I didn’t cover is the US deals will generally have a small amortization in them, the underlying loans, whereas Europe is very much bullet.
Shiloh Bates:
So you don’t have the 1% amortization, it’s just 0 amortization and
Brian Nolan:
Exactly
Shiloh Bates:
You’re due the principle at the end.
Brian Nolan:
Speaking to our US guys. Obviously when a CLO goes post reinvestment period, it becomes a bit more restrictive on what you can reinvest and the documents are very prescriptive in terms of the source of the funds and what you can do with that. So I know having that amortization coming in on 250 loans makes things significantly more complicated in the US to reinvest post reinvestment period. So that’s something that we’ve become more aware of as we have our monthly meetings and we talk about what’s the workload in each of the teams and they’re spending a lot of time on figuring out reinvestment and we’re going, what are they doing until we found out what the reason was. So that’s an interesting quirk. I dunno why that is the case, but yeah, Europe bullet loans don’t have any amortization.
Shiloh Bates:
One thing you mentioned was that the management fees are higher in Europe in the US for broadly syndicated. I would say 40 basis points is probably a fair fee, and then the incentive is 20 over 12. The 12 has to be earned in cash, so it takes a while for that to be paid to the manager. Obviously they have to earn it. What’s the average fee across the pond?
Brian Nolan:
I would say up until maybe the last couple of years, if I look back on ours, the incentive would be the same, but the headline number would be 50 instead of 40. I would say in the last couple of years it’s maybe begun to compress a little bit, so maybe into the mid forties, but long-term average has always been higher than the US and I think obviously we’ve got quite a big manager in both markets, so we can see that over time. But I don’t know if the US is compressing in the same way that Europe is right now. But up until two years ago, we didn’t really have any struggles getting 50 basis points on every deal. I would say that’s maybe more of a hot topic at the moment than it historically has been.
Shiloh Bates:
Great. Well why don’t we leave it at that. Brian, thanks so much for coming on the podcast. Really enjoyed our conversation.
Brian Nolan:
Thanks for inviting me. I had a lot of fun.
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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:
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 the 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 in 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 a D, depending on the agency, 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 among market participants.
Middle market loans are usually underwritten by several lenders, with the intention of holding the instrument 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.
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.
LIBOR, the London Interbank Offer Rate, was replaced by SOFR on June 30th, 2024.
Delever means reducing the amount of debt financing.
High yield bonds are corporate borrowings rated below investment grade that are usually fixed rate and unsecured.
Default refers to missing a contractual interest or principal payment.
Debt has contractual interest, principal and interest payments, whereas equity represents ownership in a company.
Senior secured corporate loans are borrowings from a company that are backed by collateral.
Junior debt ranks behind senior secured debt in its payment priority.
Collateral pool refers to the sum of collateral pledged to a lender to support its repayment.
A non-call period refers to the time in which a debt instrument cannot be optionally repaid.
A floating rate investment has an interest rate that varies with the underlying floating rate index.
RMBS are residential mortgage-backed securities.
Loan to value is a ratio that compares the loan amount to the enterprise value of a company.
GLG is a firm that sets up calls between investors and industry experts.
A Risk Retention Fund is a third-party fund raised by CLO managers to comply with the CLO Risk Retention Rules.
The US CLO Risk Retention Rule was introduced in 2014 under the Dodd-Frank Wall Street Reform and Consumer Protection Act requiring CLO managers to retain not less than 5% of the credit risk associated with each of their CLOs. In 2018, the US risk retention requirement reversed for BSL CLO managers after being successfully challenged in court.
LME stands for Liability Management Exercises which are strategies often used by sponsors or select lenders to restructure debt obligations of distressed companies in order to avoid traditional default proceedings.