Month: August 2025

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 Amir Vardi, Head of Structured Credit at UBS Asset Management. He works for one of the best regarded Broadly Syndicated Loans CLO management platforms and he also invests in CLO securities managed by third parties. We discuss multiple topics including the inefficiencies in the CLO market, CLO Debt vs. Equity, CLO modeling assumptions and economics of CLOs managed by newer market participants.
If you’re enjoying the podcast, please remember to share, like and follow. And now my conversation with Amir Vardi.
 
Shiloh:
Amir, thanks for coming on the podcast.
 
Amir Vardi:
Yeah, Shiloh, it’s a pleasure to be on. Thanks for having me.
 
Shiloh:
So, how did you end up in the CLO industry?
 
Amir Vardi:
Yeah, so my background is I’m one of the very rare people to be at one firm for my entire career. I graduated from undergrad University of Pennsylvania Business School in 2004, and my first job was at CSFB as it was called at the time. It was on the sell side. So, in sales and trading and I still have a placard on my desk which are all the people that were in my starting class. It was 100+, 100 something people. And if I look through that, maybe two or three people are still here. And so actually in prep of this podcast, I literally did that. I basically took a picture of this placard, and I fed it to AI, and I said, it has all the names on it, right? So, I said, how many of these people still work at UBS? And so, the initial response was, given the time elapsed since 2004, it’s very probable that most, if not all, of these individuals have moved on to other roles, companies, or even industries. And then it went on, despite a generic answer, it went on to suggest six names that might still be here. I was one of them, so it was right on that. And then the other five I spot checked and they were all not here. That was incorrect or a different person with the same name. So, in any case. I have been at this firm for now 21 years, started as CSFB, and became Credit Suisse. Now, it has become UBS. I’ve always been around the loans and CLO space. In 2008 is when I did that switch from the sell side to the buy side to this particular group. First, I was a research analyst for CLO bonds, picking at that time 2008, 2009, single A CLO bonds in the 60s, became a trader of CLO bonds in 2009. And then as CLO issuance came back in 2011, I remember our first deal back was [in] April 2011. I was helping on that effort. I was made a portfolio manager in 2012. And then in 2013, I picked up also the responsibility for the head of CLO capital markets. Since then, I’ve had essentially that same role, which is the dual-handed role, so both CLO issuance and CLO tranche investing.
 
Shiloh:
So, how do you see CSAM and now UBS as differentiated amongst peers and on the CLO management side?
 
Amir Vardi:
So, one thing that’s different than any of the larger players for us is that every CLO that we’ve done has been homegrown. De Novo, so we’ve never bought a CLO manager. We’ve never bought CLO contracts. So, most of the other Bigs, if you look at them, they’ve gotten to their size through acquisitions. The second thing is just the length of time that we’ve been doing this. So, this started before I started here. This started in 1997. John Popp and Andy Marshak started this business. They did three CLOs in 1998 to 1999. At that point is when CSFB acquired them and before the ink dried on that, DLJ acquired them, then Credit Suisse acquired DLJ. So, they landed at Credit Suisse in 2000 and that core team, it’s obviously grown a lot, has been here ever since 2000. So, we’re now underneath the UBS umbrella, obviously, but as far as our platform, our team, how we do business, our specialty is, it’s really been the same. CLOs is really our bread and butter. So, we have some other assets, but this is 65 % of our AUM. It was probably 90% of our assets if you look at 2007, 2008, pre-GFC, we’ve really grown it post that crisis as far as comingled funds, separate accounts and so forth. This is really at the core of what we’ve done for a [long] period of time.
 
Shiloh:
Do you spend most of your time on CLO Management or investing in CLO securities?
 
Amir Vardi:
So, I spend most of my time on the tranche investing side. The issuance side, I would call a well-oiled machine. So, we built out a team on both sides, but the structuring and issuance team related to those Madison Park CLOs is well-built out. And so, I spend, as I said, maybe 30 % of my time there and, 75 % of my time on the tranche investing side. And it’s important to note that we’ve been investing in tranches going back to that 1998 inception. So, in the older days, as you know, I’m sure, but maybe some of the listeners don’t, the 1.0 deals (the deals from before 2008) had buckets. They were still mostly loans, senior secured loans, but they had buckets for CLO tranches. So, we were investing in those CLOs into other managers’ CLO tranches. And we also had some funds that had buckets. So, it’s really post-2009-10 that we’ve built out our dedicated structured credit business. That is, funds that are exclusively investing in, we have all sorts, but it could be European investment grade, it could be US seniors, it could be equity. We have a series of CLO equity funds. But we’ve been actually investing since 1998.
 
Shiloh:
Amir, you have been in the market obviously for long time. What’s like one or two things that you find intellectually interesting about CLOs?
 
Amir Vardi:
Yeah, it’s a good question. I think it’s a dynamic market. It changes enough to keep things interesting. It evolves. The underlying loan market evolves. The structures, meaning the CLOs that sit around the loans evolve. There’re new players. Some players go away. There’s M&A. There’s consolidation. I’m a particularly data-oriented person. There’s just so much data that you can dig into and slice and dice various ways and do various types of proprietary research on how different managers are doing different things, who does what well and who has a particular style and stays in their lane and veers out of their lane. There’s just so much, it’s almost a never-ending amount of research and things that you can do within this market. I’ve anchored my career to the CLO market for over 20 years and still haven’t yet gotten bored of it. Have you Shiloh?
 
Shiloh:
Well, my career is anchored to CLO’s as well at this point. And I think one of the things I like about CLOs is I just think it’s very inefficient market. I went to grad school at the University of Chicago where they beat market efficiency into you. But, the reality is, the equity tranches I invest in are like 50 to 70 million in size and the BB tranche might be around 30 million. And these securities don’t trade a lot if you know what you are doing I think there’s high potential to outperform peers and I think there are lot of smart peers in the market, but if you got good gameplan and good research, effort. I think the potential to turn alpha is certainly there.
 
Amir Vardi:
Let me just say I totally agree with you that there’s two sides to it. On the one side, things are getting more liquid and more efficient. And on the flip side, there’s absolutely still nuance and a reason that people who are really in the weeds are close to the market and the documents and the managers can really outperform whether that’s by how you trade and maybe you can get better prices or looking for specific things in the document or picking managers in a different way. There’re so many different ways to outperform. So I’d say that there is enough inefficiency certainly AAA liquidity is extremely good AA liquidity I’d say is pretty good and equity liquidity is spotty, but it’s there you can sell your bond there is inefficiency and I totally agree with you so, your professors at University of Chicago were not wrong, but it doesn’t apply to all markets.
 
Shiloh:
Well, the beginning of my career when I was doing you know mostly direct investment in loans. I found that the reality there is that any loan to a good company made by a good firm could go bad you know there could always be some change to the business model that results in a restructuring whereas in our business we are dealing with the statistics really of the pool. So, you are CLO equity maybe assuming a 2% default rate through the entire portfolio of loans you are not betting on any loans in particular to do well or not and I found that kind of statistical analysis of the entire pool to kind of may be resonate more with how I view the world.
Amir Vardi:
Investors often ask how many line items do need to have to be diversified? And to some extent, you could buy one CLO. You could just sit there with one CLO and have 300 underlying loans. I wouldn’t stop there. My answer tends to be something like 30. If you buy 30 CLO bonds, the underlying number of issuers is around 1500, which is large. It’s almost every loan in the market, as long as it’s not 30 bonds from the same manager. 30 bonds from, say, 20 to 30 managers are going to be extremely diversified. But that starting point of even one CLO has 200, 250 plus individual companies. You’re in such a better place.
 
Shiloh:
So now there the recessionary risks in the market are up post liberation day, does UBS as a bank have an economist that has a call on what we should expect over the next year or so?
 
Amir Vardi:
At the end of the day, it’s not a driver of our credit decisions. Our credit decisions are really made at the fundamental bottom-up level company by company. Obviously, each industry has its own dynamics and the macro view there is obviously important. We might have certain out-of-favor sectors and in-favor sectors and those are based on macro views. But it’s really much, much more about the individual company, its business, who the sponsor is (that is, the owner of the company). The capital structure being put in place, the credit document, and those business factors have our macro view kind of baked in, but we don’t start with saying we are now, you know, now because of tariffs, let’s decrease our chemicals exposure across the board by 2% and, let’s increase our telecoms up by 3%. It’s really company by company analysis. So even within an industry, there’s so many differences. I mean, take like chemicals, for instance, there’s parts of chemicals where like commodity chemicals that might be very negatively impacted by oversupply by some foreign actors. And then there’s other parts, specialty chems that use that as an input. And therefore, to the extent that’s happening, their input costs just went down, but they can still sell at the same price. Their margin just went up. So, there’s literally a winner and a loser. Side by side within the same broader industry.
 
Shiloh:
Does the recent market volatility makes CLO equity or double BB’s more or less attractive to you or maybe other parts of the CLO capital stack?
 
Amir Vardi:
Yeah, I mean, equity is tough. I guess to answer we probably should see better value in debt at the moment. I think probably in particular, it’s probably the most meat on the bone in the AAA. And that’s kind of just because we tend to lag. The CLO debt tends to lag the loan market and all markets. So, you know, I’d say equity was really much more interesting than it had been, let’s say, pre-liberation day. So, at the end of 2024, end of 2025, it had been much more interesting than it had been. I’m talking about primary markets, so creating a deal, much more than it was in 2022. So, post-Russia, Ukraine invasion of 2022 and 2023. So, you were able to lock in really tight liability prices, and that has proven to be a valuable thing. But right now, the liabilities have widened and now everything’s widened, and everything’s come back in, as you said, with Trump receding from the initial tariff talks. But the CLO debt has really lagged. And then if you see a deal pricing today or tomorrow, it doesn’t mean it’s good or bad it really depends on the other side of the equation, which is we’re able to buy a bunch of assets in the 97s and 98s. But on paper, I’d say it’s hard to look at CLO equity and say, this looks great. But from a debt perspective, I think that there’s value in AAA. It just looks much more attractive relative to its alternatives, which is agency mortgages or corporate investment grade bonds, or any type of liquid ABS like credit cards, student loans, even CMBS. You’re getting better spread and yield than CMBS, which has real fundamental issues, largely tied to kind of post-COVID office, not everyone’s returned back. There’s some real stress there.
 
Shiloh:
 Well, a lot of what I’m doing, as you know, is in private credit CLO’s,  but the tariff volatility, I think, for private credit double BB’s  really was an opportunity, because spreads blew out from 650 basis points over SOFR  to more like 800 we didn’t see the tariffs as posing really a risk to the underlying bonds, but we did want to benefit from the incremental spread, so saw that as an opportunity. And then for CLO equity, the reality is, it’s down for the year. And some asset classes have come back. The S&P 500 is back to positive for the year, at least when we’re recording this. I think for an investor, who’s investing new capital today and is expecting and things that economic risks are up which I would agree with. CLO equity has lagged, and it’s one of the kinds of discounted opportunities in the market that people may want to take advantage of. So, when you say CLO equity, I think your words were maybe hard to get a conviction around it today. What kind of outcome would you expect from here if it’s not of high conviction to you.
 
Amir Vardi:
They can be negative. I mean, it’s a highly sensitive asset class to how the manager performs. So, I’d say from today, if you pick a good manager, a bad outcome should be a mid-single-digit return. So, if you made 5 to 8%, that’s probably not where you’re supposed to get on equity. Obviously, you should have upside into the high teens, and your base case is probably 12%, 13%, 14%. But I don’t see that base case being 12%, 13%, 14% today. I see at this exact point in time, you went and bought loans today and basically went and printed a CLO today where the debt is, you’re probably looking at an upside case of 12%, 14%. So that’s everything has to go well. And there are still ways to get to high teens because there’s a lot of options embedded in CLOs. So, for instance, if you look at the 2007 deals, they probably were modeled to that magic number of 12 to 14%. Things got really bad in 2008 and 2009. The 2007 vintage was a fantastic vintage. But it’s because the CLOs were able to go through 2008 and that severe sell-off in the loan market, they didn’t have to sell loans because CLOs don’t have a situation where they’re a forced seller of loans. And in fact, they were on the other side. So, there were a lot of forced liquidations by some, not by CLOs. CLOs were the beneficiary of that because if you just had to sell and you were a CLO manager and you had the guts to say I like this loan, I’m going to bid $65 for it. I’m going to bid $55 for it. And there’s a tremendous amount of value creation that took place in 2008. And then actually also as you go through 2010, so the credit markets completely froze for a few years. When they unfroze, these companies had not had the chance to extend their term loan maturities. And now they finally did. But of course, they were way wider in 2010 and 2011 than they were in 2007. So, you had these “amend and extends” and you had a massive amount of increase in the weighted average spread of your assets. Meanwhile, your liability spreads don’t change. You have the ability to take them lower, but they don’t go higher. And that might be a way to explain why equity is quite interesting today, should we have a recession. But we do sit here, Shiloh, with defaults kind of at 4% and yet loan prices, the ones you’d want to buy in a CLO are pretty close to par. So that, I think an astute manager can find some lower priced loans and maybe navigate well and add some value, but the starting point is a little bit more difficult from an equity perspective. So that’s why I say that.
 
Shiloh:
Yeah, but isn’t it one of the challenges for the market that, because a lot of money has been raised in our asset class, for the loans in particular, that when recessionary risks are up, the loan market just doesn’t trade down like it used to and those discounted loan opportunities that you want to buy maybe there are discounts but they’re not at the same discounts they would have been in the past.
 
Amir Vardi:
I do think that in the first part that you said there, people raised so much money. I think that’s part of the problem. I think that so many new players into the CLO space, if you’re going to be a new player, you have to come with a lot of cash to buy your own equity. No one’s buying a new manager’s equity, period. So many new players and so much money having been raised for equity is creating all these CLOs, but at the same time, you don’t have nearly enough new loans. And the new loan supply, 21 was a better year and since then it’s been just very, very scarce. So, the combination of not enough new loans, but a lot of new players and a lot of people trying to start CLO platforms and a lot of money being raised by existing platforms for their own equity in what we call the captive equity funds, I think, is really compressing that arb. You’re creating a lot of CLO issuance, [which] keeps the debt spreads maybe wider than they ought to be, and it’s creating a lot of demand for loans. And that’s caused a significant spread compression through repricings and spreads there are really shockingly low. I mean, low 300s, tighter than we’ve seen in a long, long time.
 
Shiloh
So, your firm, it’s been around for almost three decades. Why do you think people are giving money to newer CLO managers and taking that risk?
 
 
 
Amir Vardi:
Just to clarify your question, is it why are the people who own the company doing that? Or is it why is someone who’s unaffiliated with a company? Because it’s kind of two different answers. I can answer the first one for sure.
 
Shiloh:
Well, it was actually the latter that was my question. I mean you’re a CLO equity investor. Are you investing with first time managers? I assume not.
 
Amir Vardi:
I don’t know if anyone does. Look, why does someone do the first one and then, yeah, why does someone do the second one? I’ll ask you because I don’t know. But why does someone do it in the context of I own the manager? It’s because, yes, I don’t think that those investments on their own are particularly interesting because a new manager is going to have to pay up. Because no one knows them, so they have to pay up quite a bit on their liability costs and yet they’re going out and buying the same loans as everybody else, so, SOFR plus low 300s. So that return profile isn’t that compelling but if you do four of these deals or five of these deals and each of them is a little bit less bad than the prior one because your debt costs are getting tighter because people get to know you and you’re becoming more of what people call a liquid manager. If you get to the point of having good pricing, tier one pricing, so similar to all the top players, then you can start to attract some third-party equity with some fee discounts. And then as you go on, maybe there’s less fee discounts. And if you perform well, those fees go up. And every time you raise third party money, even with some fee discount, that’s building the value of your enterprise, of the manager. So, there’s some wild success stories. I think obvious one, I’ll say it, is Elmwood, which Elliot started and got off the ground. So, there’s a few success stories. There’s a bunch of people who are trying to chase that model and build an asset manager who specializes in CLOs, which is worth a lot. So that trade has definitely been a good one. It’s not going to work every time.
And it really depends, did you hire the right people, did they pick the right credits, etc. So, there’s a lot of people trying to do that right now. Now the second one, why do you buy deal five from a manager? I mean, probably you believe in them and probably you got enough of a manager fee discount.
 
Shiloh:
Well, at a previous firm, I did some emerging manager investing, and kind of how we thought about it back then was you could get a 15 basis point fee repaid, which, considering the leverage in the structure, might be worth a percent and a half to you in terms of incremental IRR or cash flow, but, but to your point, that doesn’t account for the fact that you know your cost of debt is going to be higher, so maybe you give all that up. But if you’re with a smaller manager, you might think, okay, these guys are going to be nimbler with the assets. Maybe they’ll get allocations of loans and trade them back to the agent on the break and make a quarter or three eighths or something like that and slowly build par that way. But the actual experience at the time was that the smaller managers just really struggled to get allocations of the loans that they wanted. And so you didn’t have that par, build, and the higher cost of debt, really weighed on returns and now that’s just not a business that we’re in.
 
Amir Vardi:
And there’s stats on that. I don’t have the exact number Shiloh, but the top, let’s say 10 managers get 80%. It’s kind of the number that comes to mind. But there’s a reason that the top managers get disproportionately more of what they want. So, if you start with the premise that a loan is well over subscribed, there’s not enough of it to go around. At the end of the syndication process, a bank could choose to just allocate pro rata. That sounds fair. Everybody gets 40 % or let’s say it’s three times over, everyone gets 33%. That is generally not how they do it. They tend to look around and say, the large managers [may] get early looks on deals. And then that gets them on their way to syndicating, let’s call it a multi-billion-dollar deal. And then at the end, if it’s widely oversubscribed, because we were helpful in and are also putting in a ticket early, we’re going to get maybe a high percent of it, someone who came in late and put in 10 million, they might get 1 million, they might get 2 million. That’s what from my vantage point I’ve seen from an allocation perspective. So, from that, yeah, I agree with you. It does tend to favor the larger players.
 
Shiloh:
Well, it doesn’t sound like either of us are investing equity dollars with new managers, but does seem like new platforms launch every couple months or so, and maybe I could see the attraction if you’re a part investor in the CLO’s manager or maybe that could make sense.
 
Amir Vardi:
Yeah, there’s so, so many and it’s always a surprise to me that someone wants to put themselves through that. There’s definitely a light at the end of the tunnel. Because everyone wants to be that Elmwood example, but maybe four out of five of them don’t get there and it is a struggle. Can I bring up one more thing about large managers which is in the context of these new, the last few years, everyone talks about liability management exercises. It was already our view – and like we’re a big manager so obviously we’re going to have this view, we’re going to talk about our book – it was our view [that] you wanted to be big. We talked about allocations. It also helps to have a big enough platform that you can afford to have, let’s say, 25 credit analysts. So, you have a very deep bench that are very focused on, let’s say, one sector. They get really, really good at that sector. They know all the companies alterin the sector, know all the CFOs and the CEOs in it. So, they get really, really good at their sectors. And that’s really what drives credit performance is, it’s really what you don’t buy, but it’s those research analysts. So, if you’re big, you can have a lot of them. You can have good ones because you have the fee revenue to pay them, etc. Allocations, size of the team. But the new thing that’s, I think probably been talked about quite a bit. But it’s just a very obvious one is the liability management exercises. And what that is, is a distressed exchange. So, in the last couple years, companies have been able to, recapitalize their debt, in some cases, do what’s called discount capture. So, reduce the balance of their debt. Other cases, maybe they’re raising new money to extend their runway. A lot of times that comes with pretty juicy economics. And, typically, any one of these types of transactions, you’ll need 51%. If you have 51% of your lenders, you can amend and do whatever you want. The documents are fairly loose, and the lawyers are very creative. The benefit of being large is if you’re trying to get to 51 % with the fewest number of counterparts to deal with, you’re going to look at your lender list, you’ll sort it by the biggest to the smallest, and you’ll pick the top five that gets you to 51%, the top X that gets you to that number. You really want to be on that list. The reason is then the byproduct of these things is there’s the “in group” and the “out group.” And there’s a very big difference in recovery; it’s funny because you see recovery rates quoted on distressed exchanges JP Morgan’s got data out that shows it’s like 65%. That’s the most recent number I just saw today. But if you think about it, no one gets 65%. That’s an average of two things. Some people are 10 to 20 points higher, and some people are getting 10 to 20 points lower. There’re not always two groups. There can be three groups, four groups, but to be big means that you’re much more likely to be in that “in group”.  And so, when things go wrong and an LME happens, it’s very challenging to be in the “in group” when you only own one or two percent of the loan.
 
Shiloh:
Okay, makes sense. So, coming back to the previous topic of CLO equity returns, I assume you were previously talking about the primary market, but I imagine that you’re investing in both primary and secondary?
 
Amir Vardi:
Yeah, definitely. We’re more so in secondary, usually.
 
Shiloh:
And that’s because presumably the return opportunity there is better?
 
 
Amir Vardi:
It depends on the time. I guess maybe it’s recency bias. In recent years, we’ve been much more involved in secondary up until recently. So, we play primary when we think there’s better value in primary. So actually, it did flip probably second half of 2024. And in the first few months of this year, we did see better value in primary. And actually, what we were doing was we were basically selling secondary. Secondary was all north of par, generically speaking. It could be par or 101, par and a half, but we were finding better price because primary is going to come at 100, at par. Better price and spread than primary. So, we were buying that and actually selling secondary and doing that rotation in order to fund those primary purchases. But prior to that, you know for pretty much all of 23 and almost all of 22, we did nearly no primary, and we were very active in the secondary. In 22, I’d say 15 % of our trading volumes were primary, so 85 % secondary. And in 23, it was even more stark, it was 98% of everything that we traded in the CLO tranche market was secondary. 2% was primary. We just saw so much better value, discount prices on the bonds, and better yield potential.
 
Shiloh:
I think, to be successful in CLO equity, you need to look at both primary and secondary for the best value, and I think a lot of our competitors just approach the market with primary only mandate.
 
Amir Vardi:
And that’s one of those inefficiencies, the “primary only” mandate, which stems from, you know, folks that need a lot of time to process. Secondary, you don’t have time, same day “bwic”, next day, at best. Primary market participants need weeks of time to put together a package to present it to their investment committee. They want to have a lot of say in what the document looks like. There’s a lot of folks that are just not set up to do secondary. Primary is cleaner. It’s an easier thing to buy. It’s cleaner. Secondary is a little bit, depending on the bond, it’s going to have a little bit more seasoning to it. So, it does keep people at bay, and it’s part of what we talked about earlier, which is part of the inefficiency. It keeps people away, and therefore there’s better value there.
 
Shiloh:
Well, in my opinion, that captive fund vehicles would be the worst way to invest in CLO equity. I mean, those are funds where investors have committed to do the next four or five deals with the manager and that manager is going to call, call the equity capital and start earning a fee on it as soon as possible. The initial profitability, or projected profitability of the CLO is not the main driver of CLO creation, and then what the end investor gets out of it is four or five CLO equity investments, exposure to a minuscule part of the market in four or five CLOs that had high loan overlap and are super correlated. I think it makes no sense.
 
 
Amir Vardi:
So basically, between captive equity and third-party equity as two kinds of distinct strategies where it seems like you’re getting the same thing, you’re buying CLO equity. I think the third-party equity side of things is better. It’s more opportunistic. You’re getting that diversity across managers. You’re getting diversity across vintages that you don’t get in captive equity because you’re just going to buy six or eight deals from one manager across one or two vintages. And they’re not ever going to buy in secondary. They’re not set up to do that. So, there’s no buying in secondary and there’s no selling; if there’s inefficiencies, sometimes you want to sell into a really strong bid. They’re just holding it for life. One thing that they have on their side will be that there’s not this feeling of two sets of fees, one at the CLO level and one at the fund level. There’s some truth to that. But I think that the third-party funds are probably more than worth their fees, I think at the end of the day, you’ll have a better net return there than you will in the captives. So, you’re more than worth the fees.
 
Shiloh:
Well having the third-party equity at a minimum will ensure that the management fee is done at a fair market rate and the same thing for the underwriter fee.
 
Amir Vardi:
That’s what I was alluding to as far as I think a sophisticated third-party investor can push the manager’s fees to what you call market level. And that moves around with the market, and it probably moves around with a particular manager and maybe through time. But those captive funds have a set discount and, ostensibly it’s X percent discount off of full fees. Well, was that manager getting full fees? Is this really a discount, as you’ve been told? So, yeah, I’m a little bit suspect in some cases. I think some are actually probably pretty attractive and a bunch of them aren’t.
 
Shiloh:
Well I think this goes back to our conversation about how inefficient our market is and how there’s a lot of players out there who are implementing their strategies, in a way that wouldn’t make sense to the two of us.
 
Amir Vardi:
And the conflicts go back to what you said, which is you’re giving the manager money in a fund and the fund doesn’t have fees and they are the decider of when to do a deal. And when they do a deal is when they start to earn fees. When that CLO closes, they’ll start to earn manager fees on the par value of the CLO’s assets. So, they’ll take 50 million from the fund. They’ll turn it into 500 million CLO. They’ll start to make, let’s call it, 40 basis points on the 500 million, what do you think that manager’s going to do? I think they’re going to print.
 
Shiloh:
So, at times you’ve seen these captive equity funds, creating CLOs with initial profitability that’s probably worse than the CLO BB note and again they do that because they want those fees.
 
Amir Vardi:
I think 2023 was a perfect example of that. I certainly would have preferred buying primary BBs. This is generic, because it’s always case by case. Primary BBs over primary equity. I would have preferred secondary BBs over either of those two things and secondary equity probably above all three of those things. But last on that list would have been primary equity, which is what captive equity is doing. It’s buying primary equity in that manager’s deals.
 
Shiloh:
For CLO equity, do you think of there as being a bid ask spread or is it that equity often just trades through BWICS or auction processes where the buyer and seller are matched up through a dealer who earns just like a small fee for their time on that transaction.
 
Amir Vardi:
I think there’s a bid-ask spread. I think it gets asked by investors into our funds, what’s the bid-ask spread? And I can kind of quote it. If you ask me on AAAs, I’d say it’s 10 cents. In equity, I’ll typically go to some offering runs and look and say, okay, bid-ask is two points, but the reality is like you’re transacting inside of that. And that’s probably true in every market, but it’s very true in this market. So, the real bid ask then is not a two-point bid ask. It’s something like, you are probably skinny it down to maybe it’s half a point. But I think I understand your question because of the inefficiency of the market, you might actually be able to flip the bid ask. In other words, you can sometimes get bids that you feel are very good and you’re selling it above theoretically like the offer side and sometimes you’re able to buy stuff at a level that you think is like below what quote the bid side is. So that yeah, I think that there is a bid ask. It’s not at all clear what that is because unlike other markets, the CLO market is a bit weird. Each of the tranches is very small. And so, it’s not like every single CLO tranche is quoted by a bunch of dealers every day. They mostly are not quoted by any dealer. And they mostly don’t trade any given day. But there’s enough things that look a lot like them that do trade every day. And so, you can get an idea. There’re daily marks. How they’re able to do that is they’re able to say, this manager’s bond that had these features traded at this DM [Discount Margin], and I’ll take that DM and apply to all other bonds that are similar in those features. So, it goes back to why is this market interesting? It’s not efficient. There’s supposed to be an answer to what’s been asked, if you’re a trader that, I think some traders are very good at being able to sort of invert that.
Shiloh:
So, you may have heard that we’re living in the golden age of private credit. So, are you managing private credit assets on your balance sheet there or investing in private credit CLOs?
 
Amir Vardi:
Is it still the golden age of private credit? Or are we passed that, I think we’re probably still in it. Yeah, it’s a gap for us. We have not ever invested in what we used to call middle market CLOs and now private credit CLOs. I think there’s a place for that. Obviously, you do it. We’ve always gotten comfort from knowing the underlying loans, so in the area that we traffic, which is the broadly syndicated CLO market, we do know 98 % of the underlying loans. We know all the managers, we’re in a lot of the same deals. There’s a decent amount of overlap. So especially when we’re investing in the BBs or in equity, we get comfort from that whereas in the middle market, I think if we were to approach it, we would be very disciplined with which managers we work with. It’s so more about the diligence of the managers. We just would not know the underlying companies. Even under NDA, you’d get the list of names and you kind of scratch your head and say, okay, I can understand what they do, but I don’t know the company. We haven’t looked at it. So, I get comfort that our research analyst team has looked at the names. So that’s kept us away from the middle market. I think it’s not nearly as much of an issue at the top of this structure. So, I think middle market CLO AAAs are safe, and you still want to be a little disciplined with managers, but you can probably have a broader lens there. The other aspect is liquidity. So, because we’re an asset manager. Most of our funds have certainly daily marks, also some different terms, but generally have the ability for the client to redeem and the tranche market on the middle market side is less liquid. It’s getting better. You tell me, I’m actually curious, but my sense it’s less liquid. So that’s kept us at bay. And that might change. I think we’re probably supposed to take another look at it, but that’s why we’re not in that space.
 
Shiloh:
So, for private credit equity and BBs, they’re going to be significantly less liquid than their BSL counterpart but if you’re talking about BBs, for example, on the one hand, less liquid and the underlying loans aren’t traded, but the positive, there is that you get 12% equity, initially in the deal, rather than the 8% you get in broadly syndicated and that initial equity matters a lot in terms of how robust, the CLO BB is to defaults on the underlying loans that initial equity is very valuable.
 
Amir Vardi:
There’s no doubt I mean, the same thing with Europe. You have better subordination, as they say, at every level and probably even more so in middle market CLOs than in European CLOs. And there’s value to that. It’s just more cushion for mistakes, more loss absorption capability. Like I said, it’s a gap for us. That’s where it’s rooted in. It’s just knowing and having that comfort of like, I really do know what I’m investing in. And with the middle market space, I think there’s some managers that are really good there. And if you’re able to source their paper. Let me ask you about this Shiloh, are you ever able to buy BB secondary, middle market deal with BB and secondary? Or is that like in April, you said it got to 800, you’re talking about primary deals done in April?
 
Shiloh:
SOFR + 800 is where things traded in the secondary so through auction processes or directly through brokered dealers who are trying to earn like maybe 50 basis points bid ask spread.
 
Amir Vardi:
There is a bid-ask spread in CLOs
 
Shiloh:
Indeed.
 
Amir Vardi:
I kind of look at it on paper and think that probably the equity could be very interesting just because the spread is so much higher, so much higher, and then your liability cost is only a little bit higher. Like, the arbitrage should be a lot higher. And yeah, you’re getting less leverage, I would think on paper, mean, on paper, looks like it’s a lot juicier of an asset and just not something we’ve participated in, but has that been your experience?
 
Shiloh:
Yeah. So, it is my experience. So if you’re sitting around and you said to yourself, Hey, should I do middle market, or should I do broadly syndicated CLO equity, and you were indifferent to the underlying assets, and you just ran your projected return case through Intex, what you find is that the middle market CLO is going to spit off a lot more cash, and that’s because the underlying loans are SOFR + 500 maybe a little shy of that. And then when you look at the CLO’s financing costs, starting with AAA, for example, the AAA in middle market CLOs is 30 bps wide to broadly syndicated. And as you go down the stack, the basis is going to be higher. But the natural profitability of the CLO, which is just, is the rated earns on its assets, less the CLOs financing cost, the CLO, the private credit CLO the middle market CLO is going to be much more profitable, and so your initial IRRs are higher. And then you talked a bit about liability management exercises. But you know, in private credit, that’s not really a thing. So private credit is one lender or a club of lenders. They’re all friendly. There’s no lender-on-lender violence. I think the docs are better, and so I think recoveries, they may not hit 70. Maybe 70 is becoming an antiquated number, but I would expect them to be much better than broadly syndicated as well. So there’s a couple of things that have worked in our favor on these investments.
 
Amir Vardi:
Can I ask one thing? So, I get all that and it sounds really good. The one thing I haven’t wrapped my head around is just how do you get out? What is the exit? So, you’re going to cash flow better and maybe it’s not that relevant but, what do you think is going to be how you get out? You’re selling it? It’s getting called? There must be some way to get out of the trade in the end.
 
Shiloh:
So, the typical middle market CLO has a reinvestment period of four years, and then after that, the CLO naturally de levers, and then over time, all the debt would be repaid and the equity would get what remains, but that’s not really what we’re hoping for. We own CLO equity in semi-permanent capital vehicles. They’re interval funds, and basically, you know when the CLO’s reinvestment period ends. Our goal would be to extend the CLO’s life or to do a refinancing. And if you find yourself in a position where you know neither of those are economical, then a lot of times, instead of just, having the CLO do a full wind down, a natural wind down, the CLO manager will just buy the loans from the CLO at fair market value. So that would be an appraised value that comes from a third party, like Standard and Poor’s or Houlihan Lokey. And so, they can value all the loans that remain, and from that, the manager can give you a calculation of your liquidation value, and they might take those loans and put them into a new CLO that’s ramping or a BDC, or some other account that they’re managing.
 
Amir Vardi:
So it’s similar in concept to a [BSL] CLO being called, but as opposed to the loans being sold in the market at fair market value, the loans are being taken back by the manager at fair market value into some other fund on their platform.
 
Shiloh:
That’s correct. So, one last question for you, Amir, when I say 2 and 70 in our business, people know exactly what that means. It means 2% defaults and 70% recoveries. Those are kind of the base case modeling assumptions that I think a lot of people use. Is that way you use around the shop, or are those numbers a little bit antiquated?
 
Amir Vardi:
Those are antiquated. I mean, I think that is probably what most people use as what they would call a base case. From an equity investor perspective, I think most people are probably running a whole bunch of other scenarios and we do that too. But from a base case perspective, for one thing, 2 and 70, 2 is below the average default number. A little bit rosy and then recoveries aren’t 70 anymore. So that’s a little bit rosy as well. So, I think the bigger issue isn’t that that’s too rosy. It’s that it’s just antiquated. I’ve been thinking about it a little bit differently. I mean, if you think of what 2 and 70 really mean, it’s a loss rate of 60 basis points. So, for the listeners, 2% of your portfolio defaults, 70 recovery means 30 % you lost on each loan. So, 2% times 30% is 60 basis points. Actual realized loss will ultimately depend and be very different based on the manager. But if you look at that historically and back it into a default recovery, that’s fine. I mean, that’s kind of one way to get to that same place. But there’s so much more that goes into the actual losses at the end of the day. All of the managers cumulative decisions of what credits to buy, the trading that they’ve done, lower priced loans that they bought or lower priced loans that they sold, what recoveries they got and add in LMEs into that, all that stuff, the reinvestment price assumption. I actually think, at the same time that you have 2 and 70, too rosy is probably aspects that are too conservative, like reinvestment price assumption. People generally just assume it’s like 99.5 [or] par and at times it is lower. And the constant prepayment rate, which is what percent of your loans repay you, the number people typically use is 20. And the reality is historically it’s actually higher than that. My bigger issue also isn’t necessarily what numbers you choose to use. It’s that whatever assumptions you make going in are not that correlated to the actual outcome at the end. There’s some research on this and we recently ran an analysis on our own deals, the Madison Park deals. We actually found it was inversely correlated. So, we took all the deals at issuance. We basically ran exactly the same assumption. So, it could be 2 and 70 and 20 and you know, weight average spread at the current [level], we did a very consistent thing. We said, let’s just run what this looked like. And then we said, what actually happened? And it was actually slightly inversely correlated. Not that I can explain why that is. The R squared was weak, but the correlation was slightly inverted, weak correlation. And it’s essentially not a great indicator of what you ultimately will get because these things are around for so long that, in time isn’t all that helpful. I do think if you were to run like 3% defaults and 50 recovery, you’ll never buy equity. We didn’t really get into it, but you know, all those options in the CLO structure, we’ve talked about extending the deals, which are called resets, refi’ing the deals. We mentioned in 2008, 2009, there’s various ways that equity can win, but you’re basically not modeling any of those things. So, I kind of get why people choose some rosy numbers because it’s sort of like compensating for all the things that are just impossible to model.
 
Shiloh:
I agree. So, the 60-basis points loss rate is probably too optimistic but we’re probably being conservative on refinancings, extensions and buying loans at discounts during recessionary periods. So, I think being too optimistic in one place and too conservative and another probably nets you out to the right place.
Well, Amir thanks so much for coming on the podcast, really enjoyed it.
 
Amir Vardi:
It was a pleasure to be on. I also just wanted to add, Shiloh, that in our little CLO market, which isn’t nearly as little as it was when we both joined it, you’ve been one of the biggest advocates of this space and educators, mass market educators through your book and your podcast. So I actually want to really thank you for that. So, thanks, Shiloh.
 
Shiloh:
It’s great to hear, appreciate it.
 
Amir Vardi:
Thank you.
 
*******
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, our 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.
Risks:
§  CLOs are subject to market fluctuations. Every investment has specific risks, which can significantly increase under unusual market conditions.
§  The structure and guidelines of CLOs can vary deal to deal, so factors such as leverage, portfolio testing, callability, and subordination can all influence risks associated with a particular deal.
§  Third-party risk is counterparties involved: the manager, trustees, custodians, lawyers, accountants and rating agencies.
§  There may be limited liquidity in the secondary market.
§  CLOs have average lives that are typically shorter than the stated maturity. Tranches can be called early after the non-call period has lapsed.
 
General disclaimer section:
Flat Rock may invest in CLOs managed by podcast guests. However, the views expressed in this podcast are those of the guest and do not necessarily reflect the views of Flat Rock or its affiliates. Any return projections discussed by podcast guests do not reflect Flat Rock’s views or expectations. This is not a recommendation for any action and all listeners should consider these projections as hypothetical and subject to significant risks.
References to interest rate moves are based on Bloomberg data. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of, or potential or actual portfolio changes related to securities of those companies, unless otherwise noted. All discussions are based on U.S. markets and U.S. monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global Speaker are those of the speaker as of the date of the broadcast, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and flat Rock global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research or investment advice.
 
It is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered. None of the information provided should be regarded as a suggestion to engage in, or refrain from any investment-related course of action, as neither Flat Rock Global nor its affiliates are undertaking to provide impartial investment advice. Act as an impartial adviser or give advice in a fiduciary capacity. Additional information about this podcast, along with an edited transcript, may be obtained by visiting flatrockglobal.com.