Month: December 2025

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 Greg Borenstein, the Portfolio Manager of Ellington Credit Company, ticker: EARN, a closed-end fund focused on CLO Equity and mezzanine.  We talk about EARN’s conversion from a mortgage REIT, the backdrop for CLO equity and junior mezz, why CLO equity captive
funds are negative for the CLO market, and if math majors are the best CLO
investors.  Throughout the podcast we talk about tails, which in CLO parlance refers to loans trading below 90 cents on the dollar. 

One legal disclosure is the views expressed in this episode regarding EARN or other securities are solely those of the guest and are not endorsed by Flat Rock Global. Listeners should rely only on the fund’s official filings and
disclosures when evaluating investment merits. I’m always looking for interesting guests to have on thepodcast.  Email us at info@flatrockglobal.com if you’d like to come on.  And if you’re enjoying the podcast, please remember to share, like and follow. And now my conversation with Greg Borenstein. Greg, thanks for coming on the podcast.

Greg Borenstein (01:21):

Nice to see you Shiloh. Happy to be here.

Shiloh Bates (01:23):

Why don’t we start off with your background and how you ended up being a portfolio manager at Ellington?

Greg Borenstein (01:28):

Sure. So, I had the privilege of starting in 2007 at Goldman Sachs on actually at the time, what was a prop desk, since those existed back then, where the desk focused on structured credit, a lot of CLOs but also some credit derivatives and some other things. I then moved over as that came to a conclusion in 2010. Spent a few years on the secondary trading desk there at Goldman till I moved over to Ellington in 2012 to start the secondary CLO trading business here. And since then, it’s grown into a bit more of an expanded role, but that has been my path to this point.

Shiloh Bates (02:08):

Okay. So what have you found
interesting about CLOs? Why gravitate towards this asset class?

Greg Borenstein (02:13):

I think what’s interesting about it is the ability to generate a superior risk-adjusted return. And I think when you think about the breakdown of what gives you a return off of an investment across markets, you potentially have a risk-free rate, which right now is more than zero. You also have your credit spread risk premium and oftentimes when you look at more liquid markets, that’s almost implying a default rate if you were to look at things in high-yield or IG. There’s also an illiquidity premium that comes on top of products. It’s usually warranted to some degree, but often a little harder to define. I think overall, when you take a look at the risk-adjusted return you get in CLOs for a product that still does transact to some degree, I think overall it generates a lot of opportunity to really add alpha above what would otherwise be credit beta within the product.

 

Shiloh Bates (03:15):

So, there’s a number of these closed-end CLO funds out there. I mean, why don’t you give us the history of your fund and maybe how you see yourself as differentiated in the space?

Greg Borenstein (03:29):

So EARN is a little bit unique while it is a CLOs closed end-fund now, it was actually an agency fund and EARN has been around for over a decade as the precursor to this was trading more agency pools and that sort. And so, the firm decided to repurpose the vehicle and convert it into a CLO closed-end fund for a variety of reasons. But, we do have a larger REIT, EFC, which does traffic in a lot of the mortgage products. It does do some CLOs as well. So I think from a public vehicle standpoint, the firm’s had experience with both the larger and the smaller REIT on that space and a lot of our investors in the public vehicles were used to and comfortable with us investing in CLOs through the years. So, a natural transition to take EARN and convert it solely into a CLO vehicle seemed like a nice compliment to some of the other things going on at the firm.

Shiloh Bates (04:24):

As part of the rationale there
that the closed end CLO funds have historically traded at premiums to book
value. So maybe to capitalize on that?

Greg Borenstein (04:34):

We have a board on EARN, which all
these closed-end vehicles will have and the board certainly saw the benefit
considering the precursor to this was trading at a discount and overall the
popularity of some of those agency mortgage REITs simply weren’t growing as
much. And so, I think, taking a look at the attractiveness of the CLO
closed-end space with the ability to trade more at book and offer the ability
for shareholders to benefit from the growth and scale of a vehicle like that
certainly was one of the compelling reasons to the board to be in favor of the
conversion.

Shiloh Bates (05:09):

Okay. Have you guys fully
converted EARN into CLOs or are there still some mortgage securities in there?

Greg Borenstein (05:17):

No, it is fully converted.
Actually, this is a unique story at the end of it, but we first started adding
CLOs to EARN at the end of 2023 I think in the fourth quarter or so, September,
October-ish. And, from there we telegraphed in our earnings call that we were
beginning to do this. We eventually came through and announced our intent to
convert this to a CLO closed-end fund, which was very long and interesting
process to take an existing REIT, de-REIT it and then eventually transfer it
over to a CLO closed-end fund. The technical conversion date was on April 1st,
and so, we really had a interesting time with that as April 2nd was liberation
day. It was after the conversion though, up until the very end, that we did
need to keep a certain amount of the portfolio in certain mortgage-related
items. And so, immediately after the conversion, very early on in April, we
finished selling the remnants of the mortgage pool and fully converted
everything into CLOs. And today, as it stands, it’s all in CLO-related investments.

Shiloh Bates (06:25):

So again, a number of these vehicles out there now seems like a growing list every year. How do you guys see yourself as different from peers?

Greg Borenstein (06:33):

So EARN’s overall objective is to create a discussion with the board, an attractive and appropriate dividend, while also looking to preserve NAV through CLO investing. I think what may separate EARN a little bit from some of the other competitors is we have a far higher concentration in mezz[anine debt] than maybe some of our peers. Right now, we see, as of the latest portfolio close to an even split between equity and debt and that can change based upon the opportunity, but at the moment right now, we see debt to be attractive enough to scale that up. But we also will have a portion of the capital allocated to Europe and that can be taken up or down depending upon the opportunity we see there. So, we do try to increase the breadth of the market that we can invest in depending upon the opportunity.

Shiloh Bates (07:26):

Okay. Well I think the allocation
to mezz in a year like this was definitely a good call. So starting with CLO
equity, I think it’s been a pretty tough year. How do you see the performance
of the asset class so far this year?

Greg Borenstein (07:42):

I think it’s been certainly an up
and down year for CLO equity. One thing I would add, too, that does
differentiate the vehicle a little bit is, and this relates to how we use mezz,
is that EARN does have credit hedges involved in the vehicle and a lot of this
is around some financing we’ll use with mezz securities, but that’s just
another thing to add on to the way it might be a little bit different than some
of our competitors, but we can talk about that.

Shiloh Bates (08:07):

Yeah, I would love to hear, I saw that in some of your materials. How does your hedging specific, you’re short specific credits that would be in CLOs or you’re short the mezz in some cases or?

Greg Borenstein (08:20):

Sure. So, the hedges are involved mainly because we’ll use financing on some of the mezz. We can look at an equity investment. I think a lot of folks in this space will look at the overall total return of what CLO equity could give you and you’re structurally levered when you’re in CLO equity. Coming up into mezz, you’ll have some subordination. It’s not always the case that the overall yield or the overall distribution might be what you want for a CLO closed-end fund, but providing some financing, but then pairing that with protection should you be using financing, and need margin. And so, it’s less local at-the-money hedges, we’re not using single name credits.

(09:17):

It’s actually very hard to pair up what’s generally first lost tail credits in CLOs to necessarily having liquid shortable CDS positions or something of the sort where you can track that. So it’s generally an index form. There’s a variety of ways, be it options, index tranches, maybe shorter dated index positions. A lot of these you’ll see in the public portfolio of EARN, but we think that these provide convexity in the event of a drawdown in regards to managing what would be the overall return profile to help improve the Sharpe of the portfolio as well as address any liquidity needs should there be a severe drawdown and the financing potentially is called in the other direction. So, it helps solve for both of those.

Shiloh Bates (10:07):

Is that like the equity equivalent of buying, out-of-the-money puts?

Greg Borenstein (10:12):

It’s a way to think about it for sure. And there’s a cost to this. Is the cost outweighed by what you’re getting on the financing side with some of the mezz? And so, a portion of the portfolio we think is a nice balance to just being long to CLO equity outright.

Shiloh Bates (10:26):

Great. So then, in terms of CLO equity performance, my view is it’s been pretty tough year. How do you see the factors that are driving the market there today?

Greg Borenstein (10:37):

So, completely agree. I think when
you look at what happened in the market, it reminds me a lot of 2019. You have, in general, good markets. Equity markets have rallied, most credit markets have performed well, but you have a tail, you’ve had increased dispersion. You take a look, there’s a lot of winners and losers. We’ve had elevated rates for a little while and some of the interest coverage pressures have pushed on a portion of the loan market. Tariffs have obviously caused a high degree of volatility and uncertainty, but if you look at this across other credit markets, it’s been the same story elsewhere. The high yield index of, it’s a hundred names of high-yield CDS positions. If you take a look at it, the bottom 10%, the 10 widest names are now accounting for, call it roughly 35-40% of the spread, which historically is comfortably above averages.

(11:31):

If you’ve taken a look at, in
high-yield index tranches for example, which you can tranche out the yield index to senior mezz equity, the zero to 15, which is the equity portion of this, has been a large underperformer. And so, you’ve seen tails in a lot of areas of credit vastly underperform. So in CLO equity we know some of the single name stories, some of these tail names, LMEs, those things have hurt. And on the other side of it, a lot of quality loans. We see a lot of points through the year, the vast majority of the portfolio trading at or above par. And so, the prepayment risk and spread compression you get on the other end of the equation has been a double whammy for equity. And overall, it just hasn’t produced as you know, the type of total return that equity investors would’ve expected, especially beta adjusted for this type of year. It’s not like everything has struggled this year.

Shiloh Bates (12:24):

I mean from my perspective, I’d say it’s an uptick in defaults and people quote defaults a lot of different ways. I mean if you look at just actual traditional bankruptcies, not elevated really. But, if you look at, throw in the LMEs, the restructurings, and you just throw in the fact, the tails that you’ve been talking about are loans that have traded down, probably haven’t defaulted, but in CLO equity, you feel the pain of that as well. So really any loan that trades below 90 is an issue, and there’s lots of these loans out there. So, that’s feeling pain on the loan loss side. And then, all the other loans that aren’t in the tail are performing well. And they’re going back to their lenders and asking for lower spreads and they’re getting them. And so, I kind of viewed this year as really the potential for a lot of upside in doing refinancing and resets. And, the upside’s there, but actually it’s being offset to a large extent by just the spread compression you’re losing on the assets. So, the loans can reprice in a lot of cases in six months, whereas CLO securities, there’s a two year non-call period. And so, the spread or the natural profitability of these things of CLOs is diminished as a result. And then the third factor, I’d love your opinion on this, but I mean I think CLO equity just trades wide in general, so it’s not like across other credit markets, everybody’s willing to accept a lower future returns, and in CLO equity think the market trades wide. 

Greg Borenstein (14:01):

I definitely agree with your point
around a couple things there. It isn’t just defaults coming through. There
actually hasn’t been an uptick in defaults this year necessarily, which if you
listen to everything around First Brands, you would think that we’re entering
the heightened default period, but overall it’s not so different than last
year. But, you also have things like distressed exchanges that aren’t
technically defaults, but there’s an impairment that comes in, and for certain
CLOs, loans trading down, especially if there’s a downgrade risk, can
potentially put cash flows at risk too. So it isn’t just a function of losses.
To your point, and I agree there that the hit of the tail plus the refinancing
of the spread compression has not been enough to offset what’s generally been a
nice year of CLO liabilities coming in and tightening. But with two year non
calls, it’s more of step function and how that may be monetized.

(14:53):

So some unique deals may have
benefited this year, but as a whole it’s been a tougher story. To answer your
question though, to get back to the point around is CLO equity trading wide, it seems like over time it’s gone from some investors who maybe look at this as an overall yield to looking at how it cash flows because the market has more and more leaned into valuing these options in regards to being able to reset, refi, liquidate. They don’t wall out a yield table. If you look at these
run-to-maturity, oftentimes that’s not the end result. So, from a cashflowing
perspective, I think there’s an argument from a lot of investors that it’s
still a very robust cashflow. In fact, in 2022, I thought that CLO’s equity
held in relatively well for the right good quality, cleaner managers, because
while yields moved up just on rates moving, overall CLO equity didn’t seem to
sell off in the same way because I think you had a lot of investors in that
space simply looking to capture the cashflow profile. So maybe the view of it
was coming in a little different. And so, what makes it such an interesting
product is, so many investors are looking to take different things from it, be
it, an overall yield objective or a cashflow objective. And when you relate it
back to something like EARN or the closed-end fund space, while there is a
total return concept, there’s clearly a focus from the retail space that looks
at it on dividends.

Shiloh Bates (16:21):

So, the part of your profile
that’s in mezz, can I assume that mezz is primarily just the par market and the
only issues really in mezz are just getting refied or reset at tighter spreads?
Is that how you’d see it?

Greg Borenstein (16:35):

Well, a lot of mezz is at par. A
lot more than there used to be. I think that mezz can be interesting. This is
an aside, but if you go back to 1.0 days, most pieces of regular way CLO mezz
did just fine. CLO equity did great. So by definition there were very few
issues in CLO BBs. In fact, I think you’ve in the past been a big proponent of
what the overall credit quality of BBs themselves are compared to other areas
of BBBs and corporates and we couldn’t agree more with what’s historically been just a very solid quality product with CLO BBs, fundamentally. You have seen an uptick though in some of these deals that maybe have been reset a couple times where the tail hasn’t necessarily been able to be cleaned up and you’re going to have some BB’s that take impairments.

(17:25):

And so there is a portion of the mezz market that for all intents and purposes is behaving like equity. It is first loss, is at-the-money, it’s 10 points of NAV up or down, it’ll be felt by the BB’s as opposed to a healthier deal where it’s felt by the equity. So, away from some of that, and away from a handful of other potential situations, right now we see a lot of mezz, to your point, close to par and unless there’s a low coupon issue, anything that’s trading at a discount is starting to pick up credit risk. And in fact, I think that’s been an interesting story this year, especially around some of the noise with First Brands and some of the other potential credit tail issues. Some BB’s have come off in coverage and you can see it through the reset market when CLOs come back to get a new life and extend themselves out, BB holders have become a little more discerning around differentiating where perhaps a tail has formed in some of these pools and are just looking to be compensated a little bit more to underwrite that BB risk there.

Shiloh Bates (18:27):

Okay, so by my math it’s a 25
basis point default rate for the asset class over 30 years, talking about BBs.
But do you think fundamentally going forward that’s not the number? Do you
think it’s higher going forward? One thing is the spreads on BBs are higher.
So, that’s a fundamental change.

Greg Borenstein (18:46):

Sure, we don’t know for sure what it will end up being, but in terms of the BBs that are ultimately retiring beneath getting par back at the end, I’d expect that it’s going to pick up based on what we’re seeing in the market. To your point, it may still end up being a positive total return. Getting some of these coupons above what’s a higher base rate right now, produces very nice cashflow. And so net of that, the BB investors still may be all right with that. What’s interesting about BBs, they’re not digital necessarily, and impairment may mean 90 cents on the dollar. So, it doesn’t mean it’s necessarily going to zero. But overall, in terms of things that may take some degree of loss, I’d expect that you’re going to see more than 25 basis points.

Shiloh Bates (19:33):

Okay. So as you guys grow your fund, are you seeing more of the opportunities in mezz or is CLO equity trading cheap here and you’ll take advantage of that?

Greg Borenstein (19:44):

Well, as someone who generally sources their opportunities in the secondary market, it’s an easy answer to say we do both and it just depends where the opportunity is and where the price is coming. I think overall we’ve tended to shift considering everything we’ve talked about with some of these issues around dispersion, credit issues, compression, where we’ve started to favor mezz a little bit more through 2025 and lean into that at some point. That being said, there are still interesting opportunities in equity. I think, as you were saying before, some of these equity pieces have backed up, they’ve widened, they produce good cashflow profiles and some of these managers have done a very nice job. When you look at
the better quality managers in the CLO space, maybe their loss rates are a
little bit lower, maybe they’re able to obtain debt levels that are better,
that are tighter.

(20:36):

So, for the equity, not as much credit risk needs to be taken to be able to give you a good return. So, in some cases, there’s so much differentiation when you get into the CLO equity space, you have unique managers, you have unique vintages, you have unique docs, so no two deals are alike. And in some cases I think there’s definitely opportunities to be had in CLO equity. We’ve just found that looking at the numbers in terms of where we’ve rotated our portfolios, it’s tended to favor, going into mezz, have the subordination and protection from some of these idiosyncratic concerns. 

Shiloh Bates (21:12):

Okay. So, I think one of the things that’s maybe different between our firms or me as an investor, is I do a lot of private credit CLOs, and there we actually, we buy in the primary, that’s where you can write a big check. But for broadly syndicated loans where you guys are playing, you can do primary or you can do secondary. And, it sounds like your preference is secondary, and I know your background is working on a CLO trading desk, but why do you see the better opportunity in the secondary versus primary?

Greg Borenstein (21:43):

So, I’d also say that we do have positions in sort of the middle market private credit side. It’s not the majority of the portfolio, but I think there has, at points in time, been some very attractive opportunities there. I’m not sure your take, but some of these folks have been doing it a very long time, have done a great job. You look at the loss rates, you talk about BB loss rates, I’m sure I don’t have to tell you about the loss rates going back decades of some of the better managers in that space. And on top of that, for the rating, there’s generally pickup and spread

and subordination. You can make the argument, obviously these are not always as diversified. So, from a rating agency model perspective, that forces a
subordination issue more. There could be chunkier hits there. So, you are
trusting the manager on these larger positions that they’re taking and knowing.

(22:32):

But, the numbers have borne out
for those that have been around long enough that some of those that do it well,
it’s not been an increased credit risk versus regular away credit. So, I think
there’s a portion of that that is interesting. That said, I think why we like
secondary the way that we’re set up, we have other pockets of capital and the
lens that we view things is how do we produce a superior risk-adjusted return
in the assets that we buy. And so the transparency that we get in the secondary market, our ability to analyze bonds, we just have a greater degree of confidence when we know the portfolio. Broadly syndicated loans have prices, you can see price depth, you can see transactions. And with that information, you can assume probabilities. As you know in this market, a loan priced at par is a different risk than a loan priced at 70.

(23:21):

And right now a loan priced in the low 90s maybe isn’t something that comes without risk. And, we’re able to discern and quantify that. Sometimes at new issue, you don’t have all the information around how a model portfolio may translate and you don’t always have the same opportunity in terms of dislocation in a primary market versus what can happen in secondary. And so, with a background a little bit more in trading, that tends to be our preference. But that said, there’s times we certainly come in, sometimes access can only come through the primary market

for some of these fundamentally strong positions and it comes on a deal-by-deal and market-by-market basis.

Shiloh Bates (24:02):

So, what about for broadly syndicated equity? Would you ever buy that in the primary today or does secondary trade at much more favorable levels?

Greg Borenstein (24:13):

We’ve done primary equity and at
points in time it’s been attractive. I think at periods last year and into
early this year, if you take a look at EARN’s portfolio, you can see that we
entered into several primary transactions. I think it’s been tougher this year.
I think right now just creating the arbitrage through primary debt levels and
then ramping a portfolio, I think that’s been a pretty big concern. Having a
cross bid offer to source however large the portfolio is of loans, I think has
really eaten into what the end economics are. You can talk about if there’s
other levers to pull, be it with the warehouse or things you can work on with
the bank or the manager to try to get economics to a place that makes sense.
But oftentimes, I think we found that we felt more comfortable coming into a
deal that’s already done and traded and priced and not being dependent on a
model translating to the investment as something that’s maybe already in
existence that we have more assurance on.

Shiloh Bates (25:14):

Okay. My view there is BSL and the
primary are very tough. Like how we would model it, I don’t know, maybe it’s
11%, 12% opportunity, whereas in the secondary I think it’s 3% higher. It’s
really different. I was, well maybe not surprised, but I think a lot of the
primary issuance is being driven today by the risk retention funds. They’re
always going to print deals, but we’ve definitely seen the better opportunity
in the secondary.

Greg Borenstein (25:42):

To your point, the primary market
equity hasn’t always been a market clearing level, so some of these may be
retained. To your point, a lot of places don’t have to sell. It’s not like all
of this equity is going to third party necessarily. That said, primary equity
you can make the argument could be tighter to some degree if you’re sourcing a much cleaner portfolio versus something in secondary that’s already began to have some amount of credit problems in the tail. I mean listen, deals will have hundreds of loans. It’s expected that there’s going to be some degree of losses through the years and with some deals, depending upon where in your lifecycle you are, the shorter you get with CLO equity, the more your value shifts to ultimate PO return on the loans and away from the cash flows. And so, depending how you want to assess that risk, that can I think influence return a bit. But overall, I don’t think it changes the sentiment that I think we both tend to agree on, which is there’s better value in secondary than primary as of today, generally.

Shiloh Bates (26:41):

Okay. And then I think one of the
key things for our asset class is just going to be, we talked about how loss
rates on loans are elevated. Do you see that as something that continues well
into next year and beyond, or is it that we’re working through and
restructuring the weaker loans in our CLOs and that once we get through that
process, loss rates will decline substantially and profitability in the trade
will come back?

 

Greg Borenstein (27:11):

Well, there’s two things there.
The second part around profitability in the trade coming back, as you know,
there’s a few other factors that go into the equation. If all of a sudden AAAs
go back to pre-crisis levels, that would help.

Shiloh Bates (27:26):

Yeah, it’s the LIBOR plus 25 bips. Yeah. 

Greg Borenstein (27:29):

So barring other things that do
influence that, I think that from where we are here, there’s no reason to see
why this environment changes immediately. I think that there’s potentially some constructive factors coming in if rates ease from our conversations with
managers. There’s definitely a view that some of these companies need it. While it doesn’t seem like interest coverage ratios are overall stressed, companies would rather pay less debt than more. So, I think that having that come off I think would be helpful, but I think it’s going to take a second to do that. Also, what we’ve heard, taking a look at the post COVID period of some of the debt that got issued immediately following, not all of that was written with great terms for lenders and some of these are causing problems now and it may still take a little bit of time to maybe work through what potentially could be a tail.

(28:24):

And the other thing we haven’t
addressed, and I’m not going to claim I’m an expert on this, but everyone’s
obviously been very engaged around how AI is going to affect things. I think a
world of what’s that going to do, what’s happening with tariffs, just the more
the landscape changes, the more winners and losers are produced. That could
come into CLOs. The large majority of loans may be fine, but if events are
happening that may stress certain tails and whatever that specific shock may
be, that could lead to slightly more elevated losses persisting for a little
bit of time. So, while long-term some of these things may be constructive, I’m
not sure how long it’ll take to finish working through the exact state we’re in
right now.

Shiloh Bates (29:07):

Okay. Well, coming back to my
comment on the risk-retention buyers of equity, my opinion is that
risk-retention funds just muck up the entire market for us because they’re
creating CLOs, they’re calling this capital, they’re buying the equity in deals
that I wouldn’t sign up for, and I assume you wouldn’t sign up for either in a
lot of cases. And by doing that, they’re keeping loan spreads tight. So, that’s
more demand for loans and it’s more demand for CLO liabilities. This issuance
that, in my opinion, is non-economical results in lower loan spreads and higher CLO financing costs. And, if this wasn’t a big part of the market, I think our asset class, I’m talking about equity in particular, would be much more
profitable. But instead, you have all these non-economic actors creating CLOs.
That’s my opinion. I’d love to hear what you think.

Greg Borenstein (30:06):

It’s impossible to disagree with
that. Taking a look at the way the CLO markets evolved, in some senses, you
think about the popularity of it, you quote a 25 bip loss rate historically on
BBs. This product was a big winner from the financial crisis. You think about
what was going on in structured credit, some areas CDOs and CLOs, I remember trying to explain to people, this is a little bit different. These are real corporations beneath here. And, not only was debt fine, equity had a great return, there’s some things that were serendipitous to both the way the
vehicles worked as well as the market we had on the return that allowed CLO
equity to really take advantage there. But, when risk retention came in and a
lot of these managers were forced to try to solve for this, I think a lot of
these arrangements were struck.

(30:55):

A lot of money was raised, there’s
a lot of money that’s been raised for a lot of things and even though risk
retention was fairly quickly repealed by the time we actually got to it, I
think a lot of investors see the value in a profitable CLO management platform and sometimes the equity can be linked to that. So the economics of someone investing in a fund captive to a manager might be a little bit different than what those economics would be for a third party investor. So, they’re not necessarily solving for the same equation that you may or I may when we’re looking at entering the transaction. And, it’s not always even a, they have some agreement that gives them different cash flows, it’s more there is some bigger picture valuation that is going on in some of these cases that is just going to take a much longer time to play out.

Shiloh Bates (31:47):

Well, for me, I’m just looking for
attractive risk-adjusted returns. I don’t have any other goals in in the asset
class, so I appreciate that. So the closed-end funds that focus on CLO equity,
usually they trade at premiums, but this year they’re trading at some
discounts. And I believe how it works is you need to be trading at a premium to grow and to issue more shares. So what’s the crystal ball on seeing a return in a more stable or higher share price that enables these funds and yours to grow?

Greg Borenstein (32:21):

So, for long periods of time, they
have been at premiums. Taking a look at what’s happened this year, there’s been
a lot of volatility in credit. Liberation Day was the first thing to knock
things back a little bit. And, looking at some of the idiosyncratic issues that
have come through the market, I think it’s just led what’s predominantly a
retail investor base to have been a little concerned around what is the risk in
maybe some of these vehicles? Even though I think a lot of my peers and I would
discuss this isn’t a private security that has no liquidity on it and isn’t
necessarily being valued correctly, these are CUSIPs that trade. A lot of times
you have comps on them, especially if you’re a more active trader in the
market, that you can get your head around that valuation and have accuracy
there. So, it seems like the investor base in the market is going to have to
have increased comfort with what they deem as the risk in these vehicles.

(33:19):

I don’t know if there’s
potentially some relationship to after BDCs got hurt with some of the reasons
that those had sold off and relating some of those issues over here. It’s not
the same product, but it’s possible. Other areas of credit that may seem analogous
could have felt some of those effects. And so, I think that settling down, and
the confidence to come back there and maybe seeing some good performance would help. I think it’s unfair though, to simply deem it’s a baby getting thrown out with the bath water type-issue when the first thing we addressed early on here was it’s been a tough year for CLO equity, which is generally what this asset class is very exposed to, the closed-end funds I should say.

Shiloh Bates (34:01):

So, one thing about the closed end
funds that might strike people, it’s just how the distribution yields are very
high and part of that is because CLO modeled, the equity returns are high. But
another part of it is that when the CLOs produce their tax statements, a lot of
times the taxable income coming from the CLO is higher than where the company might think returns or profits are going to actually be. So you have a little bit of a mismatch. A lot of times you have higher taxable income from the CLOs than GAAP. Those are the specific terms. So, how do you guys think about that mismatch?

Greg Borenstein (34:44):

It is definitely something that’s
very topical and we spend a lot of time on. It’s something that our board has
been very focused on. Having, once again, a large REIT having EARN in its prior form, you will look at some of these issues. The idea that you end up
distributing out a bit of income to the point that your principle will need to
drop to support that. As CLO equity buyers, this is the nature of the product a
little bit. We know that if we buy something at you, were quoting a 12% yield
earlier, the annual dividend in terms of cash on cash is generally going to be
higher than what we see as the yield because the NAV is just going to drop in
time. There’s some degree of NAV erosion. So it’s a large focus of ours. As you
know, being an equity investor, your distributions, the cash-on-cash
distributions will tend to be higher than I think what the yield you get is.

(35:41):

And that can lead to distributions
that are maybe outsized versus total return and are paired with what is a
slight principal decline over time. And so, sometimes what you see in these
vehicles is a dividend being paid out, but NAV slightly drop over time. I think
it’s certainly a concern and it is a reason why we do keep a portion of the
book trading in mezz. Having things that pay off at par, it’s harder to find it
in this type of market, but in a market that maybe provides the opportunity
where you can buy mezz at a discount, you can actually have a pull up in that
value and paired with equity, it can produce an overall profile that produces a
good appropriate dividend and also a good book value. It preserves good book
value. And weighing those together, I think, is important because overall, both of those should matter and are part of the objective when providing the right type of risk-adjusted return ultimately to shareholders.

Shiloh Bates (36:46):

Well the nice thing to your point
about the mezz, is that it’s very clear what your income is and what’s return
of principal. So that makes things easy. So a few just closing questions that
I’ve thought of while we’re chatting. One is, you’re part of a big successful
hedge fund. I imagine that a lot of the strategies around your firm are held in
pretty tight confidence or you guys don’t want what you’re doing to get onto
the market, whereas for your CLO closed-end fund, you’re a public filer on
Edgar and so everything you own is put out to the world on a quarterly basis.
Is that a little bit of a culture shock around the firm there?

Greg Borenstein (37:25):

It was definitely something that
we weren’t sure how it was going to go and our holdings will be out here. It
honestly has been less of a big deal. It’s honestly been helpful so far because
the amount of times someone has come into us to say, Hey, you’re a holder of
this, we want to take a corporate action on doing something with this equity.
As you know, Shiloh, the market, everyone’s generally very cordial and with so
many places issuing as well as investing, I think that it has a degree of
comradery and professionalism where people aren’t adversarial with each other.

(38:17):

And the strategy we employ for
this vehicle in particular, it’s similar to the rest of our strategies. And
that once again, whether we’re buying something into EARN, whether it’s in a
fund that maybe hedges and protects its downside explicitly, maybe it’s in an
SMA that’s looking to do something else, it still doesn’t change the approach
we take in terms of trying to justify that each line item in the portfolio is
truly adding alpha above its sort of liquid replacement.

Shiloh Bates (39:25):

I saw that in your bio you have a bachelor’s in Applied Math from Johns Hopkins. I studied financial mathematics for a master’s degree. Do you find that CLOs is very quantitative in this or is it that there’s lots of data but the calculations aren’t that complicated? Or do you feel like the bachelor’s in applied math was very helpful, especially at the beginning of your career?

Greg Borenstein (39:48):

I think it’s helpful. It’s
interesting. We were having a conversation recently on the desk where a lot of members of the team have math backgrounds and I do think it was helpful. I think that coming up, I started on a prop desk that had a few other things
going on and especially, will trade things like credit derivatives, and I think
in that area, it’s pretty helpful. I think that in CLOs you see a lot of
different backgrounds. You can see quantitative math engineering backgrounds.
You see law backgrounds, all the document work, things like that. I’m probably biased just because of my approach to the market, but I think that it can be a successful background in that it sort of teaches you to think about different outcomes, way different probabilities, understand uncertainty and variance and maybe overall, be it from a portfolio management angle or be it from the way a CLO actually works, just the value and the implications of things like diversification.

(40:48):

So I think it’s a little bit about
the view and how you think about things, whereas I think that now there’s so
many very high-quality third-party analytics, it isn’t valuing the security
will necessarily be impossible for someone without a higher degree. But I do
think it’s helpful, especially I think about the way that we operate here in
terms of the general strategy, which is having a lens through looking at things
as risk. And, I think that helps you do a lot there, having strong quantitative
backgrounds. But I’d be curious to hear your view on this since you’re the
highly educated one.

Shiloh Bates (41:22):

Well, I didn’t want to say that,
but what I found is that in my study, so I was a political science undergrad
and I have a few master’s degrees. One’s in public policy. And for those areas,
if you want to do well, it just you want to get an A, it’s really just about
how much you study and do all the reading. But basically most people can get an A if they really apply themselves. And then for mathematics, I don’t think
that’s the case. At some level, people tap out. And the tap isn’t, I don’t have
more time to put in, it’s just, Hey, my mind is not capturing this high level
of mathematics at the same level as some other people in the class. And so, you realize that. So you really get pushed in mathematics and you get to whatever level you can attain. And then you start working in CLOs and I don’t do a lot of financial mathematics. The complicated things are like partial differential equations or stochastic calculus. I’m not doing either in my normal day here. But it just gives you a confidence with numbers that if you can be successful with applied math, whatever level you got to that most of the mathematical challenges that come to you in your workday will be five rungs down from that.
And so, if you have the confidence and skillset that you built in university,
that I think you can do really well.

Greg Borenstein (43:06):

Ellington has a very strong academic culture to it too. And so, I think you see a great deal of that here in terms of hiring a lot of quantitative backgrounds, especially think about Ellington was founded in 1994 as more of a mortgage shop initially, but back then the edge you had in terms of being very quantitative and analytical in the earlier days of these types of products made a huge difference. To your point, I don’t think it’s that you’re going to be doing lagrange multipliers on the desk or anything, but your comfort with numbers and just understanding in terms of your thought process, way to think, and the way that these products may behave. Concepts of things like duration and convexity we talked about in themarket, but to have a sense for the way correlations may work, the way one thing may move when another starts moving. I think it’s a helpful mindset to have and approach it. And one last funny story, you think about the rigor of it – having gone to Johns Hopkins, it did not have a reputation for grade inflation. And you see kids in the engineering school wearing around T-shirts that said, without my C, your A is meaningless. So, in a world where you hear things about that going on.

Shiloh Bates (44:19):

Well, I studied financial math at U Chicago and it’s also no grade inflation. It’s bell curve, and if everybody in the class is smart and applying themselves, some people will do well and some won’t, and that’s how they do it.

Greg Borenstein (44:32):

Well, that’s how math people will
grade themselves. Fair distribution.

 

Shiloh Bates (44:39):

I hear you. So Greg, is there
anything topical that we haven’t covered?

Greg Borenstein (44:46):

No, I think we’ve touched on a lot
of things. I think that it’s an interesting time in the market. I think it has
been a little bit of a frustrating year, I think for folks down the stack as we
talked about with some of these credit issues, and I think it’ll be interesting
to see how the market moves forward. We mentioned First Brands earlier just
because it’s impossible to have a CLO conversation with not mentioning it, but if you take a look, this wasn’t the most unique thing to ever happen. Defaults do happen in the CLO market constantly. So, does it reveal what the investor base is maybe worried about with what’s going on in certain areas of credit or lending or things like that? So, as much as I’d be curious to hear your point of view, broader, outside of CLOs, will you see the market may be negatively or positively impacted by things we may see in other large areas that have grown a lot or are changing or things like that.

Shiloh Bates (45:41):

Greg, my closing question is always describe as CLO in 30 seconds.

Greg Borenstein (45:46):

A CLO is a way to pull together a bunch of risk from corporations looking to finance themselves, and by putting it into a tranched-out structure, you are increasing the demand for those underlying companies. By tranching out the risk to be able to send it to a more diversified investor base rather than finding folks to simply buy the loans outright. You’re creating a AAA profile for AAA investors. You’re creating an equity profile for equity investors and everything in between, and this structure benefits those underlying loans in terms of increasing demand through the structure.

Shiloh Bates (46:27):

Great. Well, Greg, thanks so much for coming on the podcast. Really enjoyed it.

Greg Borenstein (46:31):

Thanks, Shiloh.

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.

–         
Payment In Kind, or PIK, refers to a type of loan or
financial instrument where interest or dividends are paid in a form other than
cash, such as additional debt or equity, rather than in cash

–         
A covenant refers to a legally binding promise, or lender
protection, written into a loan agreement.

–         
Net Asset Value (NAV) – The value of a fund’s assets minus
its liabilities, typically used to determine the per-share value of an interval
fund or investment vehicle.

–         
Dividend Recapitalization (Dividend Recap) – A refinancing
strategy where a company borrows to pay a dividend to its shareholders, often
used by private equity sponsors.

–         
Continuation Vehicle – A fund structure that allows
investors to roll their interest in an existing portfolio company into a new
vehicle, while offering liquidity to those who want to exit.

–         
Equity Cure – A provision that allows private equity
sponsors to inject equity into a company to fix a financial covenant breach.

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.