Collateralized Loan Obligation (CLO) Equity is the riskiest tranche of a CLO, but also has the highest return potential, while notes rated BB are usually the CLO’s junior-most debt tranche. Both securities have attractive fundamentals, but it’s important to realize that these securities have some distinct features from other asset classes. Several key differences revolve around market illiquidity, conflicts of interest, CLO structural features, and market size. Below are a few lessons learned from our time in these asset classes:
1. CLO Equity investing, in particular, is not a great investment for investors that do not already have deep relationships in the market.
Imagine a CLO arranger has a $50 million equity tranche to sell in a new CLO. Who gets the first look? Given the investment size, the arranger generally cannot show the deal to multiple potential investors at the same time. That’s because each investor may want a majority of the equity, and if they all want the deal, many will be disappointed. So, the arranger starts with one account, and if that account passes, he moves on to the second. The pecking order is established by who does the most business with the arranger, among other factors. People new to the CLO asset class are going to find themselves last in line and will only see CLO opportunities that multiple others have passed on.
Similarly, it’s important that an investor sees other relevant market trades before making an investment. If you see a one-off trade from a broker dealer, it may end up being a fine investment, but you need to make sure you paid a fair price that is in line with recent market transactions.
2. An investor in CLO Equity should approach the market with the broadest possible mandate.
Many investors who want exposure to CLOs invest with one CLO manager in a GP / LP fund format that will invest in the next several CLO Equity tranches managed by that same manager1. This is an easy but inefficient way to invest. The investible universe of CLO Equity tranches is over 1,600 deals. The options are as follows:
Primary CLOs – the financial market in which investors purchase newly-issued CLO securities
Secondary CLOs – where investors can buy and sell previously issued CLOs from other investors
CLO Warehouses – short-term financing vehicles provided by an investment bank to CLO managers to accumulate a pool of leveraged loans that will eventually be securitized into a CLO
Middle Market CLOs – CLOs with underlying collateral consisting of middle market loans rather than broadly syndicated loans
An investor in a GP / LP manager fund will be targeting the smallest fraction of the investible market, and there will be high overlap of the leveraged loans in each of the CLOs. Slowly waiting for the GP / LP fund to call capital may also be undesirable.
3. A CLO manager may not make the best CLO Equity Investor.
Many CLO Equity investors are also CLO managers, and they effectively market their CLO management skills as being useful in picking CLO Equity investments. However, this can quickly result in some conflicts of interest. Is the CLO Equity investor really looking at the whole market for the best opportunities, or is he simply helping the home team by investing in his firm’s CLOs? Let’s say the CLO Manager has syndicated almost all the CLO Notes for a new deal, but a few unsold parts of the capital structure remain. Perhaps those unwanted securities will end up in the CLO Equity Fund?
4. CLO BB Notes are robust, even when the market value coverage (market value of leveraged loans and cash / CLO debt through the BB Note) is less than 100%.
When the leveraged loan market sells off, potential returns in BB Notes can be equity-like. On its face, it seems very risky to invest in a CLO BB Note when, if the CLO was hypothetically liquidated, the proceeds would not result in full repayment. But, very few CLO BBs have defaulted, and there are two ways that the market value coverage likely ends above 100%, which is a requirement to get a full repayment on the CLO BB Note. First, many of the CLO’s leveraged loans will repay at par, thus increasing the market value coverage over time, as the fair value of the leveraged loans typically are below par. Second, if the CLO’s leveraged loans materially underperform, the diversion of cash flow that would have otherwise gone to the equity will also benefit the market value coverage. Do not underestimate the value of this CLO structural protection for the BB Note.
5. Allocation to Middle Market CLO Equity and BB Notes has the potential to reduce overall portfolio risk.
Middle Market CLOs offer exposure to a unique set of levered loans that aren’t represented in other CLOs. Projected equity returns are comparable to CLOs backed by broadly syndicated loans, but middle market loans tend to retain their value better in down markets. Changes in fair value of Middle Market CLO Equity are primarily driven by the actual performance of the underlying levered loans as opposed to technical factors influencing the broadly syndicated leveraged loan market.
1) GP / LP refers to a private fund structure where the General Partner (GP) typically manages assets on behalf of Limited Partners (LPs) who have contributed investment capital. GP / LP funds are not regulated under the investment Company Act of 1940.
DISCLOSURES
Past performance is not indicative of future results.
This Insight article is not an invitation to make any investment or purchase shares in any fund and is intended for informational purposes only. Nothing contained herein constitutes investment, legal, tax or other advice, nor is it to be relied on in making an investment or other decision. Nothing herein should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment, or to engage in any other transaction.
