Podcast: The CLO Investor, Episode 5

The CLO Investor Podcast, Episode 5

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 and the CLO industry, and I interview key market players. On May 15th, I attended
the Creditflux CLO Symposium in London. Creditflux is one of the papers of record for the CLO industry and their annual conference in London is always, for me, a must-attend event. It was great to see lots of familiar faces and the panel guests were really top notch. Some of the themes of the conference were the rise of middle market CLOs and declining CLO financing rates. Usually my podcast is me interviewing other market participants, but in this episode I’m posting a fireside chat I did at the conference with Credit Flux Managing
director Tom Davidson. Credit Flux also has a podcast that I’d highly recommend. It’s called The Last Tranche, and I was a guest there a while back.  Some of the topics we discussed were CLO education, current opportunities in the CLO market and CLO equity risk adjusted returns, which I emphasize are more important to me than total returns. And now my conversation with Tom Davidson.

Tom:

Welcome, Shiloh. Before we get going on the fireside chat,
maybe if you just want to introduce yourself with your main job.

Shiloh:

Hi everybody, I’m Shiloh Bates. I’m the CIO of Flat Rock
Global. We manage about a billion of AUM. We focus on CLO equity and CLO double Bs. And then within those two asset classes we have a preference for middle market CLOs, as you know.

Tom:

Great. Now for those of you who called the first fireside
chat, my colleague Lisa Lee and Jane Lee, Lisa upped the ante on us by announcing that Jane is an award-winning documentary film producer. Luckily enough, Shiloh also
has a side gig, which is as an author. I’ve got a copy of his book here. We also have a few more copies if anyone’s interested. This is CLO Investing with an Emphasis on CLO Equity and Double B notes. So maybe we should talk a bit about the book. Why did you decide to become an author?

Shiloh:

There’s a saying that it’s great to have written a book, but
it’s not great to be writing a book. The genesis though, really is in 2020 I had some free time on my hands and so I wrote a 60 page just kind of like manual, or the way I go about approaching investing in CLO equity. And we put
that on our website. I was really surprised at how many people read it and my competitors mentioned it to me, CLO managers and people that were just kind of interested in the space, they read it. And so that gave me the idea to just go ahead and do the bigger book. It’s about 220 pages, but a lot of what’s written in the book is stuff that I’m constantly as part of my job educating investors. And so some slides from our pitch decks are in the book.

I’m frequently answering their one-off questions for
investors. And so I came up with the outline for how I wanted to tell the story of CLOs. And at the end of the day, there’s really like maybe four concepts that make CLOs different from other asset classes. So I would agree it’s not
as, especially in equity, it’s not as straightforward as investing in a high yield bond or a leveraged loan directly or certainly a stock. If you want to learn about CLO equity and Double Bs, one option is a book obviously, but if you didn’t do that, you can spend a lot of time Googling and finding different articles and you can kind of put together the information you need. But the idea with the book was to put it all as kind of like a one-stop shop for your CLO needs.

Tom:

And it’s an amazing read if you haven’t had a chance to read
it. As I say, we have a few copies, it’s come out, so come and find us. I think one of the interesting things is obviously you wrote this a few years ago now, the market’s changed pretty dramatically in a lot of ways since then. What would you change now? What do you wish you’d written in the book?

Shiloh:

In the segment about double Bs in the book, I make the point that if the MVOC, so if the market value of all the loans in the portfolio plus the cash, that if that does not cover the full balance of the CLOs debt, AAA to
double B, that means you have an MVOC of less than a hundred percent. So it might be 98 or 99, something like that. And a point that I made in the book was that you can very comfortably buy bonds that are not covered and still expect a payout. And the reason really is twofold. So one is that if the loans don’t perform well, the CLO will not pay the equity and that profitability will be trapped in the CLO and ultimately that will benefit the double B. But then the
other part of it was just that the loan index was trading at discount of the levels.

And so at the end of the day, loans are either worth par or
they default and get some recovery, but there’s no in between. That’s kind of the binary thing. And our view was that most loans trading at discounts, it was really a function of heightened risks in the market, political risks, economic
risks, and that at the end of the day, there would definitely not be enough defaults to really impair a lot of the double Bs. That part has actually paid out, I think very few double Bs. Definitely very few have defaulted. I would expect very few to default in the future, but today a double B that’s not
covered by its fair market value given how much loans have traded up, is a much higher risk situation than it would’ve been last year at this time.

Tom:

Great. You are obviously very passionate about this investor
education piece. I know as well as the book, you have a new podcast as well. I have a podcast as well. Welcome to the space. It’s always great to see some competitors joining in. Tell me about the podcast.

Shiloh:

The new podcast is called the CLO Investor, and basically in
the first episode I just talk a little bit, I do a CLO 101 and just talk about the market to establish that foundation for people who need it. And then in the second podcast I interview a colleague, we talk about our strategy in
the market and what we find interesting. The third and fourth podcast, which we will drop soon, one is an interview with David Williams, who’s a CLO banker at Scotia who I know you know. And then Evo Turkejiev is a broadly syndicated CLO manager at New Mountain Capital. From the perspective of writing the book and the podcast, I try to approach it as from the angle of somebody who’s an investor
in the space, and I hope people will find it beneficial as once you figure out how to be a podcaster, when you have good guests on, they do all the work. You just have to think of the questions that they do all the talking, and then you talk for an hour and then hopefully it’s a quality product that people like.

Tom:

Absolutely. Let’s get into the equity investing side. And I
think one of the things which I find interesting is it’s actually quite hard to unpack for people looking at equity investing. How well is CLO equity performing as an asset and how much is added on by the alpha from managers? And
I think this is something you’ve done some work on.

Shiloh:

Well. Yeah, so one of the things that we put together
starting about four years ago was a CLO equity index. And it’s available on our website, it’s public. If you invest in any of the debt securities, double B to AAA, JP Morgan has great indices for that. Palmer Square does as well. And on any
day you can see, oh, how did double Bs do today or single A whatever you’re interested in. But with equity, you really can’t do that because there’s just not enough trades in the market. So what our idea was in putting together the
CLO equity index was to take information from what’s called public filers in the US. And so I’m a public filer myself, meaning that every quarter I tell our investors, these are all the CLO equity pieces I own. This is where I mark them
at 3-31 or 12-31.

I have a number of competitors who do the same. And so if
you know that somebody owned 10 million of a specific CLO security and they had it marked at this price a quarter ago and this price, now you just need to figure out what was the payment received on the equity in the interim, and you
can calculate a return in that way. And so our index construction basically matches a Cliff Water direct lending index. They do the same analogy or the same methodology where you’re looking at other public filers figuring out what
they owned, what the specific return was in quarter. And I feel really good about the results because all those marks are marks that are coming from managers who are registered investment advisors. So there’s a lot of regulation. It’s not just people really thought about the mark, it’s not
just something that just came at thin air.

That’s kind of the regulatory setup there. And so we’re able
to mark about 500 different CLO equity tranches using this methodology. And one of the things that’s not ideal about it is that I have to wait to put the index together. So for 3-31, so for March 31st, I don’t know yet what the CLO equity return was. I need to wait for everybody to file with the SEC, and that takes 60 days for a lot of folks. But if you look at the index, one thing, the returns really for the last few years have looked very good. So last year, CLO equity did 22%, which I think people were pretty excited about. And then if you look at a three-year annualized rate, it’s about 12. And if you go back five years, it’s like nine. So the more recent performance of CLO equity has been the better.

Tom:

I think it’s interesting you can compare and contrast that
with on the credit flux side, we track fund performance a lot of CLO equity funds. And as you say, last year, I mean I guess all of the returns were above 20%. And that makes sense now because almost anything you bought would’ve
delivered that. But equally, some investors are producing returns much higher than that, more than that 30%. I think some of them were hitting 40%. So clearly there is also a lot of alpha you can add as an equity investor as well.

Shiloh:

So the way I think about it and how we approach things at
Fire Rock is it’s not, your awards are a total return award. And how I think about it is we’re going for the best risk adjusted returns. So a lot of times at Flat Rock, we’re looking at CLO equity pieces or double Bs where we think the outcome will be very favorable and the return opportunities are quite high. But there’s also just an amount of risk that goes along with the securities that’s just kind of above and beyond what our investors would want to sign up for. Internall, we would look at some of these deals and say, oh, that’s something I would do in my PA if I could. But it’s not something we’re doing with shareholder money. And so what we try to do in equity is to provide a low double digit net return to investors with a high focus on reducing the downside risk. I’m guessing that for people who hit a 30% return for last year, they probably, the trade to get there would’ve been to buy single Bs at a discount or equity that was potentially a risk of missing payments. And both of those would’ve worked out to your point. But investors in those funds are signing up for a level of potential volatility that mine are not.

Tom:

So turning to your investor hat away from the education hat,
what’d you like at the moments out there? What are you buying?

Shiloh:

We have really, since the inception of Fire Rock CLO, middle
market equity is kind of the core of what we’ve been focused on at the beginning of the year. We saw some pretty interesting opportunities there, and in the last two months we’ve seen some middle market issuance, but there really
hasn’t been a ton of new loan creation in the middle market. And so that’s been a hindrance to CLO issuance. And then we’d also seen recently that sometimes the manager takes all the equity themselves and they even take the double B
sometimes, which is another security that we would want if they would sell it. And so a lot of the recent issues or issuances have been middle market CLO where the securities offered are triple A to single A or triple B. That’s not where I’m playing. The two things that really we’ve liked about middle market equity and continue to like are the natural arbitrage in the deals, it’s more favorable.

There’s more profit in the CLO, you get higher cash
distributions each quarter one. And then through this conference today, a lot of what panelists have been talking about are a liability management exercises and low loan recoveries. Well, these are not really an issue in the middle
market. So in the middle market, it’s private market. There’s no distressed hedge funds buying the loan. And the secondary, if the loan does get into issues, usually it’s just one to three lenders who need to figure out a way to
move forward. And so in the middle market, I would expect recoveries to be around the 70% area. That is what we put into all of our modeling projections. And then broadly syndicated, the consensus is for lower recoveries. Certainly
those are the two benefits for CLO equity. We’ve, I think, benefited from that historically. And the trend should continue as well.

Tom:

And obviously, I guess from your side, its liability spreads
do keep coming in is actually good from an equity investor perspective.

Shiloh:

On the last panel, I learned that the spread between the
broadly syndicated AAA and the middle market AAA, I’ve always thought about it as about 50 bps over 10 to 12 years. That’s kind of what it’s been, but now it is certainly moving tighter. And I am all for tighter middle market aaas. I
also invest in middle market double Bs where I don’t need those to trade any tighter. And then for the equity, anything that trades tighter creates more profitability for the CLO and better equity distributions.

Tom:

Yeah. And then I thought the other interesting part of that
panel was a talk about improvements in liquidity in the secondary, and we were talking about this, the guys there were very positive about some of the work which has been done on transparency in middle market CLOs. I’m not sure we necessarily agree that it was quite there yet.

Shiloh:

When we look at a middle market equity or double B piece, for example, the middle manager sends us a list of the 200 or so loans that are going to go into the CLO, and they’ll give us some metrics around the loan, what’s the leverage, the interest coverage, the loan to value. And usually we
find seven or eight loans where they’re of particular interest or they stand out for one reason or another. And so we get the CLO manager on the phone and we talk through those credits. And usually there’s a very satisfactory answer
for why these kind of few loans stood out, if you will. And then after that, I think middle market reporting is a little bit mixed. So if you pull up the deals in Intex, sometimes you’ll see a mark for all the loans that’s relatively recent. For other CLO managers, you might see only loans that are rated triple
CA mark.

If the loan’s defaulted, there has to be a mark. Also, the
best thing for a CLO manager to produce is a mark for every one of the 200 loans. I realize it may be a quarterly mark, it may be stale, but if the manager reports the information in that way, they’re going to find that their bonds are much more liquid in the secondary market, and that will lead to
better pricing for them in the primary as well. So that’s something that they should care about. I think there’s some challenges for the managers in that if you have a publicly traded BDC, you don’t want to put out loan marks for the
same loan that’s in A BDC in another fund kind of ahead of when the BDC might be reporting. There are some challenges there, I admit, but the more current marks and percentage of loans marked is better for all the investors in the deal.

Tom:

Great. We’re pretty much out of time now, shall I? So in
fact, we are exactly out of time. Thank you so much. Thank you for joining me.

Disclosure AI:

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

AUM refers to assets under management. 

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

The London Interbank offer rate (LIBOR) was a broad measure of the cost of borrowing cash overnight for banks on an unsecured basis, leveraged loans or corporate loans to companies that are not rated investment grade broadly. 

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

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

A collateralized obligation (CLO) is a structured finance
product that is backed by a pool of assets other than leveraged loans. 

Global financial crisis or GFC refers to the banking downturn in 2008 and 2009. 

Risk retention is when the CLO manager acquires securities in its CLO to meet regulatory requirements. 

Junior capital is financing that has a lower priority claim in debt repayment to a secured term 

Loan spread is the percentage difference in current yields of various classes of fixed income securities versus treasury bonds. Or another benchmark bond measure yield is income returned on investments such as the interest received from holding a security. 

The yield is usually expressed as an annual percentage rate based on the investments cost.

Current market value or face value amortization is the process by which the CLO repays its financing after the reinvestment period ends. CLO equity missing
payments happens when there are too many triple C rated loans or defaulted loans in the CLO 

The Flat Rock Global CLO equity index can be found on the Flat Rock Global website.

Liability management exercises or LME are an out of court
restructuring of a company’s debt in which the lenders take a haircut on the principal balance of their loans. 

References to interest rate moves are based on Bloomberg data. The credit quality of fixed income securities and a portfolio is assigned by a nationally recognized statistical rating organization, such as Standard and Poor’s, Moody’s or Fitch as an indication of an issuer’s credit worthiness ratings range from triple A (highest) to D (lowest) bonds rated Triple B or above are considered investment grade credit ratings. Double B and below are lower rated securities, also known as junk bonds. 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 US markets and US 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. 

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applying any of the information offered.

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