Podcast: The CLO Investor, Episode 16

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. We’re closing out what I think was a very good year for CLOs. There was 200 billion of new issue CLOs created, which was an annual record. On top of that, 290 billion of CLO securities were refinanced or extended. In terms of CLO returns, the

Palmer Square Broadly Syndicated BB Index was up 22%, and the Flat Rock CLO equity index was up 11% through the first nine months of 2024. The full year results will be available in about 60 days as that

data comes from public filings not yet available. Today I’m speaking with Chris Gilbert, the head CLO banker at Natixis. His firm is a leading underwriter of broadly syndicated and middle market CLOs.

Natixis was the first bank to issue a reinvesting CLO after the financial crisis. The CLO’s underwriter, or banker, brings a CLO to life by arranging the CLO’s financing and mediating the negotiations between all the investors in a CLO from AAA to equity. After the closing date, the underwriter earns a fee and going forward, it’s the CLO manager, a different party, that works on the CLO’s loan portfolio. Chris generously helped me with the book I published on CLO investing in 2023. If you’re enjoying the podcast, please remember to share, like and follow. And now my conversation with Chris Gilbert. Chris, thanks for coming on the podcast.

Chris :

Shiloh, thanks so much for having me.

Shiloh:

So where are you talking to me from today?

Chris:

I’m in New York City.

Shiloh:

Okay. So why don’t you give our listeners a little summary of your background and how you ended up in the CLO banking business?

Chris:

Absolutely, and if you’ll indulge me, I’ll start at the beginning. I was telling somebody else this the other day, and it’s interesting how it all came together. So I started my career in 1990 and my first job I had was working for a consulting firm and our primary customer was the Resolution Trust Corporation, which a lot of people today don’t even know what that is. And it was a government institution that was temporary. It existed from 1989 to 1996 and it was set up to resolve insolvent savings and loans. There was a savings and loan crisis that happened in the eighties, generally due to a real estate bubble. And our job was to go in and look at these failed savings and loans and try and triage what had happened, what had gone wrong, and there’s litigation around it. And we would support the Resolution Trust Corporation in thinking about what had happened.

And it was a fascinating lens to learn about the role of credit, lending, and financial institutions in America, the way they all came together and what could go wrong. And I think that’s given me an interesting outlook into what has become my career in CLOs. After that, I worked at Goldman Sachs for a number of years. I had roles both in credit and technology investment banking where I saw another rise

and fall where I was there for what people call the dotcom bubble and saw some of my clients go from being, really, the bell of the ball and on the cover of every hot business technology magazine to all but insolvent in a period of two or three years. And of course technology has risen again, and I left there and ended up at what is now Natixis. I’ve been here for 19 years now, going on 20, and I’ve been focused on CLOs for pretty much that whole time. And CLOs are obviously collateralized loan obligations and their financial structures that have been created to allow people to invest in corporate loans and in different risk profiles, and it’s been quite a ride.

Shiloh:

So what’s something interesting you find about the CLO business in comparison to maybe some of the other jobs you’ve had in the past?

Chris:

Sure. Part of it is the community. Some of the other jobs in the past have either been focused on looking backwards or focused on short trade. CLOs, it’s very much a tight community where there are probably a few thousand people that regularly look at CLOs as investments, as creating the structures, as being part of managing them, and investing them. There are probably four CLO conferences in the year that are broadly attended. I’ve seen you at many of them and I know you know many of these people. And year after year you see the same people. We understand the trades, we understand the participants in the community, and it’s really a situation where people have gotten so deep in understanding the risk, the structures, and the trades and how it all fits together.

Shiloh:

So you mentioned CLO conferences. So one of the biggest ones is Opal that takes place in Southern California. That was a few weeks ago. What was the vibe at that conference?

Chris:

It was extremely positive. People were there, they were coming off of a year, and we’ll talk about it later, I think of really record levels of activity. It was curious because some people were talking about they were wishing for a bit of a pause and a break just for their personal lives so they could see their families given the frenetic level of activity and nobody saw it on the horizon. I think investors had cash that they were looking to deploy. I think managers had had some success in refi-ing and resetting their deals, which means that they may have reset the prices that they pay on their liabilities to investors to more attractive levels for them given the buoyant atmosphere in the market. And people are looking forward to positive momentum and good levels going into 2025.

Shiloh:

At Opal, how do you spend the two days? Are you with managers trying to sell CLO securities, or going to panels, or on panels? How do you do it?




Chris:

I did speak on a panel. I loved it. There was a panel on middle market loans that was, I think, well attended and well regarded. So I always enjoy speaking before a group of people about a subject where there’s so many informed people in the room. But most of the time I spend in a small curtained off part of the room with no windows. And as a banker, my role, we’re an intermediary. We’re not a principal to

trades. I don’t manage the loans, I don’t own the paper. I help put the trades together. So we spend time introducing and or updating conversations between CLO managers, the people that invest in the loans, and CLO investors. We’ll broker the conversations. We’ll sit in the room if there’s something that I can contribute, or if I see a bridge in the conversation where I can help add value, I will. But most of the time I’m listening and I’m putting people together. I also have side meetings where I try to arrange new business. I’ll talk to a manager or somebody who may want to sponsor a CLO in the equity to taking the most risky piece to drive the creation of a new transaction. And there I might have a one-on-one with them to see what their future plans are and if I can be helpful to them in connecting them with other parties in the market to create a new trade.

Shiloh:

So one of the things I maybe neglected to ask you early on in our conversation is, so you’re the head of CLO banking at Natixis. I think a lot of people outside of CLOs may not be familiar with Natixis as a bank. So why does Natixis have this outsized presence in CLOs in the US?

Chris:

I think there’s a few reasons. One is history. This business has been in place, I said I’d been there for 19 years, the business has been going for 21 years, so I missed the first two years of it. But we’ve been focused and dedicated to the space for a long time. When the industry was in its infancy, we were an early joiner. I think that momentum has helped us. We went into the Great Financial Crisis with over $9 billion in exposure of lending to people who are involved in the CLO space, and where some other banks pulled out of the market, they may have aggressively collapsed facilities and push people out of positions.

Natixis did not do that. So we emerged from the Great Financial Crisis with, I think, one of maybe two banks with a reputation that was relatively pristine for supporting our clients through the very absolute worst of times. And that credibility carried over and it allowed us to become an important player in 2011 when we did our first post-crisis trade and then 12 and 13 and 14. And it’s continued. We’ve benefited from those relationships, and as we did, we grew experience on the team. We developed expertise and structuring and placement. We built a big sales force around the product, and success begat success. And we’ve continued to today, where it’s been a great business for the bank.




Shiloh:

Do you think that one of your competitive advantages versus peers then is just the warehouse facility that you’re willing to put in place? Is it that the terms that you offer there are considered to be pretty friendly to investors like myself?




Chris:

Yes, but. And so much in our market, there’s a lot of nuance there. The terms we offer on their face are probably pretty comparable to a lot of our competitors. I think the thing that distinguishes ourselves is the reliability in how we interpret the terms. So within these warehouses, within these facilities, when there’s a market disruption, call it Great Financial Crisis, call it COVID, call it the Energy Crisis of 2015.

Sometimes the banks that are providing the warehouse facility, the lender, may take a somewhat aggressive stance with their borrowers, and their risk departments may clamp down, and suddenly the credit you thought you had may not be there. I think the experience that Natixis has had through so many cycles in so many years, we’ve gained great confidence in this product and these structures to the very highest levels of our management. Natixis is a French bank.




Our headquarters is in Paris. I don’t know that the Parisians are an expert in the United States financial markets, but they are an expert in how CLOs have played out through cycles. So for example, when COVID happened, the market shut down for a period of months. Natixis was the first arranger to arrange a reinvesting CLO, and we priced it in April of 2020 when other people were pulling away from the




market, we were leaning into the market. It’s one of our core areas, it’s an area we focus on. It’s one of the pillars of our business.




Shiloh:

Is Natixis a bank that takes the AAAs and AAs of the CLOs that you’re selling? Do they have a big appetite there?




Chris:

Again, it depends. So that’s probably my answer to all the questions. But there are banks that have a demand for AAAs in their Treasury unit. They use it as a cash substitute. They might be deposit takers in the U.S. and they like the floating rate product with virtually no credit risk implied by the AAA rating.

Natixis is not a deposit taker in the United States. We’re not a deposit taker in France. Our parent, BPCE

Group, is one of the biggest deposit takers in France, but we don’t use AAA CLOs as a Treasury function. My business does has a limit to take AAAs of CLOs as part of our business to support our transactions and advance deals, but we don’t have the natural Treasury demand for that. We do see that, in a lot of US banks, a lot of Japanese banks, increasingly Japanese banks have immense demand for this product as a cash substitute. We use it differently, more as a component of my business.




Shiloh:

So a lot of the business that we’ve done together has been in middle market CLOs, which is, as you know, a niche in the larger total US CLO market. It’s a little bit over 10% of the market and it’s growing pretty rapidly. What do you see as the key drivers of the growth in middle market CLOs?




Chris:

I think it’s a few things, but I think the primary thing is the growth of middle market. So one of my little sayings I like to say is “capital follows capital”. And there’s been immense growth in the deployment of capital to private credit lenders, middle market lenders in the United States. It’s businesses that they’ve been around since the late nineties. But in the past five to eight years, the rate of growth has been astronomical. It’s been spurred by I think, one, the success of the asset class in delivering returns to limited partners. People like state pension funds, like sovereign wealth funds, like endowments, they’re investing in middle market credit, private credit as an asset class. So as those investments grow, the people in those businesses that are making middle market loans to middle market companies, they’ve got more money that they’re investing. As they do, they need to borrow more to support their businesses.

They tend to operate their businesses at what we call a two times leverage position. Meaning that if they invest in $300 million of loans, they take a hundred million dollars from their investors that those pensions and endowments and sovereign wealth funds I mentioned, and they take 200 million in borrowings. That could be from me as a bank or my competitors as banks, or, as the deal progresses, as their platform grows more and more, the CLO market, they’ll borrow money from there. And that will be what spurs their growth. So as they’ve grown, we grow in lockstep.




Shiloh:

So for next year, as you guys start to consider which mandates that you want to work on, how do you guys screen out which middle market managers or broadly syndicated managers are going to be ones that you want to work with and that you’re going to want to bring to market?




Chris:

Absolutely. This is a thing we spend a lot of time thinking about. I tell people I get two to three calls a week from a manager that says, “Hey, I want to do a middle market CLO with you”. And of course we




love that, we love to hear that, but then we need to spend some time understanding their business, and some people just aren’t ready. So we need to understand, one, is the debt market ready for them? Do they understand this manager, this platform? Two, does this manager have the operational capabilities to handle a CLO? There are plenty of really smart lenders out there that I think are really good at middle market lending, but there’s a level of complexity to middle market CLOs. There’s detailed interaction with the rating agencies to help the rating agencies understand the portfolio and the loans they have. There are detailed interactions with the trustees to provide extremely rigorous monthly reporting on each and every one of the collateral loans across 20 plus dimensions like industries, spread, maturity, callability, all sorts of features that the CLO measures, and constraints to make sure that the credit risk is properly protected, and they need to be able to deliver a diverse portfolio.




We like to say that you should have 45 or more loans in the portfolio, and ideally 60 plus. And as that goes, some platforms just don’t have that. They might have a great track record of doing 20 loans per fund. That could be a good credit strategy. It’s not a good CLO strategy. So we try and look across these dimensions and find the people that check all the boxes. And we also like to liaise with people like you, to understand what are your views on the manager, and their strategy, and how would you look at the investments in that stack? Because if the smart investors are ready to show up, then that’s a good connection. If you’re wary of a platform, then we need to know that.




Shiloh:

Are you seeing a lot of middle market CLOs with only 60 loans in them? It seems to me like maybe 150 is maybe more like the average number there. Are you seeing numbers less than that or…?




Chris:

We do see numbers less than that, and I don’t know want to say a lot, but there are a few factors that drive the number of loans in a middle market CLO. One is how new the platform is. Newer platforms, they’ll be a little bit more concentrated, or maybe a lot more concentrated. Two is strategy. Some managers like to spread their investments out across a lot of obligor’s borrowers to avoid risk of a concentrated loss. Others may like what they call a “conviction investment strategy” where they want to be really sure on a smaller number of investments instead of spreading it across a wide number. And another factor that can dictate the number of loans in a CLO, which is a little more complicated for an investor to see, you may see it, but other investors may not get to this level, is the type of capital that supports it.




And by that I mean we talked earlier about pensions, endowments, sovereign wealth funds supporting a CLO, being the equity or risk money behind it. Some platforms have set themselves up to allow all their loans to be spread across all of their vehicles, all of their CLOs, all of their investors. And there you’ll see, generally, a larger number of loans. Some platforms are more set up to put loans in as they’re originated. So there’s what we call a vintage effect, where a CLO will be more concentrated in loans that are originated in a certain period of time. Perhaps if the CLO ramped in 2023, there’ll be a lot of 2023-era originated loans and they won’t have the ability to trade across their vehicles to spread them out and increase the number of loans. So short answer, not a lot with that low number, but not zero.




Shiloh:

So one of the things that has been interesting this year is that the financing rate, let’s just talk about AAA because it’s easier, but middle market CLOs, the AAA is more expensive. And, not only is it more expensive, but it’s shorter. It’s a four year reinvestment period instead of a five year reinvestment period for broadly syndicated. So that favors the AAA buyer. And then the two big other structural features are, you get more junior capital supporting you if you’re a middle market AAA. And the final one is after the




reinvestment period ends, really middle market CLOs are really done investing, but for broadly syndicated, there’s some flexibility to keep the party going, at least for a while. So the middle market CLO AAA is more expensive and we’re talking about the basis between that and broadly syndicated at different times over the last, call it five years or so, I would think of the basis normalized as somewhere between 50 and 70 basis points. Does that jive with your experience?




Chris:

Yes, historically that has been the level. We’ve seen a recent reduction of that.




Shiloh:

So what do you see today’s level as, 30 bps? Or




Chris:

25 to 30. Indeed, it’s much tighter.




Shiloh:

So that is, I think, one of the things that’s really been beneficial to middle market CLOs this year because our financing cost is down compared to where it was historically. And although the middle market AAA is more expensive, the 25 or 30 bps you’re talking about, well, the loans in the middle market have probably 125 bps or more of incremental spread. So for the equity, that ends up being a pretty compelling story. So what do you think has driven this favorable change in the basis over the year?




Chris:

I think there are a few things. One is liquidity. I think that people have historically said that middle market loans trade at a premium because they’re less liquid than BSL loans and the AAAs, and by that I mean they don’t trade as often. So if it’s difficult to trade your loans, people will charge a higher liquidity premium, and hence a higher financing cost. That liquidity premium I think has, and should have, reduced. If you look back three to five and more years, middle market CLOs represented eight to 10% of the market generally year on year end. BSL CLOs represented 90 to 92% of the market. In 2023, middle market CLOs jumped up immensely. They represented 23% of the market. That percent came down a little bit in 2024 to 14%. But if you look at new issue CLOs, so the creation of new CLOs, middle market were 19% of the market.




So almost a fifth of the market. BSL CLOs did have a lift because some of the old deals were repricing themselves in the current environment. So as middle market CLOs grow to become a larger percent of the market, that liquidity premium should go down. There’s more bonds, they should trade more often, if it’s a natural function of their growth. I think a second reason, I’ll come up with three, is as the market’s grown, more investors have onboarded the asset class. People have to pay attention to it, and people have had a hard time getting the bonds they want, what we call allocations, the ability to buy BSL CLOs, and some of them have added middle market to their stable to fill their investment quotas. And the third is simple, a little bit, what I call math. People say, gee, 50 to 75 is the level, but instead of talking about basis points, we should talk about percent of credit spread. So credit spreads have tightened. Last year we would pay around 2.3%, 230 basis points over the risk free rate. The SOFR rate for AAAs. Nowadays it’s probably 150 basis points. So it’s significantly in. So instead of measuring that 50 to 75 in an absolute number, the 50 to 75 is a percent of 2.3% versus 25 to 30 is a percent of 1.5%. That accounts for some of the difference. It’s a portion of the credit spread, not an absolute number, if that makes sense.




Shiloh:

So do you think that that basis can continue to tighten or do you think people think 25 or 30 bps is fair?




Chris:

So first of all, I’m terrible at projecting things, but I’ll tell you my projection here. For a long time when it was 75 basis points, the people investing in it said it was fair, but it tightened to 50 and they were sad because they thought 75 should be the number and then it tightened to 40. And they were sad because they said 50 should be the number. So it keeps tightening and I don’t see why it shouldn’t continue to. The market always surprises me, but there’s no fundamental reason the liquidity is increasing. I think people are understanding the value proposition. Investors have onboarded the asset class and they’ve onboarded the managers, and, as you said, the fundamentals, the mechanics, the shorter life, the absence of reinvestment, post reinvestment period, those speak to tighter spreads in a theoretical sense. And I sometimes get stuck in theoretical. There’s no absolute barrier why it shouldn’t flip the other way. Maybe they’ll someday trade at a discount to BSL. I don’t know.




Shiloh:

Okay. So that was the difference between broadly syndicated and middle market in terms of pricing. But the other difference is that we’ve been talking about, so one is just what’s the loan to value through the AAA? And I think the middle market, it’s around 55%, for broadly syndicated, I think it’s roughly 65%. Is there any chance that the middle market leverage moves closer to broadly syndicated over time? Or are we working with rating agency constraints there, or how do you see that? And maybe the same question, too, for the reinvestment period, could we get an extra year out of the deal in the middle market?




Chris:

I’ll answer the reinvestment period first because that’s the easy one. We absolutely can go to five years and I’d say 20 to 25% of the market this year has gone to five years. So there’s no barrier. It’s not a rating agency constraint, it’s a market convention. It may continue to gravitate toward five years. There’s no real barrier.

Shiloh:

Unfortunately, I’ve seen those only in the trades where the manager takes the equity and the double B unfortunately. So I think those are deals where, yeah, third parties weren’t involved.

Chris:

I think that’s right. But as market convention grows, as the increasing comfort comes toward that, hopefully we’ll show you some, and then you’ll get some longer trades we’ll see. And on the advance rate, or the credit support, so there are two drivers there. One is market convention. I think when we look at the rating agency models, when we model out a middle market CLO, and we model out a broadly syndicated CLO often, but not always, there’s a lot more cushion in middle market CLOs than there are on broadly syndicated CLOs for rating stresses. By which I mean, all things equal, you could have a higher advance rate, you could have a more aggressive structure, and still get the same ratings under the rating agency criteria, for many, but not all, middle market CLOs. Broadly syndicated, we don’t usually see as much cushion, although occasionally there are some.

However, investors historically have demanded those lower advanced rates that higher credit support. So market convention is often driving the structure rather than finding the edge of where a ratings will come out. So there’s room for it to move. If that did leave, I think middle market CLOs would still have a lower advance rate. Broadly syndicated., they tend to have slightly higher ratings. We could talk about why that is on the collateral pool. And they tend to have more diverse names because of some reasons we’ve talked about. So broadly syndicated deals would probably always have a little higher advance rate, but I don’t know how much higher it would go. And I think market convention will probably keep it around where it is today.

Shiloh:

So for an investor like me, as you know, I can buy in the primary market when CLOs are being created, and I can also buy them in the secondary market if we think that’s where the better risk adjusted returns are. And my understanding of your business is that sometimes selling equity in the primary, the arbitrage, which is the natural profitability of the deals, is really strong, and you get a lot of buyers to show up for the primary. And then what’s not strong, I think you guys know it’s not strong, and you understand when people are hunting around in the secondary instead, how would you characterize the current market? Is it a primary buyer market or are there better deals in the secondary realizing secondary might not be your primary focus?

Chris:

Sure. Right now we’re seeing a more robust primary market across the board than we have in a while. It feels like the active buyers of primary equity are increasingly active. It’s tough to find loans at good prices. We see just as the CLO market has been buoyed, the collateral market has been buoyed, but we are seeing natural formation of CLOs with third party equity right now. I don’t want to say it’s been the best time I’ve seen in my career, but it’s active and solid and open.

Shiloh:

It was kind of the best arbitrage you’ve seen in 2021 when LIBOR floors on the loans was still in the money and we could get pretty good debt prints or when was the easiest time to sell CLOs or is it always a little challenging?

Chris:

It’s never easy. I have to tell my bosses how hard it is so they pay me. If it ever gets easy, what am I doing here? It’s tough for me to pick the right spot. And honestly, it would never be a year. It’s going to be a month because what you want, the ideal time and the best CLO we ever did was probably one where you price the CLO. So the creation of a new CLO, there are three key periods that people might think about. One is the marketing period, where we’ll go out to investors and we’ll usually start with a AAA investor because it’s the biggest class and the most bonds to sell it. We’ll agree on a price level, a financing rate, and once that’s set, we’ll go out to the rest of the capital stack, the mezzanine, if there is equity to be sold, they probably need to be in place first because the one generating the impetus for the trade.

And then we’ll probably spend five days or so talking to the mezzanine investors, the double A’s, the single a’s the triple Bs. And if we sell them the double B’s, we’ll agree on a price very quickly. And then we’ll have a date, which will be a very specific day, when we price the CLO. At that point, we will write trade tickets to all the new investors. We know where all the bonds are going, and we’ll agree on a closing date, which will probably be about five weeks out. So on that pricing date, the CLO may not own its whole portfolio. In some few cases it might not own any loans. At most it’ll own 60, 70% of the loans it’ll buy. So the best deal will be when you price the CLO, and then the market tanks the next day, and it goes down, and you can buy those loans cheap, and the CLO will take all the money it got from the bonds and it’ll buy a lot more loans because it can buy them more cheaply. So it’s not a year, it’s a day, it’s a week, it’s a month, where you have that mechanic and that’ll be the best vintage and you can’t see it coming.

There’s an element of luck there, and the equity buyer who bought it will be really happy. And in some sense, a lot of equity investors will, it’s almost like dollar cost averaging, where you go in and you buy multiple deals across multiple timeframes and one of those will be your bonanza where the market does exactly that.

Shiloh:

So refi and reset activity has obviously been very elevated recently, and one of the reasons to own CLO equity today is that as the CLO begins its life with a non-call period where the AAA to double B rates are what they are. And you can’t really tinker with the CLO if you’re the equity investor, but once the non-call period rolls off, you can refinance tranches or portions of the CLO at lower rates, you can extend the life of the CLO. I’ve been saying that instead of reset because it makes a lot more sense to people.

Chris: That’s what it is.

Shiloh: So I think for an investor in CLO equity, I would look at a portfolio and say, okay, when’s the non-call period coming off on the CLO? And is the CLO’s financing in the money to do something? So that really just means, for example, is the AAA more expensive today than it would be if the non-call period rolled off today?

So it’s like a hypothetical calc, and from what I’ve seen, there can be material upside from refis and resets because, I think how people view the market, and this is funny, but the fair market value of CLO equity doesn’t trade or really isn’t valued with a lot of optionality or expectation that this favorable thing’s going to happen. You do it and then you get credit for it, and until you do it, then nobody cares, which is funny. So at any rate, refis and resets, very valuable to CLO equity, and there’ve been a lot of ’em this year.

Could you just maybe walk through, for our listeners, the process of a reset? We know when the non-call periods coming up, it’s a bank like yours that puts together the extension or refinancing. What are the nuts and bolts of doing this?

Chris:

Absolutely, and you’re absolutely right. One of the amazing things about CLO equity is the value of the optionality in that you have the control, you have the control of the timing to do it, not to do it. It’s interesting, when I started my career, the first 10, 12 years of it, there was no such thing as a reset and they’ve become common in the market over the past eight or so years, and they bring incredible value to the equity, and I think it was enterprising equity investors that figured this out and it’s now become a feature of the market. So the process, which you asked about: So it’ll be the equity, someone just like yourself who has control, majority of the equity, typically, that will make a direction. They’ll come out and they’ll say, okay, we are going to call this debt. We’re going to take the old debt, we’re going to get rid of it, and we’re going to issue new debt.

They’ll come to a bank like myself to say, okay, Chris, Natixis, we’d like to remarket our debt. I have the Shiloh Bates CLO 2017. Obviously there are no CLOs named after you. It’s hypothetical. But this CLO, we look at the debt prices and it’s way too high. I look at the current market, I can do better. I would like you to go out to investors, I’d like you to replace it. So the first step is, we have to file something called a cleansing notice. That is something that gets rid of concerns about securities laws where we might be talking to people about inside information. That cleansing notice tells the market, “Hey, I’m thinking about doing something with this deal. I might call it, I might refi it, I might reset it, I might collapse it. I don’t know what I’ll do, but it’s in play”.

So that lets us start to talk to investors. At that point, we’ll make a plan with the equity, we’ll look at the portfolio, we’ll look at where we see the market. We’ll make a recommendation. Should we do a refi, which doesn’t extend the deal? It doesn’t change fundamental terms of the deal. Or do we want to do a reset, where we open up the whole deal? We may extend it, we may change the advance rate, we may change specific terms, but it can be a fundamental change. At that point. Once we’ve made the decision, we’ll typically start with a AAA investor. We’ll go out to find, initially, the existing holders of the debt. We’ll ask them, do you want to roll your position? We see you have a hundred million dollars investment in this deal, $20 million investment in this deal. We’re looking at a reset. We’re going to extend it by two years, three years, whatever it is.

You get the first look. Here’s the price we think is appropriate. If they decline, we’ll go out to new investors. If they accept, they get the paper, so long as they’re willing to transact at the terms of the equity and the arranger myself agree to. After that, we proceed down the capital stack to the mezzanine debt.

We agree to prices, first talking to the rolling debt, the existing investors, then going to new ones. Once the prices are agreed, just like we talked about before, we’ll have a pricing date. We’ll agree to a closing date. There it might be shorter than the five weeks we spoke about earlier. Maybe it’s three weeks out. And then once that closing date happens, the old bonds will be extinguished and new bonds will be issued to the new investors.

Shiloh:

And then presumably the CLO has another two year non-call period. So that’s two years where the debt investors will be protected and earn their spread.

Chris:

That’s right.

Shiloh: Okay. So is this a lot of work?

Chris: It is a lot of work. It’s an immense amount of work, especially for my team. My team, we coordinate the new structuring conversations with the radiant agencies, conversations with the law firms that write all the documents, conversations with the trustees that hold the collateral for the loan and handle the monthly reporting, conversations with the collateral manager who do the investings, conversations with the equity. We’re at the center of a web of investors, service providers, attorneys that run this process. I like to joke and say that resets are the worst of all worlds for banks because the work is probably often more than a new issue transaction and the fees are less. So it makes me sad, but I think it’s virtuous for the market because it keeps the equity engaged and involved, and if it makes their investment prospects better, it can build the market for all of us.

Shiloh:

So let me ask you this. Let’s say I own a CLO and the non-call period is coming up, and the AAA rate on the existing CLO is 10 bps wider than current market. To do a refinancing, should I think of that as when the non-call period rolls off, is it something where a bunch of things need to come together and hopefully a refi will happen? Or is it that the non-call period’s up, market spreads are tighter, and we’re doing something?

Chris:
One is on the economic side, one question is on the economic side, we will do something called a payback analysis where you cited 10 bps and that’s a nice savings, but there are costs to do in refi. It’s not costless. You’re going to pay the rating agencies a fee. You’re going to pay the lawyers a bunch of fees because they got to draft a lot of documents, and you’re going to pay me a fee. So there’s a fixed cost to doing this. We’ll spend some time looking at what the interest savings will be, and we’ll see how it compares to the fixed costs. And a rule of thumb we use, and listen, there’s exceptions to every rule, but a rule of thumb we use is if that payback is longer than six months, maybe you think about it, maybe you wait, maybe you go, if it’s inside of six months, it seems a lot more attractive and you probably do go and execute. So that’s a big factor in doing this. If you have a portfolio that has had difficult performance, that could influence your decision as well. The market spreads might be 10 basis points tighter, but if you have a deal that has performed worse than the market, then that 10 basis points may not fully accrue to you. So there’ll be an analysis of the portfolio and the performance of the transaction itself.

Shiloh:

But even if a CLO has underperformed, there’s still an analysis to do. My point is, the refi and reset opportunity, it’s not for the honor roll of CLOs, it’s for almost all CLOs that have performed reasonably well. That’s how I think about it.

Chris:

I think that’s right, absolutely. And you talked about a 10 basis point differential, which is not a lot. So that one might be cuspy. You might want to look at the best performing ones today. The different deals coming off their on-call might be a full point inside of where they were done, and if it’s that much difference, performance is almost irrelevant. So you have to look at the degree of tightening in the market and the improvement of the financing costs versus the portfolio. But today, I think any deal, regardless of performance, should be a candidate.

Shiloh:

Okay, because I saw during the COVID period, I was very familiar with two deals where they missed payments, so there were excess defaults in the portfolio. There were excess triple Cs. So instead of paying the equity, the cashflow was used to either delever the CLO or buy more loans, buy more loans, actually delevers the CLO as well. And one of the things that surprised me was that for those underperformers in 2021, we were able to come back and do refinancing. So again, it doesn’t need to be the best performing CLO for us to start having these conversations.

Chris:

That’s exactly right, and we’ve done some of those. Those might be a better refinancing candidate than a reset candidate. People may not want to put money in for longer, and you might just refinance the AAA and AA bonds, which are the biggest part of the cap stack, that the BBs might be a harder conversation in those situations.

Shiloh:

Yeah, so the concept there is if you’re extending the life of the CLO, it needs to have a certain amount of equity in it. And if you’ve had a lot of loan defaults, either you’re going to have to cough up more equity, or maybe you could issue an X note or something. Maybe there’s another partial solution by issuing additional debt in the deal. But the CLO market has been doing really well. The CLO issuance has been strong. CLO returns have been good for this year. Do you see anything on the horizon that could change the direction the market’s going or what key risk would you focus on?

Chris:

That was a lot of the conversation of the Opal Conference. We spoke about where do people see a catalyst for a change, and honestly, I’m not a great forecaster, but I don’t see an obvious catalyst for change within the CLO market. Investors seem robust. People have told us they have cash to deploy and are looking to buy new deals. Our managers are telling us that the credit in their portfolios is reasonably good. So barring some sort of exogenous macro event, I don’t know what changes it. And I half whimsically say I don’t even know what that would be. It’s not just CLOs. We’ve seen almost all assets rally. We’ve seen equities rally, we’ve seen Bitcoin rally, we’ve seen investment grade and high yield rally. We’ve seen the government in France falling. We see martial law in South Korea. We see turbulence, multiple wars, and the market just goes up.

So I don’t know what changes it for CLOs and I don’t know what changes it for the market broadly. It seems a source of strength and I think CLOs, if there were to be a change, I still like CLOs, we are secured by first lien corporate loans, which are the first out if there are signs of corporate trouble, and if you’re buying AAAs, you’re the first out on the first out, top of the heap of everything and the equity, you’re subordinated to CLO debt, but you are secured by first lien loans in corporate America, diversified pool. So it seems like the type of structure that’s weathered other storms and makes intuitive sense. I don’t see a catalyst for change, but I’m always surprised by things in the world.

Shiloh:

The other thing I wanted to just hit is with the Trump administration coming in January, it seems to me like what’s going to be the effect? So I think probably more deficit spending, maybe tariffs, the result of which it’s going to be higher for longer on rates. People ask me, well, what about for the underlying loans? I don’t think really, the loans in CLOs start their lives with a 50% loan value, so the marginal tinkerings of politicians in Washington really shouldn’t affect our business too much. That’s my take. Is that how you see it or…?

Chris:

More or less? Yes. My expertise isn’t macro, but I think that’s right. I think we have two advantages. One is CLOs are floating rate products secured by floating rate underliers, so we shouldn’t be overly exposed interest rate risk as such. I know that people do worry about interest coverage from an elevated basis. So rates are SOFR since we are a floating rate product. But as you say, our loans are made at a relatively conservative advance rate, and as the expectation of higher rates comes into the market, we are seeing purchases of companies happen at lower multiples, which means that the financing happens at a consistent advance rate or loan-to-value ratio, then it’s less leverage on the companies in a better interest coverage position on new loans that are made in an environment with higher rate expectations. So I’m hopeful we’re in a good spot and it seems like there’s a lot of reasons why our market aligns itself to adjust to economic changes.

Shiloh:

Great. Well, Chris, thanks so much for coming on the podcast. I really enjoyed our conversation.

Chris:

Shiloh, thank you so much for having me. I was really thrilled to be here, and I appreciate the opportunity. 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




AUM refers to assets under management.




LMT or liability management transactions are an out of court modification of a company’s debt. Layering refers to placing additional debt with a priority above the first lien term loan.

The 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 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 on 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 D, depending on the agency issuing the rating, is the lowest or junk quality.




Leveraged loans are corporate loans to companies that are not rated investment grade.




Broadly syndicated loans, BSL, 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.




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.




EBITDA is earnings before interest, taxes, depreciation, and amortization. An add back would attempt to adjust EBITDA for non-recurring items.




ETFs are exchange traded funds.




LIBOR, the London Interbank Offer Rate was replaced by SOFR on June 30th, 2024. Deliver means reducing the amount of debt financing.

High yield bonds are corporate borrowings rated below investment grade that are usually fixed rate An unsecured default refers to missing a contractual interest or principle payment.

Debt has contractual interest principle 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 pledge to a lender to support its repayment.




A mon-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 an underlying floating rate index. General Disclaimer Section

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 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. 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 advisor, or give advice in a fiduciary capacity. Additional information about this podcast, along with an edited transcript may be obtained by visiting FlatRockGlobal.com.