Understanding CLO Performance Through Market Cycles

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 Mike Hatley, Senior Advisor at Rothschild & Co.  Mike is a pioneer in the CLO market, with three decades of experience.  Mike and I were colleagues at ING Capital in the early 2000s.  In this podcast we discuss a brief history of CLOs, and various downturns in the loan market.   

I’m always looking for interesting guests to have on the podcast.  Email us at info@flatrockglobal.com if you’d like to come on. 

If you’re enjoying the podcast, please remember to share, like and follow. And now my conversation with Mike Hatley. Mike, thanks for coming on the podcast.

Mike Hatley:

My pleasure, Shiloh. Thanks.

Shiloh Bates:

Why don’t we start off by talking about where you are before we get into the history of CLOs?

Mike Hatley:

I am at Rothschild & Co. in a group called Five Arrows. That’s the alternative assets arms at Rothschild & Co. Five arrows has more than 29 billion euros of AUM and has offices in London, Paris, New York, Los Angeles, San Fransico, and Luxembourg; I am based in the Los Angeles office. Five Arrows does corporate private equity both on the primary and secondary fund investing side. It does co-investments and it does senior and junior credit. On the credit side, we are a CLO issuer and have roughly $3.6 billion dollars of AUM at this point.

Shiloh Bates:

Okay. So how many CLOs is that?

Mike Hatley:

We currently have 9 CLOs that are reinvesting and are about to open a warehouse for a 10^th CLO.

Shiloh Bates:

So, you’re a broadly syndicated CLO manager. I think there’s maybe 130 plus different CLO managers out there. What are some of the ways that you see yourself as differentiated in the market?

Mike Hatley:

I think we have probably one of the more experienced investment teams in the market. I’ve been involved in the CLO market since 1997, so I’ve seen a lot of iterations of CLOs and a lot of changes over those years. We’ve got very, very low staff turnover. Well, the last analyst that left us retired a few years ago, but before that, I think the last analyst that left us was in 2017, maybe 2018, somewhere along that line. So, people tend to stick around, so that’s helpful. It’s helpful being part of a global platform like Rothschild & Co. We have our team that’s on the ground in LA. There’s also a team on the ground in London that does Euro denominated CLOs, and we talk to those guys on a daily basis and I think just the fact that we have a long-term, 20 plus year track record of out-performance against the various loan indices.

Shiloh Bates:

So, I guess good returns is ultimately the best differentiator out there.

Mike Hatley:

I think so, it definitely helps.

Shiloh Bates:

So why don’t we start with the beginnings of your career. Did you start off working for a bank before you transitioned to the loan market?

Mike Hatley:

I did. I worked for a commercial bank. When I got out of grad school, I worked for a bank that was originally called United California Bank that renamed itself First Interstate Bank, and I worked there for about nine years and did the traditional, back at that time, about a one year training program. Where we went through credit training. We worked in a branch for three or four months, so I got to open new accounts, I got to be a teller, I got to load the ATMs with cash and process the deposits out of there. It was interesting. It was interesting learning that stuff. So, did that, and then I worked in the national lending division there for a number of years. I actually went back and ran the credit training program there for a couple of years. At the end of my career there I was working in the correspondent banking group, so my clients were other independent banks in California.

Shiloh Bates:

So, then when did you move to the CLO market?

Mike Hatley:

Well, before moving to the CLO market, I moved to the retail loan fund market. So, the first retail loan fund was called Pilgrim Prime Rate Trust, and that fund started in 1988, and I joined that fund in 1989. I left the bank to become a credit analyst for Pilgrim Primary Trust. So, we were there from ’89 until 1995 and the mutual fund company got sold, and they moved the company to Phoenix, and none of us that were working in the group wanted to move to Phoenix.

Shiloh Bates:

It was ING that acquired the Pilgrim Primary Trust?

Mike Hatley:

Yes, eventually, but not initially. So, the firm that acquired Pilgrim back in ’95 was a company called Express America. They were formerly a mortgage banking operation and they had sold their servicing portfolio and had a bunch of cash on the balance sheet and needed a business to invest in and they bought the Pilgrim group. So in ’95, my boss and a gentleman that you’re familiar with, Mike McAdams, knew some folks. None of us wanted to live in Phoenix and he knew some folks that worked at Citi, and talked to them about lifting all of us out of Pilgrim to join Citi. That eventually didn’t work out, but those guys knew some folks at ING, and ING did hire the entire group of us, including the guys from Citi, and we formed ING Capital Advisors back in ’95, and we did our first CLO in 1997.

Shiloh Bates:

So in 1997, was that the first CLO issued or were there a handful of other competitors back then?

Mike Hatley:

There were other CLOs that had been issued at that time. I think there were actually some that were issued earlier in the nineties, but not very many. But we were definitely one of the first CLOs back in ’97, certainly not the first. I think Hyland Capital was around at that time. They did some CLOs. I’m trying to think who else was around back then doing CLOs, I don’t remember, but Hyland, I definitely remember.

Shiloh Bates:

Would Anthony Clemente have been in the market back then or at Invesco?

Mike Hatley:

He was in the market at that point. I’m trying to think exactly. I know Anthony, he and I were credit analysts together for the retail mutual funds, Merrill Lynch had a retail fund, and Anthony worked there when I was at Pilgrim.

Shiloh Bates:

So, he’s at Caneres now.

Mike Hatley:

Yeah, definitely known him for a long time now at this point.

Shiloh Bates:

So, you start issuing CLOs, and maybe you could just contrast a little bit. I mean, what was the CLO structure like back in the 90s, and were the investors similar people to what you’d find in the CLO market today? Or was it a different cast of characters?

Mike Hatley:

I think one of the differences is that the CLOs were bigger back at that time. The first one that we did was $800 million. The second one we did was $700 million in the third one we did was $ 1 billion. And so they were very, very large size. They had much, much larger bond baskets back in those days. We had a basket of we could do 15% high-yield bonds in that basket, and I think part of it was somewhat necessary for diversification because if you think about it, back in ’97, I think that the total size of the leveraged loan market was maybe 240 different issuers. So, if you needed to get diversification, there were a lot of high yield bond issuers that weren’t loan issuers, so that was helpful. Other things we could invest in, we could invest in structured finance securities back then so we could invest in other CLO debt tranches.

Shiloh Bates:

And people did do that. They took advantage and bought a lot of other people’s BBs and BBBs.

Mike Hatley:

Yeah, exactly. Interestingly too, the liability side was different back then. In a lot of cases the AAA tranche was structured as a revolver, which was pretty nice flexibility because if you had issues with the structure and you were potentially going to violate tests, you could just pay down the revolver and get back into compliance, but then you could reborrow it if need be. Other differences, in the early days, the liability side only went down to BBBs. There weren’t any BB tranches or B tranches. And I think largely lack of demand, the buyers of the BBBs were in a lot of cases insurance companies, and they needed investment grade ratings at that time, and they really didn’t have a place for a BB. Other differences, back in the good old days, the reinvestment period was seven years. Interestingly, the first one that we did had a provision that the equity investors could decide after five years if they wanted to, they could end the reinvestment period.

I’m not exactly sure why they’d want to, but that flexibility was in the structure. The other difference is the management fee. There was no senior and subordinated management fees. It was all subordinated. So, if the equity wasn’t getting paid, we weren’t getting paid. Although interestingly, I’m not exactly sure why the concept was written in to most of those early deals, but there was a replacement manager concept that was written into the deals, and if there was a replacement manager, then they would get a senior fee of 25 basis points, only if it was a replacement manager.

Shiloh Bates:

Interesting. One of the trends of the market now is lots of refis and resets or extensions. That wasn’t a part of the market back then.

Mike Hatley:

That was not, that’s a nice innovation from not all that long ago. The other big difference back then, there was a CCC basket in terms of you couldn’t buy more than a certain level of CCCs, but there was no haircut if you exceeded the basket. The only penalty was you just couldn’t buy any more CCCs. The other big difference is there wasn’t the concept of a discount obligation. So, if you wanted to, not that we ever did this, but if there was a loan trading at 30 cents on the dollar that was a performing loan and you bought it, you got 70 points at par that you picked up on that particular trade.

Shiloh Bates:

So, what about in terms of investors? Were there a lot of people like me whose full-time job was to buy equity and other CLO securities investing in your deals?

Mike Hatley:

There were not as many as there are today, but there were a handful of people that I would say were sophisticated investors that knew what they were doing that either had funds that were set up to invest in the CLO equity or their firm was familiar with the equity. We actually did have a couple of insurance companies that did take the equity in the early deals. ING, our employer was always an investor in the equity tranche in those deals. Frequently, the investment banks that underwrote the deals also took down a small piece of the equity in those deals, I think mostly to trade.

Shiloh Bates:

So, I met you in 2000 where I started working for you and other folks at ING Capital then and I came over from Bank of America’s High-Yield group. So before 2000, was there really any cycles in terms of the underlying credits? Were there industry sectors that gave CLO managers and loan fund managers issues?

Mike Hatley:

Yeah, I would say there are always some of those industries that cause issues.

Shiloh Bates:

The one industry that was having some issues, I believe in 2000 was nursing homes. So, maybe that was playing out, but I guess there were a lot of nursing homes where the rate reimbursements changed and left these businesses underwater.

Mike Hatley:

That is exactly right. I think we had three or four nursing homes in the portfolio and out of the three or four, three of them went bankrupt. And I think one of them eventually skated by without going through bankruptcy, but was definitely a stress credit for a while. And all these LBOs were done of nursing home companies and then the Medicare reimbursement rates changed, and it was not a pretty picture. If you think back to the early 2000 timeframe, telecom was definitely an industry that caused a lot of heartburn. You had global crossing, you had 360 networks.

Shiloh Bates:

Windstar, Telligent.

Mike Hatley:

Oh yeah, man, you remember those.

Shiloh Bates:

Well, I worked on these deals. So, then in working on telecom, it was a great experience for me as a young credit analyst. The performance of the loans was quite bad and you named some of the names. So, their business model was just laying dark fiber around the country. There’s a lot of enthusiasm for growth in internet traffic. And the reality is, from the perspective of the first lien senior secured loan, that was really only in a lot of cases 15% or 20% of the capital they raised. So if you think of that, roughly equivalent to your lending 15 cents on the dollar as a first lien lender. So, for you to see a default there or be impaired at that loan to value, that’s really surprising for a lot of people. So, building out these networks was a pretty big part of the loan market. And, recoveries in a lot of cases would’ve been, I don’t know, 30 cents on the dollar or even less. And that’s brutal for CLOs because in first lien loans you’re expecting, back then, maybe an 80 cent recovery.

Mike Hatley:

It was painful. And what made it doubly painful was, like I said, we had 15% high-yield bond baskets in those deals that were sub-advised by another manager. And telecom bonds were a big part of the high-yield bond market, and those recoveries were in many cases even more brutal than the recoveries in the loan market. So, that definitely was not helpful.

Shiloh Bates:

So, then in the 2000-ish area, one thing that I think was helpful was just the financing costs of CLOs. So, back then a AAA was SOFR plus, well, LIBOR was the base rate, but LIBOR plus maybe 24, 25 bips.

Mike Hatley:

Yeah, certainly by the time we got to ’05, ’06, ’07, it was 24-25 bips, the first CLO that we did back in ’97, it was LIBOR plus 30 and a half bips for the AAA on that one.

Shiloh Bates:

Let’s bring that back.

Mike Hatley:

Yeah, exactly. The second one was LIBOR plus 45 bips. So definitely having cheap liabilities was very, very helpful.

Shiloh Bates:

One of the things I was also looking at in Bloomberg was just that in the beginning of 2000, LIBOR was high. LIBOR was 6% ish for the early part there.

Mike Hatley:

Exactly. So that definitely helped the equity returns for sure.

Shiloh Bates:

So then in the early two thousands, how much of the loan market is CLOs versus the loan funds or the total return swaps, which I think also merit a comment?

Mike Hatley:

Oh, the total return swaps, those were really hot back in the day. The ones that we managed were the old Chase KZH structures is what they were called. And they were effectively market value structures that were five times levered and the leverage was rated BBB by Fitch, and the insurance companies loved those structures. I think Chase did $20 or $30 billion worth of those KCH structures, and we had three of them that we managed. And the largest one, unbelievable, as I think about it now, was $1.3 billion market value structure. So, they were hot for a while when you had pretty low volatility and loan market prices, which we had had in the early-mid-late nineties. And then you got some volatility that came into the market with the telecom and the dotcom crash and all of that volatility in the markets and those structures started to underperform a bit when market values came crashing down.

Shiloh Bates:

So, in the total return swap, it’s basically like a mark to market margining, where every day or month or whatever it is, you report the market value of your loans, and if there’s too much price depreciation, you need to cure it. And the ways you could cure it would be either putting in more equity or selling to delever. Those are the options. So, very different from CLOs today. There’s no mark-to-market margining. The only prices that matter in CLOs would be a defaulted loan. The price matters if you have excess CCCs. Some of the prices matter, but people were comfortable with this structure back then. I guess to your point that you just hadn’t seen a lot of volatility in these first lien loans and probably, the thought of getting a margin college wasn’t really on the top of anybody’s mind.

Mike Hatley:

Oh, definitely not. I was just looking back at some of the statistics from in that timeframe, and between January of ’92 and December of ’97, the average monthly return in the loan market was 71 basis points. And out of that, there were only four negative months in all those years of loan returns, and every time there was a negative month, it was followed by a positive month the following month. Then ’98, you had the Russian debt crisis that caused some volatility to come into the market. Then, like I said before, you got the dotcom bursting and you got the telecom, and as you brought up the nursing homes, that was another sector that blew up and started some volatility in the market as well.

Shiloh Bates:

So, then let’s fast forward to the period pre-GFC. So. my recollection of that market is tons of demand for leverage loans, not enough loan supply, loans repricing tighter, and generally a pretty low default rate. Is that how you characterize the pre-GFC period?

Mike Hatley:

I would definitely characterize it that way. And we did a CLO in 2001, and the deal was called by the equity investors in 2005 right after the reinvestment period ended. That had a short reinvestment period because it was a deal that was done post 9/11, and there was some volatility obviously in the market after 9/11. And, when we called that deal in 2005, I think it was the summer of 2005, spring/summer, somewhere in that timeframe, we sold the loan portfolio $400 million deal, I think at a price of about 101 for the entire portfolio. So, loans were really hot in that data. I was looking at that not long ago. There were a number of the loans. We did a BWIC.

Shiloh Bates:

That’s the auction process where you put out the loans for sale.

Mike Hatley:

Exactly. In contrast to the typical BWIC. That’s not done today. We did it where it was all or none, you had to buy the entire portfolio. The reason that we did it that way is because we knew that we weren’t going to be able to get all the loans to settle on an assignment, but the long-term problem of the loan market is settlements take more time than they’re supposed to. And we knew that it would be a challenge to get all the loans to settle by assignment in time to pay off all the liabilities. So, we figured if we had one counterparty, we’d do a master participation agreement and that would solve the settlement issue. It worked fine, and some of the individual loans were over 102. It was amazing.

Shiloh Bates:

Interesting. I remember when I was committing to loans back then, a lot of times we would be committing something like $50 million across different funds and allocations would be maybe $20 million or something like that. So you get way cut back and then you could buy more in the secondary, but you’d have to pay up for it – par and a half or something like that. So, the incentive was to participate in every deal because almost every deal traded well and traded up. So, even if you didn’t like it, you could make a little gain settle to somebody else.

Mike Hatley:

Exactly. And we certainly did some of that back in that time. We’re okay with this one, and we can hold it for a month or two or sometimes less.

Shiloh Bates:

So, getting into the GFC, a lot of people think of the beginning of GFC as the period where the Bear Stearns mortgage hedge funds collapsed. In the loan market, is that when it starts in your mind or do you have another event where the warning signs just went really elevated?

Mike Hatley:

I remember going to one of the conferences back, I guess it was even before Bear Stearns blew up, and I remember talking to a guy from S&P at that conference and he was really, really concerned about what was going on in the mortgage market at that time, and that was before anything had blown up and wow, I guess I should pay attention. I really wasn’t paying all that much attention at that time to what had been going on in the mortgage market. But I think Bear Stern certainly was the personification of, oh wow, something is really wrong here. There were also a lot of real estate loans that were in the bank loan market back in the pre-GFC days, and those had some pretty ugly recoveries on those.

Shiloh Bates:

So, that was raw land that was going to be sold to the big home developers, and it was financed separately. When home prices collapsed and real estate prices collapsed, those struggled as well.

Mike Hatley:

There was that. Then there was some resort, the Yellowstone Mountain Club, that was based on the value of that land. And in the crisis, people weren’t buying properties in the Yellowstone Mountain Club at that time.

Shiloh Bates:

Well, they are now.

Mike Hatley:

Oh yeah, it’s turned out great for whoever owns it now, but it didn’t turn out so great for the people that were there back in that timeframe.

Shiloh Bates:

So then during the GFC, the loan market traded all the way into the low sixties, which it even traded lower than high-yield bonds, which really shouldn’t be the case given the loans are secured. Is the biggest driver there, just that as loans traded down, you had in these TRSs, the total return swaps, for sellers? And this just created this loop of loans traded down, somebody got a margin call, sold, and that drove prices down further. Do you view that technical pressure as the biggest driver of the move or there’s a fundamental component to it as well, which anything cyclical really struggled during that time?

Mike Hatley:

I think that technical was a really big part of it, and we did a CLO in 2000 that was a unique CLO in that it was both a cashflow CLO and a market value CLO. It had both overcollateralization tests and it had market value tests. I think there were two of those deals that got done and we were one of the two that got done. And when market value CLO, you basically get a different advance rate based on what price the loan is, and if the loan is trading 95 to par, you get a nice high advance rate. If it’s trading at 80 to 90, it’s a lower advance rate. If it’s 70 to 80, it’s a much lower advance rate. And below that, it’s a really, really low advance rate. And really the only way to cure the tests is to sell some of the lower price loans and reinvest in higher price loans.

So, we were able to stay on sides on the market value test only by selling loans that we wouldn’t otherwise have sold, but we had to in order to keep passing the market value test, because if you failed the market value test and you didn’t fix it within, I think it was something like 10 business days, maybe it was 15 business days, if you didn’t fix it, the AAA could call the deal, and force you to liquidate the entire portfolio at a pretty inopportune time. It would’ve been for the equity. We were definitely forced sellers, that particular CLO, if you can believe it, it was a $600 million CLO and it was 30 times levered. The equity tranche in that deal was $20 million. So it was an interesting structure, that’s for sure. So, we had to sell a bunch of loans that we didn’t want to sell, and we started failing the over-collateralization test as a result of that. But we kept passing the market value test, and I think there was about a two to two and a half year period where the equity didn’t get paid anything. But, when market values recovered, and we were able to buy some things at pretty nice prices, at the end of the day, I think the equity ended up getting to 6% IRR, which we felt pretty good about given the dark days where they weren’t getting paid for two years.

Shiloh Bates:

Well, I think one of the attractions for me of CLO equity is that even in downside cases or scenarios, returns tend to either be mildly positive or maybe mildly negative. But in CLO equity, you’re probably not going to double your money unless you buy something in a really discounted market. But on the other hand, your downside has a floor to it as well. So then your CLOs, there’s no mark-to-market margining. There’s no force liquidations, but the worst thing that happens to you in the equity is that payments are missed. So the profits of the CLO, instead of going to the equity, they’re used to either buy more loans or to delever the CLO. Is that what you were experiencing back then?

Mike Hatley:

The CLOs that we did in ’06, ’07, so the group that was ING Capital Advisors, we effectively did a management buyout of that group in 2005 and formed a firm called Westgate Horizons Advisors. And, we did three CLOs at Westgate before the crisis, and did two of them in 2006, and we did one in 2007 before the crisis really hit in earnest. And, those CLOs in the crisis, we did have one CLO that missed one equity payment, and it was not the reason you would think, it wasn’t because we had a whole bunch of defaults in the portfolio that caused the over-collateralization tests to break. The reason that we had one missed equity payment was because when Lehman Brothers failed in ’08 in what was that? October? LIBOR spiked, and we were unfortunate enough that the liabilities in that CLO rolled over on the day that LIBOR peaked.

So, we locked in really, really high LIBOR on our debt tranches, and none of the loans rolled over their LIBOR contracts on that date. And we had others that had locked in at the end of September. So we had a mismatch on the LIBOR. So, we failed the interest coverage test, which is the only time that’s ever happened in my career. It was very annoying because there wasn’t anything that we could do about it, so we missed an equity payment, but there were a lot of deals that were in the market at that time that had enough defaults. And I’m trying to think back. We did have the concept of the CCC haircut back in those days. I think that had come in at that point. So you had enough defaults or excess CCCs that there were a number of CLOs that did miss an equity payment or two, but they were able to generally reinvest in new collateral and get those tests back on sides after a period of time.

Shiloh Bates:

When I started investing in CLO equity, I think one of the biggest criteria that people used in my seat was looking at a firm and just saying, Hey, how many distributions to the equity did you miss during the financial crisis? That was probably a top three metric people were using. Not so much anymore because GFC is quite a number of years back, but…

Mike Hatley:

There are a lot of firms that weren’t around that weren’t around.

Shiloh Bates:

That weren’t around or it’s different people now anyways, but closer to the GFC, that was certainly a top metric. So, the loan market, it hits its low at 60 cents. And then as the loan market rallied, was it a quick recovery, or was it a multi-year time period to feel like the market was normal again?

Mike Hatley:

No, I think it was a pretty quick recovery. I think the all time best year for loan market returns, according to the indices, was ’09.

Shiloh Bates:

’09.

Mike Hatley:

Yeah, it was up 50% in ’09. So, that was incredibly helpful to have that bounce back in the market.

Shiloh Bates:

So, the market bounces back. And then two other things I think really benefit CLOs. One is the introduction of LIBOR floors. So back then LIBOR, was it zero or?

Mike Hatley:

It never got down all the way to zero, but I think it did get down to 25 basis points or so at one point.

Shiloh Bates:

Yeah, so basically the LIBOR floor is giving the owner of the loan additional income, saying, Hey, the loan is LIBOR plus a spread, but if LIBOR is lower than the floor, we’ll call the floor LIBOR. So, that resulted in a lot of incremental income into the CLO. And then new loans, when they were issued, just came at really wide spreads. So you’re adding new issue loans at LIBOR plus 450 / 500.

Mike Hatley:

Exactly. That was so helpful. And, we had liabilities locked in for a seven-year reinvestment period, and the AAAs were 24, 25 basis points. The total cost of funds was 60 basis points or something. It was fantastic. As old as I am in my career, I’d never seen anything like it again, but it was a fantastic time. The other thing that was really, really helpful back in those days is those CLOs had the ability to invest in debt tranches of other CLOs, and we started doing that too early. We got a little ahead of ourselves on a small portion, but then when debt prices cratered, we started buying AAAs at 75 cents on the dollar. And, we did that a couple of times, and as the market recovered, those prices went up to the end of the 80s, and then we would sell the AAAs in the mid-80s, and buy AAs in the 75 range. And we kept doing that AAs down to As and built back a whole lot of par in the tranches that we bought.

Shiloh Bates:

So, this by the way, is how I ended up being a CLO investor, working for a CLO manager. Instead of buying corporate credits to go into the CLOs, we saw this opportunity, we started buying BBBs and BBs of other people’s CLOs and putting them into our CLOs. The market had recovered somewhat when I was doing it, but it was 60 cents, 70 cents on the dollar. A unique thing about how CLOs were working back then is you could buy something at 60 cents and as long as it was performing, which these were. You mark it at par for your over-collateralization tests, which is pretty helpful. You did give up on spread. So these BBs and BBBs did not have high spreads, so you missed some income there. But, this is a time where I was learning and understanding the market better, but you could look at these CLOs, and just without using this sophisticated software of today, just ask yourself in Excel, “Hey, what percentage of these loans would have to go bad such that this BB or BBB isn’t money good?” And even then, in this period of extreme stress, it was very hard to imagine losing money on these BBBs and BBs. And in fact, that actually turned out, I mean, that’s also consistent with a 30-year track record for these investment de minimis defaults.

Mike Hatley:

I totally agree, and back in the day, the thought that I had as a CLO manager was, okay, we’ve had some credit losses. I want to build back some of the par from those losses, and I can buy this AAA tranche at 75, and I’m highly confident that I’m never going to lose a penny on this. Or, I can try and pick a loan at 75, and it’s a single loan. I’m not sure. I think I’m going to weigh in on buying that AAA CLO at 75 and then AA’s at A’s and BBB’s and I’m down to BB’s, and we never lost a penny on any of those CLO debt tranche investments.

Shiloh Bates:

So, then coming through the GFC, one of the things that happened as a result of the loan market trading way down, it was just more competitors enter the market, I think. So, today, the biggest publicly traded alternative asset managers used to be heavily weighted in their investments to private equity, and then they saw loans trading to companies where they were the owner at extreme discounts, and they’re like, well, they’re planning on making a nice return on the equity. So, if the senior secured debt’s trading at a discount, that must offer a pretty compelling opportunity. So, it seems like that jumpstarted a lot of the competition in the market from managers. So I worked, at one point, for Benefits Street Partners, they got their start in the GFC seeing this opportunity in discounted loans.

Mike Hatley:

Yeah, I think that was really helpful that you did have other folks come into the market that saw the opportunity, Hey, if I’m buying good loans, at 60, 70 cents on the dollar. That’s going to be a really nice IRR.

Shiloh Bates:

Yeah. And so I think some of the private equity firms did this in their private equity funds. They just bought discounted loans in companies that they already knew and liked, this is the best risk adjusted returns we’re going to do.

Mike Hatley:

It makes perfect sense.

Shiloh Bates:

Okay, so we come through the GFC, we see a lot more competition for the loans. What’s some other little mini cycles or industries that the loan market has post some challenges for the loan market? So, maybe autos during the GFC, our biggest loan defaults were like a TXU, so that’s energy. What did you see as some of the bigger risks in your portfolios?

Mike Hatley:

Other ones? Remember the Yellow Pages deals?

Shiloh Bates:

 Oh yeah.

Mike Hatley:

There were a number of those that were originally BB credits that were nice yielding credits, and I think they all defaulted at one point or another. There was a cycle of the movie theaters. There were a number of movie theater deals that were done that went through bankruptcy. What other ones did we go through?

Shiloh Bates:

Was gaming, maybe casinos have always performed well with the exception. Caesars was a big bankruptcy, but other than that, casinos have been pretty stable?

Mike Hatley:

Even in that one. We got 100 cent recovery on the Caesars. The only bad gaming deals that I remember doing, and unfortunately I did them personally as a credit analyst, were a couple of the construction loans for new casinos, for single-site casinos. You can have construction delays, which we did, that can put you behind the eight-ball. You can have a number of things go wrong on a single site, but the broadly diversified gaming companies that have multiple properties across a number of jurisdictions, those have performed just fine over the years.

Shiloh Bates:

And then, I guess there’s maybe two more periods that we could hit. So, one is the COVID period. So, the loan market trades into the high 70s, and a lot of businesses peak-COVID were shut. Everybody’s at home. How did your CLOs fare through that time?

Mike Hatley:

We took some hits during that time. We were, I would say, a little bit overweight in the leisure sector. And the leisure sector, certainly, when you can’t go to the movies, the movie theater credits are not going to do well. When you can’t go to the gym, the gym credits are not going to do very well. So, we definitely had a period in a couple of the CLOs, a couple of the older CLOs had already been through the energy cycle where some of the oil and gas credits that had gone bad in the, what was that, 2015 timeframe.

Shiloh Bates:

Oh yeah, we didn’t hit that. The 2015, 2016 oil and commodity price downturn.

Mike Hatley:

So, we had a couple of older CLOs that had gone through that cycle and then to go through the next downturn, they turned off equity for a payment or two. But then the snapback from that was another pretty rapid snapback in terms of loan prices and the defaults leveled off.

Shiloh Bates:

Is one takeaway from how quickly the market recovered from COVID that it was actually all the Fed stimulus, as kind of negative for CLO returns for CLO equity returns, at least in my opinion. And the reason is that the longer the loan index sits at a discount to par and slowly, in a recessionary period, loans don’t really prepay a ton, but there’s always some companies prepaying for whatever reason, and the ability to buy discounted loans, given the leverage and the structure, man, it’s so powerful. And so, again, loans traded into the 77s. Man, if they would’ve stayed there for an extended period of time, we really could have benefited. And instead, if you look at the chart, it’s a pretty sharp increase, pretty close to par shortly thereafter.

Mike Hatley:

Yeah, it didn’t take long. And I think you’re right. I think if we had had prices stay down another six months to a year, certainly for the reinvesting CLOs, that would’ve been really beneficial. And you’re right, even in those dark days of the GFC, we did have loans that prepaid and we did get cash that came in that we could redeploy into stuff that was in the 80s or whatever.

Shiloh Bates:

It’s funny, I almost forgot the commodity price downturn. So 2015, 2016, I’m totally surprised, I forgot about it because I think it has some similarities to today’s market, in that 5%, roughly, of CLOs that had heavy exposure to oil and gas or another commodity, and where the commodity and prices moved, these businesses, it didn’t make sense for them to pull a barrel of oil out of the ground. [It] costs more to do that than to sell it in the market. So not only were the businesses bleeding cash, but if there was going to be a default, what’s the recovery for one of these businesses? It’s not going to be 70 cents or 80 cents. So you had this one pocket of the loan market under extreme stress, and unfortunately the other 95% of the market was doing great, was like a par market. And, what really benefits me as a CLO equity owner is when we hit a recessionary period, I want all loans to trade down. If you’re taking some losses, on one hand. I want to be able to buy some nice discounted loans on the other, and that was not happening in 2015, 2016. I think it’s similar to now. There’s not an industry like oil and gas where the defaults are clustered. Rather, it’s cats and dogs and cats and dogs that are not going to recover 70 cents. And nobody will go near those loans and everything else is around par. So that’s not a great setup, at least for equity. I mean, if you’re an investor in AAAs to BBs, it’s all good. Doesn’t really matter. But for equity, it’s not a great backdrop.

Mike Hatley:

I hadn’t thought of it that way, but I think you’re right, Shiloh. I think that the stuff that’s defaulting now, it’s in a lot of different industries. It’s not clustered in one particular industry, but the overwhelming majority of the market’s trading near par. So, you really don’t have a whole lot of opportunities to offset some of those hits if you are unlucky enough to be in some of those credits that default.

Shiloh Bates:

So, I think one of the trends that goes through this whole history that we’ve chatted through is that [there’s] lots more CLO managers. Lots of money’s been raised in the asset class, and one of the results of that is financial covenants. So when we were investing in loans together, I remember back then we used to get four covenants. You got a max leverage, total leverage, max senior leverage, interest coverage, maybe a fixed charge variant, and sometimes even max CapEx. So, you didn’t want your business to spend too much on growth. And now, I think it’s been like a straight line down, but basically now the broadly syndicated loan market is covenant lite, and if there’s a covenant, it’s like a warning sign. It’s a syndication that people needed a covenant to do the loan. How do you think about that? Obviously, we’d prefer to have covenants. We don’t have them anymore. Again, I’m just talking about broadly syndicated loans. Is it material or how do you see it?

Mike Hatley:

I don’t think it’s overall material, but I’m with you. I definitely loved the time when we used to get covenants. I think where it is material is when we had covenants and you had a borrower that was in danger of tripping a covenant, you would get back to the table and there would frequently be an increase in the spread or there would be a fee to waive the violations. So, we definitely in the GFC days even, a lot of the benefit that we got was from doing amendments and bumping up spreads and getting fees. I think that helped. I don’t think covenants necessarily prevented defaults, but you could still have defaults of companies that had covenants there. I’m not sure that the recoveries were necessarily any better when we had covenants, but all things being equal, I would certainly prefer to have them in the credit agreement.

Shiloh Bates:

Sure, you have a lot more experience on this than me, but my experience was when borrowers were busting covenants back when we had them. That yeah, to your point, you charge them 25 bips, you reset the loan to a higher spread, but the company’s ability to pay the higher spread was bring questioned. Sometimes you actually didn’t reuse the spread. You’re like, well, liquidity is tight. So it was beneficial to the economics of your return, but at the end of the day, whether or not the business defaulted or not was independent of the covenant. In fact, there probably aren’t a lot of businesses that have been saved by bankers sitting around a big conference table telling the CEO and CFO how they need to run their business.

Mike Hatley:

I think that’s exactly right.

Shiloh Bates:

That would surprise me.

Mike Hatley:

It was that smart banker that came up with the key.

Shiloh Bates:

Yeah, somebody from outside our industry who’s never worked a real operating job in his life had some great ideas.

Mike Hatley:

Exactly. Never had a manufacturing job.

Shiloh Bates:

So then maybe related to covenants. Another big trend going this 30 years is loan recoveries. So, if you had asked in 2000 when we started working together, I think 80 cents was a good recovery for first lien senior secured loan. For a lot of the last, well, I think in CLOs, if you invest in CLO equity, you’d assume a 70 cent recovery. I think that’s been kind of a standard maybe for the last 15 years or so, maybe 10 years, but people are transitioning away from 70 to a lower number. So, what do you see as the driver there, and is there any reason for optimism?

Mike Hatley:

Oh, that’s a good question. I think part of the driver of the lower recoveries now is one of the topics we haven’t really discussed. The LME transactions where people are exploiting weaknesses in the documents to effectively lender on lender violence, if you will, and if you’re in the group that’s putting in the new money and getting preferential terms, then your eventual recovery is going to be better than the rest of the poor guys that were not part of that group. So, I think that’s hurt recoveries overall.

Shiloh Bates:

So, there’s a whole industry of lawyers who take the credit agreement between the borrower and the lender, and they try to give the borrower some flexibility that’s to do things that are not in the interest of the lenders. To your point, there can also be lender on lender violence where different lenders have different recoveries. Obviously, that’s huge in terms of recoveries, but is there anything besides that? Is there any economic reason? If the loan documentation hadn’t changed to benefit the private equity firms, would recoveries still be in the 70 cent area or is there something else to it that’s working against us?

Mike Hatley:

That’s a good question, and I honestly don’t have a good answer to that one. I’d have to do a little work and take a look at the specific loans and the recoveries on those loans to see why this loan recovered only 50 instead of 70 or 80.

Shiloh Bates:

Do you think rewinding the clock that the loan to values might’ve been a little bit lower in the past? So today, a lot of businesses are just, it’s a first lien only capital structure, so that’s maybe 50% of the acquisition in first lien debt, 50% in equity. And then maybe, if we were talking 15 years ago or before that, it might’ve been 40% first lien debt and then maybe you had a second lien or a bond and maybe the difference between lending at a 40% loan to value and a 50% doesn’t sound like a lot, but if you do the math and just look at a recovery, that 10 points would be, well, it’s more than 10 points, but is that part of it, do you think?

Mike Hatley:

I think that’s a very good point. The capital structures today, we definitely see a lot more loan-only structures. Back when we were working together, there were frequently unsecured debt below us as well as subordinated debt below us, so there were more layers of capital to absorb the loss in a default, and now it’s all on the loan to absorb that loss.

Shiloh Bates:

Is there any advice or anything that you could share from your long career?

Mike Hatley:

That’s a great question. I think the one thing that I’ve learned over a number of years of seeing a lot of different innovations in CLOs is, don’t be the first manager to do that innovative new CLO structure, like the one that I told you about earlier that was the hybrid cashflow market value CLO. We thought, Hey, this is really cool. We’re one of the first managers to do this thing, and I sure would’ve liked it better to let a couple of other managers be the ones learning, what are the things that we didn’t think of when we agreed to do this particular innovative structure.

Shiloh Bates:

Mike, my closing question is always, describe a CLO in 30 seconds.

Mike Hatley:

Explaining a CLO in 30 seconds is a pretty tall task, but I’ll give it a crack. A CLO is like a specialized finance company that makes hundreds of commercial loans to companies like American Airlines, Avis, Chobani, Draft Kings, to name a few that are in our portfolios. It gets the funds to make these loans by issuing multiple classes of debt to investors like banks and insurance companies. The safest, highest rated classes of debt are paid first and carry the lowest interest rates. Every quarter, after collecting all of the interest income from the loans, interest payments are made to the debtholders, and whatever is left over, goes to the owners of that finance company. That was, I think pretty close to 30 seconds.

Shiloh Bates:

Good stuff. Well, Mike, it was great to see you. Thanks much for coming on the podcast. Really enjoyed the conversation.

Mike Hatley:

Me too. Shiloh, I’ll always enjoy chatting with you.

Disclosure AI:

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

Definition Section:

–          Secured overnight financing rate SOFR is a broad measure of the cost of borrowing cash overnight, collateralized by Treasury securities.

–          The global financial Crisis GFC was a period of extreme stress in the global financial markets and banking systems between mid-2007 and early 2009.

–          Credit ratings are opinions about credit risk for long term issues or instruments. The ratings lie in a spectrum ranging from the highest credit quality on one end to default or junk on the other. A AAA is the highest credit quality, a C or a D, depending on the agency, the rating is the lowest or junk quality.

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

–          Broadly syndicated loans are underwritten by banks, rated by nationally recognized statistical ratings organizations, and often traded among market participants.

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

–          Spread is the percentage difference in current yields of various classes of fixed income securities versus Treasury bonds, or another benchmark bond measure.

–          A reset is a refinancing and extension of a CLO investment period.

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

–          LIBOR, the London Interbank Offer Rate, was replaced by SOFR on June 30th, 2024.

–          Delever means reducing the amount of debt financing.

–          High yield bonds are corporate borrowings rated below investment grade that are usually fixed rate and unsecured.

–          Default refers to missing a contractual interest or principal payment.

–          Debt has contractual interest, principal and interest payments, whereas equity represents ownership in a company.

–          Senior secured corporate loans are borrowings from a company that are backed by collateral.

–          Junior debt ranks behind senior secured debt in its payment priority.

–          Collateral pool refers to the sum of collateral pledged to a lender to support its repayment.

–          A non-call period refers to the time in which a debt instrument cannot be optionally repaid.

–          A floating rate investment has an interest rate that varies with the underlying floating rate index.

–          RMBS 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.