Author: Shiloh Bates

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. Today I’m speaking with Bilal Nasir, Bank of Montreal’s Head of CLO Trading. When I first began investing in CLO Securities, I found my conversations with CLO traders to be extremely helpful. That’s because I’m both a client of CLO trading firms, but also CLO securities are relatively illiquid, and so CLO traders are, like me, buying securities they expect to appreciate in value. (Though likely they will trade the security away before holding it too long.) During the podcast, Baal uses the term “risk profiles” as a fancy way to describe the different characteristics of various CLO investment opportunities. If you are enjoying the podcast, please remember to share, like, and follow. And now my conversation with Bilal Nasir. Bilal, welcome to the podcast. Thanks for coming on.

Bilal: Hi Shiloh. Thank you so much for having me and it’s a real pleasure. Just at the start, I would like to note that the views expressed here are of my own and not necessarily of my employer.

Shiloh: Got it. So why don’t we start off by you telling our listeners a little bit about your background and how you became a CLO trader.

Bilal: Absolutely. So I started working on Wall Street right out of grad school here in New York and I found myself to be joining a bank right smack in the middle of the great financial crisis. So in September of 2008, I started working within an equity quant group at Lehman Brothers. That lasted for a few months and then the group got disbanded and then I moved into the credit world within Barclays. As you know, Barclays bought Lehman, and I was doing analytics on credit default swaps. In a couple of years from there, I joined BNP Paribas doing, again, mostly quant related stuff. I was working very closely with the structured credit trading desk and in 2012 is when my CLO career really started, joined the desk from there on and I was working at BNP till 2019 as a senior trader. Late 2019 I joined Deutsche Bank to run the CLO trading effort there and I was there till, call it the summer of 2022, and then joined BMO thereafter. So Bank of Montreal at BMO, I oversee the CLO trading effort. I trade both US and European CLO markets. We are an active participant in the market, up and down the cap stack, but specifically focus at the top of the stack, AAAs and then deep mezz and equity. Also trade some niche sectors like middle market and recurring revenue ABS.

Shiloh: Was CLO an asset class that you targeted at one point or was it just something that fell in your lap and you ran with it?

Bilal: So I was working within the structured credit world. I was getting a lot of exposure to bespoke tranches and this was the next big push that, BNP Paribas, the desk there wanted to get involved in, in terms of the primary issuance and secondary trading. So in a way it was something that came up as an opportunity and I got excited about it. I wanted to join the trading desk in general after years of being as a quant. So it fell in my lap, but also it was an opportunity that I saw and it looked like I was joining a very interesting product space.

Shiloh: Great. So Bilal, how are CLO securities traded?

Bilal: So yeah, once a deal is being brought into the primary market, I would say a parallel to that world is the IPO stage of a stock or a company stock offering. So once the deal prices, or it closes, the CLO tranches are free to trade in the secondary market. Investors, generally, they’re looking to buy a certain tranche of a deal in secondary market or they’re looking to sell a tranche in the secondary market. So they’ll access liquidity and they would be looking to sell or trade their positions either outright and that would be a broker dealer like myself or BMO Capital Markets. We make markets in the product and they would come to us and sell the security outright or a broker dealer would facilitate bringing two parties together like a buyer and seller. Typically, as I was mentioning earlier, right when the deal prices, we don’t really see tranches trading off the break. One reason for that is it takes a lot of effort to get allocations in the primary market, as you very well know. It takes some time and these assets are very attractive and interesting for investors. So that’s one notable fun fact.

Shiloh: But is it also, though, that right when the CLO forms after pricing and then maybe closing just that the deal doesn’t have all of its assets yet. So it might have a hypothetical portfolio where 90% of the assets are identified, but there’s some remaining to buy. So isn’t it also that the CLO isn’t fully ramped at closing?

That is a reason that there’s not a ton of trading right out of the gate in these securities.

Bilal: So that’s true, but we were in a market say 2017, 2018, where there was just so much demand for paper where we did see some trading very shortly after pricing. But typically, to your point, there’s a element of the deal hasn’t fully ramped, but also there’s a longer settle date as well. So typically right out the gates when the tranche has priced, there’s a T plus 30 settle date dynamic as well. So you don’t really see tranches trading right off the break.

Shiloh: Okay. So the reason for that delayed settle, though, is that for example, if I buy a stock through my E- Trade account, it closes, it settles the next day, but there’s this delayed settle in the primary, the T plus 20 or 30 that you mentioned, and that really just gives the CLO some time to continue to ramp its assets, so it might not be fully invested. So the delayed settle gives the CLO time, the debt securities are spoken for, but everybody knows the CLO is going to form, but it gives you an extra month of free time to ramp up and get the assets you need into the CLO before the debt starts accruing its interest cost.

Bilal: Correct. And then moving right along, I think each tranche, the way it’s identified, it has a CUSIP or an ISIN

Disclosure AI: Note a CUSIP or ISIN is similar to a social security number for a person.

Bilal: Typically we see a lot of US investors buy the 144-A version of tranches and overseas or European investors, they would look to buy Reg-S.

Shiloh: So the 144-A means it’s a private offering not registered with the SEC, basically.

Bilal: Yes. And then once we are talking about a normal CLO tranche that is past 30 days of its issuance, these tranches typically trade T plus two or T plus one as it’s now cash settled, but that has evolved from T plus three to T plus two to T plus one in certain instances.

Shiloh: And the T there is just the trade date. So t plus one means if we do a trade on one business day, it settles the next.

Bilal: Correct. And then one unique thing in terms of trading when it comes to CLO equity is buyers and sellers typically agree on who collects the upcoming payments. So that’s part of the trade confirmation dynamic or protocol.

Shiloh: So as you know, for me, I’m primarily focused on CLO equity and CLO BB. So one option for me is just to buy these securities in the primary when the CLO is being created, which we do. And then in the secondary market, my options are for buying or selling. I could just reach out to you or another trader directly and offer to sell or buy a position, or I could use an auction process known as bid wanted in competition or BWIC. Why don’t you walk our listeners through how the auction process for CLOs work?

Bilal: So investors like yourself will typically maintain some distribution of all the relevant broker dealer desks in the market, and typically we would receive, or secondary desks receive, an email blast saying we’re looking to sell a portfolio of positions, debt or equity. The heads-up there, generally, is a day in advance and at times we see the same day list with CUSIPs or ISINs or bonds there. Generally that happens when there’s tranches that trade a lot more frequently, like triple A through double B, and then it’s a normal market environment and a lot of people are familiar, they don’t have to do a lot of work there. There’s a specified time of the process. Let’s say it’s 10:00 AM Eastern. The desk will send in bids and there’s a cutoff period or a grace period until which bids are accepted. So it could be 30 minutes, maybe an hour into the process. And then once bids are submitted, they have to be good for a specified time. So typically it’s around two hours, and then the process takes on from there in terms of who gets notified if you’re going to get maybe another round of feedback or not until the results are announced.

Shiloh: What I’ve seen for BBs and equity is that there’s really two types of processes. So one is a best foot forward, and basically that means I’m selling a piece of equity, I reached out to all the investment banks that trade in it and I say, okay, I’m selling this piece of a CLO, this tranche if you will, I’m going to sell it tomorrow at noon or at least take bids for it and in the best foot forward process, I’m going to just sell to the highest bidder. There’s not going to be multiple rounds of bidding, so that’s best foot forward. And then another way to do it, which I think is also common, is to have a top three process. And usually how that works is that of, say, 10 or so bids, or potential bids that you get all at the top three, know that they’re in the top three and they can all bid again. And then the idea there is that whoever finished first in the top three, that person really can’t improve upon themselves so they can increase their bid, but if it turns out at the end it wasn’t necessary for them to do so, then they’re able to buy it using their old bid. Are those the two most common processes that you see?

Bilal: So as you know, these are typically the most common. I think one thing to note around the best foot process is just a much cleaner, a much more transparent process. It’s usually the protocol or the go-to process that we see on upper IG tranches. So AAA, AA, single A, there’s really no feedback given. It’s like lead with your best and the results are notified within a couple of hours. I think on the top three process, yes. So there’s this round of feedback, there is a variation that folks use which is a strict top three versus a light or a soft top three process. So sometimes the risk profiles can have very divergent interests. So there is an element of giving a round of feedback as to maybe if investors are keen to buy a certain risk profile that they can sharpen up. We see that happen quite a bit.

And then it is interesting to note that at times the BWIC process can be a little frustrating because you may or may not have bonds awarded. There’s a certain reserve level that investors have in place and what that really means is that, as I mentioned earlier, these securities are very attractive and interesting and sometimes there’s internal valuation in terms of what would it take to sell the security and also replace it. If you were to think about that and do the levels that you see, or the execution levels that you see, are they in line with that?

Shiloh: So I think if we were working on PhDs in economics, it’s a very common dissertation theme to have a thesis on auction theory and what gets the highest proceeds to the seller. Is it your view that the top three process is the process that’s best for the seller and maybe also for the buyer because they get some incremental information during the process?

Bilal: I think it can be an effective way to get interest, but at times, what we see in the market, sometimes there’s some unique risk profiles that are put out for sale, could be some more storied names, or something that requires a little more analytical understanding. Could be CLO equity. If you access liquidity via a BWIC process where everybody broadly bids at times the interest may not be there. So it is not the most efficient way to get the best liquidity and at times a trade by appointment or what do we call out of comp can also be effective.

Shiloh: So let’s come back to the out of competition sale in a second. So how we’ve done BWICs at Flat Rock, really my whole career, how I’ve thought about it is I’ve just done a best foot forward process. So I just take bids, there’s no color given, and we sell it to the highest bidder or not. So what I’ve seen from that is just that it creates I think more variability in the bids you get. So some bids will be poor and you don’t need them and that’s fine and then other people will really step up. But what I’ve seen is that the best foot forward process creates what I would call big covers. And what that means is after the BWIC, usually some market color on the trade is put out to the market, and nobody tells you where the trade occurred at what level, but they’ll often tell you the cover bid, which is the second highest bid.

So you get some information there. And what I think is that the best foot forward process results in a variability of bids and usually a cover. The highest bid is usually pretty good, and then you can discard the rest. Whereas in the best foot forward process, I think a lot of times, the bids just coalesce around one level, and it may not be the optimal level. I would say if you’re BWIC-ing a security and you actually definitely need to sell it, then the top three process would probably be the way to go. If it’s, hey, I’m BWIC-ing a few positions and I want to sell one or two of them and maybe not all depending on where bids come in, then I think that’s when I would use a best foot forward process,

Bilal: The best foot forward process, if, when the market is very well defined, I think it can be a very transparent process. Typically higher up the stack, you don’t see a lot of divergence, so people tend to use for let’s say AAA, AA or single A securities a lot of best foot forward, there’s a functionality that is available in Bloomberg where people put out these lists and it’s maybe automated, you take the top bid, and then there’s the second best bid, and they both get notified. But I think the top three process can offer some feedback and, at times, folks don’t really want to start very strong and they want to see if their bid is contextual and it gives them an opportunity to then sharpen up.

Shiloh: I think one other challenge with the top three process, though, is let’s say I’m auctioning a few securities and I say bids are due at noon. Well basically no bids come in at noon, they all come in late, at different times. It’s kind of a joke. So you’re never really sure, okay, is 12:45, then, is that the cut where I define the top three? And then what happens if five minutes later somebody else comes in with a good bid and now they’re in the top three? I think it becomes quite a tricky process to manage fairly

Bilal: Totally understand and I agree, of late, I think the frustration that comes along with the BWIC process, it can take a lot of time and at times bonds don’t end up trading. So that adds to the complexity of the process and I think there’s no real ideal way, but it just depends how the process or what process you want to manage. Over time, I think the process has become a lot smoother, whether it’s the best foot forward or top three. As the space has grown, people have just gotten an understanding of what and how things work and it’s, I think from an investor perspective, when you are looking to access liquidity for sure, it’s much easier process to manage on a best foot forward basis. Sometimes you actually get good execution as well because there’s just no back and forth and games. There’s no game theory involved.

Shiloh: That’s right. And then the result of the BWIC process, though, in your experience, lots of bonds just don’t trade. So whatever the best bid was, didn’t work for the seller, and people did a bunch of work, and have nothing to show for it. So how often does that happen?

Bilal: I think it definitely happens more frequently when it comes to the mezzanine and equity tranches and especially when the market gets very dislocated, it’s often used as a tool to maybe share some color and some price discovery data points for everyone to see. This is where the bids came in for this profile. I do think that to my earlier point, some of these risk profiles are just very attractive. So folks are just unwilling to let go assets cheaply if the bid is not very strong. So that’s another undercurrent that we see in the market through the BWIC process that people will just try to use that color to maybe then go find bonds in the context of the bids. So there’s a little back and forth there.

Shiloh: So then instead of using this BWIC auction process, another option I have for buying securities, or selling them, is just work directly with a trader like you. So what’s the advantage or disadvantage of just doing it that way?

Bilal: So I think the process is much easier. I think if you go to or if you work with a desk that specializes in certain of bonds they will have access to or they’ll be in touch with other investors that own those securities so they can really just make the process a lot simpler. There’s only two parties involved, really, it’s the buyer and the seller. And then also I think we’ve seen just the execution level be a lot, I would say stronger or in market context. It’s not theoretical or academic, it’s the real market when you have a buyer looking for a specific profile and a seller looking to sell that specific profile. So it’s much cleaner, it’s much efficient. A lot of bonds do trade that way, what we call by appointment, because folks really don’t want to put them on BWICs and get the desks that may or may not be involved in trading that profile to be sending in bids that are out of context

Shiloh: In the BWIC process for sure, when you get bids for something you’re selling, I would describe it as I get two kinds of bids. So one is a bid from someone like you where there’s an end customer who wants the bond and they have bid it accordingly. The other bid that I would get would be something I think from a trader or a trading desk where there is no end client that wants the bond and so that’s, we’ll call it a back bid, or it’s at a level where the trading desk is comfortable owning the bond and they’ll find an investor to take it later. That’s the strategy there. So you get this tiering of bids in the BWIC and then what I think is translating that or bringing it back to trading out of comp, it seems like a lot of times dealers are getting hit on their back bids in auctions for one reason or another and then they take that bond into inventory and maybe sit on it for a while, trade it away to another investor at a gain. Is that how you see your business model or are you actually pairing buyers and sellers more frequently where you’re not actually holding a ton of bonds in inventory or how does your business model work?

Bilal: So I think the business model on our side is much more we’re trying to make markets and looking for real demand and we like to trade as opposed to build a lot of inventory. So I think it’s mostly market making, bringing buyers and sellers together, and I think we’re just a desk that is comfortable bidding a lot of interesting profiles. So that’s maybe up the stack or deep mezz and equity. So we do talk to a lot of investors that find that part of the cap stack interesting. Hence we have a lot of buyers and sellers that we’re in touch with rather than just holding securities for a long time and sitting on that and taking them down for both. We have certainly the capability to provide liquidity to our end clients whenever it’s needed. At times you may not find a buyer that same day, but certainly we like to turn the book over and bring buyers and sellers together and like to trade more frequently than other desks.

Shiloh: So it sounds like you can invest and trade up and down the stack. Are there any securities out there today, issued by CLOs, that you find particularly compelling?

Bilal: It’s hard to get overly excited about the market given we’re sitting on CLO debt spreads and yields, and the broader credit markets, sitting at all time tights, maybe even off 2021. But I do think the risk-reward that you get, if you invest in some BSL profiles, like maybe some BSL AAA or middle market AAAs are interesting. And then down in mezz, some junior triple Bs I think are interesting. Some mezz profiles like in double B, single B, offer attractive yields, and I do also trade Europe. So I think there’s some interesting risk profiles, maybe double As look attractive right now. Lastly, I do think that CLO equity is getting more and more attractive given the liabilities are at their tights and the arbs improve quite a bit. So CLO equity is certainly going to be very relevant.

Shiloh: The arb is the natural profitability of the CLO?

Bilal: Correct. I think the payments on CLO equity are looking a lot better and we’re seeing a lot of interest and I do see a lot of interest for that part of the cap stack as we go into the new year as well.

Shiloh: Do you think equity will look all the more attractive in an environment where rates are coming down?

Bilal: So I think it will because we’re going into a benign credit environment, we’re looking to see, I think it’s the expectation that M & A activity will pick up, so there’ll be more opportunities to buy more loans for CLO managers, sort of like the workhorse of this little complex.

Shiloh: So one of the trades that we’ve I think partnered with together on was just the, I don’t want to use the word distressed, but the dinged up double B trade where maybe if you liquidated the CLO, theoretically, when we bought the double B, you would’ve been underwater, you couldn’t have liquidated all the loans and gotten back a hundred cents on the double B. How do you get comfortable owning securities where for example, the double B is often the junior-most debt tranche and the loan portfolio has seen a pickup in loan defaults. How do you get comfortable owning securities with that profile?

Bilal: I think there’s a couple of things to mention there. Obviously you have to do a lot of analysis of what the underlying risk to the double B is, what are the underlying loans that it is most sensitive to. But I think the other dynamic is the structure of what is at play. So these deals, as you know, they’re a lot more seasoned and they’re either very close to reinvestment period or out of reinvestment period. So there’s an element of what happens to these deals if there’s scheduled principal payments that come through and how is the CLO manager, what liberty do they have to reinvest into the deal?

Shiloh: So in that trade you bought a CLO double B at a discount to par, and you’re hoping that the manager isn’t going to buy more loans with the proceeds that come back as loans prepay. You want the CLO to delever, that’s the better outcome for the BB in that case.

Bilal: So effectively you would hope that the deal becomes static, but then you really have to get comfortable with the underlying credit. The deal that we’re talking about is more seasoned, there’s a lot of tail risks, so is really the race against the time, which is does the bond delever faster than the tail can get further stressed? So I think there’s that undercurrent.

Shiloh: So the tail being the worst performing loans that still remain in the CLO at that point? Bilal:

Correct. And what’s different about this trade versus when you buy maybe a double B that is from a relatively newer deal is it’s still going to take some time for the credit selection to play out in different years, but here the investor is buying and has a pretty good sense of what the outcome could look like, so it’s a differentiated risk profile. And then if the deal delevers faster than what is expected, then you could have your debt, especially double B, deep down mezz to be called and there’s a natural pull to par. So yeah, those are things to think about in that trade and for deals that they still have some runway in terms of their reinvestment period. Again, I think the contrast there is you have some clarity as to what makes up the portfolio of the deal versus maybe a newer deal that hasn’t really seen stresses that come along maybe a year like Covid or 2022 and those stresses just play out in your portfolio.

Shiloh: The way I think about the distressed double B trade is that an option you have if you sit in my seat is to buy, say primary equity, and in that for a new clean portfolio with a great manager, you might run a case where 2% of the loans default each year and you’re targeting returns of mid-teens. So that’s one option for you. The other option has been, and this really isn’t a trade we see a lot of today because the market’s rallied so much, but through 2023, a lot of times, instead of buying equity, you could buy a discounted double B and it’s going to be a dinged up portfolio and that’s why it trades at discount obviously. But in those cases you might run a 5% default rate and conclude that you’re still money good through the double B, and you might be able to get returns that are comparable to equity, or, in some cases, better than equity. Again modeled at a 2% default rate. So the double B comps really well to equity in markets where there’s some stress, which again I wouldn’t define as today.

Bilal: Look, I absolutely agree and I think what happens in the CLO market is it’s not a very continuous market in the sense that if you want to go buy a certain asset class rating in the secondary market, say you wanted to go buy CLO equity, it takes some time and effort to really find the profile. So a lot of CLO equity buyers were looking to pick up CLO equity in late 2022, early 2023, but there was just not much available for sale. We did see some of these dinged up double Bs come up for sale, and, to your point, they were trading at levels that could match equity-level returns. So I think that drew a lot of interest in them, plus the point about the default rate, you’re right, what we’ve seen even in GFC or in Covid and even now is just vector shocks in terms of default rate spikes as opposed to very high cumulative default rate till the end of the deals’ life cycles. I think that’s why some of these trades are interesting because these BBs, they’re money good, they may not see any kind of impairment.

Shiloh: So of the CLO universe out there, there’s maybe a hundred plus broadly syndicated managers who are active and 20 or so middle market managers. Do you see a lot of trading activity in the managers that are less well known, managers that are maybe competent but still building out their franchise, or do you stick to trades with some of the biggest CLO managers out there?

Bilal: We definitely look at newer CLO managers. It’s a combination, but I think it’s a growing complex. So there’s new entrants into the CLO world and we tend to be a little more manager- agnostic and really look at performance and I think we see that happening across the investors that they’re looking for maybe newer strategies that a manager could be undertaking. We’re seeing a lot of CLO PMs move from one shop to the other and what is being marketed is there’s a change in our investment strategy going forward in order to win more investors. And I think it certainly makes sense if you have a newer manager that has just raised an equity fund and looking to issue deals, let’s say three or four, I think they would love to get more investors onto their platform by offering them more conservative tools. So I think it’s definitely an

interesting play and then they could offer to give up some spread in return and make the investment more attractive. So we definitely see that happening and that’s a trade that I think is worth keeping an eye on. So we definitely traffic and I think we’re definitely one of the desks —

Shiloh: So wait, the newer manager trade, basically the trade off is you own a debt security and you get a spread premium, so you pick up something in terms of return, but if you’re not going to hold it to maturity, the liquidity of that manager is something you need to think about? If you were ever to want to sell the security, the price isn’t going to be comparable to a manager that’s more well known in the market.

Bilal: Yeah, definitely. I think liquidity is definitely the aspect there to keep in mind, but it’s also worth looking at, or understanding how did the CLO manager raise their equity fund if they’re promising some bigger returns. So they could be looking to invest in riskier portfolios to overcompensate for that. But then we see investors that have more insurance based pedigree that are entering the space, certainly know of a couple. What we’ve noticed is liquidity tends to improve as soon as there’s a few data points in terms of performance, and it’s also very data driven as soon as folks see the deal trading or the tranche is trading a little better there a sense of an understanding that develops this risk is trading akin to other similar in its cohort.

Shiloh: And then for middle market CLOs, which is important to me, is a little niche for us here at Flat Rock, how do you get comfortable trading middle market CLO securities where the underlying loans don’t have a daily traded price?

Bilal: So I think that’s the question that is in demand and I get the most often when I’m trading middle market CLOs. I think part of it is the structure of the middle market CLO I think is much stronger. I think that comes into discussion and then the fact that these deals are compensating you by giving you that extra spread over. Now it’s debatable in markets like these where you’re at the tights whether you are getting enough compensation in terms of spread pickup on each of the tranches. So there’s that, and then there’s nuances like what happens after the reinvestment period. So there’s a lot of investors that care about whether they’re going to get extended or whether their investment is going to see extension risk or not. But there is another element to the point that you made earlier about maybe taking a bet on a newer manager. So I started trading middle market CLOs before they were so cool, and I think there was a bent towards going with bigger platforms that can originate a lot of assets. So the main thing to think about there is whether that manager has access to enough assets to swap out maybe a stressed deal. So I think that is one of the things that people care about. It comes up in conversations and we’ve seen some investors getting to look under the hood by signing NDAs. So I think that’s another way that people have gotten comfortable.

Shiloh: Just signing a nondisclosure agreement will give you access to some loan level information?

Bilal: From a secondary perspective. You can also look at some key performance metrics of the deal. So even though you won’t have stats like MVOC or par creation to be as relevant because there’s no understanding of what that means within middle market CLOs, but you could look at how the triple C buckets are doing.

You can look at whether the equity returns are looking, how they’re looking. So there’s a few things that you could look at to ascertain the quality.

Shiloh: Bilal, is there anything else we should discuss that’s topical to you or your business today?

Bilal: I think one thing that we are seeing right now within the market is just the growth of the retail interests within CLOs. We’re seeing a lot of demand for As and triple Bs emerging, and I think what that has done to the secondary market, we’re seeing a lot of resilience even during bouts of volatility, we didn’t really see a lot of outflows from some of these CLO funds or the ETFs, so I think that’s very notable. I think for our business, we’re expecting to be active in the middle market complex, we’re an active participant on the secondary side, so I think we’re in an interesting space, an interesting time where we are seeing growth in the CLO market and more focus on the product internally, externally, and we’re positioning ourselves to be a relevant player within both BSL and middle market on the secondary side and on the origination side.

Shiloh: Great. Well, Bilal, thanks so much for coming on the podcast. Really enjoyed our conversation.

Bilal: Thank you very much for having me.

Disclosure AI:

The content here is for informational purposes only and should not be taken as legal, business, tax, or investment advice, or be used to evaluate any investment or security. This podcast is not directed at any 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 period. 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 software 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 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 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 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 merit 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.  

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. 

Today I’m speaking with Lauren Basmadjian, Carlyle’s head of Liquid Credit, where she oversees $53 billion of assets under management. The Federal Reserve began its cutting cycle in September with a 50 basis point cut, and SOFR has come down almost twice that from its highs, so we discuss how that is expected to affect our industry. We also discuss her outlook for CLO spreads, loan defaults and recoveries, and how she thinks about investing in CLOs managed by other managers. If you’re enjoying the podcast, please remember to share, like, and follow. And now my conversation with Lauren Basmadjian. Lauren, thanks so much for coming on the podcast. 

Lauren: Happy to be here. 

Shiloh: Why don’t you tell our listeners a little bit about your background and how you became a CLO manager? 

Lauren: Sure. So I started in 2001 at a place called Octagon Credit Investors, which is a boutique below investment grade corporate credit firm, one of the oldest CLO managers. I spent 19 years there before I came to Carlyle to run the liquid credit platform. And today I run the liquid credit platform globally for Carlyle, which is about $53 billion dollars of assets under management, the vast majority of which are CLOs that are managed by Carlyle, or that we invest in other managers as well. And we are the oldest piece of Carlyle credit, so also established in 1999, and the largest liquid CLO manager. 

Shiloh: So how many CLOs do you guys usually print or create in a year? 

Lauren: So it definitely depends on the year. This year will be a record year for us, most likely between new issue resets and refinancings. We’ve already done 23 CLOs this year. Our record was 25 in 2021. 

Shiloh: Is that high number just because financing costs are attractive today, in your view, is that the key driver?

Lauren: That is certainly one of them. When you think about how wide liabilities got after Ukraine, it really made resetting deals impossible because you were going to increase your weighted average cost of debt for the most part. So in a way you have two years of a backlog of resets and that’s part of what’s led to such an active year for issuance this year. It’s not just new issue, but as liability spreads compressed pretty immediately in January of 2024, resets started to make sense again and we had a lot of deals in the backlog for that. 

Shiloh: Well, I’ve been in the backlog as well and it’s good to work through some of those deals for sure. So you’ve been in the market for a long time. What’s one or two things that you find interesting or unique about the CLO market? 

Lauren: In general, one of the most interesting things, and you could probably attest to this, is though it is a trillion dollar market, so large and liquid, it still does feel like it has a niche feel to it where not everyone invests in CLOs. And I think there’s probably some reasons for that. They’re associated with CDOs, for example, but CLOs did not blow up the economy during the financial crisis, but they’re also complex and there’s no standardized documents. So it takes more time to analyze the investments and you really have to invest in staff to do that. And so even though it’s a large liquid market, there are many investors that don’t have an allocation. 

Shiloh: Yeah, it’s funny. When I go to CLO conferences, I just see, even though the market’s grown so much, I really just see a lot of the same players. 

Lauren: Absolutely. 

Shiloh: Supposedly the market’s growing in investors as well as AUM, but I just see a lot of the same folks and that’s it. I think for me, one of the things that’s pretty interesting about the market is just, you can buy, for example, CLO equity in the primary or the secondary market, and at times these two markets just trade at totally different yields. So a lot of times primary is a lot tighter than secondary, and anybody would be able to get better risk adjusted returns by buying in the secondary for sure. But I think one of the things that accounts for the difference is just that the primary process is really the fun process. That’s the one where we’re all working together, we’ve got a manager, and there’s a warehouse and we’re trying to get the best debt execution and we’re commenting on docs. And for most people, especially newer to the CLO market, I think that’s the process that’s going to feel good to them. Whereas in the secondary, the CLO exists, some broker dealer is offering it to you, and really the only thing to negotiate is a price, and most people probably assume the dealer in between is taking a fair amount of economics for themselves. I think that just pushes a lot of people to the primary. 

Lauren: And I think we’ve also seen, with the slowdown in CLO issuance in 2022 into 23, there was a very specific profile in the secondary. It was either a really high weighted average cost of debt profile that you could buy and plan on a reset or repricing, or deals that were close to ending the reinvestment period or had a shorter reinvestment period left. So in order to diversify your maturity wall of investing, I think a number of investors came back to primary where they were going to get five-year reinvestments and diversify their book a little bit. I think that, especially with the cleaner pools, led to some of that new issue demand that we’re seeing this year. 

Shiloh: Are there any profiles of equity that you think have worked out particularly well? One that comes to mind would be, for me, any CLO that ramped during a period of stress where loans were bought cheaply. 

Lauren: A hundred percent. Could not agree with you more. I think that we’re trained to think of CLOs as an arbitrage product. 

Disclaimer: Note: By arbitrage, Lauren is referring to a CLO where the equity is owned by a third party looking for favorable risk-adjusted returns. 

Lauren: Most of the time they are, but they’re also an amazing way to buy discounted loans in long term, non-mark to market financing. And if you could close your eyes when the cost of debt’s really high and just say, we’re going to buy good assets cheap, and eventually we trust that the market’s going to come back and we’ll reprice our liabilities, I think those are the best deals. 

Shiloh: Agreed. And those deals are good both in the primary and then often are sold in the secondary too at compelling prices. So Carlyle is obviously one of the biggest managers, or biggest, I guess depending on how you do the cut or the stat. How do you think your platform is differentiated? 

Lauren: There’s a couple things. One is we are one of the oldest managers, so you could look at our performance through multiple cycles, even back to dotcom bust, financial crisis, energy, Ukraine, inflation. So you could see how we’ve performed. Two, because we’re big, we’ve invested behind it. So we have over 20 analysts in the US over 10 in Europe. We have a five person restructuring team, which I think is a key differentiator going forward. And we’re able to do it because we have the financial wherewithal to invest in the resources. I think that’s going to affect outcomes going forward, especially as we move out of the bankruptcy court and into this liability management paradigm that we’re living in. We also are very connected internally at Carlyle and we use the One Carlyle network in our diligence and our tracking. Coming from a boutique manager, it’s really different for me. It’s amazing the access you have to deal professionals, to strategic advisors. Just being able to get on the phone with people who know the industry, know management teams, or even our Washington resources. It just really is this One Carlyle network. It sounds like a buzzword, candidly. I thought that’s what it was when I read about it before I came over. But the connectivity is really strong and we’re all looking to help each other in our investment decisions. 

Shiloh: Is part of that that when you’re looking at a new loan opportunity, if it’s a leveraged buyout, that it’s very likely that Carlyle’s PE team has looked at the company and already formed a view? That’s part of your credit research and analysis? 

Lauren: It is. We may have looked at it or we may own a similar company. It’s all compliance-chaperoned.   

Shiloh: With you guys issuing so many CLOs, can there ever be too many or do you ever hit a point where there’s maybe just not enough demand for your CLO liabilities regardless of how well you guys are doing on the assets? 

Lauren: I would think of us relative to the market. So the market has stopped growing right now. I actually think it will grow again next year. But I would think of us relative to the market and as well, CLOs traditionally take two weeks to price. And I think part of that is this non-standardized documentation, which is not going to change. But I think as a market, we need to become more efficient with a quicker process in the primary, or multiple processes at the same time. If that doesn’t happen, then I think there is a cap to how many total transactions you could do, and we’re probably nearing that cap this year. 

Shiloh: Okay. And that’s because you just don’t want to be in the market with overlapping deals. You want to get one done, move on, and then the market opens back up to you again, that’s how you think about it? 

Lauren: Our equity investors generally don’t want us to do that unless we have a clear path for bespoke pricing. And we are finding those paths today where perhaps we’re syndicating AAAs in the US in one deal, but have a hundred percent buyer in Japan for another deal. So they’re not competing. And I think being able to identify separate paths is the way that you could bring more than one deal at a time to market. 

Shiloh: So the Fed cut by 50 bps in September. Does that matter to you at all in terms of CLO issuance or the performance of the underlying loans? 

Lauren: Yeah, rates coming down matters. What I’d say is that we’re already down about 80 basis points in SOFR and that’s going to flow through to our borrowers who mostly have floating rate debt. Some of it’s hedged. But you’re going to start to see that come through in the fourth quarter. And if you see further anticipation of cuts, SOFR likely comes down even before the cut. And that’s real cash benefit to our companies. I think that also leads to less downgrades, or dare I say, even upgrades, eventually, for the underlying loan borrowers. So those are the positives. There is an effect to CLO equity with rates coming down. CLO equity has benefited from a higher base rate, but we all use the forward curve in our modeling. And so right now we’re looking at terminal rates around three and a half percent in our models. To me it’s a question of is it higher or lower than what the curve is expecting versus how many more cuts because the curve is anticipating cuts, which is then flowing through into the CLO equity pricing. 

Shiloh: Yeah, I do a fair amount of education with our investors on this. And then the idea is that when you buy CLO equity, it’s a string of cash flows and to model that, you’re looking at a forward curve. So we’re already budgeting for the fact that rates are expected to come down. That’s already in the projection. It’s already been in the projection for some time, which is very different from owning loans directly. When rates come down, you just get less in income and that’s it. There’s no forward projection or anything like that. And I guess the other part of it, the other thing we’re reserving for in CLO equity is just that we assume that, I think most people assume 2% of the loans will default each year and the recovery will be around 70, maybe a little short of 70 depending, but is two and 70, are those numbers from the past or do you think those are numbers that you can still hit or how do you think about it? 

Lauren: I think it’s numbers from the past, but probably for maybe a different reason than what people are anticipating. There are very few in-court bankruptcies now and where a lot of street analysts expected us to jump to three, four, 5% after Ukraine, it didn’t happen, right? And today we’re around 80 basis points, but what’s happened in the last year and a half is distressed exchanges, discount capture, liability management, whatever you want to call it, where a borrower comes to you and says, “Hey, your credit agreement’s really loose. We’d like you to give us some discount. Us as equity, we’re not taking a loss before you are. You, debt holder, you’re going to take the loss and then you could close up the document and I won’t strip assets for you. I won’t dilute the value of your collateral.” And so that’s become commonplace. Before you had transactions that offended everyone and we all knew the names. It was J Crew or Chewy, and we all talk about them with brand names, but there’s been dozens of those now. And when I think about it, I think there’s more that’s going to be out of court. I think bankruptcies are going to be fewer, so we won’t be at an average 2-3% going forward. What I’d say if there’s any positive to that is that companies are generally asking for outside of court. It is very different and a much lower impairment rate than what we’ve seen historically for bankruptcies. So on average, the range that you’re usually seeing for the discount or the impairment out of court has generally been around two to 20 cents with the average a little over 10. So I think you almost have to think about a higher percent when you include the out of court stuff, but also a higher recovery because you’re not taking the same type of haircut off this. 

Shiloh: So if I’m modeling CLO equity and I use a 2% default rate and a 30% loss given default, so that’s like 60 bps and that’s really the key number, like, I hope it’s lower than 60, but whichever way of the two variables we get there is fine by me. Do you think 60 is optimistic over the next year or two, or how would you think about that? 

Lauren: I think it’s realistic, but here’s this other thing about the difference in how the market is changing is, before, if you owned a loan, you got the same recovery no matter what manager owned it, manager A owns a loan, manager B owns a loan, and they both get 60 cents back. And with more of these out-of-court processes, you are seeing groups that are put together to be a majority and be able to extract more value and better recoveries out of the process. Generally speaking, these are larger managers that are important to bankruptcy advisors, companies, sponsors, or they just have the right to be in there because they’re so big and they’re a top five holder. So I do think that the best thing to do is just avoid the bad credits, but that’s very difficult to do in totality. The second best thing to do is get in the right groups. And so you could see that 60 basis points, maybe even if they own the same loan, same exact loan by different managers, you could see some managers have a 20 point swing on recoveries based on what groups they get into. 

Shiloh: Do you think on these out of court restructurings that there’s a difference in private equity firm DNA and that some naturally are going to gravitate towards trying to get their first lien lenders to take a discount and others maybe are more old school and that’s just not how they’re thinking about the agreement between debt and equity? 

Lauren: I think that before there were a lot of sponsors that were worried about being viewed as a bad actor and what would that mean as they continue to do deals and their access to capital. I think unfortunately the advisors in general have done a really good job of convincing companies and sponsors that this is common practice and it’s not going to be viewed as egregious. If they did it with all of their companies, or half of their companies, sure, that’s a problem. They may be  cut out of the market, but to have one, two or three, it’s acceptable. And so I think sure, they’re probably a select group of sponsors that still view lenders as partners, but for the most part I think that’s done. 

Shiloh: I think I’ve heard one private equity firm say that actually they think it’s their fiduciary responsibility to try to put it to the lenders when they can. It’s like, oh, wow. 

Lauren: To preserve the equity. Right, they’re fighting for the equity. I have heard that as well.

Shiloh: It’s an interesting way to think about it. So I imagine around Carlyle you buy a lot of, or your firm buys a lot of CLO securities, many that are not managed directly by you, is that correct? 

Lauren: That’s correct. 

Shiloh: Are you involved in that process? 

Lauren: Yeah, I sit on the investment committee for that. 

Shiloh: Okay. And how do you think about what’s interesting to you and what managers you want to partner with in that? 

Lauren: So we have a team between structurer, traders, analysts that are looking at third party opportunities, so buying debt or equity and other managers’ CLOs. One of the things that we do is a deep dive on the portfolio because we do lend to a lot of companies and we have this huge research team. We try to incorporate their views. We even look at our view of WARF, meaning, well, we have our own rating system. 

Shiloh: WARF is the weighted average rating factor. 

Lauren: Right. The Moody’s equivalent, the numerical equivalent of the letter rating. And then we create a Carlyle one and say, well, our analyst team thinks this portfolio is riskier or safer than what the market is seeing, and we’re using our name-by-name analysis to do that. So that’s one thing. But I’d say in general we want to see consistency of performance. I mean, as you put together a portfolio of investments, we’re buying certain managers for their attributes. Maybe one is a lower spread manager, what we think is really stable, great historical default rates, and then we have another manager that we think is Alpha where they do take more risk, but we get compensated in the total return for that. What we get concerned about is when we see style drift from managers, and that’s what we try to identify early. 

Shiloh: What securities generally work for you guys at Carlyle? Are you putting equity and BBs into GPLP funds? 

Lauren: Yeah, we have a number of funds that invest across the capital stack. I’d say that it looks more like SMAs for investment grade, but we have retail products for lower tranches. So we have a fund called CTAC, which is a cross-platform credit product at Carlyle, but part of that fund is CLO equity and CLO double Bs. We have a public equity fund that is CLO equity. So we find different fund structures work better depending on the tranche, and we try to marry the liquidity needs, the investor needs by fund with the right end investment. 

Shiloh: You do a pretty heavy overlay I imagine, where you just look at somebody else’s CLO and just kind of determine, hey, what percentage of these loans are approved by you or sitting in your CLOs? I imagine that weighs pretty heavily. 

Lauren: We do. We have to be careful to just think that our view is always right and just buy the loans again that we like. But yes, absolutely. I think it’s actually more helpful on the bad loans, if that makes sense. So things that we passed on or think could have trouble, but the price doesn’t reflect that yet. And maybe we do own that loan and that could be the case too, but I think that it’s really identifying that tail risk that makes more of a difference in saying, yes, these 100 credits are totally fine. 

Shiloh: So a substantial majority of my investments are in middle market CLOs. Is that something that you’re involved in? 

Lauren: And that’s such an interesting space because it’s growing rapidly where the rest of the CLO space is a little stagnant right now. Traditionally, as you know, you’ve had most of CLO equity that’s for middle market or private credit CLOs be captive or financing trades, and you would place the debt through more traditional routes. Still today, a lot of middle market CLOs or private credit CLOs are financing trades, but you’re seeing third party equity interest because the cash flows are better because the arbitrage is much more robust than in liquid credit CLOs. So we are looking at that. We’ve issued a private credit CLO this year, but it’s been a financing trade. We’ve done another reset of an existing one, but we are taking a look at what a third party model looks like for private credit CLOs, meaning should we be issuing private credit CLOs with investors like you? 

Shiloh: You should be. That’s my opinion. Are you involved in that? So the selection of middle market loans for CLOs around your platform, is that something that you’re also involved in or is that a separate team? 

Lauren: So it is a separate team. We have a totally separate analyst team for direct lending and private credit. Our teams talk a ton and you’ve seen more movement of loans between the two, more idea generation between the two. But there’s a fully built out direct lending team. That said, I do sit on the investment committee for private credit as well. So I am approving the loans that we’re buying, but the team doesn’t report into me. It’s really a collaborative effort across the platform. And also it’s really beneficial for me to see, as a liquid investor, what’s happening in the private markets and it gives me an idea of what could be refinanced there, for example, or what kind of profile of loans they’re looking for. So I joined maybe two years ago and I think it’s been really additive to my thought process when investing in liquid credit.

Shiloh: Was it kind of a little bit of a shock or a surprise? If you go from liquid credit where, I don’t know, the EBITDA numbers for a borrower might be a hundred million plus, and then you find yourself somewhere where people are making loans at like 20 million of EBITDA, maybe with better covenants, maybe with a better LTV and better docs. 

Disclaimer: Note LTV means loan to value and Shiloh should know better than using three letter acronyms in his podcast. 

Shiloh: But still the difference in company size is substantial. Is that kind of an easy thing to get your head around or how did you think about that? 

Lauren: So no one’s ever asked me that question. It is so hard. It was hard for me to look at these companies and say, how do you lend to a company that’s like you said, twenty million dollars and buy and hold it? 

Shiloh: Yeah, no liquidity. 

Lauren: That’s right. Where in liquid markets, one, the average EBITDA of a company is a billion dollars at this point, and two, I could sell it if I changed my mind or all these things changed. So how do you underwrite to buy and hold? And that did take me a while. It took me at least a few months to get used to looking at the deals, thinking about them differently. I will say there’s a different level of information that you could get, diligence. Obviously the documents are way better and tighter than you see in liquid. There’s still a relationship with sponsors that I think we’ve lost in the BSL market. And so when we were going through Covid and then inflation, what was very clear is that we were seeing a lot more equity checks come in into direct lending from sponsors to support the companies than really I’ve ever seen in the liquid market. So I think I had to get used to looking at those smaller companies, but also with a lens of all the extra protections that we get by doing that. 

Shiloh: What do you think is a good premium to get paid if the loan has no liquidity at all and you’re going to hold it to maturity versus having kind of the broadly syndicated liquidity? What do you think that’s worth in basis points? 

Lauren: So today I’d say we’re at 350 for the liquid market and you’re seeing private credit go down to 500, 525 for good credits. 

Disclaimer: Note: Those numbers were spreads over SOFR in basis points.

Lauren: And that does feel a little tight. Now we’re both repricing, so the spread may change shortly again, but I think that you would generally want at least 200 basis points for that illiquidity premium. It’s illiquidity and size. Maybe I’m still stuck on that size thing that you asked about in the last question because I think that there are some of these hybrid private credit BSL issuers that they have a billion dollars of EBITDA and they’re really big companies, but they chose to access the private credit market. I think those probably should have less of a spread premium than the true middle market universe. 

Shiloh: Is there anything else happening in CLOs or your platform that you think would be interesting to discuss? 

Lauren: I think the most interesting thing is just the continued evolution of these liability management exercises. To me, we went from a covenanted market to cov-lite after the financial crisis, and this is the next sea change for me where we went from if you had a problem, you’re doing it in court to now seeing, even if you don’t have a huge problem doing it out of court, and seeing our documents used against us to advance more money if a company needs it or take a discount capture. I think that’s the big theme out there. Where I would say that’s positive is we lend to 600 companies in the US, over 200 in Europe. Our data is pretty good, I think probably better than index data. We see so many private companies and the resilience has been impressive. As we’ve said, the companies have been through so much in the last four years. Low investment grade corporate credit should be really hurt by higher interest rates because they have a lot of floating rate debt. And we’ve seen the percentage of our companies that produce cashflow is way higher today than it was a couple of years ago, like in 2021 for example, which seems counterintuitive because rates are so much higher and growth has slowed, but it’s because companies are focused on it. And it’s amazing that when management teams focus, they can start to produce cashflow. They’re figuring out how to become more efficient, maybe cut back on CapEx or hiring, but about 70% of our companies are producing free cashflow in this higher rate environment. We haven’t seen third quarter numbers yet, but for the second quarter, average sales growth of about 5% and average EBITDA growth of 10%. So I think there’s been pretty resilient market in the face of a lot of negativity of downgrades and distressed exchanges, but companies are figuring out a way for the most part to make it work. 

Shiloh: One last question. Do you expect that CLO liabilities will continue to contract here going into year end or they’re kind of in the middle of a lot of these conversations, I imagine? 

Lauren: I do. There’s so much supply, so I think it would be tightening much further if there wasn’t as much supply. But that said, AAAs have had negative issuance, net issuance, because the pay downs have been so intense for AAA buyers year to date from amortization of post reinvestment period deals and call deals and resets and refinancings. So I think as that market has shrunk and it’s performed really well, we’ll see continued demand to redeploy that money and I think that leads to continued tighter spreads especially. And then the rest of the stack, usually CLOs figure out a way to work, and loans are repricing.

About half of our portfolio has repriced year to date with an average reduction in spread of 44 basis points. That means we lost 22 basis points on average in spread. Liabilities have to reprice too to make the arbitrage work. 

Shiloh: That’s right. Great. Well, Lauren, thanks so much for coming on the podcast. It was great to talk to you. 

Lauren: It was a pleasure. I really appreciate you inviting me. 

Disclaimer: 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 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 period. 

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. 

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 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 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 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.

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 in the CLO industry, and I interview key market players. Today I’m speaking with Stephen Anderberg, the sector lead for US CLOs at Standard and Poor’s Global Ratings. We discuss how CLOs are rated, and trends in upgrades, downgrades and defaults. The Federal Reserve cut interest rates by 50 bps on September 18th, so we discuss how that is expected to move the CLO market. We also discuss how CLO ratings have performed relative to the more well-known corporate rating system. Many of the securities we discuss are rated speculative grade or “spec grade” by S & P, which means not investment grade, or more specifically, that’s when a borrower has the ability to repay but faces significant uncertainties, such as adverse business or financial circumstances that could affect credit risk. That’s according to the S & P website. If you enjoy the podcast, please remember to share, like, and follow. And now my conversation with Steve Anderberg. Steve, thanks so much for coming on the podcast. 

Steve: Shiloh. Thank you very much. Really appreciate the invite and I’m looking forward to the conversation. 

Shiloh: Likewise. Why don’t we start off by just going through your background and how you ended up as a CLO ratings analyst at S & P? 

Steve: So my current role at S & P is Sector Lead. I’ve been with S & P now for 25 years and before that worked with the city of New York in the Office of Management and Budget. Within S & P, I’ve always been with structured finance. I started in ABS surveillance back in August of ’99 looking after the ratings of collateralized bond obligations. And from there pretty quickly started working on CLOs, which at that point I think literally had six transactions outstanding, something like that. From that I’ve seen the CLO market evolve and grow through the 1.0 era, before the financial crisis, and the 2.0 era that followed. And obviously today it’s a trillion-dollar asset class and the core part of most investor portfolios, and structured finance investor portfolios. 

Shiloh: You were rating CLOs in 1999, is that right?

Steve: I was in the surveillance group, so doing the monitoring and rating changes on collateralized bond obligations, which actually did see a lot of rating changes. And then the CLOs, which really didn’t. 

Shiloh: I was just curious because I started on the buy side working for CLO managers in 2000. So like you, I’ve been around since the very beginning and seen this and experienced this huge growth. 

Steve: It’s been amazing to see it evolve from a bank loan market and then to grow into a trillion dollar market that we have today. It’s really astonishing. 

Shiloh: Agreed. So Steve, how are CLOs rated? 

Steve: The CLO ratings at S & P are built on a foundation of the corporate ratings, and by corporate ratings, I mean both the fundamental credit rating assigned to the company, a single B minus, double B minus, whatever it is, and then also a recovery rating that’s assigned to each loan in the collateral pool. And in BSL CLOs, something like 98% of the collateral carries a public rating and the company rating is used to infer a likelihood of default in the modeling. And the recovery rating obviously is used to infer the recovery assumptions in the cashflow modeling. So when we look at a CLO, when we rate a CLO, we put the portfolio into our credit model CDO evaluator, which simulates default rates for portfolios that are commensurate with our different rating levels. And then it provides something called a scenario default rate at each CLO tranche rating level. And you can think of these as the scenario default rates as our hurdle rate at each rating level. So for example, within a typical BSL CLO collateral pool, if you run that through the model, you might get a scenario default rate of say 68% at the AAA rating level, which just means that for a tranche from a CLO to be rated AAA, that’s collateralized by that pool of assets, the tranche is going to have to be able to withstand 68% of the collateral defaulting over the life of the CLO without the tranche missing any interest or principle. 

Shiloh: So each loan has its own probability of default and also the loans have some correlation with each other. So they’re in different industries or similar industries. So you’re running simulations through the loan pool and just trying to figure out what the AAA and AA survive, and then that ties back to the actual ratings that you give. Is that how to think about it? 

Steve: That’s exactly how to think about it. With the one caveat that we’re not looking at the debt rating, we’re looking at the company rating. And the reason for that is that the debt ratings get notched up and down based on the recovery prospects. So a senior secured loan is typically going to be one or two notches higher than the company rating, and we already capture recovery elsewhere. So we look at the company rating across our CLO analysis.

Shiloh: So when a CLO is coming to life and it’s not maybe getting the ratings that it is targeting, the solution to that is either to have more equity or to have a more diversified pool of loans, or a higher rated pool of loans. Are those the options? 

Steve: You could either rejigger the collateral pool and maybe put some higher rated assets in, or you could change the capital structure on the CLO to make it work under the methodology. One thing that’s nice as an asset class is that the models are available externally, including to the arrangers. So for the most part, when they’re submitting a transaction to us, they have an idea of what’s going to work and what’s not going to work, so we don’t have to go back and forth as much. 

Shiloh: And then one of the things I’ve noticed that maybe wasn’t intuitive to me right away was just when something’s rated AAA and sold as such through banks, a lot of times it seems like the rating agencies would actually be willing to provide more leverage at the AAA or AA in that it’s actually the cap on how deep the attachment point is, actually comes from end investors, not the rating agency. 

Steve: That is true up and down the capital stack that sometimes you end up with a tranche that could pass at a higher rating level that’s going out at a different rating level. And then it could be based on investor preference. There’s also you need a cushion in place. You’re not going to want a AAA that goes out and has a very tight rating cushion, both for just downgrade prospects of the tranche itself or tranche rating, but also because the manager does not want to get cut off from trading if they fail their CDO monitor test, which affects reinvestment. So they want some cushion in place there. 

Shiloh: So nobody wants to have ratings that are close to where they would be potentially downgraded if the CLO has some missteps. And then at Flat Rock, we’re an investor both in broadly syndicated CLOs and middle market CLOs. How does the rating approach differ between the two? 

Steve: It’s a really good question. Middle market CLOs are an area that’s seen tremendous growth over the past several years. In the aftermath of the GFC, it was typically, if you look at the overall issuance, it was in the maybe high single digits and then after 2016 it bumped up a little bit. Now it’s more like 20% of total CLO issuance. We use the same criteria for both BSL CLOs and middle market CLOs. There are a lot of structural and collateral differences between the two that get captured in the quantitative modeling. There are two key differences though from a rating approach, even under the same criteria, both having to do with the assets. So if you look at BSL CLOs, probably 98% of the assets carry a public rating. In middle market CLOs, that’s not the case. The majority of the assets are not rated and yet to run CDO evaluator, you’re going to need a rating on for each company in the portfolio. And so for those, we do credit estimates, which are basically, for the CLO manager’s purposes, just an estimate of what a rating would be if the company had a rating, and they could use that in their management of the CLO, and we could use it in our analysis. So credit estimates instead of ratings. And then the second difference is recovery assumptions. The spec grade public loans have a recovery rating tied to them that guides the recovery assumption, the CLO modeling, but the credit estimates don’t come with that. So there we have a standard table for recovery assumptions. So you have one set of assumptions, senior secured, non cov-light loans, and other set of assumptions for senior secured cov-light loans and so on down the stack. 

Shiloh: So for middle market loans and for broadly syndicated loans that are going into CLOs, either way they get rated, just the question is whether or not it’s a public rating available to all market participants or it’s a less formal process, the credit estimate that S & P also does. 

Steve: In order to do the analysis, you need a rating or estimated rating, implied rating on every company in the portfolio. It doesn’t work without that. 

Shiloh: So how has your ratings framework changed over time? 

Steve: The criteria does not change that often. It changes when our view of the fundamentals changes. So we did a really big update in September of 2009, which affected almost all the assumptions within the criteria, the assumed default rates, recovery rates, correlation, and a host of other things. If you look at the 1.0 CLOs, you could get to a AAA rating with maybe a 26% par subordination. But then coming out of the GFC, in part because of rating agency changes, in part because of market changes, it was more like mid- thirties now. So the criteria change of September of 2009 was part of that. Just required more par subordination to get to a AAA. And then after that there was a smaller update in June of 2019, which is to take into account the totality of data from the last of the 1.0 transactions, which were paying down at that point. 

Shiloh: So it sounds like, since the GFC, that to get the ratings that CLO investors want, there has to be more par subordination, or really equity, really at each level. So the AAA has more equity supporting it and the double A same all the way down the stack. So that’s beneficial. Obviously, you know we’re an investor in double Bs, so double Bs get more equity, that’s great for them, it means lower probability of default. But given how CLO securities performed through the GFC and beyond, why was it necessary to make your modeling assumptions or your framework more conservative from the perspective of the debt investors? 

Steve: Given what we were going through at that point and the data we’re looking at during the GFC, we were rethinking how correlated pools of credit might perform under different stressors. So we revisited the criteria based on that, and there was a lot that came out of it. The modeling assumptions became more punitive, especially at the higher rating levels, especially for AAA. Should point out, by the way, CLO AAA has performed really well in the history of the market. There’s never been a AAA default, but the criteria change did require more subordination for those. And there are other changes as well in terms of what we expect to see in the CLO transaction documents and other things. All just making sure the ratings produced and the criteria would be commensurate with the economic environments we thought they should be able to survive. 

Shiloh: The Fed has been in a hiking cycle. How has that affected CLO ratings? 

Steve: Given the 50 basis point rate cut on September 18th, this is obviously a timely topic. The key issues looking forward are going to be the path of interest rate cuts, but also what happens with earnings growth in the spec rate corporate space. The rate cuts this week provided a tailwind for leveraged loan issuers since they’ll be devoting less cash interest payments and able to use it for other things, including investing in future growth. And if we were to end up in a situation where EBITDA growth turned negative, the rate cuts will provide some cushion there. So definitely at least a modest credit positive for CLO collateral. In terms of CLO issuance outlook, I think the impact of the rate cuts is a little bit more opaque. I’d be interested in your perspective as well here, but resets and refis are just going to continue to dominate issuance this year and maybe next year just given the overhang of transactions that are out there, that are outside the non-call period with spreads that are wider than current market spreads. For CLO new issuance, we think that insurance demand for floating rate product is going to remain very strong and that will have a benefit for CLOs in general. And anecdotally, we’ve heard that insurance companies have raised a trillion dollars in annuities, and that’s a lot of dry powder to deploy into the CLO market. And Japanese banks, the ones we’ve spoken to, remain well positioned to continue to buy CLOs. So between those two things we think that would be supportive for CLO issuance next year. 

Shiloh: One of the things that has surprised me about interest rates and the market reaction is just that if you would’ve asked me in 2021, and broadly these syndicated CLOs were printing at, call it, there’s a LIBOR back then, but 115 basis points over was where some AAAs were getting done. And as the Fed started hiking, actually the spreads on AAAs went wider. And I would’ve thought people would be clamoring for AAAs because the higher base rate the return offered was higher. But actually the market reaction I think was twofold. It was banks sensing, potentially, the beginning of a recessionary period just were putting the brakes on buying new AAAs, one, but also because the base rate was higher, a lot of investors just didn’t want to take the extra risk and earn the AAA spread over LIBOR or SOFR for example. They were happy just earning the base rate. So now I think what’ll happen is, as the Fed lowers rates, I think what’s going to happen is people are going to be very interested more in the spread than they were in the past because the base rate isn’t going to be as high. And I think that’ll continue to put downward pressure on spreads, up and down the stack from AAA to double B. That’s how I think this is going to play out. 

Steve: I think you make an interesting point, Shiloh. So I fully agree that to some extent at least investors look at the all-in yield on a tranche so that as the base rate becomes less a driver of that, they’re going to focus more on the credit spread. So that could push for wider credit spreads going forward or at least put a damper on further credit tightening. Spread tightening. It is interesting, there are other factors that drive all this as well. And you look back at 2021, which was, so far, the all-time record for new issuance, 185 billion of CLO new issuance. And in that case the banks were just flush with deposits from COVID stimulus checks and needed a place to deploy. The cash rates were very tight. So CLOs just offered an attractive spread above the base rate, and that’s just where a lot of the money went, and that’s just drove issuance for that year. 

Shiloh: But I think I see it may be slightly different though. I think as the Fed cuts that actually spreads are going to continue to decline. And the reason is I think it’s maybe opposite of the theory. You’d be like, okay, well if the Fed’s cutting, I care about all in yield, so the spreads needs to be higher. But actually that’s definitely not what happened on the way up. On the way up, the Fed was hiking and investors were acquiring, at least for a while, more spread. So here I think what’s going to happen is AAA is going to be all the more interesting now because they’re going to need to earn it. They’re not going to be able to just take the base rate. So that’ll be more competition for AAAs and down the stack. 

Steve: I think that’s true if you look at 2022 and 2023, which showed very wide spreads on AAAs and other tranches of CLOs, economic growth or lack thereof and fear of a recession just drives a lot of this. So maybe that would be the dominant factor in driving credit spreads going forward. 

Shiloh: Prospects for recession definitely would be a big factor in there as well. So changing topics: The CLOs do have bond buckets, usually it’s 5%, the typical cap on bonds that can be put into a CLO, I think that’s the number. And a lot of times these are floating rate secured bonds, so they look a lot like loans anyways. But what are you seeing in terms of manager usage of bond buckets today? 

Steve: Interesting question. So we thought with the rate cut, it was a good time to take a look and to see where we were. So obviously the addition of bonds to CLO portfolios is a phenomenon we’ve seen over the past couple of years as higher interest rates took hold. And there was really a way for managers to pick up part the cost of giving up some spread. And there was also a pretty substantial weighted average rating factor, a WARF benefit, since a lot of the bonds came from slightly higher rated issuers, in some cases a lot higher rated issuers, than the typical leverage loan issuer. So I think we’re at like 2% of total collateral. So still modest in terms of actual usage of the bond buckets, but if you look, the median WARF or SP WARF of the bonds is 2165 against a median WARF of the CLO collateral overall of 2,700. So that’s a pretty significant difference. 

Shiloh: So the WARF is the weighted average rating factor, and that ties into probability of default for each underlying loan. 

Steve: That’s exactly right for each of the underlying issuers. So a lower WARF indicates, at least from a rating perspective, a higher quality collateral pool. And if you look at the bond holdings, I think we just did a quick snapshot yesterday, 82% of them are from spec grade issuers, so it’s as expected, but 14% were from triple B issuers and then 4% actually came from single A minus or higher, which you don’t usually see those higher rated obligors within C collateral pools. It was just a phenomenon for the bonds.COVID stimulus checks and needed a place to deploy. The cash rates were very tight. So CLOs just offered an attractive spread above the base rate, and that’s just where a lot of the money went, and that’s just drove issuance for that year. 

Shiloh: But I think I see it maybe slightly different though. I think as the Fed cuts that actually spreads are going to continue to decline. And the reason is I think it’s maybe opposite of the theory. You’d be like, okay, well if the Fed’s cutting, I care about all in yield, so the spreads needs to be higher. But actually that’s definitely not what happened on the way up. On the way up, the Fed was hiking and investors were acquiring, at least for a while, more spread. So here I think what’s going to happen is AAA is going to be all the more interesting now because they’re going to need to earn it. They’re not going to be able to just take the base rate. So that’ll be more competition for AAAs and down the stack. 

Steve: I think that’s true if you look at 2022 and 2023, which showed very wide spreads on AAAs and other tranches of CLOs, economic growth or lack thereof and fear of a recession just drives a lot of this. So maybe that would be the dominant factor in driving credit spreads going forward. 

Shiloh: Prospects for recession definitely would be a big factor in there as well. So changing topics: The CLOs do have bond buckets, usually it’s 5%, the typical cap on bonds that can be put into a CLO, I think that’s the number. And a lot of times these are floating rate secured bonds, so they look a lot like loans anyways. But what are you seeing in terms of manager usage of bond buckets today? 

Steve: Interesting question. So we thought with the rate cut, it was a good time to take a look and to see where we were. So obviously the addition of bonds to CLO portfolios is a phenomenon we’ve seen over the past couple of years as higher interest rates took hold. And there was really a way for managers to pick up part the cost of giving up some spread. And there was also a pretty substantial weighted average rating factor, a WARF benefit, since a lot of the bonds came from slightly higher rated issuers, in some cases a lot higher rated issuers, than the typical leverage loan issuer. So I think we’re at like 2% of total collateral. So still modest in terms of actual usage of the bond buckets, but if you look, the median WARF or SP WARF of the bonds is 2165 against a median WARF of the CLO collateral overall of 2,700. So that’s a pretty significant difference. 

Shiloh: So the WARF is the weighted average rating factor, and that ties into probability of default for each underlying loan. 

Steve: That’s exactly right for each of the underlying issuers. So a lower WARF indicates, at least from a rating perspective, a higher quality collateral pool. And if you look at the bond holdings, I think we just did a quick snapshot yesterday, 82% of them are from spec grade issuers, so it’s as expected, but 14% were from triple B issuers and then 4% actually came from single A minus or higher, which you don’t usually see those higher rated obligors within C collateral pools. It was just a phenomenon for the bonds.

Shiloh: So it sounds like some CLO managers have bought high quality bonds, probably low coupon, but bought them at a discount to par. And that helps with the CLOs over collateralization tests 

Steve: And just generally offset par losses that might’ve come from elsewhere. 

Shiloh: And then one of the trends we’ve seen in the market really over the last two years is the rise of the liability management exercise. So I did a podcast recently with Drew Sweeney of TCW on this, but the LME is the out of court restructuring where the private equity investor that owns the firm and the first lien debt agree to some restructuring, which probably entails a haircut, the first lien lenders taking a haircut on their debt. How has the rise of the LME affected your business and your ratings? 

Steve: So you’re right in pointing out that most of the LMEs have come from private equity owned or sponsored companies. There have been a couple with publicly owned companies as well, but one point I would make is that CLO portfolios are very diverse. The median portfolio has something like 300 obligors in it. So the impact of any one obligor in a collateral pool going through a liability management exercise is fairly muted. And we have noted, by the way, a difference in approach between the bigger scale managers, the higher AUM managers and the smaller managers, where the larger managers are more likely to leverage their scale and engage in the LME process and try to come through with a more positive outcome, something that’s more accretive to the recoveries. The smaller managers would be much more likely to sell and just get out of the situation because they may not have to scale to ensure they get our seat at the table. 

Shiloh: And then what’s the trends in loan upgrades and downgrades, for example, today? 

Steve: So the higher interest rates and slowing growth we’ve seen over the past couple of years have definitely put pressure on lower rated corporate borrowers, and, some of them at least, have been straining under the burden of higher debt service costs. And by late 2023, the downgrade rate for spec grade companies had risen considerably and peaked at three and a half downgrades for each corporate rating upgrade as of October of last year. And then it’s moderated a bit since, although it’s been choppy month over month. I think at this point most corporate loan issuers have adjusted to higher rates by cutting costs, deferring CapEx expenditures and doing other things. And then another benefit of the current market is that spec grade companies have been able to refinance or reprice their outstanding loans, in some cases cutting their interest expenses by 50 basis points or more. So they’ve got the benefit of two rate cuts just by refinancing their outstanding debt. So we’re definitely in better shape than we were, say, a year ago, 

Shiloh: The Fed beginning to cut: Should we infer from that, that maybe more upgrades than downgrades are on the come here?

Steve: So you are absolutely right that the decrease in rates is going to create a tailwind for highly leveraged borrowers. And it will free them up, at least to some extent, from the burden of interest payments and allow them to redeploy that money into other things, including CapEx, which could benefit growth going forward. In terms of the ratings, it’s already largely baked in, and when the analysts look at a company rating, they’re taking into account the forward rates and taking it into account when it’s not in the ratings. So the very fact of seeing the rate decrease, unless something is to change in the path going forward that makes us change our assumptions, I don’t think you would see a large number of upgrades based solely on that. 

Shiloh: So that was upgrades and downgrades for the underlying loans and CLOs, but what about upgrades and downgrades for CLO securities? 

Steve: So we haven’t downgraded a AAA CLO tranche rating probably since 2012. It’s been a long time. It really takes a considerable amount of economic stress before that happens. And I took a quick look at the past four years, going back to the beginning of 2020, at what the CLO tranche ratings were doing. And obviously 2020, given the pandemic, the shutdowns, the impact on spec rated corporate issuers was pretty significant. And there were a lot of downgrades in the CLO collateral pools and the liability ratings follow. So something like 13% of BSL CLO ratings from S & P got lowered in 2020 and a lot fewer middle market ones, 1% middle market ratings got lowered that year, but every year since from 2021 onward, there’ve actually been more CLO tranche upgrades rather than downgrades. So I think it’s a pretty good record, especially given the level of corporate downgrades in 2022 and 2023. The CLO managers were able to reposition the portfolios in most cases and go out against the downside and just the structural mechanics protected the transactions and they’ve done pretty well in the course of a stressed economic period. 

Shiloh: So transitioning from CLO upgrades and downgrades, the more important thing to me would just be defaults. So have we seen an uptick in CLO security defaults since the COVID period? 

Steve: The short answer is not really. We’re just about to update a piece and show that we’ve had 61 CLO tranche defaults through both the 1.0 and the 2.0 era. But the asset class is large enough now that every year you’re going to see a small handful of double B tranches that might default. Usually these are, right now, what we’re seeing is transactions that originated before the pandemic and then suffered again in 2022 and 2023 and just weren’t able to cover, at least on a projected basis, the debt outstanding at the double B level. But 61 tranche defaults out of 18,000 or so rated tranches over the past 30 years is a pretty good record. 

Shiloh: Agreed. So the default statistics that you just mentioned, how did those compare to the loan ratings? Does a double B CLO, is it comparable to a double B corporate, or how should we think about the ratings between the two?

Steve: The short answer is CLO ratings have done very well, and in every case, performed with fewer defaults against comparably-rated corporates. You have to be a little bit careful on how you do it, because fundamentally, if you’re looking at CLO ratings, they’re originated and then seven or eight years later, or maybe sooner if it gets reset or whatever, they’re not there anymore. With corporates, you have ratings outstanding for a long time, but Meredith Coffey from the LSTA published a piece back in July of 2022, actually using some S & P data and comparing the default rates for CLO tranches against the default rates for like-rated corporates. And if you take a look, for example, at double B, for CLO 1.0 transactions, the double B default rate for CLO tranches rated double B, it was something like 4%. For CLO 2.0, so far the double B tranche default rate has been well under 1%. And then if you look at corporate ratings over the same period, it’s more like 9%. So there’s a pretty significant difference between those two. 

Shiloh: But you’re quoting there the cumulative default rates. How I would think about it is like an annual default rate. So if the cumulative, you said it’s 4% for the 1.0s, so maybe if they were outstanding for seven or eight years, call it eight years, then it’s a 50 bps default rate per year. And then for say the 2.0s, you said 1% cumulative. Well, how many years do you think those double Bs were outstanding for maybe five, something like that? So it’s 20 bps per year would be the default rate there. 

Steve: Yeah, for an individual transaction, of course it’s going to be extraordinary, unlikely you’d see a default in year one. But if you want to look across the universe of tranches, you could look at it that way. Any way you stack it up, CLO tranche ratings come in pretty well below the comparable corporate ratings. 

Shiloh: So one of the questions I’m frequently asked, I tell them, Hey, the double B default rate has been quite low, and their response is, well, are we on the precipice of a massive default wave? Is the future going be very different from the past and maybe embedded in that is the question about higher base rates. But I think your answer on upgrades and downgrades answers that question. If the CLO securities are, as you said, for the most part, upgrades is the trend, not downgrades. 

Steve: That’s true. I mean, even during a stressed economic period, if you want to get a sense of how the CLO ratings might respond under different levels of economic stress, we actually publish a series annually, a series of stress tests, and the BSL iteration of that should be out this month or maybe early next month. We take all of the CLO tranche ratings and run them through basically four sets of stressors with successively more later defaults and successively bigger triple C baskets. And then we look at the impact for our rated universe of these stresses. So if you want to see what would happen to the double Bs, for example, under a scenario where 20% of loans default and the triple C baskets blow out to 40%, as unlikely as either of those things would be, you could do that. 

So Shiloh, if I could ask you a couple of questions and turn the tables, how do you use ratings into your investment process or processes at Flat Rock? 

Shiloh: We’re not really ratings constrained. So we own CLO equity. Obviously CLO equity is non-rated, so we’d like the CLO debt securities in the CLO to be rated well, but we don’t have a regulator, or a capital charge regime. Well, our regulator is FINRA and the SEC, but we’re not an insurance company or a bank where we need to maintain an overall rating or portfolio quality. So for equity, you’re not rating those securities, so we make our own judgements. And then for double B, your opinion on the credit quality of the note is certainly important, but we’re doing our own scenarios and work ourselves. So you said you’re for stress cases, we’ve got a bunch of stress cases as well, but at the end of the day, sometimes we would buy double Bs. That would be the weaker end of maybe where you guys would rate, and we would do that because they’re cheaper in the market and we think they offer good returns, and maybe they’re later in their life and they don’t need all the equity subordination that they might’ve had originally. If a double B is upgraded, which I don’t think we’ve seen too many of those, I don’t think it really matters that much in terms of trading level because… it’s funny. One difference in CLOs from other markets is that when a CLO security is issued as double B, I think the industry nomenclature just keeps it as double B. That’s where it was initially rated. That’s the part of the capital stack that it is. And if you guys upgrade it to triple B, I think people would continue to call it the double B. And if it was downgraded to single B, maybe somebody would still call it a double B, but acknowledge that there’s been some losses on the loan. Rating is a very important part of the market, but it’s really affecting, I think, especially the guys who are playing in the investment grade parts of the stack. So the AAA investor needs that rating for the bank, wants to make sure that rating is maintained through the life of the CLO. But some of the debt’s downgraded in one of our deals definitely means there’s been some par losses on the loans. But for us, that could just mean we bought the equity cheap in the past. It wouldn’t necessarily correlate to how we’re doing down the stack. 

Steve: Interesting. And how constructive are you on CLOs just as an asset class, say going into next year, how do you see the combined impacts of rate cuts and either economic growth or lack of economic growth impact in the asset class? 

Shiloh: So I think one of the things that will change now with the Fed beginning what we think is going to be this cutting cycle here is just that the relative attractiveness of double Bs has really been pronounced over the last two years. So the Fed hiked a lot, and you could get at least in, let’s talk about middle market CLOs for example, the yields on those securities, CLO middle market double Bs, have been in a 13% area. So a lot of people looked at that and said, Hey, that’s a great return. Why would I want to take first loss risk and be in the equity? So some of them made that rotation or that new allocation, and then now as the Fed cuts, the yields, the double Bs are going to be going down, one, and then two for CLO equity, the projected returns there are not going to look that different even though the Fed is cutting. And the reason is that I think most people who sit in my seat, they’re running an IRR calculation through the cash flows that the CLO equity is supposed to produce or is expected to produce. So there’s already baked into that a declining SOFR curve. So there’s already a budget there. If you’re buying equity today and you’re targeting mid to high teen returns, you’re budgeting for that decline in SOFR over time. Whereas for the double B, those payments are made quarterly and they reset quarterly and they’re going to be resetting lower, and that’s going to result in less cashflow to the double B. So my point in that is just I think you’re going to see a rotation out of double B; CLO equity is going to become relatively more interesting. And I think the two things that may benefit CLO equity here are that one, the lower interest expense burden for a lot of companies, it’s not going to matter. The loan’s money good, and maybe you’d rather have the higher base rate there, but some weaker borrowers in the market will actually benefit and have more cash, more liquidity, better interest coverage. And for CLO equity, that could mean a marginal difference in terms of default rate, more favorable to us. So I think that’s a potential benefit. And then the other part of that is, again, if you’re targeting mid to high teen returns for CLO equity, as the Fed cuts, other competing asset classes are going to offer lower comparative returns and CLO equity, the rates, we don’t see them coming down. So on a relative value basis, I think it’s going to make equity look more appealing than maybe it has over the last year and change. 

Steve: Interesting. 

Shiloh: Well, Steve, thanks so much for coming on the podcast. Really enjoyed the conversation. 

Disclosure: 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 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 period. 

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, or London Interbank Offered Rate, was replaced by SOFR (Secured Overnight Financing Rate) on June 30, 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 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 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.

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 in the CLO industry, and I interview key market players. Today I’m speaking with Ted Goldthorpe, the Head of BC Partners Credit Business. We discuss some of his lessons learned in what you’ll hear is a very impressive financial career. While most asset managers grow their business by launching new funds, Ted is also active in acquiring other asset managers. We talk about why that makes sense for his platform, and we also discuss the evolving landscape of private credit and business development companies. If you’re enjoying the podcast, please remember to share, like, and follow. And now my conversation with Ted Goldthorpe. Ted, thanks for coming on the podcast. 

Ted: Thanks for having me, Shiloh 

Shiloh: Why don’t you walk us through a little bit of your background and we will take it from there. 

Ted: So my background, I started my career in investment banking, and then during the Asian crisis I was in the FIG group. And then during the Asian crisis there became a lot of opportunities to invest in Asia, but particularly around financial institutions. So I got moved into private equity and then ultimately into distressed. So most of my background early on was on a distressed investing business. And then moved over to a group called the Special Situations Group where I ran a lot of their illiquid businesses, so things like a structured equity business, a turnaround business. I ran a Canadian business, a regional business as well. And then at the end of all that, I took over, ultimately the Global Bank Loan and distressed business on the investment side for Goldman Sachs. And then a lot of my career macro has an impact. So Dodd-Frank and Volker came out. It was much harder to do what we’re doing at Goldman 

Disclaimer: Note. Dodd-Frank and the Volker Rule were regulations put in place after the financial crisis of 2008. The goal was to strengthen the US banking system. 

Ted: So a number of us moved to the alternative asset management space. So I landed at Apollo where I ran their opportunistic businesses and then was there, ran their public company, did direct lending, ran their hedge fund, and then ultimately moved to start BC Partners Credit business. So BC Partners been around since 1986. It’s a very, very, very blue chip, white shoe firm that’s been around for a long time, but it had only really done private equity, so we diversified their business to credit. So today we manage about $10 billion. It’s split between sponsor finance, non-sponsored finance, and specialty finance. And we invested across a number of different, either long-term, locked up capital vehicles, or permanent capital vehicles. 

Shiloh: So one of the things I’ve noticed is a lot of the leaders from other alternative asset managers got their roots in the Goldman Sachs special situations desk or bank loan trading. What was in the DNA there that got so many people their head-start in the business? 

Ted: I think it was a couple different things. Number one is a really deep commitment to fundamental underwriting on both sides of the business. And then the thing that’s interesting about it is when you look at the people who grew up in the special situations group, a lot of those people have moved on to more locked up capital structures. So Fortress Sixth Street, one of the guys now has taken a very senior role at Blackstone. So that’s the path that those guys went on. Off the trading desk, originally it was David Tepper, but then post him it was Jonathan Kolatch and Ed Mule who started Silverpoint, and Anchorage, and all these amazing firms. That all came out. So it was more of like a hedge fund beginnings that’s now transitioned to institutional capital. But Goldman was very, very good about providing us capital and providing us capital at times where there was good times to invest. So the key I thought to us and our success was mandate flexibility. If we had a big investment in alternative energy in 2005, 2006, it became much less interesting. So we monetized a lot of assets and transitioned to other areas, and to this day, all of us continue to adapt to whatever the environment is. So a lot of things that I did 10 years ago, we just don’t do today. So you always got to evolve as a platform, but also as an investor you have to evolve as well. 

Shiloh: So from your time at Apollo, is there a handful of lessons that you took away from that experience? 

Ted: I think Goldman Sachs really taught me a lot about investing. So what makes a good investment, what makes a bad investment? And really the concept of risk-reward, and not selling tail risk. 

Disclaimer: Note selling tail risk means earning a profit in calm market conditions, but exposing yourself to massive losses in downside scenarios. 

Ted: And I worked with some phenomenally amazing investors there. Obviously Apollo is a best-in-class investment firm as well. The one thing I learned at Apollo is the asset management business. So Apollo is so strategic around a lot of these broad themes that you’re hearing about in the market, and they’re way ahead of people. So insurance, the rise of retail, all the big areas, origination, permanent capital, all these things that today seem obvious, weren’t obvious 10 years ago and 15 years ago. And Apollo is very, very early into a lot of these places. So I give a lot of credit to the management team over there who really sees things way down the road. And when you look at how our BC business is set up, we’re like a mini-Apollo. We have an insurance company, we have a retail business, we have a bunch of permanent capital, and we have institutional funds. I learned a lot from them around the importance of focusing not only on the asset side but also the liability side and your funding. 

Shiloh: So why was BC Partners a good platform to build out your credit business? 

Ted: Good question. So in a publicly traded context, incentive fees don’t really get a multiple. So management fees trade a big multiple. The reason why BC is interesting is the private company. So I think the partners here are indifferent to how we make the money. It’s just a matter of making the money. So it fits our investment style a lot better. I mean, typically my DNA is invested in higher returning type asset classes, and those asset classes oftentimes are much more incentive fee-based versus management fee-based. So because we’re private and because we’re a partnership, a lot less pressure on us to grow. And at the end of the day, even though Apollo’s all about making as much money as they can, again, incentive fees just don’t trade a great multiple, and in a partnership, that issue is not as relevant. I think Apollo is still in that business, but a lot of other big asset managers have exited that opportunistic business and that’s created a huge opportunity for us for this exact reason we just talked about. Opportunistic is hard. You need a lot of people, it’s risky, it’s headline risk. And at the end of the day, if you’re not going to get value for it in your stock price, why are you burning the calories to do it? 

Shiloh: I think people in the market look at it as the management fee is a perpetuity, and they’ll put, like you said, a very high multiple on it, and then for incentive fees, you could have earned nice incentive fees for 10 years or more, and a buyer will look at that and assume you’ll never make an incentive fee again. So that discrepancy is really quite stark in the market 

Ted: In Apollo, I always called it recurring non-recurring revenues. Apollo would always get incentive fees, and we couldn’t tell you exactly where they’re going to come from, but it’s not like we got zero incentive fees some year. We always got ’em from somewhere. But as a shareholder, it’s hard to underwrite that. It’s hard to model out incentive fees across a lot of different businesses over time. So people just give you zero credit for it. So there’s a little bit of a public-private arbitrage. 

Shiloh: So recently I listened to a podcast where you were on, CreditFlux, and they asked you a question about is private credit a bubble? Is it overheated? And just would love to hear your answer, your take, on that question. 

Ted: I got to remember what I said, but listen, I mean, to me, it’s every day for the last 15 years I’ve read on the front page of the paper, “Bubble in Private Credit?” and I think people look at the amount of money that’s been raised, and view it as a lot of money. If you track it versus private equity, it’s actually lagged. Most of private credit, it’s only 40% of our business, but a lot of private credit money is used to back private equity deals. So private equity has grown faster than private credit. That’s number one. Number two is when we started the business, we used to focus on companies with 10 to 50 EBITDA. And I remember a huge milestone in our space is when Blackstone did the first billion dollar unitranche. And that today happens every day. So that was only 10 years ago. And instead of doing these, it used to be called middle market lending. Now private credit is doing much bigger hold sizes and competing not only with each other but also with the banks and the syndicated markets. So the high yield market has shrunk, as has the loan market the last couple of years. And a lot of it is the private credit markets taking share. And again, 10 years ago, we did not compete against liquid markets. Secondly, we’re pushing into a whole bunch of new areas that we didn’t play in before, that used to be dominated by the regional banks. So GP, NAV financing, lender to lender finance, all these other areas, consumer finance, again, 10 years ago, 15 years ago, that was GE Capital. And I remember when I worked at Apollo, people were talking about the bubble in BDCs and all this stuff. GE capital’s middle market lending business was larger than the entire BDC sector combined. So if you took every BDC and add ’em all up, and you added up all the middle market credit managers, they were smaller than GE Capital. So GE Capital isn’t here. As much as people talk about new entrants, people don’t talk about the big people who’ve exited and the size of those numbers. So I think Silicon Valley Bank is 20% of venture lending, and they’re not making new loans right now. That’s a huge impact on supply-demand. Wells Fargo used to be our biggest competitor. We haven’t lost a deal to Wells Fargo in 15 years. As much money that has been raised, there’s also money that’s shifted out of the banking system, and being redeployed in other places. So it’s not apples to apples. It’s a very long-winded answer of saying, I find it very ironic when banks call our sector the shadow banking system. I always find it very interesting because everything I do is published and every investment I make is in my 10-K. And you go look at a bank, we have no idea what they own. You can’t itemize out every single loan they’ve made. So I find it ironic that they call us the shadow banking system when that system’s much more opaque than us. 

Shiloh: Well, sure. And there’s a lot more exposure to commercial real estate for banks as well. And then when we were maybe prepping for this call a while back, one of the things you teased me with is you mentioned that you occasionally teach at Harvard and Columbia. Would love to hear some of the advice you give to MBAs who are thinking about maybe entering our business. 

Ted: My advice would be: This is an awesome job. I have the coolest job in the world, and I think when I was in college, I didn’t really understand. I went to investment banking and I thought I knew what it was, but I didn’t really know what it was. And same with private equity. I went into Goldman Sachs’s private equity area and I thought I knew what it was and it wasn’t. So all I’d say is we have the coolest job. I wake up every morning, I get to learn about businesses, I get to meet CEOs of companies. I probably meet 20 management teams a week, and what we do is super interesting. And just think about this versus anything else I could have and would’ve done. We have an unbelievably interesting job. So I’d say that’s number one. And then number two is, I always say the same thing, which is you can’t really have a long-term plan. So it’s good to have a five-year plan and a 10 year plan, but when I was investment banking, I didn’t even know what distressed debt was. And then here I am a couple years later on a distressed debt business doing stuff that I didn’t even know what it was three years ago. So the advice I always give young people is, a lot of your career, you have to make micro decisions. People always say stuff like work for good people. And to me that’s like, of course. That’s like saying marry somebody you like. Of course you want to work with good people, but you have to take a step back sometimes and look at the macro. During the 2006 time period, it wasn’t like people thought housing was cheap. Everybody knew the subprime thing was crazy, but obviously people didn’t forecast severity. They didn’t think that it was going to unwind and Lehman would fail. So I think you have to take a bit of a macro approach, too, when you’re picking a career, in the sense of it’s probably not a good idea to go into the cigarette business today. But when you look at other businesses with tailwinds, if the industry is doing well, oftentimes there’s a lot of opportunity for young people to do well as well. I’ll say one more thing, and this is what I always say to people: People always say “take a risk in your career”. And I can’t disagree with that more. What I always say is take calculated risk. To go to some startup out of college and try to become the next Mark Zuckerberg and be the 10th guy there… For every one of him, there’s thousands of people who are not him, and then you don’t have a brand on your resume. So it’s always good, if you can, to start at Apple, or Amazon, or Goldman Sachs, or McKinsey, or somebody like that. And if you are going to go to startup, make sure it’s calculated risk versus just risk. 

Shiloh: Do you think the distressed debt business is a good one for investors today? 

Ted: I got to be careful on this one. I just don’t think distressed debt is a good asset class. If you back-test returns for a very long period of time, distressed returns are not that great. And what I would tell you is I think distressed is a really interesting asset class, every four years, but it’s not always interesting. So going back to my comment about mandate flexibility, having the ability to do distressed is really important, but if you’re only doing that, it’s a really tough business. So today, distressed debt’s not interesting. And it really hasn’t been interesting for a while. Even in 2020, just because it was a broad selloff, you could buy Charter bank debt, cable company, who knows what’s going to happen in the pandemic, who knows what was going to happen in the next couple of years? No one knew a vaccine was coming out. The one thing you do know is people are going to pay their cable bill and they’re going to do that every month, or more importantly, their high-speed data bill. So that bank did trade at like 78. Meantime, cruise line debt was trading at 70. So yes, cruise line debt was cheaper, but who knew that? Yes, we all thought people would get back on cruise ships, but we didn’t know when and how long and how much cash they’d burn through in the meantime. So just buy the easier thing. Even 2008, you could buy anything at 60 cents. I don’t view that as a great distress cycle. You can go buy great companies bank debt at 60, 70 cents. You didn’t have to go buy some piece of — company that has a terrible balance sheet. So I think the last real good distress cycle or good relative returns was in the early 2000s, post Enron, WorldCom, Adelphia, all these things all happened at the same time. It was an unbelievable time because the market hadn’t reached a level of sophistication that it’s today. Today, there’s such sophisticated people in our market, and when I say that I’m not just talking about Oak Tree, I’m talking about Eaton Vance and Fidelity. They’re very sophisticated in this area now. And unless you have a ton of capital, you don’t want to go into distressed because you get run over in these LME trades and creditor-on-creditor violence. If you’re a little guy, you’re going to get absolutely destroyed. And I just don’t think it’s a good idea to do that. 

Shiloh: Do you think part of the last attractive opportunity set is just a function of how much capital has been raised in these distressed funds? 

Ted: One thing that’s always talked about in newspapers has been a great thing is the rise of passivity. ETFs, no fees, outperforming active management. In 2020, we had six of our seven worst trading days of all time, in a row. And you and I could debate this, but it wasn’t worse than 2008. So why is it that we had our six worst trading days in 2020 and not in 2008? And the answer is, everybody we were buying debt from in March of 2020 was an ETF. So when an ETF gets inflows, they buy stuff, and when they get outflows, they sell stuff. So when we went to business school, we learned about the efficient market hypothesis. And obviously when so much of the market now is in passive hands, it becomes much more flow and technical driven than fundamental driven. And that’s, by definition, not efficient. So the key, I feel, is to buy assets during periods of dislocation, and then sit on the sidelines for the rest of the time. 

Shiloh: And then in terms of the, maybe tracking back to the MBA classes where you’re guest lecturing, besides what they should be doing as career advice, is part of what you’re lecturing there, just what are some differences you should expect from what you’re learning in the classroom versus what you’re going to experience in real life in the job? Is that a big part of what you’re teaching? 

Ted: Yep. There’s 10 key tenets to my business school education, most of which has been wrong. For example, you learn that classic formula: inflation plus currency equals… Currency should always adapt to the inflation rate over time. So if the markets were efficient, why is there a Japanese carry trade that’s persisted for 25 years? So like the markets had a massive spasm in July around the unwind of the carry trade. And again, if the markets were efficient, and that formula held, that carry trade existed for a long, long time. That’s just one example. Or I use the efficient markets hypothesis, which you know what that is. And then again, the world’s changed. The number of banks has declined by a lot. The number of public companies is down a lot, 75%. And more and more capital is flowed into alternatives. The world is a very different place today than it was 25 years ago. The idea of Apollo and me being super excited about insurance is we had that conversation 25 years ago, be like, what? How is that exciting? But now it’s exciting. 

Shiloh: I think some of the differences I’ve noticed would be in school you learn valuation is DCF, and if you start in my firm of yours and that’s your first inclination is to do that, that’s probably not going to get you very far because there’s just so many assumptions. It’s correct theoretically, but you have to put so many assumptions into a DCF that, at the end of the day, probably not super useful, but things trade at a multiple, they trade at a multiple of earnings, or they trade at a multiple of EBITDA a and that’s really how people think about it. And then the capital asset pricing model, beta times the return, less the risk free, or people using that. Maybe you’d find that if you hire a valuation expert, and they put together a 40 page valuation on something, maybe that would be in there somewhere. I think it’s good to know the theory, but it’s not what practitioners are doing. We think about risk, really, as it’s something that you have intuitively in your head after a ton of reps, as you’ve said in a previous podcast, but there’s no way to necessarily quantify… When you invest in a middle market business, there’s some chance it’s going to go bankrupt. That’s the risk you’re taking. But how you would really put a number on that to quantify it, I think that’d be really challenging. And the risk is low. It’s a low number. 

Ted: I agree with that a hundred percent. It’s good to learn this stuff because it’s the theoretical underpinnings of, again, six times EBITDA, and that’s cheap, ties into a DCF. You can actually tie it all back to theory, which I think makes sense. But your point about beta is a good one. Why is it that Bitcoin gold stocks are all trading at all time highs? Spreads are all time tights and Treasuries are rallying. That doesn’t make any sense. Every correlation’s gone to one and we think about portfolio diversification and allocation of capital. Again, these things are supposed to move in different ways. And when correlation goes to one, it comes back to we’re supposed to rethink some of these asset allocation models. 

Shiloh: So one of the things I think you’re doing at BC that it’s very interesting is that most of your competitors, I think they’re just growing by launching new funds. And at BC Partners, it looks like acquisitions is part of the strategy. So I’d love to hear how you think about that and what you’ve accomplished thus far. 

Ted: Credit’s very different than equities. You and I could start a hedge fund in equities with $30 million and make money, and you and I, 20 years ago, could have started a credit business with you, myself and A CFO. The barriers to entry are so high and the costs are so high, fees have gone down, compliance has gone up, legal has gone up. So you need a big business. When people talk about all these people entering private credit, it’s just not true. It’s the same people, they just have a different business card, but it’s not that easy to get into our business. So I think the reason there’s opportunities to buy is scale is becoming very important, and both to service our clients. So as their deals get bigger, we have to hold more and more debt from them. And on the GP side, for us, the economics of our business, we need to invest in distribution. So we need to hire IR people and build out our retail distribution, everything else, which is expensive. So you need scale to be able to do that and it becomes like a flywheel. So I’m not saying AUM is, we’re big into controlled growth, but for example, there’s a space called the business development company space, or BDCs, and there’s a number of sub-scale BDCs that just didn’t trade well, that couldn’t grow. The management team was stuck. We took five of them and rolled them all together and now we have a bigger BDC, and it trades better, and shareholders are really happy, and we’re more relevant to clients. Scale has just become more important, and sometimes buying is better than building. I think people look at it and say, well, why you spend all this money? For me, I’ll give you an example. We bought a retail business and it came with a team and a five-year track record and AUM. If I started that business from scratch, it would’ve taken us five years and I would’ve spent more money than what we did on the acquisition. So you obviously grinded it and did it organically, which is one way to do it. 

Shiloh: Yeah, for us it was just organic. 

Ted: And it was great. And you guys have had massive success, but for every one of you, there’s a lot of notyous. So you guys have done the best amongst a lot of people. We just made the decision to de-risk. Let’s buy it. It’s going to cost us the same to build it, and if we build it, it’s not without risk. You guys have had great performance, great AUM growth. That’s not a guarantee when you start a business. 

Shiloh: Do you find it’s a competitive space, acquiring other asset managers that are subscale, or maybe haven’t had the same performance you’ve had? 

Ted: I think there’s a big valuation arb between big platforms and not big platforms. Because Oak Tree is not going to pick up the phone for a hundred million dollar BDC. It’s a waste of their time. They raise more money in a day than the four month process for them to buy it. So when you look at the big BDCs that have sold, they’ve traded a big multiple premium to the small ones just because who’s going to waste their time on a small BDC? So this is my own view. I don’t think it’s that competitive. And the reason for that is because most of my peers are pure investors, so they’re really, really good at investing. To buy companies there’s a whole separate skillset. It’s M and A, it’s social, it’s pitching boards. It’s convincing shareholders that you’re doing the right thing, getting shareholder votes. There’s a whole other set of things you need to do. So I think everybody fantasizes about it and wants to do it, but they don’t really know how to do it. And it’s not rocket science. Anybody could do it. It just takes time and you have to go for a lot of beers and you have to grind out on these processes. Obviously it’s competitive, but I think we’ve shown that we’re pretty good at it. And then once you do your first one, it becomes much easier to win because people now see, okay, you got this done. They talked to the employees who came over who were super psyched to work here, and it becomes a little bit of a self-fulfilling prophecy. 

Shiloh: Are you surprised that there’s not more M and A activity in the BDC space? Because it seems like there’s a lot of BDCs trading pretty substantial discounts and not really a lot of shareholder activity pushing for change. How do you think about that? 

Ted: I think a lot of the BDCs that needed to get merged have merged. I don’t think you’re going to see a wholesale wave of BDC mergers. I think there’s some niche areas within BDC space that probably need to be consolidated, but by and large, I think a lot of that consolidation has been done. I think the one thing that people aren’t talking about is there’s lots and lots of money that have been raised to do BDCs, interval funds, et cetera, that are subscale in the non-traded space and there’s a lot of stranded assets and funds in that space. So it probably makes sense for some of those guys to come together or merge with a public company. So I think if I had my crystal ball and rolled forward three years, I think a lot of the M and A will be private companies either merging with public, or private companies merging together. And things like closed-end funds. There’s lots and lots of closed-end funds that don’t know what to do. They’re perfect candidates to merge with. So I think you’re going to see what I would call non-traditional M and A. 

Shiloh: One of the things we’ve seen over the last few years is that there’s a real trend towards just the private BDC, which stays private perpetually, rather than going public. Is that something that your LP investors are more interested in that structure than the traditional publicly traded BDC? Is that what you’re seeing? 

Ted: I think there’s different markets for both. So my shareholders in my BDC are pretty different than my LPs and my private BDC. And again, a lot of my LPs in my BDC want the steady distribution of cash. They don’t want the daily mark to market and the stock, and they want to be tied to NAV, not market. So I think it’s two different buyers. And if we could take our BDC public at two times book, I think our LPs would be pretty open-minded to it. But I think LPs have a bit of a fear that these things go public and trade at a discount. So you get dinged on your net asset value, or at least market trading price. 

Shiloh: Would you say BDC is an asset class that overall has performed well for investors and that people should have a decent allocation to in their portfolios? 

Ted: I think so. Take a huge step back. Everybody always stares at stock prices in BDCs, but they don’t look at stock price plus dividend yield. So my stock pays the 13% dividend yield. That’s a lot. So you can withstand a lot of mark to market because we’re paying out so much cash to our investors. BDCs over time, I think, have delivered for shareholders, and you get what you pay for. If you back a high quality manager, they’ve done very well. So something like an Ares has done incredibly well, fundamentally and stock price-wise and also been able to grow. So I think if you were a good credit underwriter, and you’re balanced about growth, I think they’re great investments. And again, it’s changed a lot. When I started in the space and took over, I was running, I think, the second biggest BDC at the time. It might’ve been the biggest. At that time, most BDC managers were entrepreneurs, and if you roll forward today, it’s institutionalized. So KKR, Carlisle, Blackstone, best in class firms, all have BDCs, and the entrepreneurs are largely gone. So if you roll back 15 years and look at a comp sheet, basically they weren’t attached to a large asset manager, and now the space is institutionalized. So what does that mean? I can’t say that they’re better investors or not better investors, but KKR is not going to miss-mark their portfolio. So some of the noise around some of these books that Einhorn wrote and everything else, 

Disclaimer: Note: “Fooling Some of the People All of the Time” by David Einhorn is an excellent book about investing in business development companies. 

Ted: The reality is these firms are too big and too important to screw around with shareholders. So the worries around bad behavior and stuff have just gone away. 

Shiloh: One of the things I saw during the COVID downturn though was a lot of the BDC share prices got cut in half. So if you got an exposure to a portfolio of secured loans, mostly first lien, some second, and then some other funky stuff, and down half is what you get in a downside case, I mean that really pretty unfavorably skews your risk return. That was my takeaway from COVID.

Ted: Fair, but I view it the other way around. Which is, just take 10% defaults. So in 2008, defaults in the broadly syndicated market didn’t hit 10%. And the broadly syndicated market typically has higher default rates than the middle market. So just use the number of 10%. And in the middle market, recovery’s been 80. So a really bad year for a BDC would be to lose 200 basis points of NAV, unlevered, and then they’re levered, so call it 4%. So if a BDC stock trade is down by 50% and they own first lien debt, you should buy the stock. I view it as a buying opportunity, and if you own it, buy more. And that’s always worked. Anytime you buy BDC at a big discount to book, these things always normalize and they revert to the mean. So anytime you can buy one of the best in class guys at 90% of book, they almost always go back to book. And when they go to 110 of book, they oftentimes will trade back down to 90. So in my experience, there’s been a big reversion of the mean trade and there’s some really smart BDC investors who’ve made a lot of money by doing that. 

Shiloh: Do you think that in general the fees in BDCs are too high and that’s what has some investors shying away from the asset class? 

Ted: Again, I think everything you have to look on a net return basis. So those platforms who’ve cut their fees are, generally speaking, not best in class. So if you correlate fundamental performance to fees, there’s no correlation. Meaning those who’ve cut their fees, typically, are guys who have not performed well, and those who have the high fee structures that perform well. So I tend to come at it, like, you get what you pay for. I know certain hedge fund allocators, they will only give money to managers at really low fees and they don’t understand why their performance is poor, and they have to understand you’re getting adversely selected. I just think you get what you pay for. So the thing I think that is a bigger issue is the differential in fees between what public shareholders pay, and in certain cases, what private investors pay. And maybe we have a debate about the differences, but the differences in some cases are too high, and that’ll normalize over time as well. 

Shiloh: And then transitioning to CLOs, I know you guys have a few that you’re managing, should we expect to see more issuance from your platform over the coming years or how are you viewing the CLO product as being useful to you? 

Ted: Well, I’d say a couple of different things. One is a CLO business to us is strategic because you have a library of every credit out there. So when there is a downturn, you can be aggressive and opportunistic in the whole business, and you’re more relevant to the street, and everything else. So that’s number one. Number two is one thing that you do, which I think is an awesome business that quite frankly, listen, you’re best in class and I’m not sure that we would be, but CLO is a great asset class. You just have to hold it in the right place. So if you look at 2008, no CLO has defaulted. In the height of structured products, carnage, CLO equity performed and CLO liabilities performed. So I always think CLO liabilities provide really off-market risk return, always, in any environment and in periods of stress, crazy risk/reward. 

So it comes back to size. It’s very hard to source that stuff in big size during downturns. It is a weird conversation because I feel like you’re the professor, I’m the student, and I’m lecturing you on it. But the reality is it’s very hard for me to say that CLOs and CLO liabilities and having that capability isn’t great risk reward in many different environments. So I think the problem, it gets tainted a by broad structured products and the subprime mortgage crisis has nothing to do with subprime mortgages. They’re totally different and the abuse that happened over there just doesn’t happen in CLO land. 

Shiloh: I think the difference though, by contrast, our CLO equity or double B investing versus just owning middle market loans directly, in like a GPLP fund or a BDC, it’s just that all the CLO securities, they’ve got a CUSIP, they’re trading around in the market, they’re modeled in Intex so anybody can see what’s going on. And if we’re trading, or somebody else is trading with a bank or a hedge fund, a lot of those trades are reported. So you’re going to see volatility in CLOs, CLO securities, that’s going to be quite different from just holding a middle market loan directly. In middle market loans, we see, a lot of times they’re underwritten at a price of 98 cents on the dollar, and if everything goes according to plan, the mark will be around that price for the five-year life of the loan, call it. And even if the loan underperforms, I think different managers would mark it differently. Some take a more optimistic look at it and say, “oh, well this has underperformed, but I still think I’m getting my money back and it’s near par”. I think other people would take an approach that would have the loan marked at a discount, but the end result is that the middle market loans do have a lower standard deviation than the CLO securities, less volatility, and some GPLPs just want that. But if you’re holding it for a long period of time, and you can bear a drawdown on your NAV, then my DNA is the CLO. That’s what I like. 

Ted: I think that’s very well said and that’s why I made the comment earlier about just make sure you own it in a place that has locked up capital or you can withstand mark to market. 

Shiloh: So is there anything that’s interesting to you that we haven’t talked about, or anything that’s going to keep you busy this fall? 

Ted: The thing that I’m spending my time on is, so if you think about the business of a GP, we can either scale assets very quickly, but they’re low margin and there’s other things we can do that are high margin but hard to scale. So the question is what scalable platforms are there that are high margin? So a place that we’re really active in is, and I mentioned it briefly before, is we’ve spent the last 15 years replacing banks in corporate lending. And now if you look at for the next 10 years, I think we’ll replace the regional banks for a lot of things that they do. So lender to lender finance, factory and equipment finance. It’s a strange world right now. Blackstone is able to provide us with financing. So five years ago we would’ve gone to Credit Suisse, now we go to Blackstone. We can go to other people too. Or if you think about, Apollo bought Atlas, which is Credit Suisse’s securitization business. If we had a security, something that was complicated and whatever, that’s an amazing business. So now if I have to securitize something, I’d go to Apollo. It’s interesting to see the evolution of all this stuff. When we had a problem, we used to go to the banks and the banks would help us solve it, and now oftentimes the banks come to us and they want us to solve their problems in terms of risk transfer, or reg cap relief, or leveraged finance businesses feel like they’re getting their clocks cleaned by private credit. So how do we monetize our origination efforts with your balance sheet? So there’s some really interesting dialogue and partnerships going on right now with large banks where we think about what a bank is, they have an amazing front end and amazing origination. What are we trying to build? We’re trying to build that and we have a balance sheet that is able to take on these assets. And to your point, we’re not dealing with ratings and risk charges and the Fed and we don’t have to deal with that stuff. We’re heavily regulated and we obviously have things that we’re regulated by, but it’s a very good marriage in a lot of different situations. So this whole private credit thing, I still think we’re in early days. We’ve replaced middle market lending. Now they we’re replacing large lending, now we’re going to replace the regional banks. Athene now is bigger than Swiss RE, I think. So our world is now taking over insurance and I’m actually really, really excited for the next 10 to 15 years, and I just think there’s so much growth ahead of us. 

Shiloh: Does the asset based lending and the securitization that banks are doing that’s maybe being moved to alternative lenders, does that really offer returns that are interesting to your investors? I thought of those asset classes as being quasi-investment grade or at least highly internally rated at the banks. 

Ted: So after Silicon Valley Bank, the average bank has a 25% mark to market hit to their equity. A lot of it’s driven by rates. Everyone thought there’d be a lot of M and A. Well, if there’s M and A, then you’re merging with somebody else. You still have a big hole in your balance sheet. What banks used to do in the US is they used to issue equity, but Silicon Valley Bank tried that and there was a run on the bank. So the only real solution is to ramp back on lending, and that gap over time is just going to close as things mature and duration shortens. So that’s what’s going on. Again, all this will normalize, but spreads are wide and do work for our investors at current pricing. And there’s other things we can do like back-lever it and do some other things that get to the returns that we need to get to if we want to do that. But you’re making a good point. We don’t really have a whole bunch of L350 or L400 products. We just can’t compete because if I raise money in that space, I can charge 30 bps, 40 bps, and I need an army of people to do that business. We just can’t make money doing it. What we can make money doing is if we can get a little bit higher yields, then you can charge a hundred basis points and then just do the math. We can actually afford to hire a team and build out a business. So the only counter to all that is if you can get stuff rated. So a lot of what we do is we originate illiquid stuff at wide spreads, we get it rated, and now they comp incredibly well to liquid credit and we sell that to insurance companies. That’s becoming a very large part of our business. 

Shiloh: So the SRTs, that’s the significant risk transfer, so that’s banks selling exposure to investment on their balance sheet and they’re doing that rather than issuing new equity to the market. Have you guys been involved in that? 

Ted: So we’ve been acting in that space for a long time. Deutsche Bank has a program called Craft. They have a new one called Loft, but now we’re actually seeing it at a much smaller level. We saw one from a HUD based lender, smaller bank that, again, would never have done one of these 10 years ago. So it’s becoming much more relevant for not just the big, big banks, but for a lot of banks. And it’s a win-win. If I’m taking a revolver from Bank of America as a company, you don’t want to see a distressed lender showing up at your door owning your revolver. You just don’t want that. So this is a way for them to maintain their client relationships, maintain a front end with these clients, but from a risk capital perspective, get off their balance sheets. It is a win-win, and these things price at a place where it’s very hard to lose money. You may not make lots of money, but in terms of risk return, it’s hard to lose money. All that being said, the caveat to everything I just said is the thing that SRT that always keeps me up at night is you’re selling first-loss risk. And it feels a little bit, and I dunno if you agree with this Shiloh, but it feels a little bit like we might be going into a more elevated default cycle. So if you’re doing first loss risk and defaults go up, those things aren’t good combos. So with the economy slowing down, and again, I’m not a macro economist, but it just feels like it’s slowing down, and that usually leads to defaults, and that usually leads to bad things for SRTs. So that’s the two sides of it obviously. 

Shiloh: Is one of the issues, and I haven’t looked at SRTs that much, but they’re obviously quite close to CLOs in structure. But in the SRT, it’s a pool where they may be a hundred designated assets at first and then the portfolio changes over time. Not sure how you’re in the first loss there. I guess you’re underwriting the bank’s underwriting, and getting comfortable that the loans that they continue to underwrite and put into this vehicle are ones that fit into your credit box. 

Ted: So I would say the way these are typically structured is one of two ways. So either do it against a static pool, which you can underwrite. More often than not, it’s a identified pool of loans and the bank has the opportunity to recycle some of that capital in what I call a credit box. So they obviously can’t start putting in derivatives and a bunch of random stuff in there. They have to fit a certain box, whether it’s regional, leverage levels, rating, so you can put restrictions on what the can and cannot do, and make it so it’s not purely a blind pool. And that puts limitation around the business. And then if you look at that static pool of loans with a three year reinvestment period, really you’re only taking exposure to 20% of the assets rolling off or something. So you can actually get comfortable with it from a bunch of different ways. 

Shiloh: Are you finding the SRTs that you’re interested in, or do they have assets that look similar to your private credit portfolios, or are they pretty heterogeneous in what’s in there? 

Ted: So the classic SRT that we see is the relationship lending book of big banks. So every time they do a leveraged finance deal, Deutsche Bank takes a piece of the revolver, and it sits on their balance sheet, and then they do a SRT to get that off their books. That’s the classic trade. So when we see these things, you would know all the obligors, it’s all liquid loans. We are beginning to get into more esoteric loan books, but those require a lot more work. So if you’re going to get into private credit assets, and you don’t know who these obligors are, that’s obviously a lot more work. So a lot of times the banks, when you look at who they own, they own GM, they own Pfizer, they own companies that you know. Verizon. Companies that are rated well and you know and can box credit risk. More and more and more the new ones we’re seeing, for the smaller banks, we typically don’t know any of the names, so we have to do a really deep credit underwrite. So those take a lot more time. 

Shiloh: Interesting. Well, Ted, thanks for coming on the podcast. Really appreciate it. 

Ted: Thank you so much. 

Disclaimer: 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 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 period

EBITDA is earnings before interest, taxes, depreciation, and amortization

An add back would attempt to adjust EBITDA for non-recurring items. ETFs exchange traded funds 

CMBS are commercial mortgage-backed securities. A BDC is a business development company

Basel III is a regulatory framework for banks 

Efficient Market Hypothesis posits that it’s hard to consistently beat the market 

GP NAV lending refers to lending against the equity value of a private equity firm’s investments 

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.

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. Today I’m speaking with John Timperio, the co-head of Dechert’s global Finance practice. Dechert is one of the prominent law firms in the CLO industry and someone that I’ve worked with on many transactions with over two decades of experience. John is a trusted advisor to CLO managers and investors. I asked John to come on the podcast to discuss the exciting topic of CLO regulation. This podcast is going into the weeds, so buckle up. If you’re enjoying the podcast, please remember to share like and follow. And now my conversation with John Timperio. So John, welcome to the podcast.

John:

Thank you for inviting me.

Shiloh:

Are you guys having a busy August at Dechert? It seems there’s a lot going on in the market.

John:

We are as busy as I can remember across our finance practice. So I co-head the finance practice at Dechert and we do CLOs. We do ABS, CMBS, and large loan real estate, and all of those silos are going gangbusters. The CLO piece in particular has just been extraordinarily busy, in particular with private credit CLOs, which continue to enjoy or bask in the spotlight of investor demand.

Shiloh:

Gotcha. So how does somebody become a CLO lawyer?

John:

For me, it was a fairly circuitous path. I’ve been doing this for 33 years out of law school. I started doing real estate that market, this was 1991, was dead, transferred into the bankruptcy group, which was going on, firing on all cylinders at that point. When that slowed down after a few years, given my background and understanding of bankruptcy, remoteness and structures, it was a natural segue into structured credit when I started doing structured credit full time in 1998. It was also an interesting period in the market. It was right at the beginning of the CLO world. So I had at that point moved to Charlotte, North Carolina and was doing a lot of work with a bank, First Union, which was highly focused on middle market credit, middle market CLOs, and was able to get in on the ground floor of doing. And those are still
a huge piece of our CLO business 25 years later.

Shiloh:

There’s a lot of CLO lawyers out there. John, how does Dechert differentiate itself?

John:

Great question. There are a lot of CLO lawyers out there, although if you look across the market, there are probably five or six firms that do a bulk of the work. I think what differentiates Dechert is our platform and I think there are a lot of terrific lawyers that can agree to make collateral management agreement, read an indenture, make comments. I think what differentiates us is in addition to the CLO platform, we have the world’s best Advisors Act practice. And if you’re an asset manager, frequently with your CLOs, you have tons of Advisors Act questions or if you’ve got a BDC, you have all these conflicts and other issues that come up. So we’ve got this great platform which includes terrific advisors act practice. Our tax practice is top-notch in the middle market area, really groundbreaking in terms of their views. The tax issues in the private credit space are a lot more challenging for people to get their arms around because you have someone that’s actually originating a loan.

So you have to figure out a strategy if you have an offshore deal or offshore investors. So those can be more challenging. So we’ve got terrific tax practice. So really I think the reason clients hire us is not exclusively for the CLO piece, but it’s all the other pieces. We’re also the world’s leading rated funds practice, CLO equity fund practice, and when clients are putting all those things together, that’s how I think the calculus is tipped in our favor in some cases and it’s been very helpful. So when we’re chatting with clients, it’s focused around the platform and the resources there, and then the fact that we did close to a hundred transactions last year I think gives them a window into the workings of CLOs that can be very helpful as they try to think about what’s market and we can give them up to date, up to the minute color on, well, here’s how this stip or request from an investor is getting settled at this point in time.

Shiloh:

So if I go to a CLO conference today, they always allocate 45 minutes to have some industry lawyers on a panel to talk about what’s new in regulatory issues for CLOs, is there anything that’s top of mind or important for CLO investors or managers today?

John:

Great question. We at the moment are enjoying a relatively, I wouldn’t use the word benign, but stable regulatory front. So good news, is unlike in the years following the financial crisis, the pace of new regulation has slowed. Right now we primarily work with asset managers. A lot of our asset manager clients are focused on some of the conflict of interest rules, which will go into effect in the middle of next year. And their compliance policies with respect to those rules and those rules prohibit material conflicts of interest between managers and sponsors and investors, and were really designed to prohibit transactions that were designed to fail, which was never a real feature of the CLO market. But 12 years later or now finally going to go into effect and managers have to focus on some compliance there and putting up some information barriers. So we’ve been talking to managers about that.

Shiloh:

So John, as you know, CLO securities have performed very well across the stack from equity to AAA on a buy and hold basis from prior to the financial crisis and forward. So what was the push to have… Why was more regulation needed?

John:

Interesting question. I think the answer just based on the hard data is that the industry did not need additional regulation. As you noted, there really weren’t any CLO tranches, there were not many, at least that went into default or didn’t pay in full. So they’ve had a relatively pristine track record in the financial crisis though there was a conflation between CLOs and a product with a very similar acronyms CDOs, which did experience a lot of problems. What’s interesting now, though, is a decade and a half removed from the financial crisis, I do think regulators understand that CLOs are safe products. We have clients who have ETFs that buy CLO liabilities and we see a lot of interest in CLO equity. So I think regulators understand that this is not a dangerous product.

Shiloh:

So the biggest regulatory change for CLOs post the financial crisis was really, in my opinion, risk retention. So maybe you could give our listeners just a quick overview on risk retention, how it worked, and then the remnants of its implementation, how they continue to effect this even today.

John:

So the US risk retention rules are aimed at requiring a securitizer, which is a party that transfers assets into a ABS transaction and asset backed security, to retain skin in the game. And they calculate that a few different ways, but by and large in the CLO space, it’s either with a vertical strip of 5% of the CLO liabilities or an interest in the most residual tranche. The equity tranche equal to 5% of the fair value of all the notes issued in the CLO and initially in the adopting release, the SEC and the regulators took the position that the collateral manager of A CLO was —

Shiloh:

— the securitizer —

John:

— exactly — very controversial position, which resulted in a lawsuit where the LSTA sued the SEC.

Shiloh:

The LSTA is the loan sales and trading organization, that’s the organizational body for the leveraged loan industry.

John:

So they brought suit and the courts ultimately decided that the clear language of the statute was what governed and the language of the statute was based on a transfer of assets into a CLO. The interesting thing  is it had two implications. One is open market broadly syndicated CLOs no longer had to comply or did not have to comply with US risk retention. And those transactions, which are the 80% of the market, a manager faces the open
market and purchases either in the primary or secondary pieces of loans into
the CLO from third parties. And basically those deals are designed to allow
these asset management platforms, which are your clients as well. And some of the largest, most well-known asset management platforms in the world to gain AUM and management fees. And the track record is pristine, as you mentioned. The other piece of the market are the private credit middle market balance sheet side of the market that is traditionally or historically always been around 10%.

Last year it was 20%. It’s been hovering in that range as there’s been a lot of buzz and focus on private credit CLOs. That part of the market does have to deal with risk retention because in those transactions you do actually have an originator of assets, generally maybe it’s a BDC or an Alts platform. They actually make the loan, they underwrite it, and then they transfer it into a CLO. They use the CLOs as attractive forms of non-market to market leverage, which frees up other capital for them to make loans. And so in those transactions though, we’ve had to comply with risk retention generally in
those deals, interestingly has not been as big an issue because generally the
platforms that originate the loan want to retain all of the equity, or at least
most of it. I know you all also invest in that equity, but it has not been as
big a problem as it would’ve been on the BSL side where you have these BSL
managers who just could never write the amount of checks that would be required to manage 50 CLOs.

Shiloh:

So then the setup today is basically this. If it’s a broadly syndicated loan CLO, there’s no risk retention in the us. So the manager is not required to buy 5% of the AAA down to equity. They’re not required to own 50% of the equity, which I guess would be the other way to satisfy that previous requirement. And you can do that and you can sell the CLO securities in the US and you’re fine, but for that US broadly syndicated CLO security, if you want to sell it to European investors, then there is risk   retention still in place in that continent.

John:

Exactly. What’s been interesting is, as I mentioned, the
middle market CLOs or private credit CLOs, they do comply. There’s some
exceptions, but by and large they comply with US. Sometimes they also comply with European risk retention in order to sell the liabilities to European
credit investors. So sometimes they have dual compliant deals. In the middle
market context, dual compliance is a little more complicated given the type of
reporting that’s required for European compliance. So it’s a little more difficult for them to do that full suite of reporting. But we have a number of clients that have done it and continue to do it. In the broadly syndicated space, even though there’s no US, we frequently have some clients that will set up structures to comply with the European risk retention rules for the same reason it broadens the investor base the liabilities and thereby increases the yield on the equity of their buying equity.

So a lot of what we’ve been doing recently with the managers we set up is set up a structure where they can subsequently use that management company that they’re establishing to hold EU risk retention and thereby satisfy the EU risk retention rules. Interestingly, for BSL CLOs, the reporting is a little easier so that they’re not as troubled, although by that aspect to comply with the European rules, they have to hold 5%. Europe measures it a little differently. They look at 5% of the notional of the portfolio. So it’s a slightly different calculation than the US, but gets you roughly in the same ballpark. So if you think about the market or the landscape private credit, by and large, you do have transfer orders and they do comply broadly syndicated, no US risk retention. They sometimes comply with European in order to facilitate better execution. What’s interesting is there’s another part of the market that’s really picked up steam and that relates to rated feeders, rated note funds, and those are really primarily or exclusively in the private credit space, but they’re initially started out as feeders into private credit funds where people were structuring a feeder so that it had rated debt to facilitate investment by insurance companies.

But now sometimes those deals are very similar to CLOs and the tranching and how they look. But what’s interesting about that market is by and large, because there’s still a lot of fun like aspects to those transactions, people have not treated those as needing to comply with US risk retention. So you do have this other category, and that’s a very burgeoning part of the market on the private credit side.

Shiloh:

Why was it that risk retention was in the US only repealed for broadly syndicated CLOs and not for middle market CLOs?

John:

It was really because the way Congress had drafted the statute was to require a securitizer to hold risk retention, and they define securitizer as the party that organizes and initiates the transaction by transferring assets into the CLO. In a middle market context, you do actually have originators that transfer much like ABS deals. In the broadly syndicated CLO market, the asset managers just acquire from third parties in the open market, much like stock picker of a mutual fund would acquire stocks.

Shiloh:

So though in middle market CLOs, even though risk retention exists, what I see is that the manager of the CLO, they want to own securities in the CLO as well. So they’re required to do it by law, but they want to own a majority of the equity. They often take strips of the senior securities. So it’s not really a burden for them. At least that’s my perception of their business model.

John:

Absolutely. I think what’s been interesting to me, well a few things. One is over the last, I’d say again, 24 months or so, we’ve seen much greater interest in CLO equity and had a bunch of clients raise CLO equity funds. I think that that on the broadly syndicated side, not on middle market, so a number of BSL managers have gone out, dedicated CLO equity funds, and used that money to invest into their own CLOs generally in a way that was EU compliant as well. And that has been something that’s interesting because if you go back five years ago, those who are very episodic, where we might do one or two a year, now, we probably have 10 going on at the moment, people are able
to raise that money. We don’t see that in the middle market space for the
reason you mentioned, the managers really don’t always want to part with that equity and really when they are, they’re going to do it with a strategic
counterparty like a Flat Rock, who they trust and they know they’re going to be a good actor in our transaction.

Shiloh:

So then is there any expected changes to the risk retention framework that exists today? Are there any proposals out there to do it differently?

John:

No expected changes. Certainly there could always be new rule-makings, but nothing we’re aware of in the pipeline. What’s interesting is some of the vehicles that we helped set up in the very early days when people thought it was going to be applicable to both BSL and middle market are still around and in some cases highly successful. The one that comes to mind is Redding
Ridge, which is 25 billion or more in AUM at the moment.

Disclosure:

Note Redding Ridge Asset Management is an independently managed affiliate of Apollo specializing in structured credit.

John:

And that was set up initially as a collateralized manager vehicle, which was an option where you set up an independent company from the main platform and raise capital into that. And that vehicle has been incredibly successful and like I said, still exists and has an AUM that’s very enviable.

Shiloh:

So I guess the punchline is risk retention has gone away, but the manager in the past was able to raise risk retention funds and presumably the funds performed well. So even though the requirement isn’t there today, they keep these funds active.

So then changing topics, I know you guys work on negotiating both middle market and broadly syndicated CLOs. What are some of the key legal differences between the two?

John:

Very interesting, and we were involved with the full evolution of the private credit market and initially those deals emanated out of an ABS-type structure where it was repurchase and all this recourse back to the originator or the assets.

Shiloh:

So an asset backed security, so different from a CLO or what’s the terminology there?

John:

It would be asset backed security. So —

Shiloh:

— securitization of business equipment or aircraft —

John:

— that was the original DNA of middle market CLOs. And then over time they did converge and now the technology is largely the same, but they have a number of characteristics that are different between the two. And first off, the motivations are vastly different. As I mentioned, middle market CLO managers largely use the CLO as just a financing source for collateral, whereas in the broadly syndicated space, they’re really using these as a way of gaining AUM management fees, and as arbitrage vehicles. High level differences as you look at the two first, the collateral obviously middle market CLOs, the collateral is less liquid; generally has credit estimates versus public ratings, and there’ve been the B minus range, whereas the BSL broadly syndicated loan space, it’s a little higher, maybe B/BB minus. Generally middle market CLOs, the loans and middle market CLOs generally have covenants, which in our BSL world is not always the case and most of the collateral will not have covenants.

It’ll be covenant light as we say. Another difference is because the collateral is a little lower rated to begin with, there generally tends to be a higher triple C bucket and middle market CLOs than broadly syndicated CLOs. So generally 17.5% or slightly more in a middle market CLO, whereas in a broadly syndicated CLO, you might have 7.5% and then other differences, there’s a lot less trading that goes on in middle market CLOs, again, both the collateral and liabilities or much less liquid. And this generally with middle market CLOs and there’s lots of exceptions to each of these, but there’s generally not reinvestment, post reinvestment period. So again, the weighted average life will vary from a broadly syndicated CLO. The other thing I’d mentioned, and this would be attractive for investors, is there’s more credit enhancement at all the levels of the tranching. The equity is generally a larger piece of the overall transaction in a private credit middle market CLO than a BSL CLO. So the structures are sturdier than a BSL CLO, which are also  have performed in a terrific way. So not to cast dispersions there.

Shiloh:

So I think one of the things that is newer in CLO documentation today is the ability to protect yourself in a scenario where the underlying loan is being restructured. So the typical CLO would prevent the CLO manager from buying an equity security for example, or participating in inter-rights offering or maybe even buying a debt security that’s currently in default. Those are things that would generally, you think of them as being prohibited. In the past, distress funds would buy up loans of underperforming companies and
they would propose, through the bankruptcy process, a restructuring where a lot of the residual value of the company would come back in equity or warrants or other securities that the CLO couldn’t purchase. And one distressed manager described their business as arbitraging CLOs in this manner. So they buy the discounted loans, they propose an all-equity restructuring, that would result in CLO managers dumping even more of the loan to their advantage. And a distressed fund probably has no issue in buying equity and restructured companies. So the distressed funds were really taking advantage of the CLO’s strict rules, and over the last few years, there’s been a real effort to true that up so that CLOs can play on an equal footing in a restructuring process.

John:

Look, that was an interesting moment where as you pointed out, you had distressed and investors realizing that CLOs were limited in what they could purchase and really trying to take advantage of that. As you note though, over the last couple of years, by, I would say consensus of the market, really all the investors, those limitations or prohibitions or risks to CLO investors have been largely mitigated primarily through allowing the CLOs to purchase workout loans, which may include some securities as part of the package. Additionally, CLOs do now have, because of changes in the Volker rules, an ability to buy permitted loan assets, which had historically been a problem prior to the changes in Volker, there was a restriction where CLOs could not buy securities, equity securities, unless they were received in part of a restructuring, and that created a lot of risk for the CLOs.

Now they can actually own permitted non loan assets. So you’ve got a confluence of things along with an ability to contribute money for permitted uses, which includes buying workout loans and equity securities, that really have closed out loophole. But it was an interesting moment because you
saw these creative distressed fund managers all realizing that there was this
problem, and CLOs obviously own two thirds of the leveraged loan market, and it was very frustrating time for our clients. A number of those older CLOs were amended, and now the new deals do have a bunch of mechanics to address that.

Shiloh:

Well, one of the, I think easiest, mechanics is just that if the CLO manager wants to buy workout loans or other loans, that would generally be prohibited. The solution is you can buy them, but you just need to use cashflow that would’ve otherwise gone to the equity. So that’s a win-win
for everybody because the equity wants to make that investment because it’ll
improve the loan recoveries and that benefits the debt investors in the stack
and doesn’t come out of their pocket. So I think that’s one workable solution
there for everybody.

John:

Absolutely. And we see that uniformly with these
supplemental reserve accounts, which are prior to the distributions to equity.
People having an ability to put money in there and use it to fund workout loans and the like. So I agree with you, very helpful. The other thing you see is, now with permitted uses and contributions, equity can also make a contribution. So it’d be on a date other than a payment date to acquire the equity securities.

Shiloh:

So then when indentures are coming together today, what do you see as top few negotiated items, items where maybe the AAA and the equity have different views, or maybe the manager and some of the investors have
different views? What are you seeing being highly negotiated in docs?

John:

It obviously varies a bit from the perspective of who’s making the request. A lot of times the AAA investors are going to be focused around consent rights to lots of different things in the documentation. There’ll be a lot of negotiation around when you have to go get controlling class consent. They may also be focused a little bit around some of the concentrations and some of the buckets. So it varies a bit. I think what’s been interesting is recently with the changes in Basel III and improved regulatory capital treatment at the AAA level where they reduced it from 20% to 15, we’re now seeing greater interest amongst bank investors. And that’s been interesting and
driven a lot of changes with loan classes and the like, and certainly been a
positive change for the market to have the banks come back at the AAA level.
The other thing we’re seeing a lot of focus on, at least at the moment, is it
seems like people are very, I wouldn’t say concerned, but focus on PIKing
assets and the treatment of PIK assets and how they impact various tests like
the overcollateralization tests. And if you have a PIKing asset that is paying
a certain coupon, making sure that that is not haircut for OC tests. So it
seems like a lot of clients the moment are a little bit nervous around assets
that may defer some interest.

Shiloh:

So a PIK loan is one in which the loan is not paying interest or partially not paying interest. So the interest that would’ve been paid is capitalized into the par balance of the loan, which is growing over time. So I guess the question there is for the purposes of the par tests or the OC tests, higher PIKed balance of the loan, or is it the initial balance of the loan? That’s what we use in that ratio, is that correct?

John:

Absolutely.

Shiloh:

So I guess the reason that it’s maybe a negotiated point. On the one hand, why wouldn’t you use the current par balance of the loan? That would make a lot of sense. On the other hand, the loan is PIK presumably because the borrower doesn’t have the capacity to pay in cash. So it’s probably a principal balance of a loan that might be more at risk than a different loan that’s just making its contractual interest and principal payments each quarter.

John:

That’s right. Another thing I think we’ve seen more of this year, or at least recently has been truly private credit CLOs. So private credit CLOs where there’s no offering circular, just a handful of investors negotiating with a manager originator. And that’s been interesting. Again, it just shows the interest level and a lot of times you have insurers buying the rated liabilities there, so there’s been an uptick of those types of transactions as well.

Shiloh:

Is there anything else interesting happening in the CLO world today?

John:

I would say the one other thing that’s been really fascinating, I mentioned all the creativity in the rated fund rated feeder space, that space not exist five years ago. And since then there have hundreds of transactions in that space, and I think we have 30 going on in some fashion at the moment at Dechert. So red hot space. Also an area where a lot of creativity going on the box is not as narrow because you’re not solving for CLO ratings methodology. They use closed end fund methodology and lower tranche attachment points. So there’s a lot of flexibility there. But the other area that has been interesting to me has been the growth of joint ventures. This is again on the private credit side, joint ventures between middle market originators, managers,
and banks. And again, if I look at it historically, I’d say, well, we had
historically done maybe one a year, one every two years.

Now we’ve seen, and you’ve seen in the press, a number announced of these joint ventures where basically you have banks who will originate private credit loans and source them to middle market originators. Sometimes the bank JV Partners will also provide back leverage to the private credit manager on that portfolio. Sometimes they set up a private credit vehicle jointly and invest into it. So there are all these different permutations there, but that area has been proliferating. And it’s an interesting thing too because if you look at what is the proper role of banks, banks have trouble holding lots of leverage loans in their balance sheet, but they can be great syndicators of credit and earn very rich sourcing fees in that process. So you have the banks dealing with this long-term secular issue of they can’t hold leveraged loans, and for the first time being creative and saying, well, we may not be able to hold them, but we can source them and earn these fees. And then you have these private credit managers who are able to utilize the boots on the ground that these banks have. So it’s a win-win situation, and that’ll be interesting as those loans eventually make their way into CLOs, but that’s been a development that is quite novel.

Shiloh:

Interesting. John, thanks for coming on the podcast. Really enjoyed our conversation.

John:

Absolutely, and thank you for inviting me.

Disclosure:

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 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 ofvarious 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.

ETFs are exchange traded funds.

CMBS are commercial mortgage backed securities.

A BDC is a business development company.

Basel III is a regulatory framework for banks.

The source for middle market CLO issuance percent is JP Morgan CLO research.

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 merit 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.

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 in the CLO industry,
and I interview key market players. Today I’m speaking with Allan Schmitt, the Head CLO Banker at Wells Fargo. Allan has structured many of the CLOs I’ve invested in, and at my prior firm, Allan was part of the team that provided our business development company, an asset-based lending facility, or ABL, and ABL is just leveraged against a pool of leveraged loans. As you’ll hear during the podcast, Wells is active both in lending against diversified portfolios of loans and arranging their securitizations through the CLO market. I asked Allan to come on the podcast to discuss rated feeders, which are a new flavor of CLO that is growing in popularity. If you’re enjoying the podcast, please remember to Share, Like, and Follow. And now my conversation with Allan Schmidt. Allan, welcome to the podcast.

Allan:

Thanks, Shiloh. Excited to be here.

Shiloh:

Is it a pretty slow August on the CLO banking desk?

Allan:

I think most people might wish it was, but it’s definitely
been an interesting summer across the board. I think we’ve seen, obviously with
CLO spreads tightening, really across the balance of the year, has created
really an overwhelming number of reset and refinance transactions for the
market. So not only Wells, but across the board, you’re seeing 10, 15 deals a
week come across the transom. So I think everywhere from the investor side, as
I’m sure you’re aware, to the underwriter side, to the manager side, to the
lawyers, the rating agencies, I think everyone is really working through the
screws to get transactions through the pipelines here in August. So…

Shiloh:

It definitely seems that way. We’ve known each other for
quite some time. And maybe you could tell our listeners a little bit about your
background and how somebody becomes a CLO banker.

Allan:

Sure. So I’ve fortunately been in the industry around CLOs
my entire career, which dates back to 2006. So started right before the global
financial crisis. Certainly as an analyst at that time, it was an interesting
period to really begin to get involved in the market and certainly had a front
row seat to a lot of the activity that was happening at that time. My entire
career has been with Wells and predecessor firms, so I’ve been fortunate from
that perspective and as we moved out of the global financial crisis, was able
to be really on the front lines as well as we built the business at Wells
around private credit lending, around CLOs, and really was instrumental in
terms of growing my knowledge base, growing both internal and external
relationships during that period. So obviously where I sit today in my current
role, lead both our CLO effort across both broadly syndicated and middle market
CLOs as well as our private credit lending business there. And as we’ll talk
about more recently expanded our offering underrated feeders as just an adjunct
to what we’re able to do for our private credit clients. So obviously a
longstanding period of time here in CLOs, but excited about it.

Shiloh:

So what are some of the key character traits of somebody
who’s successful in CLO banking?

Allan:

So I think it’s a number of things. I think first and
foremost it’s being a relationship manager, so someone that’s communicative
both to internal counterparties, but even more importantly to clients and
investors like yourself, folks that have the ability to think dynamically on
their feet. CLOs are not an overly complex structure, but they do require the
ability to put pieces together both from a structure perspective but also the
different constituents, both equity manager investors. And so being able to
play that process effectively and walk out of transactions where everybody
feels it was successful I think is a key piece. So someone who can manage that
process and communicate effectively is critical and certainly is depending on
where we’re hiring people as folks move up the ladder, really being able to
develop and institutionalize a lot of the client relationships that we have in
the market.

Shiloh:

And then for the junior people you hire, are they spending
a lot of their time doing financial models? So accuracy is the key
differentiator there?

Allan:

Yeah, I think attention to detail, right, to your point,
and being able to both be intellectual around structure, documentation, et
cetera is obviously critical. Obviously it’s a learning curve that folks have
and folks get into, but someone that has that ability to grasp both the legal
and structural aspects of the business quickly, and obviously having that
strong attention to detail, is obviously important as well.

Shiloh:

And so as you become more senior in the CLO business, is
somebody like you still in the weeds with the modeling or are you reviewing at
a high level the work that’s done by others?

Allan:

I spend a lot of my time, I think on the client
development side of things, the more strategic side, whether that’s when we’re
bringing a CLO transaction, helping to formulate the distribution process, the
distribution strategy, certainly on the structuring side as well, helping to
provide ideas and thoughts around different structural nuances or things we can
focus on within specific transactions. So while not in the weeds punching
numbers necessarily, certainly maintaining a pulse on what’s happening in the
market and how we can create better structures for our clients to optimize from
an ultimate execution perspective.

Shiloh:

So I think there’s around 15 or so different CLO banks out
there. How is Wells differentiated from some of the others?

Allan:

There’s certainly a lot of players in the market around
syndicated CLOs and even becoming more around middle market CLOs. I think from
our seat, we try to differentiate ourselves a couple ways. One, I alluded to
the bAllance sheet that Wells provides into the private credit space, and I
think that has an extension into the broad syndicated market as well. And it’s
not just about providing bAllance sheet, but it’s providing that capital in a
way that is beneficial to client and can help drive business for the platform
holistically. But it’s also around providing bAllance sheet on a consistent
basis. I think what I mean by that is our approach to lending over the course
of the last 15 to 20 years has not changed materially. I think we’ve always
been an active participant or a leading participant in the private credit
space. So our clients have confidence, have an understanding in terms of how we
approach the market.

So that consistency, we obviously want to adapt and evolve
as the market evolves, but our ability to maintain consistency across different
markets, whether it’s volatility, as we saw earlier this week or what have you,
we’re able to consistently provide that capital to clients both in a strategic
and customizable way. I think the other is, it sounds simple, but from a
customer service perspective, the relationship management perspective, our
ability to help clients on the financing side for a lot of their funds from
start to finish is critically important. When we think about a lot of the funds
that have been raised, they need multiple forms of financing, whether that’s
traditional ABL financing, CLO financing.

Shiloh:

An ABL is an asset backed loan.

Allan:

That’s right. Wells is providing the senior financing on a
pool of loans, so substituting a CLO, AAA, AA for a bank, ABL financing.

Shiloh:

So there the point you’re making is that Wells actually
likes to lend against these loans, so you’re going to require some third party
equity obviously, but maybe before there’s ACL O, there’s a warehouse set up
where somebody again puts up some equity and wells starts advancing the debt
there and maybe there’s a CLO takeout at some point or maybe there’s not. And
either way, Wells likes to take the senior risk, if you will, against a pool of
senior secured loans. Is that how to think about it?

Allan:

That’s exactly right. When we think about our client base,
a lot of the financing to private credit is not necessarily in CLOs, it’s in
that ABL structure or that bank financing structure. And so we’re able, and we
like that product, we like that lending, its core to what we do as a business
and a platform. So we’re able to provide that to clients, but we’re also able
to facilitate and think about strategically the execution of CLOs for clients
as well. So all of that from a relationship management perspective, all of that
sits within our team. So we have the ability to really provide clients with
ideas and thoughts around the best form of financing for their funds.

Shiloh:

At a previous firm, as you know, I was the counterparty to
a Wells line of credit where Wells was lending against a diversified portfolio
of middle market loans, and I think generally an advance rate of 65 or 70%. Do
you have any sense for why it is that that business works for a bank like Wells
and other firms may not find that business to be as appealing?

Allan:

I think it’s interesting. I think we’ve seen other
institutions I’d say come around or become more active and engaged in that
senior lending there. So I think when your question on how does Wells
differentiate, we differentiate because we have consistency and a long-term
process around that business. But I think other banks and institutions are
active in it, are growing in it, and it’s becoming a more competitive space
there.

Shiloh:

So one of the things I’ve noticed in the CLO equity trade
is that before the CLO begins its life, often there’s this warehouse period
where some equity is contributed and loans are acquired using leverage from a
bank and at other banks, that warehouse is really something they’re providing,
really they want it to be as short as possible. They don’t really like the
risk, they want you to be in a warehouse for a couple months, then they’re
ready to do a CLO and then they earn a fee, the bank does. And then there’s no
real exposure to the CLO after that. In some of the warehouses I’ve done with
you guys in the past, the vibe is you put up equity, Wells like lending against
the loans as a senior lender, and we can do a CLO takeout soon or later or
maybe never. And it seems you guys are fine with that, which I think is
different from some of the other shops.

Allan:

I think it certainly obviously depends on the situation
and the structure of the motivation, if you will, of that vehicle at the
outset. But to your point, we are able to be patient. Again, we approach it
very much from a client relationship type perspective and want to find the best
takeout and the best long-term structure for the client. I think we certainly
want to do CLOs, we certainly want to earn fees on the backend, but in certain
structures we’re not here to force the takeout and want to develop partnerships
for the long-term. And I think we’ve done that over the years and you can see
that obviously in some of the repeat managers that we partner with, but
definitely take a longer term view of that warehouse to take out than some
others.

Shiloh:

So then in the CLO market, the three biggest categories
for CLOs would be European versus US, and then, in the US, and by the way, we
don’t do anything in Europe. And then domestically it’s broadly syndicated CLOs
and middle market are the big two. Could you maybe just compare and contrast a
little bit the structural differences between the two and then from there maybe
we could build into the rated feeders as well?

Allan:

Definitely, and I think when you think about those two
markets, probably syndicated and middle market CLOs, at this point, there’s not
a lot of structural differences between them. You certainly have similar rated
notes, you have similar reinvestment periods. BSL might be five years, middle
market might be four years, albeit there are middle market CLOs now getting
done with five years. I think the bigger difference really when you think about
the two markets is the underlying motivations for transactions. So middle
market CLOs are used typically by managers in most senses as financing vehicles
for larger fund complexes. We talked about the ABL business that Wells does and
others do, which is a big form of financing for these larger fund structures.
And CLOs are another form of financing. So where broadly syndicated CLOs are
going to be much more of a true arbitrage structure, where the manager is
partnering with equity and are going out and buying loans in the secondary
market, buying loans in the primary market from large institutional banks. The
middle market is much more of a longer term financing vehicle where they’re
originating assets on a direct basis over a long period of time and turning
those assets out. So the motivation that you see between the two is probably
the biggest difference there.

Shiloh:

So in your terminology, an arbitrage CLO is one where
there’s a third party equity investor who’s signing up, likes the risk return
profile of the investment, and that’s who the end investor is there. And then
for middle market, a lot of times it’s a financing trade. So by that there may
be a BDC or a GPLP fund with a diversified portfolio of loans and it’s
advantageous to them to seek leverage against that because it’s long-term
leverage done at attractive rates and that enables the BDC or GPLP fund to increase
their return on equity. But in a structure like that, the equity is owned a
hundred percent by the BDC or the fund. There’s no third party equity, there’s
no Flat Rocks involved in that case.

Allan:

That’s right, and I think that’s also when you think about
one of the bigger differences between the two BSL and middle market CLOs, BSL
is typically always going to issue down through double B rated notes or all the
way through equity and middle market Cs because of that financing structure for
BDC or a fund, they may only issue down through AA or single A because the
leverage profile of those vehicles or how much leverage those vehicles are able
to run is meaningfully less. So that’s why a lot of times you won’t see
mezzanine or non-investment grade tranches issued for middle market CLOs.

Shiloh:

So the broadly syndicated CLO might be levered, was it 10
times on average, where the middle market might be leveraged seven and a half
times. So less leverage there. And then the CCC basket is another big
differentiator. In broadly syndicated, you get a seven a half percent triple
CCC bucket. In middle market, you get 17 point a half on average. Of course
there are some differences in deals and that gives the manager more flexibility
because the middle market loans tend to not be as favorably rated by Moody’s or
S & P. And then you pointed out the middle market CLO might have a four
year reinvestment period, so a little shorter than the five years you get in
broadly syndicated. I think those are the key differences. Another minor one
would just be reinvesting after the reinvestment period ends. So in broadly
syndicated CLOs, whenever you get unscheduled principal proceeds, whenever
those come back to you, which is most loan repayments are unscheduled anyways,
then a lot of times you can reinvest that, subject to some constraints in the
deals. Whereas for middle market, actually the reinvestment period ends. It’s
very simple. There’s no more reinvesting. It sounds like a subtle difference,
but I think it does actually matter in terms of how long the deal will be
outstanding for and it matters for equity returns. I think. If you think about
the aaa, which is the biggest financing cost and broadly syndicated, the loan
to value through AAA is going to be about 65% would you say, or

Allan:

62 to 65%

Shiloh:

62 to 65. And then for middle market it’s going to be

Allan:

55 to 58.

Shiloh:

So it sounds like you get a lot more equity or juniorcapital in the middle market. And then in terms of your banking team, you havea middle market team and a broadly syndicated team, or these are similarproducts and everybody works on the different deals?

Allan:

As we’ve talked about, there’s similar enough products where we generically have everybody working on similar deals. We do have some senior members of the team more from a relationship perspective that are specialized in either BSL or middle market as they think about developing client relationships and whatnot. But from a structuring deal execution
perspective, we view there to be enough similarities between the products and certainly from an investor perspective as we think about distribution of the products, that there’s enough similarity where the same individuals are able to function there.

Shiloh:

And then one of the reasons I wanted to have you on the podcast this week was just to talk about rated feeders a little bit. So that’s a new flavor of CLO in the market. What are the basics of a rated feeder?

Allan:

So a rated feeder is a structured credit vehicle where, as opposed to being secured by underlying assets directly, as a CLO would, you’re secured by the LP interest of a private credit fund. And that private credit fund can really be of any type. It can be direct lending, it can be asset-based lending. It can be all sorts of different types of private credit assets, but for the most part, most of them have been done off of middle market direct lending assets. The structure has been utilized for many years. As you think about insurance companies who want to make investments in private credit funds, they’re able to do so through a rated feeder structure in a more capital-efficient way. So again, the underlying asset that is getting levered or is getting tranched out is an LP interest of a private credit fund. So when you think about that GPLP structure, LP fund where you have multiple different institutional investors making LP commitments, some of them might be insurance companies that want to gain access to that fund.

So for them to do that through a rated feeder structure, they’re able to do so in a more capital efficient way. And the reason for that is the leverage profile of a lot of these funds, as we talked about earlier, is only one or two times leverage. So they’re run at fairly low leverage points. And so while the rating agencies are able to get comfortable by tranching out that LP interest and adding incremental rating levels to that for any investor, but predominantly insurance companies to receive incremental capital efficiency there. So historically to this point or to recently, insurance companies have bought vertical strips as we call them, buying a AA, single A, triple B in equity of that rated feeder. And so they’re buying the entire portion for that capital efficiency. But most recently we’ve really thought about that structure on a more horizontal basis, which is more akin to middle market CLOs where we’re using that same radium methodology that insurance have used in trying that out, but selling that to different investors at different risk return profiles there. So instead of one investor buying it all, we might be selling AA, single A to different investors.

Shiloh:

So I think the structural setup here is, imagine your rated feeder, let’s call it 300 million, and let’s say the underlying fund is BDC just to make it simple. Then the rated feeder takes the 300 million that it raises from third parties, it injects that into the BDC, and the BDC over time will pay dividends up to the rated feeder in the dividends on the 300 million that arrived at the BDC. But in the rated feeder structure, as those dividends get passed up to their rated feeder, instead of having all the dividends just paid out rata to the 300 million of equity, instead the setup is the tranching that you mentioned, where first there’s a AAA or AA or whatever it is, they have the first priority on the dividends from the BDC down the line, and then there’s an equity investor and the rated feeder as well, and they’re the person who gets paid whatever remains.

So again, the total income into the rated feeder is the distribution from the BDC, and it just split up, senior to junior, with equity taking the remainder. One of the reasons these exist, I think to your point, is that if you’re an insurance company, you’re basically investing 300 million into the BDC. So the insurance company can either end up with a $300 million limited partnership agreement or LP investment in a BDC, or they can end up with 300 million of investments in a series of securities rated AAA or AA, whatever it is down the line to double B, and they’ll get just much more favorable regulatory treatment for that. So if you’re an insurance company, you don’t want to own a lot of equity, you want to own as many senior rated securities as you can.

Allan:

That’s exactly right. When you think about the rated feeder, especially to your point on the waterfall and how cash is distributed, it doesn’t look that dissimilar than any other structured vehicle where cash is being distributed down through the priority of payments or through the different ratings to the equity at the bottom. I think the difference obviously is there’s effectively one asset. So one LP interest to the fund is distributing that cash into the vehicle that’s getting distributed versus a CLO that might have a hundred unique assets where the cash is coming in. So the investors are really one step removed from the assets than they would be in a middle market CLO. But you have as an lp, as the rated feeder acts as an individual LP of the fund, it has the same rights that any other LP would have in terms of access to the assets.

Shiloh:

So then I understand the rationale for why an insurance company would want to use this structure, but are you also seeing interest from other investors that don’t have regulatory capital that would care about a Moody’s or an S & P rating?

Allan:

Certainly. So obviously the insurance company has been the predominant of the product there, but we have seen an expansion of that beyond insurance companies, not so much as to where they’re focused on capital charge
treatment, but investors are more focused on where they can find increased
spread or increased return really within the same asset class. So the ability
for banks or asset managers or hedge funds or different CLO investors, the
ability for them to buy a more structured complex vehicle is going to come with it a higher spread or a higher return. So we have seen a lot of investors,
we’ve seen spread compression across markets, look at rated feeder notes and look at these structures as another way to really gain access to the asset
class where there’s the ability to garner incremental spread through that level
of complexity through that level of illiquidity there. So we’ve obviously done
a few of these to date and have probably seen the investor base on each
subsequent one continue to grow and broaden and are seeing broad interests and growth there.

Shiloh:

So the most senior securities that are issued by the rated feeder, are they actually rated AAA or is it more of AA, single A, because you are, as you said, one step removed from the assets?

Allan:

So the most senior tranche in rated feeders is really AA. Most of them are either that single A or AA is the most senior rating. It’s certainly because of the one step removed from the assets. The other piece is the fund that sits above the rated feeder is also running leverage. So there’s leverage at that fund level, usually in the form of a bank ABL as we talked about. It could be in the form of CLO tranche, it could be in some other unsecured debt tranche, but there is some form of leverage typically at the fund level that sits above the rated feeder. So that’s another reason why obviously, from a rated entity perspective, they factor that fund level leverage into the rating as well.

Shiloh:

So then let’s just compare for a second, owning the AA of middle market CLO versus the AA of the rated feeder. So in the rated feeder, you do have this ABL sitting at the fund or the BDC level that has first priority or that’s in the first security position. If you’re sitting at the rated feeder, all the management fees and incentive fees that are paid to the manager of the BDC, those are taken out before any distributions are sent up to the rated feeder. So essentially those become senior to you even if you’re AA, whereas in the typical middle market aa, the only expenses you have ahead of you would be AAA interest and a senior management fee. Maybe there’s a little bit of other operating expenses, but it wouldn’t be material. So that rated feeder AA is removed from the assets, has an ABL in front of it, but also the management and incentive fees of the fund take priority as well.

Allan:

That’s exactly right. I think the biggest difference there though is the attachment or the leverage point of the ABL of that senior debt to the rated feeder. So to our earlier conversation on comparing middle market CLOs, when you look at the attachment of a AAA on the middle market, CLO, that’s all the way down to 55 to 58% advance rate. A lot of the rated feeders, certainly on the AA side that are being issued, the senior debt or the ABL is
only the 40 to 50% attachment. So you’re adding incremental subordination
through that senior ABL to the rated feeder to make up or offset some of those incremental expenses and fees that you alluded to.

Shiloh:

So I elicit the cons of the rated feed feeder AA, but the amount of junior capital that supports that is much higher than in the CLO. At the end of the day, they’re both rated AA, so presumably they would’ve the same credit quality.

Allan:

That’s the idea. And I think there’s obviously going to be pros and cons of each, but I think to your point, one of the biggest pros is the added subordination that exists for the rated feeder notes. In comparison to middle market CLOs.

Shiloh:

Let’s maybe just also compare owning middle market equity directly versus owning it in the rated feeder. What are some of the key structural differences there?

Allan:

So I think some of the key differences when you think about rated feeders to middle market CLOs is I like to think about rated feeders, really, they combine both the warehouse period for a middle market CLO and the term securitization. So when you think about a middle market CLO, as we
talked about, there’s a warehouse period that exists that equity has to come
into, the manager has to originate assets and you’re ramping assets over an
extended period of time, and then ultimately waiting for the securitization or
the long-term financing structure of that pool of loans or what’s the most
optimal time to do that. On the rated feeder side, it really combines both of
that warehouse structure as well as the term structure into one. And it does
that obviously through the fact that the notes are issued in delayed draw form. So the senior notes integrated feeder are typically done in delayed draw
fashion. So that allows the portfolio of the fund to be ramped up on a consistent basis, but also being able to draw that leverage as assets are contributed, whereas a middle market CLO is going to be fully funded or fully drawn day one. So that’s I think one of the bigger difference. The other is when you think about middle market assets, there’s a large delayed draw and revolver component that comes alongside those assets, whether those are being contributed to the fund or a middle market CLO, the manager has to find solutions for those. And in a middle market CLO, you’ll typically find

portfolios anywhere from five to 10% in delayed draws and revolvers, and that’s a drag to equity at the end of the day. In terms of having to cash
collateralize a portion of those assets in the vehicle. With the rated feeder,
you’re going to have a similar delayed draw and revolver component to the
portfolios. But the ABL line, the bank ABL line that we’ve talked about
functions as a revolver, so it’s more of an optimal solution to fund those
assets. So there’s going to be less negative drag or less negative carry on the
fund and ultimately the rate of feeder than there would be in a middle market
CLO.

Shiloh:

One other structural difference that we haven’t really talked about is just that in the middle market CLO, it’s almost exclusively firstly in senior secured loans. So the spreads are going to vary a little bit, but it’s three months sofa plus five to five and three quarters on the high end, whereas in the rated feeder, the underlying BDC or fund might be something more like 85% first lien, and then there’ll be a fair amount of second lien or pref or some other funky stuff there. The asset pools do look a little bit different.

Allan:

For sure, the rated feeder depending on the fund, but most of the funds that are utilizing the structure, there’s a lot more asset flexibility associated with it. So there’s the ability not only at the outset, at the original ramp, to be opportunistic in certain maybe non-first lien assets or recurring revenue, which are a big part of a lot of direct lenders. Today is obviously a key differential where middle market CLOs you’re required to be 95% first lien highly diversified. You have obviously collateral quality tests or other items that the managers have to manage too. So there is a lot more asset flexibility that’s allowable in rated feeders, and I think that’s at the outset, but also as the portfolio evolves and as there’s market dislocation, managers have slightly more ability to take advantage of that asset flexibility over time.

Shiloh:

So then moving back to we were comparing and contrasting
the middle market AA and the rated feeder AA, which should offer a higher
return, in your opinion?

Allan:

The rated feeder AA should offer more return to the investors for a couple of reasons. One, there is more structural complexity associated with it, and that’s in the form of obviously the delay draw that we’ve talked about. The investors have to bear the delay draw component of those structures, and with that, the notes have to be issued in physical form. So there’s some operational burden on investors there.

Disclosure:

Note physical form means the notes are not owned electronically. Rather a notarized paper is evidence of ownership.

Allan:

There’s obviously the asset flexibility point that we talked about as well, which is a little differentiated, but then there’s the liquidity point. I think middle market CLOs have established themselves as a fairly liquid asset class at this point. They made up about 25% of the overall CLO market last year. So the acceptance of that structure across the board for investors has been broad. We’ve seen the spread basis between middle market and broadly syndicated tighten over the past 12 to 24 months. So I’d say a lot of the juice or a lot of the incremental spread for investors has come out of that. So rated feeders are a way for investors to gain some incremental spread with some of those trade-offs around liquidity, complexity, et cetera. But we obviously touched on some of the pros, the parts of ordination that we talked about being obviously a key benefit. There’s also typically a longer on-call period associated with the rated feeders, and so there are some obviously structural positives away from just the spread component that investors obviously consider and take into account.

Shiloh:

So then if we are talking about CLO equity versus rated feeder equity, would a lot of your points from the AA be relevant there where it’s a newer structure, people need to do work on it and understand it and are asking for a premium or asking to get paid a little more for doing the work, but at the same time, you’re less levered through the rated feeder?

Allan:

Yes, you are less levered through the rated feeder.

Shiloh:

So from the perspective of equity, maybe the returns model out the same because the equity investor needs to do some work, understand a new structure, but on the other hand, there’s less leverage in the rated feeder
and then maybe another con or pro, depending on how you look at it, would just be that the asset quality of the underlying loans might be different from the 95% first lien that you mentioned.

Allan:

That’s right. I think one of the key differences we touched on is obviously there’s more asset flexibility, and I think over the life of these vehicles while CLO, you’re constrained in 95% first lien, the asset flexibility given into the rated feeders over the course of a four year reinvestment period. I think there’s a lot of optionality that exists for rated feeder equity there. So I think managers have the ability to take advantage of market dislocations, of market changes, opportunities like we talked about in second liens or recurring revenue, that might come up over the course of that period that managers would not necessarily have in a more structured middle market CLO. So certainly I think the less leverage is critical, but I think one of the bigger, more interesting dynamics that we haven’t necessarily seen totally play out yet is that asset flexibility and how managers are able to leverage that to the equity’s benefit over the life of the deal.

Shiloh:

Maybe I missed it or not fully understanding, but when you say asset flexibility, you’re talking about the ability to have more second liens or other funky stuff,

Allan:

The ability to have more non-first lien assets. I won’t use funky assets, but more differentiated assets because I think one big aspect of the market is you think about second liens, there are periods of time where second liens are not that attractive or not that in vogue for managers, but there’s other times where there’s a lot of opportunity in that part of the market to pick up incremental spread for pretty attractive assets. And the same goes for recurring revenue. There’s going to be periods of time where there’s a lot of opportunity to do that in periods of time that there’s not. So the asset flexibility or the ability for the manager to really pick their spots across different parts of the market is more available on the rated feeder side.

Shiloh:

And then one last question is just should the market
expect to see a lot of new rated feeders? Is this a structure that’s going to
gain in popularity over time?

Allan:

We certainly think so. We’ve put obviously a lot of resources into the market. You’ve seen there be a slow start to the issuance of rated feeders, but I think certainly as the market develops, as the investor base continues to grow, as the process for execution of rated feeders becomes more streamlined, I think there’s definitely the anticipation that there will be incremental issuance of the product. It’s not that dissimilar to middle market CLOs 20 years ago when there was only a handful issued annually, and that’s obviously grown. I think this is a market that has the ability to really grow, maybe not to that scale, but certainly to become a large part of the overall private credit financing market over the next few years.

Shiloh:

Great. Well, Allan, thanks for coming on the podcast.
Really appreciate it.

Allan:

Thanks, Shiloh. Thanks for having me.

Disclosure:

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 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.

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 merit 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.

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 in the CLO industry, and I interview key market players. Today I’m speaking with Drew Sweeney, the broadly syndicated CLO portfolio manager at TCW. In a previous life, Drew and I went to rival high schools in Arlington, Virginia, and we worked together as credit analysts at Four Corners Capital. Now Flat Rock invests in some of the CLOs that he manages. I asked Drew to come on the podcast to discuss his perspective on the quality of loan documentation in the broadly syndicated loan market, and to discuss examples of when loan investors were not as senior and secured as they might’ve liked to be. It’s a bit of a technical podcast, but that’s the only way to adequately treat the subject. If you are enjoying the podcast, please remember to share, like, and follow. And now my conversation with Drew Sweeney.

Drew, thanks so much for coming on the podcast.

Drew:

Thanks for having me. It’s good to be here.

Shiloh:

So I’d like to start off the podcast by just asking your background story and how you became a CLO manager.

Drew:

Well, as you know, many, many years ago we worked together in investment banking and I was syndicating bank loans at the time, and I liked the idea of being an investor as opposed to a banker. So I moved from First Union, which was a bank many years ago to the buy side and began working there. And we worked together again at a place called Four Corners, which I focused on managing bank loans in market value CLOs, and some closed-end funds, and a variety other products. And then just my path led me eventually to TCW, but I think it’s the natural progression of do you like to be an investor?

And then the most common vehicle with investing in loans are CLOs. And so it’s just a natural pairing.

Shiloh:

And what do you find interesting about bank loans in particular?

Drew:

I like bank loans because they’re not always efficient. So you can outwork competitors, you can meet with management teams on a regular basis. You can apply a level of discipline to and process. And over years, I’ve been doing this over 25 years. When you apply a level of discipline and a process, you can just see what works and doesn’t then you iterate on that. But I like investing in general and then you combine that with the inefficiencies of the bank loan market and I think it makes for great opportunity.

Shiloh:

So I think the attraction for me in coming over from the investment banking side was that in investment banking you work on a lot of deals that never really come to fruition, and that can be quite frustrating.

Whereas on the buy side, if you’re investing in bank loans, there’s in an active market, you’re a credit analyst, you cover an industry or two, and a lot of times there’s just a lot of activity. So you work on a loan opportunity, you might want to do it or not, but even if you don’t, it’s good to understand more of the companies in your space. So I just felt the amount of work that you do versus the product and how interesting it is really skewed very favorably to working on the buy side.

Drew:

Yeah, makes sense. It’s been a long time since I’ve been in banking, but you’re right, the number of deals that do not go through that you spend your weekend modeling is remarkable.

Shiloh:

Now you’re at TCW. Why don’t you tell us a little bit about the loan platform in particular?

Drew:

We have roughly six and a half billion dollars of loan AUM today. We manage 12 CLOs as part of that. And I think the idea of TCW Bank loans is really, we are a bank loan team that is sitting in a very large asset manager and we try to leverage all the things about being a large asset manager and get the benefits of being something more nimble. On the bank loan side, I think we offer a pretty differentiated product. There are three or four things that distinguish us from others. We have an integrated bank loan team, which means basically our analysts are looking at bank loans, high yield and investment grade. And simply put, we always say competition doesn’t stop at capital structure. So if you’re in technology or if you’re in telecom or if you’re in cable or a variety of industries and you’re only looking at non-investment grade borrowers, you don’t really know where CapEx dollars are coming from, or trends, and you really don’t know all your competitors.

And then outside of that, I think we’ve built, probably from investing in the product, one of the most robust databases that exist. We have information on roughly 850 loan borrowers in the loan universe. And if you think about the CS index, that was 1600 borrowers.

Shiloh:

So that’s the Credit Suisse loan index.

Drew:

Yes. And then if you say of those 1600, maybe 1200 are liquid, and we have three quarters of those mapped. So not only do we see how our borrowers perform each quarter, then we see how the borrowers’ competitors perform each quarter. And it allows us to use these as building blocks in exchange. If our chemical companies are doing not what we think and these chemical companies are, we can swap.

Shiloh:

If it’s a private market though, how are you tracking loans that you aren’t participating in in the primary?

Drew:

This is what it gets back to the disciplined and outworking competitors.

We have a whole team of research associates that work along with the senior analysts and they spend a lot of time getting access, keeping access, and adding that information on a quarterly basis basis.

Shiloh:

Interesting. So the theme for today’s podcast is weak loan documentation. So the idea of being a first lien lender is that in a bankruptcy, if the business doesn’t perform as expected, if you end up in a bankruptcy, I think it happens to about 3% of borrowers each year. But in the restructuring process as a first lien lender, you’re secured by all the collateral and you’re first in line for any proceeds. So that’s conceptually how a restructuring should work. But I guess what actually happens in reality doesn’t always conform to the description I just gave. Once you make a first lien loan, some things should be prohibited. So one is the payment of dividends to the company’s owners.

The first lien lenders are not signing up for that. Again, they want to be first in line. They’d rather see that cash go to repay the loan. In most cases, you’re secured by the collateral of the company. So you want to make sure that none of that collateral can leak away from you over time or through malfeasance by the owner. So then one exception though is if you do end up in a bankruptcy, oftentimes there’s a debtor in possession loan. So that comes in when the company is out of cash and somebody’s got to put up some additional dollars so that the company can pay its workforce, for example. And then in that case, the debtor end possession financing does come in senior to the first lien term loan. When you’re committing to a new loan in the primary market, it’s the sketch, if you will, of how the loan documentation is going to read.

That comes from the term sheet. We’ll see a term sheet first. And then what’s some of the important things that you would look for in the term sheet?

Drew:

You’re looking at all the basics of what you would expect or the price talk would be, what the maturity is, what your assets, so what the collateral is, and then whether or not what’s permitted in terms of repayment of debt for IPO proceeds, what’s permitted for dividends, whether or not any bonds or loans mature inside your borrower. So you’re going through a checklist of things to make sure that in essence, exactly what you described, a first lien senior secured loan is in actuality a first lien senior secured loan. Who the borrower is too, whether it’s at the Op-co or the Hold-Co, is something else you’ll see in the term sheet.

Shiloh:

So a company may have a number of different subsidiaries in your terminology.

The Op-co actually does have some business operations that it’s doing. And then the holding company in the organizational chart, that’s just basically the owner of the different op-cos. So then the idea of the first lien loan is that all the subsidiaries, all the different parts of a company, are borrowers under the credit agreement. There’s different assets of the different subsidiaries. The idea anyway is that all of that is pledged as collateral for the first lien loan.

Drew:

That’s the idea. And in reality, back from my days in investment banking, one of the first things I was taught is you want to be as close to the assets as you can, so as close to the collateral as you can. So in a perfect world, there’s one op-co and you’re lending against that. That’s not in reality what a company with 300 million to $2 billion of EBITDA has.

The org chart’s much more complicated than that. You want to have as many of those subsidiaries as your guarantors of the loan, and then you want to make sure that the subsidiaries stay your guarantor.

Shiloh:

So what are some reasons that a subsidiary would not be a party to the credit agreement?

Drew:

Some of those borrowers aren’t part of our guarantor package just because sponsors or the companies feel they don’t need to do that to get the loan done. So there’s some optionality in it. There’s some tax consequence to it when it comes to foreign subs. And then there’s some just natural evolution where there are times when the loan market is easily accessible and there are times when the loan market is not. So a company might do an acquisition in 2018 and follow that up with another acquisition in 2021, but they don’t want to pay down the debt of the 2018 facility.

So they might finance that separately, and it might be part of our box, but not our explicit guarantor. So there’s a variety of reasons it ends up there.

Shiloh:

But the general idea is that the material subsidiaries are guarantors of the term loan. So something foreign subsidiaries, like you mentioned, may not be guarantors. Maybe they’ve pledged their equity but are not specific guarantor. Maybe a subsidiary with an immaterial amount of revenue or EBITDA could also not be pledged. Maybe they just didn’t want to go through the hassle or the paperwork to do that. So some of these subsidiaries just end up outside of the borrower group and are not considered guarantors of the first lien loan.

Drew:

That’s right. And the last item you mentioned is something that happens quite a bit, I think in certain segments more than others, but some businesses will have an immaterial amount of EBITDA and it won’t be required that they’re pledged as a guarantor, that those assets are part of our collateral.

And in technology, those may be the fastest growing assets. So they may not be at the time you do the loan, but three years from now it could be driving the business. So there’s always that risk.

Shiloh:

Then what’s the difference between a subsidiary that’s a guarantor of the loan versus an unrestricted subsidiary?

Drew:

So we have a guarantor that is a guarantor in our collateral agreement, and we have a non guarantor that has to live by the credit agreement, but it lives by the credit agreement however, and it’s part of our restricted group. And then we have an unrestricted sub that’s actually outside of our borrower group entirely and not bound by the same obligations as the collateral agreement.

Shiloh:

Got it. So then it sounds like the primary market, you’re looking at a term sheet which is going to sketch out these terms, the terms that make it into the credit agreement, which is the legally binding doc once the loan closes.

So it sounds like the credit agreement is designed to give you the first lien that you want, but also some flexibility to the borrower. And so not every single asset makes it into the restricted group or the guarantors. There is some flexibility there and it probably should be warranted. You don’t really need to take every asset. So another concept I wanted to just chat through before we maybe get into some historical cases is just the concept of baskets. What’s a basket in a credit agreement?

Drew:

A basket is going to be a carve out of some amount. So most of our covenants today are in currents-based covenants. So you’re going to have a basket for permitted liens, a basket for dividends, and that’s saying you’re allowed to dividend out a certain amount per year. You’re allowed to invest in this non guarantor restricted subsidiary a certain amount per year.

And in the example that we talked about earlier where there’s a tech business that might be fast growing but not part of a collateral, the management and the owner and the sponsor will want to be able to invest in that technology. It may be part of the future of their business. So they create these carve outs and they create these baskets. And essentially those baskets, many of them have the right to build over time based on the growth of the overall company based on a leverage ratio or a variety of other things. So those baskets are also a natural part of credit agreements.

Shiloh:

So the basket is a function of EBITDA. So if you have a hundred million of EBITDA, a for example, then the credit agreement might give you some percent of that to invest in unrestricted sub, for example, or to pay a dividend.

That’s how to think about it.

Drew:

Yes.

Shiloh:

And then as EBITDA grows over time, is it warranted that the owners of the company should have more flexibility?

Drew:

I think to some degree it is. Flexibility is warranted when the company is growing, and the issue is it’s just whenever things are manipulated. So we’ve had borrowers go grow EBITDA nicely. It could be a cyclical business, it could be a business that has competition on the horizon that maybe the broader market doesn’t appreciate. Then they’ve maybe grown through debt financed acquisition, but they’ve realized synergies and they’ve maintained add-backs at the same time. So EBITDA appears to be growing rapidly, while it’s growing, but it’s growing mostly through acquisition. And then because they’ve built this basket, they take large dividend out because the market will be hot periodically, and you go back to the market, you dividend it out, people are in need of paper, and then within six to 12 months, all of a sudden EBITDA is not growing the way you thought it was because it’s either a cyclical business, like I said, or other competition has come online and you’re realizing those adjustments are not going to be realized.

And then at that point, you’ve just added a layer of debt.

Shiloh:

So I think there’s three cases in the loan market, and I’d like to talk through all three of ’em where lenders made a first lien loan and it turned out that there were some loopholes in the credit agreements where they weren’t as senior and secured as they would’ve liked to be. So one is J Crew. Why don’t we start there? What happened at J Crew?

Drew:

I think J Crew was particularly interesting for a lot of investors because it was litigated and the litigation allowed us to see what baskets a sponsor was using or company was using in order to drop collateral out. So this is really about leakage from your borrower group. So where you lose collateral, you think you have intellectual property, it doesn’t have EBITDA associated with it. So they valued it, and they valued it at $250 million.

And they happened to have some basket flexibility between their investment covenant and their general basket that allowed them to dividend out 250 million dollar worth of collateral. And in this case, they dividend out from the guarantor to a non guarantor. So once it was in that non guarantor box, they had something that allowed them to pass through from a non guarantor box out to an unrestricted sub. So essentially they dropped collateral in the value of $250 million, which you can easily argue was an underestimated number. They dropped it out of the borrower box, and they did this to facilitate an exchange of notes at the whole-co.

Shiloh:

Okay, so the intellectual property was collateral for the first lien lenders, and then they are able to move that collateral out through baskets, the baskets you mentioned, and then they start sitting in a subsidiary where they’re no longer guarantors of the first lien loan.

And then didn’t they also raise new debt against that intellectual property?

Drew:

They did.

Shiloh:

So even if they would’ve dividend the IP to the unrestricted sub, it could have stayed in the sub and that would’ve been a subsidiary owned by the borrower under the credit agreement. So that would really not have at the end of the day hurt your position, but it was the fact that at the unrestricted subsidiary, they actually raised more debt that effectively was jumping the line, if you will, in terms of the priority of payments that was really expected when the term loan was put in place.

Drew:

You’ve had collateral that you thought was yours that doesn’t have EBITDA associated with it, leak out of the borrower. So by default, you’ve essentially been primed. You’re not at the Opco where this collateral is now held. You’re at a Opco, but you’re at an Opco that doesn’t have IP.

Shiloh:

Is the market response to this that the market saw the weakness in loan documentation and for future loans, this is something that’s tied up and shouldn’t be a worry? Or is that too optimistic way to think about it?

Drew:

Yeah, it is addressed in many credit agreements. It’s usually tied to very specific collateral. However, in the market, it’s referred to as the J Crew trap door. So essentially on every one of our credit writeups, we have whether or not the J Crew Trap door exists or it doesn’t exist, but it does exist in credit agreements today. And in fact, in many, many deals when we receive the first term sheet, it exists there and then it’s very common for it to be pushed back on. But the reality is, is people are still trying to get it in. The reality is there are weaknesses in all these documents that you can say there’s no trap door in this deal, but it doesn’t mean you have all the collateral, and it doesn’t mean there aren’t baskets that they won’t be able to provision out.

Shiloh:

So that’s J Crew. Another big case in the market was Serta. Serta is a mattress company, And what happened there?

Drew:

Serta is a story about priming. So there’s a sacred right in terms of your priority of a lien, priority of payment, or that’s thought to be a sacred, right. And you had mentioned at the outset about dips. So when a company needs to file for bankruptcy and they raise a dip, that dip goes in front of the existing first lien. It provides liquidity and it’s agreed to essentially by all parties in the bankruptcy. But a bankruptcy, when you file for chapter 11, it’s a complete restructuring. You lower the quantum of debt and you also provide for the company’s liquidity via the dip, and you can restrike all your liens and get rid of things that you don’t want, close EBITDA negative stores. There’s a lot of things that can be done. With Serta,

essentially what happened is they voted, and with a simple majority, roughly about 55% majority in a 45% minority group, they were able to contribute $200 million of new capital to help Serta with their liquidity issuance just like a dip. And then as opposed to the benefit being pro rata to all lenders, getting the benefit of participating in the DIP, and then participating in what the other debts exchanged for, the majority component was able to exchange into a second out. And then there was also a third out provided for future exchanges.

Shiloh:

So a second out and a third out, it’s a secure term loan, but the second out only gets paid after the first out is paid.

Drew:

So the new money becomes the first out. The majority holders that are in the first lien, and some of the majority holders that are in the second lien, they move into the second out.

And then the minority holders within the first lien actually exchange into what would be a fourth out behind because they preserved a small amount of third out for future exchanges. But the reality is that they became third or fourth out, so they dropped from being a first lien senior secured lender with the right of payment from first to then essentially fourth.

Shiloh:

So Serta is a story about some lenders voting to give themselves the ability to prime or step ahead of other first lien lenders. Is, again the same question as related to J Crew, is that loophole that was found in the docks and now the loophole is largely closed, or is this a continuing risk in loan documentation?

Drew:

This exists in most deals today. A term sheet can say it’s cured or not cured, but in reality, when I talked about the evolution of credit agreement before and you had expanding allowances and then you had removing restrictions by increasing baskets and doing those things, the third evolution is essentially when you can make changes to the priority of payment by a simple majority.

So changing the voting rights within credit agreements and those voting rights are pretty pervasive within credit agreements today, meaning simple majority voting rights.

Shiloh:

So then I think the third case that was very prominent in the market was Chewy. So can you tell us what did it do and why has it become a case study in the loan market?

Drew:

Well, PetSmart acquired Chewy, which was an online pet retailer, and they acquired it for roughly $3 billion. And the thing that makes it notable is that Chewy was a wholly owned subsidiary at the time of the acquisition and as a wholly owned subsidiary, it was a guarantor of our credit agreement. It was in our restricted box and a guarantor. And in fact, they raised term loan money around this acquisition. So the catch is, it’s only a guarantor if it’s wholly owned. So if you sell 1% of a business in this credit agreement and it’s no longer wholly owned, then it’s not a guarantor.

So that’s what made it unique. So essentially what PetSmart and Chewy did, or what PetSmart did is they used investment capacity to transfer out 16.5% of the Chewy equity, and then they used a dividend to dividend out another 20% to a whole-co of the Chewy equity. So essentially 37% of this 3 billion asset got out of our borrower, and then it was no longer a guarantor of our credit agreement.

Shiloh:

So because Chewy was not a wholly owned subsidiary, they were able to send dividends up to the parent and get the capital to the business’ owners. How did Chewy end up not being a wholly owned subsidiary of PetSmart?

Drew:

It’s not uncommon for a company or a business to co-own something, have joint ventures and not own a hundred percent of a subsidiary. So the idea that a wholly owned sub, and you can only guarantee the collateral of what you own wholly, so that makes sense.

So it’s relatively a benign characteristic within the credit agreement to say it has to be a wholly owned sub to guarantee this debt. So the difference is the sponsor and the company use that relatively benign clause to be able to use baskets that were permissive where they could dividend out large portions of the borrower and essentially have value escape and also make it a non guarantor of our credit agreement, which the loan traded into the seventies at the time because it was thought to be pretty horrific. I think the thing that worked out well about it is they essentially ended up IPOing Cewy for a much greater dollar amount than the value of the entire term loan, despite the fact that lenders were in a bad position as a result of the weak credit docs, it turned out that Chewy was worth far in excess of the amount that they had paid for it, and they valued it at, and as a result, the term loan lenders got out whole.

Shiloh:

So in that case, the credit agreement had this loophole in it, but the business ended up performing well and the first lien got repaid. So that’s the punchline there. But it sounds like it gave the lenders a good scare. In all these case studies, is it that the weakness in the loan doc was put in intentionally, the private equity firm that owns the company was thinking that this is something that they might have wanted to do to lenders in the future? Or is it that the docs were just drafted this way and later only after the business had some operational difficulties did somebody at the company or the private equity sponsor figure out that there was some optionality for them and that the first lien lenders were not as secured as they might’ve thought they were?

Drew:

I think, this is my opinion, but what started as — we’ll talk to certain sponsors and they won’t even know the loopholes in these credit agreements.

So I think what started as attorneys feeling like they wanted to build as much flexibility into these documents, and they were essentially showing their ability to work around the credit agreement and create loopholes, and then some sponsors took advantage of some of those loopholes. But generally speaking, a lot of documents have weakness in them, a lot of documents, and we track every sponsor. One of the things we do within our database is we track every sponsor. We know what the average price of every sponsor’s deal is, if they have 64 deals in the market or if they have 12 deals in the market.

Shiloh:

And a sponsor, by the way, that’s the private equity firm that bought the company.

Drew:

That’s right. So while many of these documents, we have one favored private equity sponsor that we have the most exposure to any private equity sponsor, and they’ve never had a US borrower lose a dollar of debt, they don’t use these loopholes.

And guess what? These loopholes exist in their credit agreements too. So I think it’s two things. One is you have some sponsors who have been aggressive with it. All these sponsors have a capital markets person who’s focused on the docs.

Shiloh:

This is the broadly syndicated loan market.

Drew:

Yeah, the broadly syndicated loan market is this broad array of investors that could be in a variety of different investment vehicles and they’re investing in many, many deals. So for every new loan that gets syndicated, you may have 130 borrowers in it, but you only have one private equity sponsor. So that control pivot and having a single point person allows them to focus and push on docs in a different way than having a confederation of investors together. So I think yes, there’s an effort by private equity to make sure these loopholes exist. A lot of times they exist with private equity firms that don’t focus on them, and I think once they existed or once some of this stuff was developed, then essentially lawyers that developed these docs have looked to make them standardized and weaker across the board.

Shiloh:

So is it then to find yourself in a situation where you’re being harmed by loose loan documentation, business really needs to underperform? First off, the business is performing well and the loan doc is weak, you’re probably fine. You also need a private equity firm or sponsor that’s going to want to do something that’s not creditor friendly and risk the wrath of the loan market. From the perspective of a private equity firm, if they do this, if they screw over one group of lenders, I would assume people have somewhat long memories in the loan market.

Drew:

I think it does influence company’s ability to borrow, and we’ve seen that before. I don’t know how long the memory is, but I think you’re right. I think generally three things are present.

Shiloh:

You need a loose stock,

Drew:

financial stress,

Shiloh:

financial stress, and a private equity firm owner who decides that they’re going to put it to the lenders and bear the reputational risk for them that might come along with that.

And it may affect the borrowing costs of companies in the future who are owned by that private equity firm.

Drew:

I don’t know the memory that the collective investment world in loans has, but what we’ve been screaming from our little mountaintop is that we track, as I just said, every single financial sponsor. We know how many deals they have in the market, we know how many liability management exercises they performed, which we can get to, but we also know what the average price of their loans are. So when a sponsor is a bad actor on a repeated basis, we’re no longer lending to them. If they’re a bad investor and all their loans traded 80, we’re not lending to them. So that essentially means I think some of the sponsors you see in the market today are going to be cut out of the BSL market.

Shiloh:

Interesting. So it sounds like when you’re evaluating a loan opportunity, it’s not just the fundamentals of the business that you care about, but it’s actually the ownership team, the private equity firm, and how they’ve treated lenders in the past. That’s an important variable in your credit selection process.

Drew:

And we meet with sponsors on a regular basis. We go into offices, we have conversations and we have relationships. And I would say it’s really clear when you talk to some of the sponsors, some of the sponsors are very operations focused. They have teams of people that help drive synergies between businesses. Some of the sponsors are very legal based and they’re looking to have a way out in the event that things don’t work well. So we try to focus on that component.

Shiloh:

Okay. What’s an LME and why is that important today?

Drew:

An LME is a liability management exercise, much like what we discussed with Serta, and it is essentially an out of court bankruptcy.

It’s not as clean as a chapter 11. You don’t restate your leases, you don’t close doors. You usually don’t get rid of the quantum of debt you have outstanding, but it does restrike a lot of the borrower’s debt, and it does usually come with a component of liquidity where the lenders are inserting some liquidity into the borrower.

Shiloh:

So we’ve seen an uptick in LME activity over the last two years. What do you think is driving these out of court restructurings?

Drew:

For context, we’ve had roughly 60 LMEs since 2014 through the first quarter of 2024, and then we had 25 LMEs in 2023 and eight in the first quarter of this year. So clearly the ramp has been significant in the last two years relative to what we’ve seen historically. And I think at the end of the day we’ve seen the things that are driving that are high rates is the first and most prevalent thing.

A component of high rates is every credit agreement prior to 2008 used to require hedging. It no longer does in post 2008, credit agreements really didn’t include mandatory hedging.

Shiloh:

So the hedging would be you’re taking on this debt on a floating rate basis, so the business was required to hedge that floating rate risk or exposure in the derivatives market,

Drew:

and you hedge it out from floating to fixed for half the term loan and then fast forward to today, and that wasn’t required. So two things happen as rates spike so quickly that companies were not able to get hedges on, and then when they did get them on, they were considerably higher than if they’re putting them on at three or four percent SOFR/LIBOR, whatever measurement versus essentially a zero rate interest rate environment. Well, you’ve already missed the benefit of the real hedge. So high rates, lack of hedging, and then I think sponsors, because it’s been such a competitive market where they’ve raised so much money, there’s just been a lot of high purchase price multiples made over the last five years.

So all those things together mean you’ve got a higher quantum of debt and you have higher interest rates, and it’s very hard for some of these companies to bridge some of the last couple of years.

Shiloh:

The LME that’s tied to the specific case that we talked about was Serta. LMEs are tied to Serta where one lender group is trying to prime another, and this is the description of lender on lender violence. That’s where that comes in.

Drew:

We’ve seen LMEs performed on a prorata basis, meaning lenders aren’t harmed if they’re not in the existing group. And we’ve seen LMEs come in a non-pro rata manner, just like Serta, where the majority holders are favored and the minority holders do worse.

Shiloh:

So the LMEs have resulted in some pretty low loan recoveries. Is that a function of rapid business, fundamental deterioration, or the lender on lender violence?

Drew:

It’s a bit of all of that. So we’re in 2024, and it sounds crazy to say, but 2020, 21, 22, 23, and part of 24 for many industries, were dictated by still emerging from COVID. It sounds silly, but we lived through a period of zero revenue for some of these businesses. They had to take on more debt to bridge that gap. And then we had inventory management issues. We had logistical issues where you weren’t able to get supplies in and then you had inflation and then you had to pass along those costs. And then we’ve had destocking. So whether it’s packaging or whether it’s chemicals, some of these companies had quite a volatile performance over the last two, three years, or a travel business. They might’ve been dealing with the legacy of COVID and how much debt they took on during that period of time. Some of the businesses are just failing, and they’re zombies, and this has forced its hand.

So there’s a variety of reasons why a company might’ve gotten here.

Shiloh:

So how do you protect yourself from lower loan recoveries?

Drew:

This is part of this sponsor outreach and having those relationships. We have somebody who’s full-time in charge of reaching out to advisors and attorneys and came from an advisor background. So when you see a company with weakness, you need to get your hands around.,”Is there a group forming?” “Is there a cooperative?” The very first step is cooperative groups started to form to prevent this lender on lender violence that took place in the market. So I don’t know if it was a year or a year and a half ago, we started seeing cooperative agreements among lenders, formed on a lot of stressed borrowers, and the idea was in the event something happens, we are prepared to act as a united front, and that was the first step.

So we try to make sure that where there’s stress in a borrower, that we’re going to get involved in being part of that group and being part of driving the solution.

Shiloh:

How do you think a CLO equity investor should think about the lower loan recoveries and potential risks in the loan documentation in the broadly syndicated loan market?

Drew:

I think you have to look at the adjusted default rate. So if you look at default rates today, its loan defaults are below 2% the adjusted default rate, if you take in LMEs, it’s around four and a half percent, somewhere around that. So there’s about a two and a half percent difference between the actual default rate in LMEs. And some of the LMEs, it’s deceiving, because you’ll get 85% of your debt restated, you’ll get 90 cents on the dollar restated. The problem is in a bankruptcy, you are getting rid of a lot of debt, you are getting rid of leases, you’re getting rid of EBITDA negative stores, and in LME, it only is a cure if the business improves on the back end of it because you’re really not getting rid of the quantum of debt.

You’re only providing for liquidity. So obviously we’re in the weeds on all these names. So there are some borrowers where you see an LME exercise done, and it might be in healthcare services, and we have one borrower that’s in healthcare services. Well, if you think about the consequence of COVID for anybody who’s in healthcare services is they had a tremendous amount of inflation within labor. So first you had wages go up, then you had a lot of nurses leave the entire system. So then that spike wages higher. So if you only have a reimbursement rate that’s set by a government entity and your primary costs are wages and you’ve been having inflation in wages for three years, it takes a long time to get through that. It takes years to get through that curve. So we had one deal where an LME was completed and it was done on a pro-rata basis.

So everyone ended up at the same spot and the lenders injected additional liquidity, essentially primed ourselves, but then all got ratable treatment. And in my opinion, as that loan trades close to 90 today, is the best decision we could have made because fundamental performance is improving for the last several quarters. It’s improving because wage inflation’s decelerating, and they’re finally able to pass on the costs of all that labor. So every situation’s different.

So I’m curious because you have more than one manager in general, what you’re hearing and what your thoughts are on potentially lower recoveries.

Shiloh:

I definitely think that for the broadly syndicated loan market, lower loan recoveries has been the risk. So a lot of times an investor will throw a stat at me, okay, here’s some low loan recoveries in the index. But really the question for me is, well, are those loans in CLOs and then even more important, are they in my CLOs?

So my view is that if you’re working with the right managers in broadly syndicated that a lot of these lower loan recoveries and loose stocks can be avoided. I also think that this year, we didn’t really talk about it during this podcast, but refinancings and resets or CLO extensions have the ability to materially increase CLO equity returns. So on the one hand, we do have these low loan recoveries. On the other hand, the upside from refis and resets is significant, and then you’re a broadly syndicated CLO manager, but the majority of our equity positions are in middle market CLOs. I’ll give you an example. A few years ago we had a new VP who was trying to understand better middle market loan credit agreement, and we had a lawyer on the phone and we were going through the specifics of the doc, and this VP that we had was asking all these questions around J Crew around Serta trap doors, add backs, and the lawyers like, “no, no. In the middle market, there’s none of that. There’s no unrestricted subs, there’s no non guarantors or no baskets, there’s no dividends”

Disclosure AI:

Note, this is one example of a middle market credit agreement. Other credit agreements may vary.

Shiloh:

So I think for somebody investing in middle market loans or middle market CLOs, I think that recoveries there are going to track more to the historical norm of the last 30 years. So I don’t see it as big of a risk in the middle market CLOs.

Drew:

Yeah, I think there’s one other big factor out there. I think most of this financial stress is coming from higher rates, which 60% of our borrowers are sponsor driven. So if a sponsor bought a company, they’ve owned it for five or six years and they want to sell it, they can’t get the multiple they want today. If we fast forward, I’m not talking about rates going to zero, but if SOFR comes down to 3% and now all of a sudden you start seeing these assets trade again and LDOs increase again, I think it goes a long way to ease a lot of the stress and the interest stress that our borrowers are feeling today.

So I think we’re in the eye of the storm in the BSL market today. Rates will go lower at some point, and that will ease a lot. The other thing in the BSL market, we don’t have a lot of nearing maturities. There’s very little still to mature in 25, and there’s very little to mature in 26. So if you have several years to wait this out, it doesn’t really matter the vol that you had along the way, as long as you can get to the point of being able to refinance your debt.

Shiloh:

These loans have initially a loan a value of 45 or 50% or something like that. So there’s a lot of cushion in there. A lot of things can go wrong in the business, and as a first lien lender, as long as the wheels don’t fully come off the cart, we should be money good at the end of the day.

Drew:

Agreed.

Shiloh:

Well, Drew, thanks so much for coming on the podcast. Really enjoyed our conversation.

Drew:

Thank you. Thanks for having me.

Disclosure AI:

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

ETFs are exchange traded funds.

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.

The Credit Suisse Leveraged Loan Index measures the performance of the broadly syndicated loan market.

General Disclaimer Section

References to interest rate moves are based on Bloomberg data.

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The CLO Investor Podcast, Episode 8

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 in the CLO
industry, and I interview key market players. Today I’m speaking with John
Kerschner, one of the portfolio managers of the Janus Henderson JAAA CLO
Exchange traded fund. As of June 30th, JAAA had a market cap of 10.6 billion,
up from 3.2 billion a year prior. I asked John to come on the podcast to
discuss his perspective on the relative attractiveness of CLO AAAs versus other
asset classes. We also discuss how his team picks CLO AAAs and if the market
should expect continued CLO tightening, some of which being driven by CLO ETFs.
And for the avoidance of doubt, there’s no business relationship between Flat
Rock Global and Janus Henderson. And now my conversation with John Kerschner.
John, thanks so much for coming on the podcast.

John:

Yeah, thanks for having me. It’s my pleasure.

Shiloh:

Why don’t you start off by telling our listeners a little bit
about your background?

John:

Yeah, sure. So I came out of business school where I went, Duke
University, in the mid nineties and joined a small money management firm called
Smith Breeden Associates based in North Carolina, but they had an office out in
Colorado, which I eventually moved out to. And so it was very mortgage-
centric. Doug Breeden, who’s an academic professor at Duke, who started the
firm, started as a lab for his research work to see if it actually worked in
real life. And so we were investing in mortgages. It was kind of early days of
the mortgage market back then. And then after a few years doing that, I wanted
something else and they decided to give me the asset backed slash non-agency
mortgage group. No one was doing that. So they said, all right, John, why don’t
you go try your hand on that? And that was the year 2000. And very quickly it
became the non-agency mortgage group because that market basically went from
zero to 2.7 trillion over the next six years. So all that growth in subprime
mortgages, I was right in the middle in so background in securitized. I joined
Janus Henderson back in 2010 and really to build out the securitized group, and
now we manage 40 billion in securitized, including our ETFs. So it’s been a
really great ride.

Shiloh:

Great. So post GFC, were you working with CLOs more or RMBS or
what were you doing then?

John:

Yeah, so during the GFC I actually
left that Smith Breeden Associates and joined a hedge fund based in Boulder
that focused on commercial real estate. So I kind of went from agency mortgages
to non-agency mortgages to commercial real estate, obviously commercial real
estate. I had a very difficult time during the GFC. Our investments were very
good. They were mostly global, but when liquidity drained out of the system, no
one really cared that much about that. They just wanted their money back. So I
did some distressed debt investing for a couple of years at this firm, and then
that platform was shrinking. So I was really looking for my next opportunity.
And Janus at the time, now, Janus Henderson obviously, back in 2010, was really
trying to build out their securitized group. They had no assets and no people,
and yet close to 20 billion in fixed income under management. Most of that was
benchmarked to the aggregate index. So they needed some securitized expertise
and that’s why they brought me in to build out that group.

Shiloh:

Okay. And so one of the reasons I wanted to have you on the
podcast was that I saw recently that JAAA, your AAA fund, had passed 10 billion
of AUM. What do you think is the biggest driver of the growth there?

John:

It’s an incredible benchmark to have passed. And look, I think
it’s very simple that before we launched JAAA, there was really no solution for
people looking for high quality, floating rate fixed income with a decent
yield. Normally most of fixed income is actually fixed rate, which does very
poorly when interest rates go up. And particularly when the Fed’s in an
interest rate hiking cycle, people were looking for a way to use those rate
hikes as a tailwind, not a headwind, but at the same time, people were
concerned about the overall economy and the fact that most people were
predicting recession. So they wanted high quality, floating rate fixed income.
And it just so happens that the CLO market is a perfect place for that. It’s
floating rate. If you buy the AAA tranche, it’s very high quality. A AAA
tranche has never defaulted in over 30 years. And yet because the Fed did end
up raising rates quite a bit, the yields are quite attractive and currently
still around 6.5%. So those three things, people just looking for a solution
that didn’t really exist out there, at least not in scale. And it’s just a
matter of fact that most people have some allocation to a cash or cash
alternative. And so this was just a product right time, right place, and it’s
just gotten a lot of take up by a lot of different investors.

Shiloh:

Do you think it mostly is taking share from the Bloomberg-Barclays
Agg or are there other asset classes where people are choosing JAAA in lieu of?

John:

I do think there’s some of that taking share from the Agg, but I
actually think it’s taking more share from what traditionally have been cash
type of investments, whether that’s money market funds or bank certificates of
deposits or T-bills, things of that nature. Because traditionally, and
obviously past performance is no indication of the future, but traditionally
AAA CLOs have outperformed cash by somewhere between 170 to 200 basis points.
Now that comes with more risk, at least a little bit more

risk. So that’s key. But there’s
still, look Shiloh, there’s still 6 trillion plus of assets out there in money
market funds. And so there’s just this massive market of people out there who
are saying, look, I still think rates may be going up, or I’m concerned about
the overall economy. I want that safety of cash and it’s given me a decent
yield, particularly compared to where cash was over the last 10, 12 years. So
why don’t I just do that? But then when they look at last year, cash basically
gave them just over 5%. That makes sense. That’s where the Fed funds rate is. But
a JAAA with a little bit more risk gave them 9%.

Shiloh:

So how are the shares of the ETF? How are they created and
redeemed?

John:

Yeah, so a lot of people when they look at a JAAA, they’re not
used to ETFs, exchange traded funds, or how they actually work. Most people are
very familiar with 40 Act mutual funds where if you want to buy a mutual fund,
you make a trade and then you get the price where that fund priced at the end
of the day, and that’s the price or level where your cash is invested in that
fund. Exchange traded funds are very different in that they trade on an actual
exchange. Our funds tend to trade on the New York Stock Exchange. So it’s just
like a stock. There’s constantly buys and sells, constant buys and sells
throughout the day. And probably most important or most different, there’s a
market maker that’s facilitating those trades. And what does that mean? So
let’s just say you have a day where you have a million buys and a million
sells.

So the market maker probably is not doing anything. He’s just
matching those buys and sells and there are no create or redeems. Now, let’s
say there’s a day where you have 10 million buys and a million sells, maybe on
that day the market maker is like, okay, I’ve taken in 10 million of cash that
people want to buy and only given out 1 million in cash that people wanted to
sell. So I’m going to ping Janus Henderson and say, we’re going to actually
have creates for $9 million. And so we have a capital markets team in
Connecticut that handles this as part of Janus Henderson, and they will tell us
we have 9 million in creates, and that’s when the risk is transferred from the
market maker to us. So we get these creates throughout the day. There is a
cutoff usually around one o’clock our time in Colorado, three o’clock on the
east coast. So if we do get creates, we can invest that cash. And so it’s
different in that you can constantly see where the fund is being priced, unlike
a 40 ACT mutual fund where it’s once a day. So that gives investors more
transparency as to where the markets are. And quite frankly, I think most
investors appreciate that transparency.

Shiloh:

Okay. So what’s the typical bite size for you guys for a new AAA?

John:

You mean as far as creates goes or when we’re buying new issue or

Shiloh:

Well, let’s say you’re buying new issue. Is it like a 20 million
investment that you’re targeting or how do you think about the appropriate size
for your fund?

John:

It depends somewhat on what class we’re targeting. So your
listeners probably, maybe some of them know this, but most CLOs new issue are
around $400 million. Some are bigger, some are smaller, but that’s kind of an
average size. And so the AAA tranche is usually somewhere 250 million,
something like that. So if you’re a CLO manager and you hire an investment bank
to launch a new CLO, usually what you have, the equity or residual tranche is
usually already spoken for by the CLO manager. They will usually buy that, but
the AAA tranche, they have to go out and buy a buyer for it. And it’s a lot of
bonds, right? 250 million bonds. So they want to find in what they call an
anchor order. Usually this is a large bank or money manager that has at least a
hundred million to put to work. And so we’ve started, as JAAA has gotten
bigger, we’ve started buying more and more in the primary market and doing
these anchor orders.

And why is that important? You get a large block of bonds locked
up, which is important when you’re getting creates almost every day. So you
have that visibility and that certainty of execution. You get it at a spread
that you’re very comfortable with. There’s some negotiation there. But if
you’re buying that many bonds, you have some say in the spread. And then you
can also dictate some of the DOC language as well. CLO documents are not
standardized, unlike every other asset class in the universe. And so you have
some say so when we started out, we were buying more and more in the secondary
5 million, 1 million, 10 million blocks, but now we’re buying as the ETFs got
bigger, we’re buying more and more in the primary market.

Shiloh:

I think there’s about a hundred different active CLO managers out
there. How do you guys decide which aaas are the most interesting to you?

John:

Yeah, there’s actually about 160 CLO managers. About 30 or 40 of
those haven’t issued in the last couple of years. So let’s just call it about
120 actively issuing CLO managers. So you’re right, there’s a lot of CLO
managers. And so we spend an inordinate amount of time doing both qualitative
and quantitative analysis on the CLO managers. We haven’t met with all of them,
but probably about 80 or 90 at this point. And we’ve definitely met with the
managers whose CLOs we’re buying. And so it’s sitting down with these managers
at conferences face-to-face or having calls with them. And principally what
we’re trying to find out there is how experienced is their team, how large is
their team, who owns them, how safe the ownership structure is. Obviously we
don’t want to be buying CLOs from managers that aren’t going to be around in
the next couple of years, how much they buy their own equity, how much skin in
the game they have, and then really how they look at risk If we have a
dislocation, are they first to sell to reduce risk or are they looking as that
as an opportunity to add risk?

And so there’s all sorts of
profiles of CLO managers. Some are more equity-friendly. That usually means
they’re managing more for the equity. They own a lot of the private equity type
CLO managers would fall into that classification. And then you have other CLO
managers that are more debt friendly, maybe don’t take as much risk. Some of
these CLO managers come from money managers or insurance companies. And so
doesn’t mean we won’t buy equity-friendly managers, but we have to be very
comfortable with the way they manage risk. And then obviously we could talk a
whole podcast on our quant screens, but we’re basically taking a look at, we
probably have 30 different, maybe even more type metrics that we’re looking at
over the portfolio, how many CCCs, how many second liens, what the rating of
the overall portfolio is, and we’re constantly monitoring that. So really just
to make sure that what the CLO manager is telling us is actually what we see in
the data month to month.

Shiloh:

Would you say a debt-friendly CLO manager is one where the spread
on the loan portfolio is low and maybe there’s a 5% bucket to buy second liens
if they want, and maybe a debt-friendly manager doesn’t take advantage of that
and then post the period ending, some managers are going to be a lot more
aggressive in terms of reinvesting unscheduled principal proceeds while others
are not. Are those the distinctions you would use to comp equity versus debt
focused managers?

John:

Those are all part of the equation for sure. There are others as
well. But basically to sum it up, it’s an equity friendly investor tends to
just take more overall risk in the portfolio, whether it’s second liens,
whether it’s CCCs, whether it’s just the overall, what we call WARF or weighted
average rating factor of the portfolio, how aggressive they are in
dislocations. Now, again, I don’t want your listeners to get the idea that if
you’re an equity focused investor, you’re way over your skis and not doing a
good job for your investors or vice versa. There are very good equity focused
investors, there are less good debt focused investors. So it’s a little bit of
a classification that you got to be careful with. But that being said,
obviously if two CLO managers are very similar in many respects besides that as
far as team and experience and track record and size and liquidity and
obviously spread or pricing, we’ll probably be more inclined to buy the debt
friendly. And people might ask, well, why is that? Why are these two type of
managers exist? And quite frankly, if you are private equity-sponsored, their
equity or their return target or hurdles are probably higher. It’s probably
mid-teens, right? If you’re more of an insurance company, maybe out of your
equity you only need eight or 9%. So different sponsors have kind of different
return hurdles and that’s just how the market is fragmented right now.

Shiloh:

So in the primary market, I think top tier AAA and actually maybe
better than me, but I think it’s like three months. SOFR plus, is it like high
130? Is that what you’d say?

John:

Yeah, that’s about right. 135 to 140 is kind of the range right
now.

Shiloh:

Does it ever make sense for you
guys to not be in the top tier if you’re not in the top tier for AAA? I mean
you might pick up another 10 or 15 basis points and in that case you’re in a
manager whose shelf maybe isn’t as liquid or it’s a platform where they’ve
issued the less CLOs or maybe they have a new management team. Does it in
general make sense to kind of stretch for that extra yield in the AAA or do you
guys kind of hew to the most conservative established managers?

John:

So your listeners might get frustrated on some of these answers.
Most of ’em, it depends, right? So there is a tradeoff there. I think that’s
very important. But I also think it’s important to define what we mean by top
tier. And most people divide the CLO management group into three different
tiers, one, two, and three. And a lot of people have misconception that if
you’re in tier three you’re not a very good CLO manager. And that’s just not
true. It really stemmed from the fact that the Japanese CLO investors, these
large banks, including Norinchukin, has been in the news recently have an
approved list of about 40 or 50. No one knows for sure CLO managers. And if you
made that approved list, you’re kind of automatically top tier. These are
usually the bigger managers. The ones that have the most deals outstanding,
have the longest track record.

That’s what gets the Japanese investors comfortable and that’s
what makes top tier, Tier two can be a little less track record, a little
smaller things of that nature. And then tier three are usually newer managers
have been around only for a couple of years. There are very good top tier three
managers. There are less good tier one managers. So it really just depends. But
to answer the question, JAAA is about 65 to 70% tier one managers, whereas the
overall index is about 50 to 55%. So we are definitely overweight top tier
managers, and you’re right that you get maybe less spread, but you get a lot
more liquidity. So we are overweight top tier, but we do look for those
opportunities in tier two or tier three where we really love the manager and
then we’re getting a wider spread. So we take that trade off very seriously and
it’s a way to add value to the portfolio.

Shiloh:

So you mentioned preferences in the docs or the CLOs governing
document, the indenture from the perspective of somebody who invests in CLO
equity, things I would care about would be flexibility to reinvest after the
reinvestment period ends. We’d also like favorable language around the par
flush

Disclosure AI:

Note. A par flush can occur when the CLO begins its life with more
loans than required by the indenture. The excess loans can be distributed to
the CLO equity early in the CLO life.

Shiloh:

And I assume that you would be on the exact opposite side of both
of those debates, but what are some preferences that you guys have?

John:

Yeah, I mean those are both very important and this really gets in
the weeds, but I think one of the big topics that have been out there is these
liability management exercises. Instead of firms just going bankrupt, a lot of
times they try to work with their, and these are firms that are using the
leveraged loan market. So if they get into difficulty, oftentimes they to
manage out of that instead of just declaring bankruptcy. And there are
different things they can do as far as priming the current investor group. That
just means issuing new loans that are senior to the current loans. And
oftentimes CLO managers have a hard time just based on the CLO docs
participating in some of those exercises. So if they’re not able to, they
really have two choices. They can be in a situation where their debt actually
now is layered to new debt, which you don’t want, or they just have to sell the
loans at a very distressed price, which they don’t want to. So some of the docs
now allow for CLO managers to participate in some of these investor groups up
to a certain extent. And we think that’s actually a positive, right? Because it
allows them to kind of do what’s best for their end investors, which ultimately
are us. So that’s one very topical point right now you’re going to hear if you
haven’t already a lot more about that in the coming months and years.

Shiloh:

So you can buy bonds in the primary or the secondary. So is the
way you think about that, that an attraction of the secondary is that you can
buy bonds and they close T plus one

Disclosure AI:

Note T plus one refers to a trade settling one day after the trade
date, that’s when cash is exchanged for the security,

Shiloh:

But might be harder to source. Whereas in the primary market, a
lot of times you’re going to make a commitment and the bond’s not going to fund
for five weeks, it might be T plus 20 or something like that. Is that kind of
how you see the trade off there?

John:

Yeah, that’s exactly right. But the other part of the trade-off is
secondary bonds tend to trade tighter. Some of that is the fact that some
secondary bonds have shorter weighted average lives. And in general, if you’re
buying a bond with a shorter weighted average life, you’re lending money for a
shorter term. So it should be a tighter spread. But generally secondary bonds
because of this in the CLO market, this dynamic you just mentioned, T plus one
versus T plus 20 or 25, secondary bonds tend to trade tighter. So we’re
constantly evaluating that trade off. Is the secondary market so tight that it
makes a lot more sense to buying in the primary market or vice versa? At this
point, JAAA in particular is big enough. We’ll probably always be buying some
bonds in the primary market just to have that certainty of the pipeline of
being able to put the cash to work. But we’re also constantly looking at the
secondary market. People who don’t invest in the market on a day-to-day
wouldn’t know this, but there are bid lists, other investors, other banks,
other money managers constantly selling. We’re constantly involved in those bid lists to see if we can pick up
secondary CLO bonds at very attractive spreads. So that’s really the trade-off.

Shiloh:

So one of the things we’ve seen develop over the last year or so
is that there’s very short AAAs, like a refinance where there’s maybe a year or
so to go on the reinvestment period and those price well inside of new issue.
Is that something that’s interesting to a fund like yours or do you prefer the
wider spread and the longer reinvestment period deals?

John:

It also depends on the dollar price of the CLO. So most people
that are listening probably understand that the typical structure for a CLO is
a two year no-call five-year reinvestment period. What that means is when the
CLO is issued, it can’t be called for two years. And then if a loan matures or
is paid off, the CLO manager can reinvest that cash into a new loan after five
years. There’s a limited ability to do that. But in general, at that point, the
AAA start amortizing down and usually a deal is either called or refi or reset
pretty soon thereafter. So what you have to be very cognizant and this decision
changes a lot depending whether the market is mostly at a premium or mostly at
a discount, right when it’s at a discount. You love those kind of short
weighted average life going into or coming out of reinvestment period, starting
to amortize because you think the deal’s going to get called. And if you’re
buying it at let’s say 97, 98 cents on the dollar, you’ll get your money back
when the market’s more at a premium, you have to be very careful of that. So
it’s really an individual bond case by case basis. Right now the market’s
actually kind of right in the middle. It’s mostly right at par. So it really
just depends on the overall spread and the comparison. I would say right now
we’re more interested in the longer weighted average life, wider spread primary
market,

Shiloh:

And then in middle market CLOs, the AAAs, their price at around 30
basis points above the spread on broadly syndicated. Is that interesting to you
guys at all or do you prefer the larger broadly syndicated CLO market?

John:

We definitely prefer the BSL market. The middle market CLO market
kind of had a moment last year when issuance, which normally was five to 10% of
the BSL market, all of a sudden became 20 or 25%. This is just because there
were a lot of leveraged loans out there that were having trouble refinancing in
the BSL market and the private credit market came around to kind of help with
that. But the problem is the private credit market really hasn’t gone through a
massive dislocation covid, a lot less transparency, a lot less liquidity.
Usually it’s one lender, one borrower coming up with the docs and figuring out
the blending requirements. So you just don’t really know what’s going on under
the hood. And yes, they come with more spread and more credit enhancement and
more protections, but if we do get a large dislocation, a, you’re going to have
very little to no liquidity and you’re going to have higher defaults almost for
sure.

Leverage is higher in that market.
Debt service coverage ratios are lower, so almost for sure defaults are going
to be higher and no one really knows if the extra credit enhancement you’re
getting is going to be enough. So we have stayed away from the middle market or
private credit CLO market because for us, we think for our investors, liquidity
is paramount. Right now it’s a liquid wrapper, an ETF wrapper. We want to make
sure that our investors can get their money back if they want their money back.
We’ve had very large creates and redeems in this space. And in fact a couple of
weeks ago we had $400 million sell and we didn’t even get a redeem. So that
means somebody sold $4 million of J AAA and we didn’t see any outflow. And you
might say, well, how’s that possible? It’s because we’re constantly getting
creates at the same time.

And so the market makers were just able to offset that sell with
enough buys that we didn’t have to get a redeem. So bottom line is that’s a
great use case for our investors of how liquid this product and this market
actually is. But we know there will be a time we will have another C type
environment or GFC environment and maybe five years or maybe 10 years, but at
some point it’s going to come and we want to make sure that we have the
liquidity in the portfolio to meet any redemptions that we have and staying in
the more liquid BSL market as part of that strategy.

Shiloh:

And by the way, I would certainly agree the broadly syndicated
CLOs up and down the stack are going to be a lot more liquid than middle
market. But you did mention liability management exercises earlier. We invest a
lot in the middle market CLOs, and one of the attractions is just that there
really is not lender on lender violence there. There’s no, and so when loans
default, we’re expecting more of the kind of restructurings that we’ve seen for
the last 30 years. We’re not really expecting much to change, whereas broadly
syndicated, the loan recoveries really have been pretty poor for the last two
years or so.

John:

Yes, no, I totally agree. I don’t want your listeners to think
that I am really reigning on the parade of the private credit or middle market.
What you said is absolutely true, and there are some very good lenders there
that have done it a long time and know what they’re doing. And there’s probably
some very good credits there. I would just say again, there’s a lack of
liquidity and transparency and maybe hasn’t been proven through a more
dislocated market. But you’re right, some of these deals may be better, quite
frankly, in a dislocated market for the you just mentioned. But for the reasons
I mentioned, that’s why we’re sticking to the BSL market.

Shiloh:

So then AAA financing costs have come in really dramatically since
the spring of 2022. What do you think is driving that and should we expect the
trend to continue?

John:

There’s several things driving that. Interestingly enough, what
happened with Silicon Valley Bank just over a year ago now, and now the news
coming out of Japan with Nor Chuan is making both regulators and banks really
focus on their investment portfolio. I don’t think people necessarily know how
big some of these portfolios are, but look, banks bring in deposits and they
make loans and sometimes they can’t

make enough loans for all the
deposits they’re bringing in, so they have to buy securities to make up that
difference. And traditionally, banks have bought very high quality fixed
income, government debt, mortgage debt CLOs, but until this recent increase in
interest rates buying kind of long duration or treasuries kind of worked for
banks and then all of a sudden the thing goes, it worked until it didn’t and a
lot of banks got underwater. And so even though CLOs may seem a little more
complicated or more risky for a bank, they’re kind of the ideal asset class.

They’re floating rates, so they really don’t have to worry about
interest rate risks and they’re very high credit quality. And that’s why so
many banks are now trading out of their long dated treasuries and mortgages and
buying more CLOs. So that’s been a huge buyer. Money managers are buying more
and more. If we were talking six or seven years ago and we were talking about
who owned what money managers would be much smaller. They’re about a third of
the CLO market right now. They were much smaller back then, but the liquidity
has improved. And so money managers are using this as a tool for portfolio
management. And then quite frankly, it’s the CLO ETFs. If you look at the stats
so far, year to date, the net issuance of AAA CLOs is almost zero. That means there’s
been a lot of gross issuance, but there’s also been a lot of liquidations and
amortizations. So basically deals getting called or deals getting paid down to
offset that. And then you add on the 6 billion of AAA CLO ETF buying that’s
actually put to market in a net supply deficit. That means money managers or
other investors have to sell to make that up. And so you can never have more
supply than demand, but the demand continues to pays with money managers,
banks, and now the CLO ETFs and that is what’s driving in spreads.

Shiloh:

Let me ask you just specifically about CLO ETFs. Do you think that
there’s enough assets there that that’s a material factor in driving AAA costs
lower?

John:

I absolutely do, and I think it will continue. Now you might say,
well, where will that come from? I mean, I think supply will continue to
increase. So basically CLOs are just an arbitrage between where you can buy the
leverage loans, how much deal costs are, and then where you can buy the CLO
capital stack. And as AAA CLOs get tighter, that arbitrage gets better and more
created because the arbitrage gets better. So I do think that as spreads get
tighter, there will a be some motivated sellers at a tighter spread. But I do
think that we have only begun to tap the investor base when it comes to CLO
ETFs. I mean, we’re at 10 billion, we’re actually at 10.4 billion, but the
market’s just over 11 billion. I think this could be a 20, maybe even a 30
billion market. Like I said, there’s still 6 trillion in money market funds out
there. And so I do think it’ll be a very big market and I think the CLO
creation machine or the new issue machine will continue to ramp up and do
enough deals to feed that demand.

Shiloh:

Well from that perspective of a CLO equity investor, I’m certainly
sharing you on in terms of the raising assets and hopefully the result is lower
financing costs for the CLOs. So one other question is just around interest
rates. So does your fund pay a floating rate dividend and the expectation is
that when and if the fed cuts, the distribution yield will come down or how do
your investors think about it?

John:

I mean, in general, that’s definitely true. One thing people have
to realize is there will be a lag because CLOs are benchmarked to the three
months. SOFR rate, secured overnight financing rate, so they only reset every
three months. If the Fed cuts rates, things like repo rates will reset
immediately lower. It takes at least three to four months because the rate will
take three months to reset, and then there’s another month delay until they
actually see a lower distribution or dividend. So there is a delay. What I
would tell investors is, look, all indications the Fed has given us is they
probably will cut either later this year or early next year. It will probably
be only 25 basis points, and it will be very much a slow cut cycle. So we’re
not thinking it’s going to be 50 or a hundred basis points like we saw during
covid. So gradually your overall distribution yields will go down, but
currently you’re still about 50 basis points, higher yield than longer term
treasuries. So there’s a lot of reduction in that yield before you’re even
equivalent to what you’re getting with most corporate debt or treasury debt. So
I think the investors are still in a very good place.

Shiloh:

Okay. So are there any questions that I haven’t asked you that are
maybe topical for your fund or for the CLO industry in general?

John:

Well, I think when we’ve been out there talking to investors, we
always get the question about the GFC and CDOs, I guess because they’re both
securitized products, one letter different, both acronyms and the idea behind A
CDO isn’t that much different from a CLO, but what makes them extremely
different is the collateral that you use to build one. So a CDO is basically
subprime mortgages, most of which should have never been issued or created and
mostly given to people that probably should not have been getting those loans.
And so when the GFC hit and a lot of these people couldn’t refinance their
mortgage, and these subprime loans were a floating rate and the rates were
adjusting up and they couldn’t pay those. A lot of people we know in some prime
space, like 70% of people defaulted. So if you were creating an instrument that
was based on that subprime market, of course it didn’t perform well.

CLOs very different leverage loans have been around a very long
time, have been through all sorts of dislocations, have been through the GFC
and CLOs perform very, very well since then. A triple-A CLO has never defaulted
in the history of the market over 30 years. And a triple-B CLO even hasn’t
defaulted since the GFC. So these instruments are time tested, very safe. They
don’t have anything to do with what happened with CDOs in the subprime market
during the GFC. And if you have other questions as far as we can walk you
through the math, like you said, the recoveries have gone down over the years,
but you still need something like four to five or even six times A GFC
environment for a AAA CLO to consider defaulting. If we were in that type of
environment, any other financial asset you owned would be in a much, much worse
position.

Shiloh:

So you mentioned that low default rate at triple B. I mean, does
that imply though that people would be better off taking a little bit more risk
and moving down the cap stack rather than investing in the triple A,

which, and I know they’ve never
defaulted, so everybody feels good about that, but would it make sense for a
lot of people to take a little bit more risk and maybe get paid for it?

John:

It’s a great question. It really depends on the investor. What I
want to emphasize when looking at JAAA versus JBBB, so JBBB invest mostly in
triple B CLOs is yes, you’re getting more yield. You’re basically going from
let’s say a six and a half percent to kind of an eight and a half percent
yield, but you’re taking on a lot more risk. Whereas a triple A CLO is only
slightly riskier than cash, maybe one or 2% volatility. Triple B CLO probably
has four to five times the volatility of a triple A CLO. So you’re getting to
the point where it’s kind of like an equity type volatility. And so some people
are fine with that, particularly if you are very confident that we’re not going
into a recession or a very constructive on the overall economy and corporate
market. But that being said, you have to understand, if we go into a covid type
experience, that type of product could be down 10, 15, even 20%. Now you’re
getting an eight and a half percent yield to offset that. But we want investors
to understand what they’re signing up for because the only dissatisfied
investor should be a surprised investor and we don’t want people to be
surprised. So if that extra yield is worth it to you, by all means we think
it’s a great product. I own it myself, but if that’s too much risk for you,
then stick with JAAA.

Shiloh:

And so what’s the best way for an investor to find out more about
your funds?

John:

JanusHenderson.com or you can search on JAAA or JBBB. We have our
fact sheet on there. We have all sorts of information on either ETF, but that
is the best place.

Shiloh:

Great. Well, John, thanks so much for coming on the podcast.
Really enjoyed our chat.

John:

Yeah, same. My pleasure and great questions. Really, really
enjoyed the conversation.

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.

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 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

ETFs are exchange traded funds.

Offset is a refinancing and extension of A CLO investment. 

The Bloomberg US Ag Index is a broad-based flagship benchmark that
measures the investment grade US dollar denominated fixed rate taxable bond
market.

JAAA and JBBB are the tickers for the Janus Henderson CLO Triple A
and CLO Triple B ETF.

For the risks of investing in these funds, please see
janushenderson.com.

RMBS stands for Residential mortgage-backed securities.

Non-Agency mortgages are mortgages not owned by a government
agency

CDO or asset-backed security is a securitization backed by
collateral that is not first lien corporate loans. 

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 or give advice in a fiduciary capacity. This broadcast is copyright 2024 of Flat Rock Global LLC.

All rights reserved. This recording may not be reproduced in whole or in part or in any form without the permission of Flat Rock Global. Additional
information about this podcast along with an edited transcript may be obtained by visiting flatrockglobal.com.

Disclaimers regarding JAAA and JBBB:

This is not an offer for any of the funds mentioned in the interview.  The returns quoted for JAAA and JBBB are past performance and do not guarantee future results; current performance may be lower or higher. Investment returns and principal value will vary; there may be a gain or loss when shares are sold. For the most recent month-end performance call 800.668.0434 or visit
janushenderson.com/performance.  Janus Henderson Investors US LLC is the investment adviser and ALPS Distributors, Inc. is the distributor. ALPS is not affiliated with Janus Henderson or any of its subsidiaries.

JAAA Fact Card

JBBB Fact Card

The CLO Investor Podcast, Episode 7

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 leverage loans. In this podcast, we discuss current news in the CLO industry and I interview key market players. Today I’m speaking with Patrick Wolfe, the middle market CLO manager at BlackRock. I’ve been investing in Patrick’s CLOs for over a decade now, and BlackRock is the largest CLO equity manager across Flat Rock funds. In last week’s podcast, Paul Nikodem and I discussed some of the metrics that are used to pick CLO managers and Patrick’s CLOs and his platform check all my boxes. Other investors seem to agree as BlackRock is able to get some of the best CLO financing rates in the market. Our primary discussion was an update on middle market loans and how Patrick sees his platform as differentiated. We also discussed the risks he sees for CLO investors in today’s economy. Many of the questions I pose to Patrick are the same ones investors are asking me, including how borrowers are managing higher interest expense and if there are enough good middle market loans for everyone to get enough. So we’re going to hear the answers in this case directly from the horse’s mouth. And now my conversation with Patrick Wolfe. Well Patrick, thanks for coming on the podcast.

Patrick:

Yeah, thanks for the invitation. Happy to be here.

Shiloh:

So I understand you were recently at a CLO conference in Barcelona. What was that like?

Patrick:

The vibe of the conference was very positive. You’re seeing a lot of demand from a lot of new regions. Slowly different regions have come back online. So it was interesting, we had meetings from people from all over Europe, from Middle East and even as far away as Japan and Korea. So it was very well attended and a lot of people are exploring adding CLOs to their portfolios or turning it back on. We even met with a bank from Greece who was exploring adding middle market CLOs. So it was really an eclectic group of people there. And the weather and the food of course is always nice in Spain.

Shiloh:

I would think that would be a very compelling part of the conference. So why don’t we start off and if you could just walk us through your background and let our listeners know how you ended up managing CLOs.

Patrick:

Happy to. So I worked for Deutsche Bank around 2006 in structured products and luckily was a junior person at the time when we went into the global financial crisis and worked all the way through the global financial crisis. Saw a lot, got a lot of scars, had a lot more hair at the time, and worked on some really interesting bankruptcies in CLOs and gained a real good foundation of how to manage A CLO and at the time how to manage CLOs in difficult situations. And then post the global financial crisis around 2012, 2013, I got approached by 10 capital partners who was more of a multi-Strat credit firm. They asked me to join them as they looked to start issuing middle market CLOs and I joined the firm in 2013. We were acquired by BlackRock in 2018, so I’ve really been in this same role for almost 11 years now. We’ve become a large issuer, middle market CLOs. I think we’re on number 14 today and we’re approaching around a little over 6 billion of middle market CLOs. But the broader direct lending platform, which the middle market CLOs sit a part of is about 25 billion today. Or I also play a senior role as portfolio manager on the broader direct lending funds. But my history and my background was born in structured products.

Shiloh:

So then why don’t you give our listeners just a 1 0 1 on middle market loans and how they’re different from broadly syndicated loans, which are the bigger part of the CLO market.

Patrick:

So there’s quite the difference between middle market loans and broadly syndicated loans, or at least there has been for the last few decades. Middle market loans, I like the phrase is very much farm to table credit as we have to go out and originate and find the opportunities and we have to structure and underwrite and actually go visit the site and spend time with management and really manufacture an investment opportunity from scratch where a broadly syndicated loan, all your large investment banks, Morgan Stanley, Goldman Sachs, JP Morgan, all these large investment banks are out there syndicating away small pieces of loans and you typically get asked a question, do you want to buy this loan and at what price? So it’s much more of like going to a grocery store. You can go on Bloomberg and sort by industry sort by rating and within a day you can acquire a hundred broadly syndicated loans with a few phone calls to a few of the big banks.

We’re in middle market, like I said, we’re out originating the asset. We have much bigger teams required and we’re typically providing financing to help the middle market economy. Think of companies around 50 million of ebitda and in some cases they are selling their business to a private equity firm or they’re acquiring a competitor, but they just need some middle market financing to grow their business or transact. And that’s really the big difference is that middle market is very much a much bigger time commitment and amount of resources because like I said, we don’t just get to go on Bloomberg and pick from a pool of loans with a few phone calls.

Shiloh:

So the typical loan that you’re underwriting today, what do you think the average loan to value is and what’s the spread over SOFR?

Patrick:

So the average loan to value is going to be in the high thirties to low forties for first lien senior secured loan. And that’s really the only place we’ve been focused in the capital structure over the last couple of years is the first lien and that today is probably around SOR five 50 to SOR 600 today at that loan to value about nine months ago, I would say it was 600 to six 50 over SOFR. So we really have seen some spread compression over the last six to nine months, but relatively speaking, we’re probably a little bit wider than our historical levels. So it still has been a very compelling time to be at middle market lending. We still get covenants in our loans. That’s a big benefit of the middle market as we are negotiating and manufacturing and structuring these. So it’s hard to say it’s apples to apples to the broadly syndicated loans because those loans typically do not have covenants. So we have in a way a better structured downside protected credit agreement at a wider spread. So that’s where we’re seeing levels today.

Shiloh:

So one of the things I’ve been seeing is private credit, middle market lending has just become more and more popular each year. Are there enough middle market loans for everybody to get their share given how many competitors there are in the market and how much money’s been raised in the asset class?

Patrick:

That’s a very common statement that people do not expect there to be enough loans for everything to go around. I think people underestimate the size of the middle market economy and also where that economy is. Those companies are in their life cycle. A lot of these businesses are still owned by founders who could be from the baby boomer generation who are getting older and we’re starting to see a lot of companies transact. And there’s a quote that there’s over 50,000 companies in this 25 to 75 million ebitda and a very high percent of those need to go through a generational shift in the next 10 years. So there is by far more loans than there are capital for today. I do think direct lending on real market lending is very underfunded. When you look at the amount of private equity dry powder that’s been raised over the last few years, there’s estimates anywhere from around one to one and a half trillion dollars of private equity dry powder, and as I just mentioned on the loan to value, it’s close to one-to-one and direct lending is somewhere in the hundreds of billions from dry powder. You really need it to be closer to parity with that. If anything, direct lending is underfunded relative to private equity and there is a huge portion of our economy in this core segment. I do think there is room for more competitors and there’s plenty of deals. We are very selective. We only execute about 5% of the deals we review every year. So that’s maybe anywhere from 60 to a hundred deals a year on average. So yeah, I do think there’s plenty. And if anything, direct lending is underfunded relative to the broader private equity markets

Shiloh:

And with a lot of your loans being created in leveraged buyouts, do you think that is some activity that’s going to pick up later this year or is it that the higher base rate of SOFR has just really slowed down that market substantially and maybe there won’t be an increase until interest rates come down

Patrick:

The last two months. We’ve seen it up month over month, April, may. We’re very, very busy. We’re continuing to see it pick up. I think rates will only pour gasoline on it. When rates do come down, I think m and a activity will pick up a fair bit and it’s going to be really on the buyers and sellers agreeing to a price. We have seen a lot of businesses put up for sale and there’s just a really big bid ask and over the last few months that’s gotten closer and you’re starting to see businesses transact. But I think once rates go down, there’s a lot of private equity portfolio companies that need to be sold. Some of these private equity funds are getting really, really long in the tooth. They’ve been in existence for over a decade and the investors are the limited partners. They want their money back.

So I think as soon as people have a good feeling that rates are coming down and you’re going to get a slightly better valuation, you’re going to see a huge pickup in it. But right now we are seeing pretty substantial pickup in m and a, but I would say that these are actually more new businesses that have grown really well and fared very well in the high rate environment. You really haven’t seen a business that’s just bumped along as a lender. A business bumping along is very much okay, you just don’t want to see it go downhill. Sometimes when a company does too well, you get refinanced really quickly and all your hard work was only worth about a year of interest coupon. So a company that just slowly grows, bumps along, it’s great. And we haven’t really seen those companies transact. It’s the private equity sponsors either hope and rates come down, it helps them grow top line or create better margins. But the election’s still out there and rate cuts. Now with the news today, people are pricing in a cut post November. It’s not the multiple cuts people originally expected, I think early part of the year. So I think there’s still some uncertainty, but it’s coming. There is a wave of m and a that we’ll see in the next, I’d say six to 12 months.

Shiloh:

So you mentioned that you’re highly selective in the loans that you make. Are there some industries or particular red flags that screen out a lot of borrowers in terms of your credit box?

Patrick:

Yeah, commodities, cyclical businesses. You really want to be careful when you need a crystal ball to predict their ability to be refinanced in the future. If they have a hard time meeting their breakevens at where a barrel of oil is priced at, you really don’t want to make a bet where the barrel of oil will be in four to five years when you’re loan needs to be refinanced. So we tend to avoid businesses linked to commodity inputs. We also tend to not very cyclical businesses as well. As a lender, you really want stable growing businesses. So where we have probably done better than most is on technology software specifically. That’s an industry that we’ve liked for quite some time now and software just continues to be a bigger and bigger part of everyone’s day-to-day life. It helps people grow their business, run their business. And during covid we saw a lot of these software businesses do fairly well where a lot of people question their ability to maintain a tough macro environment and these businesses can be very asset light. It doesn’t take many people to keep the lights on at some of these software companies so you can quickly cut expenses. So we continue to like that very much technology growing growth businesses, we are very much less into the manufacturing, high cost, fixed cost type business structures. We do like insurance services. I like to say I like car wash roll-ups more than healthcare. So those are always fun to discuss.

Shiloh:

So in terms of the competition for middle market loans, there’s lots of other firms out there who want to originate these loans. Do you see yourself as competing based on price or the economics of the loan or are there some reasons that people would select your firm that aren’t just tied to the economics of the deal?

Patrick:

Economics today seem to be less and less as much of a deciding factor. It definitely matters where it is, but everyone’s coming out around the same area. So for the ballpark, for example, if we say we think a loan should be price at SOFR plus five 50 and someone else thinks it’s SOR plus 5 75, it’s really not that big of concession where you’re seeing the ability to win transactions is really off reputation size of firm. Are you going to be able to grow with the business? Is your firm something that could be much more of a long-term financing solution partner? That was something at our legacy firm that we felt we missed out on is that we were really only able to finance your business when you were 50 million of ebitda, 75 million of ebitda. But if you very much grew and maybe wanted to go to an IPO or maybe you were going to move to the high yield market, our firm was stopped being able to provide financing.

And we have seen a number of transactions where I think we won the transaction maybe be even a hair higher on pricing, but they viewed BlackRock as much more as a long-term financing partner is that we could grow with the business if they had ambitions for an IPO BlackRock, it would be one of the bigger IPO buyers just by what we participate from our ETF business. And that’s something that I think has proven to be really helpful in competitive situations. The other place that we’ve historically excelled at is that our team on the underwriting side and the management side is constructed by industry specialization. For example, our head of healthcare comes from private equity. He’s very much still has a private equity mindset so he can have much more of a peer-to-peer conversation with the sponsor of the private equity firm or even the CEO and CFO.

He really speaks their language that definitely has helped us win transactions and competitive environment. We’re not very much a generalist or a generic banker or just a cheap cost to capital provider. We could be much more of a partner, a financing partner that’s going to understand the issues that they go through, aren’t going to be scared of a typical delay that we are used to seeing in that industry or that subsegment where someone that’s very general isn’t used to manufacturing delays in pharmaceutical drugs and that’s something that happens from time to time. So that is another place where we’ve historically been our biggest competitive advantage is that our team has industry leads and they manage the investment from entry to exit. So they continue to work with the management team and the sponsor. So that’s some of the ways we’ve been able to compete that is beyond just pricing and economics, but there are some sponsors that that’s all they care about and we tend not to excel with those sponsors because we don’t want to race to the bottom. So we tend to look for much more long-term partners.

Shiloh:

So for somebody sitting in my seat, whenever we model CLO equity, we put in a 2% default rate into all of our projections, we put a 70% recovery rate in. How do you think those projections will fare for the next coming years here?

Patrick:

So in middle market I think that’s still a very valid assumption, 2% constant default rate at that recovery. I think broadly syndicated equity is having a tougher time. I’ve seen recoveries for a few of the rating agency research reports on in court restructurings being sub 20 and you’re seeing out of court restructurings being in I think the mid fifties. So everything that people have been nervous about in the broadly syndicated loans with the weaker credit documents and not having covenants is leading to lower recoveries in bankruptcies. The benefit of middle market is we still have that feel of what the leverage loan market was 15 years ago with a high percentage of our loans or mostly all of them with covenants of the ability to get to the negotiating table before too much principle loss creeps into the story. So I do think core middle market is just even direct lending. That is still a very much a fair assumption. I do think on average we probably outperform the default rate and I think the recovery is plus or minus five to 10 points from there and probably averages out to 70. Ours is in the nineties when it comes to our CLOs that have had defaults over the last 12 years. But I do think in this credit environment there’s going to be a tougher time and I think two and 70 in our market is a very much a fair assumption when modeling out that investments.

Shiloh:

So in the broadly syndicated market, there has been some weaker credit documentation that has resulted in some low recoveries. Do you feel like in the middle market you’re still getting the documentation that you want and that there isn’t a risk of a looser documentation in your particular market?

Patrick:

There’s definitely a risk in our market and we are seeing the segmentation of middle market loans or direct lending playing a big part in that. So we view the market in three segments. Let’s say lower middle market is zero to 25 million of EBITDA is the lower segment core being 25 million to a hundred million of ebitda and then upper it being a hundred million plus that upper middle market has gotten very competitive and we’re seeing reports of less than 10% of those loans having covenants where on average the core middle market is closer to 70% of the loans having covenants. So you have seen some of the broadly syndicated credit documents start to creep into our market. We’re doing everything we can to hold the line on it. One thing you can get comfortable with is maybe not the financial maintenance covenant, but where you’ve got to be careful is some of the negative covenants like your ability to up tier or execute liability management transactions or lts. You have seen that creep in not anywhere to the same degree in the probably syndicated market. And one thing people forget, there’s very smart lawyers out there and even though J Crew Serta chewy are some of the more famous bankruptcies and we all focus on making sure the weaknesses that were exploited in those bankruptcies are tied up. There’s no saying that someone’s not going to create the new weakness.

Shiloh:

It’s a bit of a whack-a-mole I’ve heard.

Patrick:

Yes, it is exactly a whack-a-mole. There’s lawyers out there trying to figure out every which way to weaken the document and find a loophole to exploit some of these things. If you go back five years or even seven years in our credit documents, the Serta protections might not be there because no one believed they needed them. So the document is always evolving and one thing I like to highlight is there’s almost like a red yellow green from a strength protection, some of it. So right now what we thought was a strong credit protection to protect you from Serta, today’s age might be only lightly or moderate. So when you do have an amendment, do you want to rewrite that protection the document to be even stronger because even though you might’ve thought you had the protection, the lawyers find it the loophole to get it. So the document is always evolving, it’s always going to be whack-a-mole and private equity sponsors will try to find loopholes to protect their investment, their fiduciary to their investors. So if they could exploit some part of the credit document to increase the recovery or create a recovery, they’re likely going to do so that’s one thing that we’ve always been focused on is the sponsors are great until they’re not.

Shiloh:

So then one of the things I’ve also liked about middle market is just that when a company does get into stress that you only have one or a handful of lenders that are making the call and broadly syndicated, you might have a term loan that’s a billion in size and you might have 40 or 50 different people with opinions in the restructuring process. You might have a high yield bond, a second lien lawyers taking all kinds of fees for their time. All that’s going to eat into the first lien recovery.

Patrick:

That is a big benefit that we have. We’re typically the only debt and we’re mostly the first lien. It’s typically only first lien senior to secure loans. So it does make for a lot cleaner restructuring. A lot of times it’s done out of court. We don’t have to go through a formal bankruptcy system that can be very costly and just decreases your recovery as a lot of people get paid in restructurings and it could be 15 20 million in fees going out the door. So the direct lending, you have a much more of a sitting down across a table workout of a restructuring in some cases only one lender or a couple lenders. And for the most part everyone’s in agreement and there isn’t typically one lender trying to create a priming facility. It’s very much everyone’s arm in arm trying to get to the best outcome for the restructuring.

Shiloh:

So one of the questions I think I’m asked the most is just that as the Fed has hiked rates, loan yields are in, call it the 10 to 12% the area, are the borrowers able to make those interest payments over an extended period of time or do they really need the fed to start cutting in the future?

Patrick:

No, a very high percentage at least of our portfolio are still well above one and a half times from an interest coverage standpoint, meaning they’re able to still service the debt. I think for the private equity returns to pencil out to what they were initially underwritten at, they’re going to need to see the Fed to start to cut rates. We’re not seeing interest rates alone push a company into distress or de-stress. It’s typically interest rates plus a loss of the customer interest rates plus a supply chain issue. So for the most part, the companies have been able to manage the higher rate environment. They just had a lot less room for error. It kind of magnifies a mistake right now. I think if the interest rates start getting cut, it gives them a little bit more room to lose a customer to have a supply chain delay and still have liquidity to manage through. It just really has made it much more difficult for them to make a mistake. It’s hard to recover with their interest rates where they are.

Shiloh:

So do you see the higher rates is basically just transfer in economics from private equity firms to middle market lenders?

Patrick:

That’s exactly correct. We’re going from mid single digits to teen type returns on the assets and that is coming out of the equity ownership of the business. So they’ve benefited from low rates and very high returns for quite some time. And the term that gets thrown around a lot is the golden age private credit and it’s really the first lie loan is making almost equity like returns from a yield standpoint.

Shiloh:

So that’s why I think it’s so many headlines and so much interest in the asset class. It’s just that double digit returns from a security where you’re in the top of the capital structure. So one of the key trends in CLOs this year has been declining CLO financing costs triple eight down to double B. How does that affect your business in terms of issuance? Does that make it more likely that you’ll come to the market deals in the future or will you look to refi reset the deals that are already outstanding?

Patrick:

From a new issue standpoint, it doesn’t really change what we had planned for the year. From a new issue standpoint, it definitely makes things more appealing. Where it does change our plan is on the reset refinance side of the equation. So at the AAA levels we are today, a lot of the deals that we’ve priced over the last couple of years are all of a sudden it looks compelling from an equity return standpoint to go out and reset the deal for another four years and possibly lower the borrowing costs slightly. So that’s where I think you are seeing a lot more activity as people are starting to refinance and reset new deals. Middle market is less tied to a few basis points. Even when spreads were 75 basis points wider than they are today. People were still out there constantly issuing middle market CLOs because we just have a lot more spread in our assets and if a quarter basis, 25 basis points doesn’t necessarily make or break our returns like it does in broadly syndicated equity where they’re trying to get to a couple basis points of a model from an arbitrage standpoint because they’re going to magnify it 10 to 12 times and probably syndicated.

So every basis point really matters at that magnification middle market. CLOs can be anywhere from three to six times levered, so it’s less of a magnifier when we’re talking a few basis points. But I think reset activity does definitely pick up the back half of this year.

Shiloh:

So BlackRock has both broadly syndicated and middle market CLOs. Are the investors in those two different securities, are they different folks or do people play in both your middle market and your broadly syndicated issuances?

Patrick:

So we definitely do have a middle market US probably syndicated and European CLO business as well, which is syndicated loans there. We do have crossover on the debt side for sure. People are familiar with the platform, how robust our risk management functions are our Aladdin systems and they definitely get the benefits of underwritten one of the teams. There’s going to be a big portion of their underwriting completed, so they do get a synergy of that. So we definitely do see overlap on the debt investor side. On the equity side, I do not believe the middle market overlaps with the probably syndicated, but I can’t say it for a hundred percent certainty.

Shiloh:

Is there anything interesting happening in the market that we should touch on?

Patrick:

I think one thing that doesn’t get the attention in middle market loans are valuations. This has become really important recently for the AAA investors as because if a loan isn’t being marked a fair value, there’s no benefit or protection to the or other debt holders. From a triple C haircut standpoint, we’ve seen the S and p triple Cs creep up from a historical average where by nearly the s and p averages, most people are going to be having almost some form of a triple C haircut. Well, that haircut only protects you if the loans are being marked a fair value. If they have all the loans marked at par or near par, it doesn’t give you the protection,

Shiloh:

Then there’s no haircut on that.

Patrick:

There’s no haircut at that. So I was on a panel recently where another manager was saying they self mark their loans and they didn’t see the need to value their loans. And there’s just so many reasons why valuations should be done If you have a B, D, C, it has to be done, but the frequency and the way you do it is not standardized. And then when people are looking maybe to make direct lending fund investments, like if you’re just going to invest in someone’s fund, one manager might be marketing their book to represent fair value and their returns might look lower than a manager who doesn’t mark their book. So I think valuations is something that helps level set the different managers and also gives you a good third party view of the credit quality of the portfolio. One thing that I think you’re good at and the they’re good investors at is they look at the market values of our loans that are done by third party valuation agents and it could quickly tell you what loan is maybe underperforming or having issues.

It quickly highlights where outperformers and underperformers are, and you don’t necessarily need to be familiar with all the underlying borrowers, but this third party has gone in and reviewed the financials, has spent time with the budget as a really good understanding on how the company is performing. So if there was more of a standardization of valuations where everyone was doing it every quarter and they were doing it to market, there’d be a much more clear playing field where it’s really hard to light up managers side by side from a return standpoint because one manager might have unrealized losses because they’re marking their book to reflect the credit quality where one manager hasn’t marked his book and has everything at par, even though they might have problems underlying. Now you see the BDC analysts talk about it where one manager has a loan marked at 75 and two managers have it marked at par. So it’s one place I’d hope there would be more standardization and more people getting to quarterly valuations of the portfolio.

Shiloh:

I definitely see that when we pull up CLOs and Intex, sometimes all the loans are marked and that other times just some percent, it could be the CCCs are marked defaulted loans. There’s always going to be a mark for those, I think. But for my seat, yeah, if you can get a hundred percent loans marked, that would enable investors like me to compare returns apple to apples. And then it would also increase just the liquidity of a CLO manager’s shelf because at the secondary market, people would freely trade bonds if all the loans are priced and it becomes more challenging if there’s just some blank fields by the loan prices. So one thing I do see in our middle market CLOs is that sometimes there’s some broadly syndicated loans that make it into the portfolio. A lot of times these are, I call them maybe lightly syndicated loans where maybe they’re underwritten by a Jefferies or a UBS or something like that. Do you guys ever see value there for your middle market CLOs?

Patrick:

We have in the past. I’d say that market has gotten smaller over the last couple of years. We’re seeing less and less through that lightly syndicated. There’s still to us important to be middle market borrowers, so there’s still sub a hundred million of ebitda. Those do have some benefit is that you can in some situations actually drive change to the documentation. It’s not as much of a yes or no at what price transaction. It’s very much more of here’s the business. You could spend time with management if you like. You could do the same level of diligence that you typically like and in some markets they’re open to doc changes, improvements. We’re willing to come into this deal, but we need these two sections of the credit agreement tightened. Maybe we need a little bit more pricing. And in some markets we found some really compelling opportunities that almost felt private in the end where we went out and met management team and there are some that come in three days and it’s how much do you want to buy and at what price?

And those are less likely for us to participate. But they have been a way to add additional assets in some industries and even some businesses we know that was probably five, seven years ago was a common exit for us is we did a private deal and then the next step was to the lightly syndicated bank deal. We see that less and less now where a company just stays primarily in the private credit space where it goes from our market to another one of our peers that does bigger deals. With some cases we participate in enroll and sometimes the pricing is going to be so low or the documentation is not what we expect, so we just go home. But that is now, I would say the more traditional graduation from our segment to the larger segment of the market.

Shiloh:

Well, I think that’s all the questions I had. So Patrick, thanks so much for coming on the podcast. Really enjoyed our conversation.

Patrick:

Thanks. Always great to chat.

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

EBITDA, or earnings before interest, taxes, and depreciation, is a proxy for a business annual cashflow 

Roll-up strategies are when a private equity sponsor is actively looking to grow a business through acquisitions. 

Loan to value is the value of the first lie in debt divided by the enterprise value of the company. 

LMT or liability management transactions are an out of court modification of a company’s debt 

Up tiering 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. 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 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. 

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

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

ETFs are exchange traded funds.

High yield bonds are corporate debt rated below investment grade and sometimes referred to as junk bonds. 

Reset is a refinancing and extension of a CLO.

 Investment interest coverage ratio compares a company’s annual cashflow to its interest expense. 

Intex is software that CLO practitioners use. 

General Disclaimer Section: 

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