Author: Shiloh Bates

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 Greg Borenstein, the Portfolio Manager of Ellington Credit Company, ticker: EARN, a closed-end fund focused on CLO Equity and mezzanine.  We talk about EARN’s conversion from a mortgage REIT, the backdrop for CLO equity and junior mezz, why CLO equity captive
funds are negative for the CLO market, and if math majors are the best CLO
investors.  Throughout the podcast we talk about tails, which in CLO parlance refers to loans trading below 90 cents on the dollar. 

One legal disclosure is the views expressed in this episode regarding EARN or other securities are solely those of the guest and are not endorsed by Flat Rock Global. Listeners should rely only on the fund’s official filings and
disclosures when evaluating investment merits. I’m always looking for interesting guests to have on thepodcast.  Email us at info@flatrockglobal.com if you’d like to come on.  And if you’re enjoying the podcast, please remember to share, like and follow. And now my conversation with Greg Borenstein. Greg, thanks for coming on the podcast.

Greg Borenstein (01:21):

Nice to see you Shiloh. Happy to be here.

Shiloh Bates (01:23):

Why don’t we start off with your background and how you ended up being a portfolio manager at Ellington?

Greg Borenstein (01:28):

Sure. So, I had the privilege of starting in 2007 at Goldman Sachs on actually at the time, what was a prop desk, since those existed back then, where the desk focused on structured credit, a lot of CLOs but also some credit derivatives and some other things. I then moved over as that came to a conclusion in 2010. Spent a few years on the secondary trading desk there at Goldman till I moved over to Ellington in 2012 to start the secondary CLO trading business here. And since then, it’s grown into a bit more of an expanded role, but that has been my path to this point.

Shiloh Bates (02:08):

Okay. So what have you found
interesting about CLOs? Why gravitate towards this asset class?

Greg Borenstein (02:13):

I think what’s interesting about it is the ability to generate a superior risk-adjusted return. And I think when you think about the breakdown of what gives you a return off of an investment across markets, you potentially have a risk-free rate, which right now is more than zero. You also have your credit spread risk premium and oftentimes when you look at more liquid markets, that’s almost implying a default rate if you were to look at things in high-yield or IG. There’s also an illiquidity premium that comes on top of products. It’s usually warranted to some degree, but often a little harder to define. I think overall, when you take a look at the risk-adjusted return you get in CLOs for a product that still does transact to some degree, I think overall it generates a lot of opportunity to really add alpha above what would otherwise be credit beta within the product.

Shiloh Bates (03:15):

So, there’s a number of these closed-end CLO funds out there. I mean, why don’t you give us the history of your fund and maybe how you see yourself as differentiated in the space?

Greg Borenstein (03:29):

So EARN is a little bit unique while it is a CLOs closed end-fund now, it was actually an agency fund and EARN has been around for over a decade as the precursor to this was trading more agency pools and that sort. And so, the firm decided to repurpose the vehicle and convert it into a CLO closed-end fund for a variety of reasons. But, we do have a larger REIT, EFC, which does traffic in a lot of the mortgage products. It does do some CLOs as well. So I think from a public vehicle standpoint, the firm’s had experience with both the larger and the smaller REIT on that space and a lot of our investors in the public vehicles were used to and comfortable with us investing in CLOs through the years. So, a natural transition to take EARN and convert it solely into a CLO vehicle seemed like a nice compliment to some of the other things going on at the firm.

Shiloh Bates (04:24):

As part of the rationale there
that the closed end CLO funds have historically traded at premiums to book
value. So maybe to capitalize on that?

Greg Borenstein (04:34):

We have a board on EARN, which all
these closed-end vehicles will have and the board certainly saw the benefit
considering the precursor to this was trading at a discount and overall the
popularity of some of those agency mortgage REITs simply weren’t growing as
much. And so, I think, taking a look at the attractiveness of the CLO
closed-end space with the ability to trade more at book and offer the ability
for shareholders to benefit from the growth and scale of a vehicle like that
certainly was one of the compelling reasons to the board to be in favor of the
conversion.

Shiloh Bates (05:09):

Okay. Have you guys fully
converted EARN into CLOs or are there still some mortgage securities in there?

Greg Borenstein (05:17):

No, it is fully converted.
Actually, this is a unique story at the end of it, but we first started adding
CLOs to EARN at the end of 2023 I think in the fourth quarter or so, September,
October-ish. And, from there we telegraphed in our earnings call that we were
beginning to do this. We eventually came through and announced our intent to
convert this to a CLO closed-end fund, which was very long and interesting
process to take an existing REIT, de-REIT it and then eventually transfer it
over to a CLO closed-end fund. The technical conversion date was on April 1st,
and so, we really had a interesting time with that as April 2nd was liberation
day. It was after the conversion though, up until the very end, that we did
need to keep a certain amount of the portfolio in certain mortgage-related
items. And so, immediately after the conversion, very early on in April, we
finished selling the remnants of the mortgage pool and fully converted
everything into CLOs. And today, as it stands, it’s all in CLO-related investments.

Shiloh Bates (06:25):

So again, a number of these vehicles out there now seems like a growing list every year. How do you guys see yourself as different from peers?

Greg Borenstein (06:33):

So EARN’s overall objective is to create a discussion with the board, an attractive and appropriate dividend, while also looking to preserve NAV through CLO investing. I think what may separate EARN a little bit from some of the other competitors is we have a far higher concentration in mezz[anine debt] than maybe some of our peers. Right now, we see, as of the latest portfolio close to an even split between equity and debt and that can change based upon the opportunity, but at the moment right now, we see debt to be attractive enough to scale that up. But we also will have a portion of the capital allocated to Europe and that can be taken up or down depending upon the opportunity we see there. So, we do try to increase the breadth of the market that we can invest in depending upon the opportunity.

Shiloh Bates (07:26):

Okay. Well I think the allocation
to mezz in a year like this was definitely a good call. So starting with CLO
equity, I think it’s been a pretty tough year. How do you see the performance
of the asset class so far this year?

Greg Borenstein (07:42):

I think it’s been certainly an up
and down year for CLO equity. One thing I would add, too, that does
differentiate the vehicle a little bit is, and this relates to how we use mezz,
is that EARN does have credit hedges involved in the vehicle and a lot of this
is around some financing we’ll use with mezz securities, but that’s just
another thing to add on to the way it might be a little bit different than some
of our competitors, but we can talk about that.

Shiloh Bates (08:07):

Yeah, I would love to hear, I saw that in some of your materials. How does your hedging specific, you’re short specific credits that would be in CLOs or you’re short the mezz in some cases or?

Greg Borenstein (08:20):

Sure. So, the hedges are involved mainly because we’ll use financing on some of the mezz. We can look at an equity investment. I think a lot of folks in this space will look at the overall total return of what CLO equity could give you and you’re structurally levered when you’re in CLO equity. Coming up into mezz, you’ll have some subordination. It’s not always the case that the overall yield or the overall distribution might be what you want for a CLO closed-end fund, but providing some financing, but then pairing that with protection should you be using financing, and need margin. And so, it’s less local at-the-money hedges, we’re not using single name credits.

(09:17):

It’s actually very hard to pair up what’s generally first lost tail credits in CLOs to necessarily having liquid shortable CDS positions or something of the sort where you can track that. So it’s generally an index form. There’s a variety of ways, be it options, index tranches, maybe shorter dated index positions. A lot of these you’ll see in the public portfolio of EARN, but we think that these provide convexity in the event of a drawdown in regards to managing what would be the overall return profile to help improve the Sharpe of the portfolio as well as address any liquidity needs should there be a severe drawdown and the financing potentially is called in the other direction. So, it helps solve for both of those.

Shiloh Bates (10:07):

Is that like the equity equivalent of buying, out-of-the-money puts?

Greg Borenstein (10:12):

It’s a way to think about it for sure. And there’s a cost to this. Is the cost outweighed by what you’re getting on the financing side with some of the mezz? And so, a portion of the portfolio we think is a nice balance to just being long to CLO equity outright.

Shiloh Bates (10:26):

Great. So then, in terms of CLO equity performance, my view is it’s been pretty tough year. How do you see the factors that are driving the market there today?

Greg Borenstein (10:37):

So, completely agree. I think when
you look at what happened in the market, it reminds me a lot of 2019. You have, in general, good markets. Equity markets have rallied, most credit markets have performed well, but you have a tail, you’ve had increased dispersion. You take a look, there’s a lot of winners and losers. We’ve had elevated rates for a little while and some of the interest coverage pressures have pushed on a portion of the loan market. Tariffs have obviously caused a high degree of volatility and uncertainty, but if you look at this across other credit markets, it’s been the same story elsewhere. The high yield index of, it’s a hundred names of high-yield CDS positions. If you take a look at it, the bottom 10%, the 10 widest names are now accounting for, call it roughly 35-40% of the spread, which historically is comfortably above averages.

(11:31):

If you’ve taken a look at, in
high-yield index tranches for example, which you can tranche out the yield index to senior mezz equity, the zero to 15, which is the equity portion of this, has been a large underperformer. And so, you’ve seen tails in a lot of areas of credit vastly underperform. So in CLO equity we know some of the single name stories, some of these tail names, LMEs, those things have hurt. And on the other side of it, a lot of quality loans. We see a lot of points through the year, the vast majority of the portfolio trading at or above par. And so, the prepayment risk and spread compression you get on the other end of the equation has been a double whammy for equity. And overall, it just hasn’t produced as you know, the type of total return that equity investors would’ve expected, especially beta adjusted for this type of year. It’s not like everything has struggled this year.

Shiloh Bates (12:24):

I mean from my perspective, I’d say it’s an uptick in defaults and people quote defaults a lot of different ways. I mean if you look at just actual traditional bankruptcies, not elevated really. But, if you look at, throw in the LMEs, the restructurings, and you just throw in the fact, the tails that you’ve been talking about are loans that have traded down, probably haven’t defaulted, but in CLO equity, you feel the pain of that as well. So really any loan that trades below 90 is an issue, and there’s lots of these loans out there. So, that’s feeling pain on the loan loss side. And then, all the other loans that aren’t in the tail are performing well. And they’re going back to their lenders and asking for lower spreads and they’re getting them. And so, I kind of viewed this year as really the potential for a lot of upside in doing refinancing and resets. And, the upside’s there, but actually it’s being offset to a large extent by just the spread compression you’re losing on the assets. So, the loans can reprice in a lot of cases in six months, whereas CLO securities, there’s a two year non-call period. And so, the spread or the natural profitability of these things of CLOs is diminished as a result. And then the third factor, I’d love your opinion on this, but I mean I think CLO equity just trades wide in general, so it’s not like across other credit markets, everybody’s willing to accept a lower future returns, and in CLO equity think the market trades wide. 

Greg Borenstein (14:01):

I definitely agree with your point
around a couple things there. It isn’t just defaults coming through. There
actually hasn’t been an uptick in defaults this year necessarily, which if you
listen to everything around First Brands, you would think that we’re entering
the heightened default period, but overall it’s not so different than last
year. But, you also have things like distressed exchanges that aren’t
technically defaults, but there’s an impairment that comes in, and for certain
CLOs, loans trading down, especially if there’s a downgrade risk, can
potentially put cash flows at risk too. So it isn’t just a function of losses.
To your point, and I agree there that the hit of the tail plus the refinancing
of the spread compression has not been enough to offset what’s generally been a
nice year of CLO liabilities coming in and tightening. But with two year non
calls, it’s more of step function and how that may be monetized.

(14:53):

So some unique deals may have
benefited this year, but as a whole it’s been a tougher story. To answer your
question though, to get back to the point around is CLO equity trading wide, it seems like over time it’s gone from some investors who maybe look at this as an overall yield to looking at how it cash flows because the market has more and more leaned into valuing these options in regards to being able to reset, refi, liquidate. They don’t wall out a yield table. If you look at these
run-to-maturity, oftentimes that’s not the end result. So, from a cashflowing
perspective, I think there’s an argument from a lot of investors that it’s
still a very robust cashflow. In fact, in 2022, I thought that CLO’s equity
held in relatively well for the right good quality, cleaner managers, because
while yields moved up just on rates moving, overall CLO equity didn’t seem to
sell off in the same way because I think you had a lot of investors in that
space simply looking to capture the cashflow profile. So maybe the view of it
was coming in a little different. And so, what makes it such an interesting
product is, so many investors are looking to take different things from it, be
it, an overall yield objective or a cashflow objective. And when you relate it
back to something like EARN or the closed-end fund space, while there is a
total return concept, there’s clearly a focus from the retail space that looks
at it on dividends.

Shiloh Bates (16:21):

So, the part of your profile
that’s in mezz, can I assume that mezz is primarily just the par market and the
only issues really in mezz are just getting refied or reset at tighter spreads?
Is that how you’d see it?

Greg Borenstein (16:35):

Well, a lot of mezz is at par. A
lot more than there used to be. I think that mezz can be interesting. This is
an aside, but if you go back to 1.0 days, most pieces of regular way CLO mezz
did just fine. CLO equity did great. So by definition there were very few
issues in CLO BBs. In fact, I think you’ve in the past been a big proponent of
what the overall credit quality of BBs themselves are compared to other areas
of BBBs and corporates and we couldn’t agree more with what’s historically been just a very solid quality product with CLO BBs, fundamentally. You have seen an uptick though in some of these deals that maybe have been reset a couple times where the tail hasn’t necessarily been able to be cleaned up and you’re going to have some BB’s that take impairments.

(17:25):

And so there is a portion of the mezz market that for all intents and purposes is behaving like equity. It is first loss, is at-the-money, it’s 10 points of NAV up or down, it’ll be felt by the BB’s as opposed to a healthier deal where it’s felt by the equity. So, away from some of that, and away from a handful of other potential situations, right now we see a lot of mezz, to your point, close to par and unless there’s a low coupon issue, anything that’s trading at a discount is starting to pick up credit risk. And in fact, I think that’s been an interesting story this year, especially around some of the noise with First Brands and some of the other potential credit tail issues. Some BB’s have come off in coverage and you can see it through the reset market when CLOs come back to get a new life and extend themselves out, BB holders have become a little more discerning around differentiating where perhaps a tail has formed in some of these pools and are just looking to be compensated a little bit more to underwrite that BB risk there.

Shiloh Bates (18:27):

Okay, so by my math it’s a 25
basis point default rate for the asset class over 30 years, talking about BBs.
But do you think fundamentally going forward that’s not the number? Do you
think it’s higher going forward? One thing is the spreads on BBs are higher.
So, that’s a fundamental change.

Greg Borenstein (18:46):

Sure, we don’t know for sure what it will end up being, but in terms of the BBs that are ultimately retiring beneath getting par back at the end, I’d expect that it’s going to pick up based on what we’re seeing in the market. To your point, it may still end up being a positive total return. Getting some of these coupons above what’s a higher base rate right now, produces very nice cashflow. And so net of that, the BB investors still may be all right with that. What’s interesting about BBs, they’re not digital necessarily, and impairment may mean 90 cents on the dollar. So, it doesn’t mean it’s necessarily going to zero. But overall, in terms of things that may take some degree of loss, I’d expect that you’re going to see more than 25 basis points.

Shiloh Bates (19:33):

Okay. So as you guys grow your fund, are you seeing more of the opportunities in mezz or is CLO equity trading cheap here and you’ll take advantage of that?

Greg Borenstein (19:44):

Well, as someone who generally sources their opportunities in the secondary market, it’s an easy answer to say we do both and it just depends where the opportunity is and where the price is coming. I think overall we’ve tended to shift considering everything we’ve talked about with some of these issues around dispersion, credit issues, compression, where we’ve started to favor mezz a little bit more through 2025 and lean into that at some point. That being said, there are still interesting opportunities in equity. I think, as you were saying before, some of these equity pieces have backed up, they’ve widened, they produce good cashflow profiles and some of these managers have done a very nice job. When you look at
the better quality managers in the CLO space, maybe their loss rates are a
little bit lower, maybe they’re able to obtain debt levels that are better,
that are tighter.

(20:36):

So, for the equity, not as much credit risk needs to be taken to be able to give you a good return. So, in some cases, there’s so much differentiation when you get into the CLO equity space, you have unique managers, you have unique vintages, you have unique docs, so no two deals are alike. And in some cases I think there’s definitely opportunities to be had in CLO equity. We’ve just found that looking at the numbers in terms of where we’ve rotated our portfolios, it’s tended to favor, going into mezz, have the subordination and protection from some of these idiosyncratic concerns. 

Shiloh Bates (21:12):

Okay. So, I think one of the things that’s maybe different between our firms or me as an investor, is I do a lot of private credit CLOs, and there we actually, we buy in the primary, that’s where you can write a big check. But for broadly syndicated loans where you guys are playing, you can do primary or you can do secondary. And, it sounds like your preference is secondary, and I know your background is working on a CLO trading desk, but why do you see the better opportunity in the secondary versus primary?

Greg Borenstein (21:43):

So, I’d also say that we do have positions in sort of the middle market private credit side. It’s not the majority of the portfolio, but I think there has, at points in time, been some very attractive opportunities there. I’m not sure your take, but some of these folks have been doing it a very long time, have done a great job. You look at the loss rates, you talk about BB loss rates, I’m sure I don’t have to tell you about the loss rates going back decades of some of the better managers in that space. And on top of that, for the rating, there’s generally pickup and spread

and subordination. You can make the argument, obviously these are not always as diversified. So, from a rating agency model perspective, that forces a
subordination issue more. There could be chunkier hits there. So, you are
trusting the manager on these larger positions that they’re taking and knowing.

(22:32):

But, the numbers have borne out
for those that have been around long enough that some of those that do it well,
it’s not been an increased credit risk versus regular away credit. So, I think
there’s a portion of that that is interesting. That said, I think why we like
secondary the way that we’re set up, we have other pockets of capital and the
lens that we view things is how do we produce a superior risk-adjusted return
in the assets that we buy. And so the transparency that we get in the secondary market, our ability to analyze bonds, we just have a greater degree of confidence when we know the portfolio. Broadly syndicated loans have prices, you can see price depth, you can see transactions. And with that information, you can assume probabilities. As you know in this market, a loan priced at par is a different risk than a loan priced at 70.

(23:21):

And right now a loan priced in the low 90s maybe isn’t something that comes without risk. And, we’re able to discern and quantify that. Sometimes at new issue, you don’t have all the information around how a model portfolio may translate and you don’t always have the same opportunity in terms of dislocation in a primary market versus what can happen in secondary. And so, with a background a little bit more in trading, that tends to be our preference. But that said, there’s times we certainly come in, sometimes access can only come through the primary market

for some of these fundamentally strong positions and it comes on a deal-by-deal and market-by-market basis.

Shiloh Bates (24:02):

So, what about for broadly syndicated equity? Would you ever buy that in the primary today or does secondary trade at much more favorable levels?

Greg Borenstein (24:13):

We’ve done primary equity and at
points in time it’s been attractive. I think at periods last year and into
early this year, if you take a look at EARN’s portfolio, you can see that we
entered into several primary transactions. I think it’s been tougher this year.
I think right now just creating the arbitrage through primary debt levels and
then ramping a portfolio, I think that’s been a pretty big concern. Having a
cross bid offer to source however large the portfolio is of loans, I think has
really eaten into what the end economics are. You can talk about if there’s
other levers to pull, be it with the warehouse or things you can work on with
the bank or the manager to try to get economics to a place that makes sense.
But oftentimes, I think we found that we felt more comfortable coming into a
deal that’s already done and traded and priced and not being dependent on a
model translating to the investment as something that’s maybe already in
existence that we have more assurance on.

Shiloh Bates (25:14):

Okay. My view there is BSL and the
primary are very tough. Like how we would model it, I don’t know, maybe it’s
11%, 12% opportunity, whereas in the secondary I think it’s 3% higher. It’s
really different. I was, well maybe not surprised, but I think a lot of the
primary issuance is being driven today by the risk retention funds. They’re
always going to print deals, but we’ve definitely seen the better opportunity
in the secondary.

Greg Borenstein (25:42):

To your point, the primary market
equity hasn’t always been a market clearing level, so some of these may be
retained. To your point, a lot of places don’t have to sell. It’s not like all
of this equity is going to third party necessarily. That said, primary equity
you can make the argument could be tighter to some degree if you’re sourcing a much cleaner portfolio versus something in secondary that’s already began to have some amount of credit problems in the tail. I mean listen, deals will have hundreds of loans. It’s expected that there’s going to be some degree of losses through the years and with some deals, depending upon where in your lifecycle you are, the shorter you get with CLO equity, the more your value shifts to ultimate PO return on the loans and away from the cash flows. And so, depending how you want to assess that risk, that can I think influence return a bit. But overall, I don’t think it changes the sentiment that I think we both tend to agree on, which is there’s better value in secondary than primary as of today, generally.

Shiloh Bates (26:41):

Okay. And then I think one of the
key things for our asset class is just going to be, we talked about how loss
rates on loans are elevated. Do you see that as something that continues well
into next year and beyond, or is it that we’re working through and
restructuring the weaker loans in our CLOs and that once we get through that
process, loss rates will decline substantially and profitability in the trade
will come back?

Greg Borenstein (27:11):

Well, there’s two things there.
The second part around profitability in the trade coming back, as you know,
there’s a few other factors that go into the equation. If all of a sudden AAAs
go back to pre-crisis levels, that would help.

Shiloh Bates (27:26):

Yeah, it’s the LIBOR plus 25 bips. Yeah. 

Greg Borenstein (27:29):

So barring other things that do
influence that, I think that from where we are here, there’s no reason to see
why this environment changes immediately. I think that there’s potentially some constructive factors coming in if rates ease from our conversations with
managers. There’s definitely a view that some of these companies need it. While it doesn’t seem like interest coverage ratios are overall stressed, companies would rather pay less debt than more. So, I think that having that come off I think would be helpful, but I think it’s going to take a second to do that. Also, what we’ve heard, taking a look at the post COVID period of some of the debt that got issued immediately following, not all of that was written with great terms for lenders and some of these are causing problems now and it may still take a little bit of time to maybe work through what potentially could be a tail.

(28:24):

And the other thing we haven’t
addressed, and I’m not going to claim I’m an expert on this, but everyone’s
obviously been very engaged around how AI is going to affect things. I think a
world of what’s that going to do, what’s happening with tariffs, just the more
the landscape changes, the more winners and losers are produced. That could
come into CLOs. The large majority of loans may be fine, but if events are
happening that may stress certain tails and whatever that specific shock may
be, that could lead to slightly more elevated losses persisting for a little
bit of time. So, while long-term some of these things may be constructive, I’m
not sure how long it’ll take to finish working through the exact state we’re in
right now.

Shiloh Bates (29:07):

Okay. Well, coming back to my
comment on the risk-retention buyers of equity, my opinion is that
risk-retention funds just muck up the entire market for us because they’re
creating CLOs, they’re calling this capital, they’re buying the equity in deals
that I wouldn’t sign up for, and I assume you wouldn’t sign up for either in a
lot of cases. And by doing that, they’re keeping loan spreads tight. So, that’s
more demand for loans and it’s more demand for CLO liabilities. This issuance
that, in my opinion, is non-economical results in lower loan spreads and higher CLO financing costs. And, if this wasn’t a big part of the market, I think our asset class, I’m talking about equity in particular, would be much more
profitable. But instead, you have all these non-economic actors creating CLOs.
That’s my opinion. I’d love to hear what you think.

Greg Borenstein (30:06):

It’s impossible to disagree with
that. Taking a look at the way the CLO markets evolved, in some senses, you
think about the popularity of it, you quote a 25 bip loss rate historically on
BBs. This product was a big winner from the financial crisis. You think about
what was going on in structured credit, some areas CDOs and CLOs, I remember trying to explain to people, this is a little bit different. These are real corporations beneath here. And, not only was debt fine, equity had a great return, there’s some things that were serendipitous to both the way the
vehicles worked as well as the market we had on the return that allowed CLO
equity to really take advantage there. But, when risk retention came in and a
lot of these managers were forced to try to solve for this, I think a lot of
these arrangements were struck.

(30:55):

A lot of money was raised, there’s
a lot of money that’s been raised for a lot of things and even though risk
retention was fairly quickly repealed by the time we actually got to it, I
think a lot of investors see the value in a profitable CLO management platform and sometimes the equity can be linked to that. So the economics of someone investing in a fund captive to a manager might be a little bit different than what those economics would be for a third party investor. So, they’re not necessarily solving for the same equation that you may or I may when we’re looking at entering the transaction. And, it’s not always even a, they have some agreement that gives them different cash flows, it’s more there is some bigger picture valuation that is going on in some of these cases that is just going to take a much longer time to play out.

Shiloh Bates (31:47):

Well, for me, I’m just looking for
attractive risk-adjusted returns. I don’t have any other goals in in the asset
class, so I appreciate that. So the closed-end funds that focus on CLO equity,
usually they trade at premiums, but this year they’re trading at some
discounts. And I believe how it works is you need to be trading at a premium to grow and to issue more shares. So what’s the crystal ball on seeing a return in a more stable or higher share price that enables these funds and yours to grow?

Greg Borenstein (32:21):

So, for long periods of time, they
have been at premiums. Taking a look at what’s happened this year, there’s been
a lot of volatility in credit. Liberation Day was the first thing to knock
things back a little bit. And, looking at some of the idiosyncratic issues that
have come through the market, I think it’s just led what’s predominantly a
retail investor base to have been a little concerned around what is the risk in
maybe some of these vehicles? Even though I think a lot of my peers and I would
discuss this isn’t a private security that has no liquidity on it and isn’t
necessarily being valued correctly, these are CUSIPs that trade. A lot of times
you have comps on them, especially if you’re a more active trader in the
market, that you can get your head around that valuation and have accuracy
there. So, it seems like the investor base in the market is going to have to
have increased comfort with what they deem as the risk in these vehicles.

(33:19):

I don’t know if there’s
potentially some relationship to after BDCs got hurt with some of the reasons
that those had sold off and relating some of those issues over here. It’s not
the same product, but it’s possible. Other areas of credit that may seem analogous
could have felt some of those effects. And so, I think that settling down, and
the confidence to come back there and maybe seeing some good performance would help. I think it’s unfair though, to simply deem it’s a baby getting thrown out with the bath water type-issue when the first thing we addressed early on here was it’s been a tough year for CLO equity, which is generally what this asset class is very exposed to, the closed-end funds I should say.

Shiloh Bates (34:01):

So, one thing about the closed end
funds that might strike people, it’s just how the distribution yields are very
high and part of that is because CLO modeled, the equity returns are high. But
another part of it is that when the CLOs produce their tax statements, a lot of
times the taxable income coming from the CLO is higher than where the company might think returns or profits are going to actually be. So you have a little bit of a mismatch. A lot of times you have higher taxable income from the CLOs than GAAP. Those are the specific terms. So, how do you guys think about that mismatch?

Greg Borenstein (34:44):

It is definitely something that’s
very topical and we spend a lot of time on. It’s something that our board has
been very focused on. Having, once again, a large REIT having EARN in its prior form, you will look at some of these issues. The idea that you end up
distributing out a bit of income to the point that your principle will need to
drop to support that. As CLO equity buyers, this is the nature of the product a
little bit. We know that if we buy something at you, were quoting a 12% yield
earlier, the annual dividend in terms of cash on cash is generally going to be
higher than what we see as the yield because the NAV is just going to drop in
time. There’s some degree of NAV erosion. So it’s a large focus of ours. As you
know, being an equity investor, your distributions, the cash-on-cash
distributions will tend to be higher than I think what the yield you get is.

(35:41):

And that can lead to distributions
that are maybe outsized versus total return and are paired with what is a
slight principal decline over time. And so, sometimes what you see in these
vehicles is a dividend being paid out, but NAV slightly drop over time. I think
it’s certainly a concern and it is a reason why we do keep a portion of the
book trading in mezz. Having things that pay off at par, it’s harder to find it
in this type of market, but in a market that maybe provides the opportunity
where you can buy mezz at a discount, you can actually have a pull up in that
value and paired with equity, it can produce an overall profile that produces a
good appropriate dividend and also a good book value. It preserves good book
value. And weighing those together, I think, is important because overall, both of those should matter and are part of the objective when providing the right type of risk-adjusted return ultimately to shareholders.

Shiloh Bates (36:46):

Well the nice thing to your point
about the mezz, is that it’s very clear what your income is and what’s return
of principal. So that makes things easy. So a few just closing questions that
I’ve thought of while we’re chatting. One is, you’re part of a big successful
hedge fund. I imagine that a lot of the strategies around your firm are held in
pretty tight confidence or you guys don’t want what you’re doing to get onto
the market, whereas for your CLO closed-end fund, you’re a public filer on
Edgar and so everything you own is put out to the world on a quarterly basis.
Is that a little bit of a culture shock around the firm there?

Greg Borenstein (37:25):

It was definitely something that
we weren’t sure how it was going to go and our holdings will be out here. It
honestly has been less of a big deal. It’s honestly been helpful so far because
the amount of times someone has come into us to say, Hey, you’re a holder of
this, we want to take a corporate action on doing something with this equity.
As you know, Shiloh, the market, everyone’s generally very cordial and with so
many places issuing as well as investing, I think that it has a degree of
comradery and professionalism where people aren’t adversarial with each other.

(38:17):

And the strategy we employ for
this vehicle in particular, it’s similar to the rest of our strategies. And
that once again, whether we’re buying something into EARN, whether it’s in a
fund that maybe hedges and protects its downside explicitly, maybe it’s in an
SMA that’s looking to do something else, it still doesn’t change the approach
we take in terms of trying to justify that each line item in the portfolio is
truly adding alpha above its sort of liquid replacement.

Shiloh Bates (39:25):

I saw that in your bio you have a bachelor’s in Applied Math from Johns Hopkins. I studied financial mathematics for a master’s degree. Do you find that CLOs is very quantitative in this or is it that there’s lots of data but the calculations aren’t that complicated? Or do you feel like the bachelor’s in applied math was very helpful, especially at the beginning of your career?

Greg Borenstein (39:48):

I think it’s helpful. It’s
interesting. We were having a conversation recently on the desk where a lot of members of the team have math backgrounds and I do think it was helpful. I think that coming up, I started on a prop desk that had a few other things
going on and especially, will trade things like credit derivatives, and I think
in that area, it’s pretty helpful. I think that in CLOs you see a lot of
different backgrounds. You can see quantitative math engineering backgrounds.
You see law backgrounds, all the document work, things like that. I’m probably biased just because of my approach to the market, but I think that it can be a successful background in that it sort of teaches you to think about different outcomes, way different probabilities, understand uncertainty and variance and maybe overall, be it from a portfolio management angle or be it from the way a CLO actually works, just the value and the implications of things like diversification.

(40:48):

So I think it’s a little bit about
the view and how you think about things, whereas I think that now there’s so
many very high-quality third-party analytics, it isn’t valuing the security
will necessarily be impossible for someone without a higher degree. But I do
think it’s helpful, especially I think about the way that we operate here in
terms of the general strategy, which is having a lens through looking at things
as risk. And, I think that helps you do a lot there, having strong quantitative
backgrounds. But I’d be curious to hear your view on this since you’re the
highly educated one.

Shiloh Bates (41:22):

Well, I didn’t want to say that,
but what I found is that in my study, so I was a political science undergrad
and I have a few master’s degrees. One’s in public policy. And for those areas,
if you want to do well, it just you want to get an A, it’s really just about
how much you study and do all the reading. But basically most people can get an A if they really apply themselves. And then for mathematics, I don’t think
that’s the case. At some level, people tap out. And the tap isn’t, I don’t have
more time to put in, it’s just, Hey, my mind is not capturing this high level
of mathematics at the same level as some other people in the class. And so, you realize that. So you really get pushed in mathematics and you get to whatever level you can attain. And then you start working in CLOs and I don’t do a lot of financial mathematics. The complicated things are like partial differential equations or stochastic calculus. I’m not doing either in my normal day here. But it just gives you a confidence with numbers that if you can be successful with applied math, whatever level you got to that most of the mathematical challenges that come to you in your workday will be five rungs down from that.
And so, if you have the confidence and skillset that you built in university,
that I think you can do really well.

Greg Borenstein (43:06):

Ellington has a very strong academic culture to it too. And so, I think you see a great deal of that here in terms of hiring a lot of quantitative backgrounds, especially think about Ellington was founded in 1994 as more of a mortgage shop initially, but back then the edge you had in terms of being very quantitative and analytical in the earlier days of these types of products made a huge difference. To your point, I don’t think it’s that you’re going to be doing lagrange multipliers on the desk or anything, but your comfort with numbers and just understanding in terms of your thought process, way to think, and the way that these products may behave. Concepts of things like duration and convexity we talked about in themarket, but to have a sense for the way correlations may work, the way one thing may move when another starts moving. I think it’s a helpful mindset to have and approach it. And one last funny story, you think about the rigor of it – having gone to Johns Hopkins, it did not have a reputation for grade inflation. And you see kids in the engineering school wearing around T-shirts that said, without my C, your A is meaningless. So, in a world where you hear things about that going on.

Shiloh Bates (44:19):

Well, I studied financial math at U Chicago and it’s also no grade inflation. It’s bell curve, and if everybody in the class is smart and applying themselves, some people will do well and some won’t, and that’s how they do it.

Greg Borenstein (44:32):

Well, that’s how math people will
grade themselves. Fair distribution.

Shiloh Bates (44:39):

I hear you. So Greg, is there
anything topical that we haven’t covered?

Greg Borenstein (44:46):

No, I think we’ve touched on a lot
of things. I think that it’s an interesting time in the market. I think it has
been a little bit of a frustrating year, I think for folks down the stack as we
talked about with some of these credit issues, and I think it’ll be interesting
to see how the market moves forward. We mentioned First Brands earlier just
because it’s impossible to have a CLO conversation with not mentioning it, but if you take a look, this wasn’t the most unique thing to ever happen. Defaults do happen in the CLO market constantly. So, does it reveal what the investor base is maybe worried about with what’s going on in certain areas of credit or lending or things like that? So, as much as I’d be curious to hear your point of view, broader, outside of CLOs, will you see the market may be negatively or positively impacted by things we may see in other large areas that have grown a lot or are changing or things like that.

Shiloh Bates (45:41):

Greg, my closing question is always describe as CLO in 30 seconds.

Greg Borenstein (45:46):

A CLO is a way to pull together a bunch of risk from corporations looking to finance themselves, and by putting it into a tranched-out structure, you are increasing the demand for those underlying companies. By tranching out the risk to be able to send it to a more diversified investor base rather than finding folks to simply buy the loans outright. You’re creating a AAA profile for AAA investors. You’re creating an equity profile for equity investors and everything in between, and this structure benefits those underlying loans in terms of increasing demand through the structure.

Shiloh Bates (46:27):

Great. Well, Greg, thanks so much for coming on the podcast. Really enjoyed it.

Greg Borenstein (46:31):

Thanks, Shiloh.

Disclosure AI:

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

Definition Section:

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

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

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

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

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

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

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

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

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

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

–         
Delever means reducing the amount of debt financing.

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

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

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

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

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

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

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

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

–         
RMBS are residential mortgage-backed securities.

–         
Loan to value is a ratio that compares the loan amount to
the enterprise value of a company.

–         
GLG is a firm that sets up calls between investors and
industry experts.

–         
Payment In Kind, or PIK, refers to a type of loan or
financial instrument where interest or dividends are paid in a form other than
cash, such as additional debt or equity, rather than in cash

–         
A covenant refers to a legally binding promise, or lender
protection, written into a loan agreement.

–         
Net Asset Value (NAV) – The value of a fund’s assets minus
its liabilities, typically used to determine the per-share value of an interval
fund or investment vehicle.

–         
Dividend Recapitalization (Dividend Recap) – A refinancing
strategy where a company borrows to pay a dividend to its shareholders, often
used by private equity sponsors.

–         
Continuation Vehicle – A fund structure that allows
investors to roll their interest in an existing portfolio company into a new
vehicle, while offering liquidity to those who want to exit.

–         
Equity Cure – A provision that allows private equity
sponsors to inject equity into a company to fix a financial covenant breach.

Risks:

–         
CLOs are subject to market fluctuations. Every investment
has specific risks, which can significantly increase under unusual market
conditions.

–         
The structure and guidelines of CLOs can vary deal to
deal, so factors such as leverage, portfolio testing, callability, and
subordination can all influence risks associated with a particular deal.

–         
Third-party risk is counterparties involved: the manager,
trustees, custodians, lawyers, accountants and rating agencies.

–         
There may be limited liquidity in the secondary market.

–         
CLOs have average lives that are typically shorter than
the stated maturity. Tranches can be called early after the non-call period has
lapsed.

General disclaimer section:

Flat Rock may invest in CLOs
managed by podcast guests. However, the views expressed in this podcast are
those of the guest and do not necessarily reflect the views of Flat Rock or its
affiliates. Any return projections discussed by podcast guests do not reflect
Flat Rock’s views or expectations. This is not a recommendation for any action
and all listeners should consider these projections as hypothetical and subject
to significant risks.

References to interest rate moves
are based on Bloomberg data. Any mentions of specific companies are for
reference purposes only and are not meant to describe the investment merits of,
or potential or actual portfolio changes related to securities of those
companies, unless otherwise noted. All discussions are based on U.S. markets
and U.S. monetary and fiscal policies. Market forecasts and projections are
based on current market conditions and are subject to change without notice.
Projections should not be considered a guarantee. The views and opinions
expressed by the Flat Rock Global Speaker are those of the speaker as of the
date of the broadcast, and do not necessarily represent the views of the firm
as a whole. Any such views are subject to change at any time based upon market
or other conditions, and flat Rock global disclaims any responsibility to
update such views. This material is not intended to be relied upon as a
forecast, research or investment advice.

It is not a recommendation, offer
or solicitation to buy or sell any securities or to adopt any investment
strategy. Neither Flat Rock Global nor the Flat Rock Global speaker can be
responsible for any direct or incidental loss incurred by applying any of the
information offered. None of the information provided should be regarded as a
suggestion to engage in, or refrain from any investment-related course of
action, as neither Flat Rock Global nor its affiliates are undertaking to
provide impartial investment advice. Act as an impartial adviser or give advice
in a fiduciary capacity. Additional information about this podcast, along with
an edited transcript, may be obtained by visiting flatrockglobal.com.

Hi, I’m Shiloh Bates, and welcome to the CLO Investor Podcast. CLO stands for Collateralized Loan Obligations, which are securities backed by pools of leveraged loans. In this podcast, we discuss current news in the CLO industry, and I interview key market players.

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

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

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

Mike Hatley:

My pleasure, Shiloh. Thanks.

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

Okay. So how many CLOs is that?

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

I think so, it definitely helps.

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

It was ING that acquired the Pilgrim Primary Trust?

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

So, he’s at Caneres now.

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

Windstar, Telligent.

Mike Hatley:

Oh yeah, man, you remember those.

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

Let’s bring that back.

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

Well, they are now.

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

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

Shiloh Bates:

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

Mike Hatley:

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

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

’09.

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

It makes perfect sense.

Shiloh Bates:

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

Mike Hatley:

Other ones? Remember the Yellow Pages deals?

Shiloh Bates:

 Oh yeah.

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

I think that’s exactly right.

Shiloh Bates:

That would surprise me.

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

Exactly. Never had a manufacturing job.

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Shiloh Bates:

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

Mike Hatley:

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

Disclosure AI:

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

Definition Section:

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

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

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

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

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

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

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

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

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

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

–          Delever means reducing the amount of debt financing.

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

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

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

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

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

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

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

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

–          RMBS are residential mortgage-backed securities.

–          Loan to value is a ratio that compares the loan amount to the enterprise value of a company.

–          GLG is a firm that sets up calls between investors and industry experts.

–          Payment In Kind, or PIK, refers to a type of loan or financial instrument where interest or dividends are paid in a form other than cash, such as additional debt or equity, rather than in cash

–          A covenant refers to a legally binding promise, or lender protection, written into a loan agreement.

–          Net Asset Value (NAV) – The value of a fund’s assets minus its liabilities, typically used to determine the per-share value of an interval fund or investment vehicle.

–          Dividend Recapitalization (Dividend Recap) – A refinancing strategy where a company borrows to pay a dividend to its shareholders, often used by private equity sponsors.

–          Continuation Vehicle – A fund structure that allows investors to roll their interest in an existing portfolio company into a new vehicle, while offering liquidity to those who want to exit.

–          Equity Cure – A provision that allows private equity sponsors to inject equity into a company to fix a financial covenant breach.

Risks:

–          CLOs are subject to market fluctuations. Every investment has specific risks, which can significantly increase under unusual market conditions.

–          The structure and guidelines of CLOs can vary deal to deal, so factors such as leverage, portfolio testing, callability, and subordination can all influence risks associated with a particular deal.

–          Third-party risk is counterparties involved: the manager, trustees, custodians, lawyers, accountants and rating agencies.

–          There may be limited liquidity in the secondary market.

–          CLOs have average lives that are typically shorter than the stated maturity. Tranches can be called early after the non-call period has lapsed.

General disclaimer section:

Flat Rock may invest in CLOs managed by podcast guests. However, the views expressed in this podcast are those of the guest and do not necessarily reflect the views of Flat Rock or its affiliates. Any return projections discussed by podcast guests do not reflect Flat Rock’s views or expectations. This is not a recommendation for any action and all listeners should consider these projections as hypothetical and subject to significant risks.

References to interest rate moves are based on Bloomberg data. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of, or potential or actual portfolio changes related to securities of those companies, unless otherwise noted. All discussions are based on U.S. markets and U.S. monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global Speaker are those of the speaker as of the date of the broadcast, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and flat Rock global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research or investment advice.

It is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered. None of the information provided should be regarded as a suggestion to engage in, or refrain from any investment-related course of action, as neither Flat Rock Global nor its affiliates are undertaking to provide impartial investment advice. Act as an impartial adviser or give advice in a fiduciary capacity. Additional information about this podcast, along with an edited transcript, may be obtained by visiting flatrockglobal.com.

Shiloh Bates:

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 Sean Griffin, the executive director of the LSTA, formerly known as the Loan Syndication and Trading Association.  LSTA has been the leading advocate for the U.S. loan market since 1995, fostering cooperation and coordination among all loan market participants, facilitating just and equitable market principles, and inspiring the highest degree of confidence among investors in corporate loan assets. That’s according to their website. We talk about the regulatory wins they’ve had and what’s on the current docket.  

If you’re enjoying the podcast, please remember to share, like and follow. And now my conversation with Sean Griffin.

Sean, thanks for coming on the podcast. Good to see you.

Sean Griffin:

Shiloh. Good to see you as well. Thank you for having me this afternoon.

Shiloh Bates:

How did you end up being the executive director of the LSTA?

Sean Griffin:

Well, we were formally known as the Loan Syndication and Trading Association. Just this past fall, we officially changed our name to the acronym. I come from a world of acronym, being a former CLO banker. So it made total sense that we converted just to an acronym ourselves. I’m a firm believer that in your personal life and in your career, you’re going to reach certain inflection points and you’ve really got to sit back, take stock of where you are, and think about things. And, I had been active with LSTA for a number of years, serving on a variety of committees that were all related to the CLO market where I could really leverage my expertise. And I got to know the organization, what it could do, what they could accomplish, and I really got to know the people that work here. It’s a tremendous group of people, really is a remarkable organization.

There’s only 15 staff members here and they do so much with so few people. We rely heavily on our membership for support, which it’s phenomenal to have, but the staff really puts in a lot of blood, sweat, and tears to make things happen. So when you’re presented with an opportunity to potentially become a leader of an organization that means so much to a market that’s so important to the broader corporate finance landscape, certainly the more I thought about it, the more difficult it became to pass up such an opportunity. I look at it as I know I can do structured finance, I know I can do deals for a long time. This is an opportunity that’s not going to come around again in my lifetime, and am I going to look back in five years time and really kick myself for not making a change? So after a lot of deliberation with my family and making sure we understood what this would mean, I made the leap and it’s been [a] phenomenal 18 months so far. We’ve done a lot so far and we’ve got a lot left to do, and I’m super energized and super happy.

Shiloh Bates:

So when we met, you were arranging CLOs for JP Morgan, I guess it was about a decade ago. Could you just walk us through your experience before joining the LSTA?

Sean Griffin:

Sure. I was a lifelong CLO banker. So, I joined JP Morgan fresh out of undergrad in 2001. Funny story there, I received my actual offer from JP Morgan. Around a month or two after the verbal offer was given, JP Morgan and Chase merged. So I get a call from HR and I get a little bit nervous. I’m a senior in college. Oh, what’s going to happen? Good news. You still have an offer. However, we don’t know who it’s from. We don’t know if it’s going to be from JP Morgan or Chase given the merger. I still have the original offer letter in a file folder at home. I keep it near my office desk. So anyhow, I joined JP Morgan summer of 2001. At that time you weren’t hired directly into a business line. You had to interview with different teams that had headcount needs. And I met with a couple of teams on the capital markets side. And one of which was a very small team and a niche product called CDO Structuring and Origination.

I hit it off really well with a number of the team members there, some folks that I’m actually still in touch with and they’re still around the industry today, which is pretty cool. And I was part of that same team through my entire 23 [year] career at JP Morgan rising up through the ranks [starting] as a lowly analyst.

Shiloh Bates:

And you were there through the GFC as well?

Sean Griffin:

Through the GFC. The team size changed quite considerably coming through GFC and I was one of the few members to come through all of that. I will say this – periods of volatility, when I give advice to folks in the market who are just starting the careers or a couple years in, make sure you take advantage of those periods of volatility when things are rough, it’s a great opportunity to actually learn. It’s really easy to get by without knowing as much as you think you do when things are going really well, when everyone can print transactions. When you have to take things apart, understand how things really function and what’s really driving and motivating people, that’s the learning opportunity and you’ve really got to take advantage and capture that.

So GFC was a great time for me to learn.

Shiloh Bates:

So, when you were a CLO banker, I think you had a reputation for having somewhat of a encyclopedic knowledge of CLO indentures and legalese. How did you develop that?

Sean Griffin:

It’s a great question. I have a reasonably good memory, and when I would read things, I could first and foremost generally remember where things would appear in a document. I remember where the priority of payments is. I remember where all my Article 9 redemption and refinancing provisions lie. So, that came pretty easy to me. What took a lot more blood, sweat, and tears was translating the words on a page into all the financial modeling that we were doing. Coming out of college, I was a math major but not skilled in Excel, so I had to learn a lot on the fly when I started. And I think that actually forced me to understand the documents even better because I had to take that from a piece of paper on my desk to an Excel model in a spreadsheet and do that over and over. Actually, some of the first deals I worked on were CDO squares. And the first task I was given was, here’s a stack of 45 offering documents, model all these deals for us. You learn pretty quickly. 

Shiloh Bates:

Okay, that sounds like fun. 

Sean Griffin:

It was. Looking back at the time, it was time well spent. I feel like my perspective that time was maybe a different one. It was probably a little bit of a painful, “Wow, this is a lot to be piled on top of an analyst”, but I learned a tremendous amount in doing so.

Shiloh Bates:

Now you’re at the LSTA and before we start talking about your current agenda and what you’re trying to accomplish, maybe we could just go back in time and just talk about some of the issues that the LSTA has advocated for and some wins that you guys have had. So, in my mind, the repeal of risk retention is to me a big win for the LSTA, but would you see that as the biggest?

Sean Griffin:

It was certainly incredibly impactful and I think I would put that in the top two or three category. So yeah, credit risk retention would’ve just greatly curtailed the formation of new CLO product. And we saw those impacts in 2017 and 2018. I actually remember being on the phone with a client when the final court ruling came through and the appeal had been won, which was phenomenal and just that did cause a lot of chaos. So that was one big victory and allowed the market to, a few years after that, get to north of $1 trillion in outstanding and issuance over the past couple of years has just been phenomenal. Just great to see how much the market has continued to evolve and mature and how we’re now taking that technology and seeing it applied across other related asset classes. And being used as a really great financing mechanism, really thinking about your private credit CLOs that we’re seeing more and more of these days. So that was one big win.

Shiloh Bates:

So then on that one, just to be clear, and maybe I should have set this up in advance, but risk retention was the rule that required CLO managers to invest in their own deals, either through a 5% strip of securities from AAA to equity or roughly half the equity. And so, you guys got that overturned, but that was only for broadly syndicated CLOs. So, private credit CLOs still have the risk retention as before, correct?

Sean Griffin:

That’s correct. And the reasoning’s pretty simple – in your broadly syndicated transactions, your CLO portfolio manager is not originating the loans themselves. They are essentially acquiring those loans from the street, whether it’s from the primary market or the secondary market. In most private credit CLO transactions, the CLO manager is also originating the bulk of the assets in the portfolio themselves. So they’re involved with all the loan negotiations and the like from inception, which puts it outside of the scope of the court victory that we had in risk retention.

Shiloh Bates:

So that was one of the big ones. What are the other wins that you guys have had?

Sean Griffin:

The next that I would say is the Kirschner case, which was a case that was brought about as a result of some litigation related to one particular loan, and it was questioning whether or not loans were securities. And, that I would say was existential for the loan market and loans retaining their identity. That was finally resolved,. I think everything, every last appeal and the like, formally resolved shortly after I started. So I’d like to think I echoed in this new era of loans because everything was finally done and dusted shortly after I joined in April of ’24. But those two events were just huge and they would’ve impacted the market in different ways, but both would’ve had material negative impacts on the market, had the decisions gone in other directions. So, I think we’re quite fortunate. We had a lot of support from membership. I will say sitting on the other side of things when the trade association for the market comes to you and says we are going to litigate against a regulator, that was a novel thing at the time, in the mid-20-teens. That was a very, very novel thing. It had not happened before. For better or for worse, it has become part of the panoply of things that we have as a means of pushing back against regulation that is overreaching, and we’ve seen it more and more over the past couple of years, but it’s something at the time was really unheard of.

Shiloh Bates:

What would’ve been the implication if a loan was a security, what would’ve been the implication for the market?

Sean Griffin

It would’ve been immediately very difficult for the investment banks because your bank’s proper have a difficult time holding below-investment-grade securities and these are all below-investment-grade loans. So, that was you have a banking issue. At the same time, in your CLO transactions, you have a limit on the amount of securities that you can own, you usually have a small high-yield bucket. And bleeding into that, there are many deals that didn’t have high yield buckets at all. So, you would actually have a portfolio of assets that wouldn’t be eligible. You wouldn’t necessarily be forced to sell those at that time. However, acquiring new instruments would’ve been very challenging on a go-forward basis and it could have had some knock on effects for banking institutions and other investors who invest in various parts of the CLO capital structure in terms of what they’re permitted to hold based upon their own internal investment criteria. So, there’s some pretty significant ripple effects that would’ve been quite stunting to the market.

Shiloh Bates:

Would it also have added more risk to the loan underwriting process in that if a loan is a security, then there is the risk that the end investors come back into the loan originator if they think that they didn’t act in good faith?

Sean Griffin:

When you move to a securities framework and you produce things like offering documents, there’s certain things that must occur and must appear in them. So yes, that introduces differentiator risk for sure.

Shiloh Bates:

Because I think I remember in that case, well it was like loan owners suing the bank that originated the loan and they were saying, yeah, you didn’t properly disclose information that I would’ve needed to make an informed decision or some risks. That was basically the case.

Sean Griffin:

Given where I was at the time, I wasn’t immediately focused on it and I wasn’t here for the bulk of the case. So I won’t comment on all the facts and circumstances other than to say, again, in my prior seat it was something where we were all concerned about where it could go, given what the implications were for how the market actually functioned on both the loan arranging side as well as the knock on effects for your securitization market.

Shiloh Bates:

So, if a loan, though is not a security, then there’s no insider trading rules or laws for loans. For stocks and bonds securities, yes, but for loans, it’s a wild, wild west in terms of who has information and what they can do with it.

Sean Griffin:

I wouldn’t describe it as the wild west though. I would say the lenders are more sophisticated. You don’t have, for example, like in equities where you can have individual ownership of equities, you don’t have that in the loan market. So it really is an institutional market. Participants can choose to be recipients of public or private information if there is anything that is public about the instrument. I do think we’ve seen a trend in loans more recently where things are skewing with more and more companies just being private overall. So there’s not as much public private information where you could potentially cross a wall.

Shiloh Bates:

Got it. And was there a third win that you guys are also proud of?

Sean Griffin:

I would say that LIBOR – SOFR transition was a win for the market because that was what folks were feeling like was going to be the Y2K event for lending because so many of the floating rate instruments out there were based upon LIBOR, and you had $1.5 trillion syndicated corporate lending market that needed to transition. You also had a $1 trillion CLO market that would need to transition as well, and you needed that to go as smoothly as possible. And, I was actively involved with LSTA at the time. Working with them and ARC to work through what the rules of the road were for transition, what the right replacement rate was going to be, and how that all came into being. And it was a lengthy process, lots of back and forth, and there was lots of evolution and thought along the way.

So, I look at that as something that could have been far more impactful. Would it have stopped the market from completely functioning? Absolutely not, but it could have slowed things down pretty considerably. Once the transition, once LIBOR secession occurred, what happened in reality was that things worked pretty smoothly. In my old seat, I remember sitting there in January and saying, okay, the market is trying to figure out how to price things. It’s not trying to figure out what’s the right pricing mechanism, just what’s the right basis now. And that took about two weeks for the market to figure it out. And then CLOs were issuing again. So it was really a non-event for the market, but it was based upon all the heavy lifting the organization did and working with membership and policy makers over the course of a multi-year period to get to a good spot for corporate lending and CLOs.

Shiloh Bates:

So, with that transition, we moved from LIBOR, which is an unsecured rate. It was actually a polling rate, so it wasn’t actually a rate where business was done, to SOFR, which is where banks finance themselves overnight on a secured basis. So the SOFR is lower than LIBOR. So, in this transition we needed to figure out a rate to add to SOFR so that it was comparable to the LIBOR rate. And, I guess in terms of how that played out, I think it was pretty smooth, but I do think that CLOs financing definitely did increase by 26.5 bips for sure. On the corporate side, there’s been a lot of demand for loans and I think some of the private equity firms that own these companies were able to negotiate part of that 26.5 basis points down some.

Sean Griffin:

I think with the adjustment and it was either 26 for three month or just north of 11 basis points for one month. That was intended for existing transactions that had the transition language to make it as close as possible to where LIBOR was. So, that was the mindset going in and that was based upon some historical data and analysis over, I think like a rolling five-year period. For new issue transactions though, that really was a capital markets execution, whether it be on the CLO side or the corporate lending side of things. So the market will actually ultimately determine what the right rate should be. It was going to be SOFR plus something, whether that additional adjustment was part of the credit margin, but that’s more for the market to determine and I believe that’s what ended up happening in a lot of cases.

Shiloh Bates:

So, those are three big wins for the trade group. And, what are you focused on today? What are the key issues?

Sean Griffin:

I’ve got a couple of key issues front and center on my mind. There’s a big focus for us right now on education. Fortunately, we’re not fighting any real existential fires right now from a regulatory perspective. We’re through many of those. The current administration is much more markets and business friendly. So we are in a better spot from that perspective, which allows us to turn more to education, which is fortunate because with the growth and proliferation of private credit, education really is necessary. Because unlike the syndicated lending market, when you start talking about private corporate credit, it’s much more challenging to aggregate information. And because of that, that education effort becomes that much more important and impactful as long as you can pull together good information. We’re fortunate as an organization because we have access to our members, we’ve had over 600 members, around 100 banks and around 225 buy-side firms, virtually all of them are involved in both syndicated lending and private corporate credit in some way, shape, or form.

So, we have access to a tremendous stockpile of information that we can use to help tell the right story around private corporate credit, rather than let others dictate what the story is based upon snippets of information and lots of assumptions. So, that’s one big focus for it. And it’s becoming increasingly important in light of the recent executive order from earlier this summer, which is mandating the access defined contribution plans to private assets, which includes private credit. We’re hugely supportive of that as long as it’s done in the right way, as long as the right guidelines are in place, but our education efforts are going to be a big part of that.

Shiloh Bates:

So when I joined the market, you guys were the trade advocacy group. I thought of you guys as just doing broadly syndicated loans, but as the private credit market’s grown, you represent both asset classes.

Sean Griffin:

I say we represent everything that is corporate lending and the related markets. So, that’s your syndicated market, that’s your private corporate credit, and that is also the related market like CLOs. CLO is probably the most important related market that we represent. When I think about syndicated lending and private credit, it really is two sides of the same coin. And if you speak with a capital markets banker these days, they’re likely presenting their borrower, clients coming in, with a range of options. One of them being a syndicated solution, one being a private credit solution, and if they’re able to issue high yield, a high yield solution. So they’re offered a sweep of solutions. And I look at our membership and I see again, based upon the buy side and the sell side folks that are part of our membership. Virtually to a firm, they are all involved in both parts of the market. So, it makes tremendous sense. And we’re talking about senior secured lending ultimately. So, there’s lots of similarities. And, I do think there’s a lot that private credit can learn from what we’ve learned from the syndicated market over the past 30 years. Keeping in mind that private credit when it started as middle market lending decades ago, these two things have been running side by side for a number of years. They really started to converge in the early-to-mid 2022 is when you really saw the convergence flare up.

Shiloh Bates:

Okay, so education is a big priority.

Sean Griffin:

Absolutely. Education’s a big priority. The other big priority for us is we look at the loan asset class, it still functions. It’s a very laborious and manual process to administer and trade and transfer loans. That is something that we are focused on in improving. Part of it is simple loan operations. How do we take loan settlement times, which right now are too long and bring them in? How do we improve that so the market trades more efficiently, allows for more liquidity? We want that to happen. That requires a very solid foundation in data and data that is accessible to all the market participants as close to contemporaneously as possible. That’s part of it. That data foundation, though, also sets us up for the next stage in the evolution of the loan market, which is if you look across other asset classes, whether it’s equities or debt securities, they’re going to be digitized and they’re going to be tokenized in some way, shape, or form.

And, we want loans to be able to take advantage of that same technology as well. That’s not an immediate thing. It doesn’t to be an immediate thing, but it’s something the market has to be positioned to be able to take advantage of because if commerce is heading in that direction, and we as a market haven’t evolved in the same way, at least to give us the same options that other asset classes have, then we’re going to be left behind and we should not be left behind as an asset class. There’s a tremendous value in corporate lending. And I personally, and we as an organization, want to make sure that we are as well positioned as possible. The focus on loan operations has been a decades long thing that we have been focused on and working to chip away at with the advancements in technology and things like AI, that adds a new component to it, and increases the focus that we must have as an industry overall to make improvements for the market.

Shiloh Bates:

So, if I buy a stock in my trading account, it’s a electronic purchase, and the settlement happens T+1, meaning trade date plus one day, so the settlement’s the next day. And for loans there’s a target settlement, so it’s T+5.

Sean Griffin:

Target would be T + five.

Shiloh Bates:

But, many times, it slips to – could be anything. Could be T+20. And that just depends on whether the buyer and the seller actually are in a position to close the loan. So, it can just get extended for quite a period of time. Is the end goal to have it be more like other asset classes, where the closing is a fixed date, and that’s it, and there’s penalties for not delivering the security or showing up with the cash?

Sean Griffin:

So, I would like to see more certainty around settlement. Does it always have to be a fixed date? No, because one of the beauties of the leveraged loan, the loan product, is some of the flexibility it has. And I believe borrowers like it because there is some additional degree of control they can influence over things like the lending group. So, that is an important feature and we know that’s something that folks won’t likely want to concede. We want to make sure there’s a degree of reasonableness built into all of this. However, that being said, for the bulk of loan trades in the market, we would like it to be as close to a consistent date as possible. And we think there are ways to getting to that and ways to demonstrate the value to that. But, we’ve got to, as a market, be able to collect the data that goes along with that trading velocity that can demonstrate the value that is actually there. So, does the whole market have to go to T+5? No, but a subset of the market should be at that level, and there will always be outliers. And that’s okay, because the product does have more flexibility than your traditional high-yield security or equity security.

Shiloh Bates :

Are those the two biggest things you guys are focused on?

Sean Griffin:

Those are the two biggest things that we’re focused on in terms of market impact currently. I would say the third prong that we’re focusing on is more our relationship with our membership and making sure that and doing what we can to engage and interface with them in a way that is most impactful to them. So, this is our organization’s, this is LSTA’s 30th anniversary this year. So, we’re super excited about that, and we’re doing a couple of neat things at our annual conference. It’s coming up in around a month, but we also did some work earlier this year, working with our marketing partners. We did a survey of membership to understand how they’re consuming all the content and information that we produce, and we learned some pretty remarkable things from that. And what we’re finding is there are probably better ways that we could be engaging with the broader market and that’s something that we’re spending a lot of time and effort on because we want to be as valuable of an organization to all of our members as we can be, and that takes time and effort and that’s causing us to think about doing some things differently, how we’re approaching things like conferences, multimedia, how we’re creating content, what sort of flexibility folks have in engaging with the data that we have, how we’re highlighting members because we’ve got the benefit.

I think the strongest part of our organization is our membership. We’ve got a tremendous membership group. We want to be able to highlight that more. So, we’re thinking about all those things. So, over the course of the coming months, we’ll be rolling some new things out, which I hope will have the end goal of ticking all those boxes and achieving those goals.

Shiloh Bates:

So, one of the market trends over the last two years has been LMEs. So these are liability management exercises, out of court, informal restructurings. Does the LSTA have any opinion about those, or is that outside? The LMEs have, in some cases, resulted in very low recoveries for lenders. Is that something that you guys have looked at or have an opinion on?

Sean Griffin:

So while we won’t comment on a particular credit or case, what I will say is that I don’t like to see the quality of credit get eroded in unnatural ways. So, that’s something that we’re focused on. I would also say that not all LMEs are bad ones. I think there are a number of good ones out there. I think those tend to be LMEs where all of the lender participants have an opportunity to participate in whatever the solution is, as opposed to favoring one group to the detriment of another. So, I think that latter case, where you have the haves and the have-nots, those are more challenging. I think those are the ones where you see people end up with worse outcomes over an extended period of time. And that’s something where I feel pretty strongly that’s not long-term good for the market overall. It might be short-term good economically for a subset, but longer term for the market, that trend is not a positive one. So that’s something that we certainly have a perspective on. But I would say my big point is not all the LMEs are bad ones, but when you do see something that is more challenging, and look, it raises a number of questions that then folks have to go back and they’ve got an answer to their LPs and their credit committee as to why certain things are happening and how could that happen based upon the type of loan that this is. So, those are all challenges for the market participants.

Shiloh Bates:

So, the idea there is that if you and I are both participating in the same loan and there’s a restructuring, we should end up with the same recovery. Whether or not you’re a bigger investor in general or in the loan, and I’m a smaller investor, it should be the same recovery. Unless you’re willing to put up additional capital, and I’m not. And then in that case, the recovery could be different.

Sean Griffin:

From my perspective, as long as everyone has the opportunity, if they don’t have the ability to participate, that’s something else. But, as long as they have the opportunity, that creates a degree of fairness across all participants, which I think we would like to see.

Shiloh Bates:

Was there a court case about this recently where the result was actually what we’re describing? That lenders should be treated equally?

Sean Griffin:

There have been a couple of cases. I don’t think it touched upon this point in particular because LMEs still do occur, so it’s not something that’s out of the market. I do think some of the recent cases from, if I’m thinking about the right ones, there were a couple that came out either just before the Christmas holiday last year or just ahead of the New Year’s holiday last year, that at least caused folks to think a bit more carefully about the steps they were taking.

Shiloh Bates:

And I think there’s a trend on two fronts. There’s a trend, some private equity firms have a do-not-buy list, where they have a syndicated loan and some firms are excluded from buying the loan. Usually, these are distress shops that might have, or be considered to have, sharp elbows in the past. Is that something that you guys have an interest in?

Sean Griffin:

We do because of the impact of secondary liquidity, and it does have a knock-on effect for market operations. I would say that we and our model credit agreement provisions, we do talk about DQ lists.,

Shiloh Bates:

DQ, so disqualifying?

Sean Griffin:

Disqualifying lender list. And we recognize why the borrower and or sponsor would like them and we recognize the value they have. So, we’re not saying they should not exist because there’s certainly things from a competitor standpoint where you wouldn’t want competitors getting into one of your transactions and getting private financial information because they are a lender. So, that makes a lot of sense to us, and we’re generally okay with that. I feel, though that if it’s taken to an extreme and you have too many lenders excluded, it becomes very difficult as a knock-on effect for secondary liquidity. It has some pretty nasty ripple effects on the operational side of things. So, those are critical to us. Because we do focus on the secondary liquidity of the market. Because there’s so much that even though CLOs are 65-70% of the institutional term loan B market, within loan mutual funds and ETFs, you have 8 or 9% of the market, and that’s a material number. And, if you unnaturally limit liquidity or transferability, it becomes potentially more problematic for those funds, and that would be a negative outcome for everybody.

Shiloh Bates:

And then another issue is, if you and I are again lenders to the same company, for example, we could form a group and we could agree ahead of time that in any restructuring, we’ll be in the same on a level playing field. What’s your opinion on those?

Sean Griffin:

I think it’s a response to some of the LME transactions that have happened. It’s something that we discuss with regularity with both buy-side and sell-side members. Quite honestly because there are pros and cons to it and depending upon the reason something is being put together, you very quickly see that forming its own have-group within the LME community. So, you have to be careful about it. And I certainly understand that the borrower and or sponsor will have some strong views as well, especially the earlier those are formed in a process. So it is a market defense mechanism that has been created in response to some of the LME behavior that the market has seen. Is it always good or always bad? No, the answer is somewhere in the middle. I would say it’s one of the more challenging things to navigate in the market because there’s so much that becomes very, very facts and circumstances dependent.

Shiloh Bates:

So, when a private equity firm is buying a company, can they go on the LSTA website and download a sample credit agreement and then fill in the specific terms that apply to them, like the price of the loan, and the spread, and the covenants, and the like, if there are covenants?

Sean Griffin:

If the market broadly took our model credit agreement provisions and implemented them, we wouldn’t be talking about a number of the things that we’re talking about today. So, I don’t believe that’s happening, which is okay, we have to provide the leadership and the guidance that we can, but I think what you see is each of your sponsors or owners will have the terms they’re looking for in a form they would like to see. Some of it, I’m sure, is pulled from our model credit agreement, but I would say that there are places where there’s going to be some deviation. But, ultimately this comes back to this being a capital markets exercise and transaction. So, it’s ultimately, you have a seller and you have buyers in the market, and they have to mutually agree upon terms when it comes to that transaction. I think that’s why you’ve seen credit agreement provisions migrate over time. Certainly in more robust markets where it’s a more issuer friendly market or borrower friendly market, terms tend to favor the borrower more, but as you have a turn in the cycle and it becomes much more lender friendly, lenders do have an ability to take some of that back though I would say things have been skewing more towards the borrower over the past couple of years, but it’s been a friendly environment.

Shiloh Bates:

So, you guys have your big conference coming up. If somebody comes to the conference, what should they expect to learn?

Sean Griffin:

Hopefully a lot about corporate lending. Every year, we host our annual conference, and we like to cover a couple of key topics. So, we’ll cover the syndicated lending market, we’ll cover the private corporate credit market. This year, I’m actually moderating a panel of private equity sponsors, which I’m super excited about. I don’t think we’ve done that before. Everyone is very focused on, when will we see the M&A and LBO machine pick back up? It’s been a rolling, it’s six months out, it’s six months out now. I think the past two or three years. And look, when you go back to those points in time, I think everyone at the time they’re making those statements, it was 100% justified. And facts and circumstances change and that caused that launch point to get pushed a little bit further out, a little bit further out. Again, we can see that the catalyst for a very robust market next year, but there’s also risk to it.

So, we have to just bear that in mind. So we’re talking about our sponsor panel. We have a number of breakout sessions in the afternoon. This year, we’ve got one that is non-corporate credit financing related, which is pretty exciting, just given how the market’s evolving and how our members continue to evolve. We felt that would be an interesting panel to improve. But you can learn about trading trends in the market. You can learn about legal trends in the market, operations trends in the market. And each year we also try to include outside-of-the-market keynote speakers, which are pretty exciting. So we have the chief global economist from Citigroup this year joining us and we also have folks coming in and that’s Nathan Sheets. We have Patrick McGee who’s a reporter for the Financial Times coming in to speak to us about Apple in China, which I think will be incredibly interesting.

And then, we have Connor Grennan, who is the Chief AI Architect at NYU Stern coming in to talk about AI and the impacts that could have on life, the market, all the things that we do. So, it’s pretty exciting when we try to veer away from traditional finance when we have our external speakers come in because it is something that is topical and interesting and not something you might get elsewhere. And, we’ve got a lot of senior folks that attend the conference, so it’s a good treat for them.

Shiloh Bates:

I also saw you guys are starting to launch a podcast.

Sean Griffin:

We have started launching a podcast, The Credit Continuum. Andrew Berlin, our director of policy research, has been championing that. We’ve got a couple of episodes under our belt at this point. It’s been a lot of fun so far. I think he’s done a great job. It’s a great way to get different perspectives and it’s a great way for us to highlight some of our members as well. And there’s so many folks in the market who [have] this deep knowledge and expertise. And the fact that we’re able to tap into that and get some of that knowledge out there is pretty phenomenal. So, we’ve really enjoyed doing those, and we’re looking forward to having that continue into next year and beyond.

Shiloh Bates:

Is there anything topical happening in loans or CLOs that we haven’t covered?

Sean Griffin:

Other than the questions around when does the M&A and LBO and sponsor machine start up again? That’s a critical one. These are the things that I’m thinking about, and I also think about how is issuance going to feel next year on the CLO side of things? A couple of robust years in a row, or what happens when there’s not as many refis and resets to do? How does the new issue machine feel? Is there any recalibration going on in the equity side? And, how does the private credit CLO market continue to evolve? Right now, it’s been a financing tool, but at some point you could see it, again, I don’t think across the board, but in some cases moving away from financing and more along third-party as you have more and more diverse groups of capital coming into the space.

Shiloh Bates:

Great. Sean, my closing question is always, what’s a CLO in 30 seconds?

Sean Griffin:

This is a great one. Alright, I haven’t timed myself, so we’ll see how I do here. So, a CLO can be thought of as a finance company, whose sole purpose is to acquire a portfolio of financial assets, in this case, corporate loans. It’s going to finance the purchase of those assets by issuing debt and equity to various investors. That debt is typically sliced into layers, called tranches, and each of them, including the equity, has a different risk-reward profile. In other words, the riskier the tranche, the higher the potential return, while the least risky tranches have the lowest potential return. That portfolio of assets is selected and managed by a portfolio manager, who will be a registered investment advisor, and have control over all the material decisions related to that portfolio. The portfolio manager is going to operate within a set of rules governed by the transactions’ legal documentation, which includes things like portfolio diversification, credit quality, and tenure requirements on the assets themselves. And it describes how those tranches that I just talked about are actually paid. You’ve got an investment bank that’s typically hired to structure the deal and to place the tranches with investors, and you typically have rating agencies involved who are going to rate the debt portion of that CLO transaction. I think that’s 30 seconds.

Shiloh Bates:

That was great. Sean, thanks so much for coming on the podcast, really appreciate it.

Sean Griffin:

Shiloh, this was awesome. It was great to see you again. Really appreciate the opportunity. Looking forward to hearing the final product.

Shiloh Bates:

Sounds great. Thanks again, Sean.

*******

Disclosure AI:

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

Definition Section:

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

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

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

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

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

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

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

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

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

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

– Delever means reducing the amount of debt financing.

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

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

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

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

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

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

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

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

– RMBS, our residential mortgage-backed securities.

– Loan to value is a ratio that compares the loan amount to the enterprise value of a company.

– GLG is a firm that sets up calls between investors and industry experts.

– Payment In Kind, or PIK, refers to a type of loan or financial instrument where interest or dividends are paid in a form other than cash, such as additional debt or equity, rather than in cash

– A covenant refers to a legally binding promise, or lender protection, written into a loan agreement.

– Net Asset Value (NAV) – The value of a fund’s assets minus its liabilities, typically used to determine the per-share value of an interval fund or investment vehicle. 

– Dividend Recapitalization (Dividend Recap) – A refinancing strategy where a company borrows to pay a dividend to its shareholders, often used by private equity sponsors.

– Continuation Vehicle – A fund structure that allows investors to roll their interest in an existing portfolio company into a new vehicle, while offering liquidity to those who want to exit.

– Equity Cure – A provision that allows private equity sponsors to inject equity into a company to fix a financial covenant breach.

Risks: 

– CLOs are subject to market fluctuations. Every investment has specific risks, which can significantly increase under unusual market conditions. 

– The structure and guidelines of CLOs can vary deal to deal, so factors such as leverage, portfolio testing, callability, and subordination can all influence risks associated with a particular deal. 

– Third-party risk is counterparties involved: the manager, trustees, custodians, lawyers, accountants and rating agencies. 

– There may be limited liquidity in the secondary market. 

– CLOs have average lives that are typically shorter than the stated maturity. Tranches can be called early after the non-call period has lapsed. 

General disclaimer section:

Flat Rock may invest in CLOs managed by podcast guests. However, the views expressed in this podcast are those of the guest and do not necessarily reflect the views of Flat Rock or its affiliates. Any return projections discussed by podcast guests do not reflect Flat Rock’s views or expectations. This is not a recommendation for any action and all listeners should consider these projections as hypothetical and subject to significant risks.

References to interest rate moves are based on Bloomberg data. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of, or potential or actual portfolio changes related to securities of those companies, unless otherwise noted. All discussions are based on U.S. markets and U.S. monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global Speaker are those of the speaker as of the date of the broadcast, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and flat Rock global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research or investment advice. 

It is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered. None of the information provided should be regarded as a suggestion to engage in, or refrain from any investment-related course of action, as neither Flat Rock Global nor its affiliates are undertaking to provide impartial investment advice. Act as an impartial adviser or give advice in a fiduciary capacity. Additional information about this podcast, along with an edited transcript, may be obtained by visiting flatrockglobal.com.