Author: Shiloh Bates

Shiloh:

Hi, I’m Shiloh Bates, and welcome to the CLO Investor podcast. CLO stands for collateralized loan obligations, which are securities backed by pools of leveraged loans. In this podcast, we discuss current news and the CLO industry, and I interview key market players. Today I’m speaking with John Timperio, the co-head of Dechert’s global Finance practice. Dechert is one of the prominent law firms in the CLO industry and someone that I’ve worked with on many transactions with over two decades of experience. John is a trusted advisor to CLO managers and investors. I asked John to come on the podcast to discuss the exciting topic of CLO regulation. This podcast is going into the weeds, so buckle up. If you’re enjoying the podcast, please remember to share like and follow. And now my conversation with John Timperio. So John, welcome to the podcast.

John:

Thank you for inviting me.

Shiloh:

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

John:

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

Shiloh:

Gotcha. So how does somebody become a CLO lawyer?

John:

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

Shiloh:

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

John:

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

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Shiloh:

— the securitizer —

John:

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

Shiloh:

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

John:

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

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

Shiloh:

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

John:

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

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

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Disclosure:

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

John:

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

Shiloh:

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

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

John:

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

Shiloh:

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

John:

It would be asset backed security. So —

Shiloh:

— securitization of business equipment or aircraft —

John:

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

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

Shiloh:

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

John:

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

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

Absolutely.

Shiloh:

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

John:

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

Shiloh:

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

John:

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

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

Shiloh:

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

John:

Absolutely, and thank you for inviting me.

Disclosure:

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

Definition Section

AUM refers to assets under management.

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

Layering refers to placing additional debt with a priority
above the first lien term loan.

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

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

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

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

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

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

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

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

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

ETFs are exchange traded funds.

CMBS are commercial mortgage backed securities.

A BDC is a business development company.

Basel III is a regulatory framework for banks.

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

General Disclaimer Section

References to interest rate moves are based on Bloomberg data. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merit of or potential or actual portfolio changes related to securities of those companies unless otherwise noted.

All discussions are based on US markets and US monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole.

Any such views are subject to change at any time based upon market or other conditions, and Flat Rock Global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research, or investment advice. It is not a recommendation, offer, or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock
Global nor the Flat Rock Global speaker can be responsible for any direct or
incidental loss incurred by applying any of the information offered. None of
the information provided should be regarded as a suggestion to engage in or
refrain from any investment-related course of action as neither Flat Rock
Global nor its affiliates are undertaking to provide impartial investment
advice, act as an impartial advisor, or give advice in a fiduciary capacity.
Additional information about this podcast along with an edited transcript may
be obtained by visiting flatrockglobal.com.

The CLO Investor Podcast, Episode 8

Shiloh:

Hi, I’m Shiloh Bates and welcome to the CLO Investor Podcast. CLO stands for Collateralized Loan obligations, which are securities backed by pools of leveraged loans. In this podcast, we discuss current news in the CLO
industry, and I interview key market players. Today I’m speaking with John Kerschner, one of the portfolio managers of the Janus Henderson JAAA CLO exchange traded fund. As of June 30th, JAAA had a market cap of 10.6 billion, up from 3.2 billion a year prior. I asked John to come on the podcast to discuss his perspective on the relative attractiveness of CLO AAAs versus other asset classes. We also discuss how his team picks CLO AAAs and if the market should expect continued CLO tightening, some of which being driven by CLO ETFs.

And for the avoidance of doubt, there’s no business relationship between Flat Rock Global and Janus Henderson. And now my conversation with John Kerschner.

John, thanks so much for coming on the podcast.

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

Yeah, so during the GFC I actually left that Smith Breeden Associates and joined a hedge fund based in Boulder that focused on commercial real estate. So I kind of went from agency mortgages to non-agency mortgages to commercial real estate, obviously commercial real estate. I had a very difficult time during the GFC. Our investments were very good. They were mostly global, but when liquidity drained out of the system, no one really cared that much about that. They just wanted their money back. So I did some distressed debt investing for a couple of years at this firm, and then that platform was shrinking. So I was really looking for my next opportunity.

And Janus at the time, now, Janus Henderson obviously, back in 2010, was really trying to build out their securitized group. They had no assets and no people,
and yet close to 20 billion in fixed income under management. Most of that was benchmarked to the aggregate index. So they needed some securitized expertise and that’s why they brought me in to build out that group.

Shiloh:

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

John:

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

Shiloh:

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

John:

I do think there’s some of that taking share from the Agg, but I actually think it’s taking more share from what traditionally have been cash type of investments, whether that’s money market funds or bank certificates of deposits or T-bills, things of that nature. Because traditionally, and obviously past performance is no indication of the future, but traditionally AAA CLOs have outperformed cash by somewhere between 170 to 200 basis points. Now that comes with more risk, at least a little bit more risk. So that’s key. But there’s still, look Shiloh, there’s still 6 trillion plus of assets out there in money market funds. And so there’s just this massive market of people out there who are saying, look, I still think rates may be going up, or I’m concerned about the overall economy. I want that safety of cash and it’s given me a decent yield, particularly compared to where cash was over the last 10, 12 years. So why don’t I just do that? But then when they look at last year, cash basically gave them just over 5%. That makes sense. That’s where the Fed funds rate is. But a JAAA with a little bit more risk gave them 9%.

Shiloh:

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

John:

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

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

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

Shiloh:

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

John:

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

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

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

Shiloh:

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

Disclosure AI:

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

Shiloh:

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

John:

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

Shiloh:

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

Disclosure AI:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

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

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

Shiloh:

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

John:

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

Shiloh:

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

John:

There’s several things driving that. Interestingly enough, what happened with Silicon Valley Bank just over a year ago now, and now the news coming out of Japan with Nor Chuan is making both regulators and banks really focus on their investment portfolio. I don’t think people necessarily know how big some of these portfolios are, but look, banks bring in deposits and they
make loans and sometimes they can’t  make enough loans for all the deposits they’re bringing in, so they have to buy securities to make up that difference. And traditionally, banks have bought very high quality fixed income, government debt, mortgage debt CLOs, but until this recent increase in interest rates buying kind of long duration or treasuries kind of worked for banks and then all of a sudden the thing goes, it worked until it didn’t and a lot of banks got underwater. And so even though CLOs may seem a little more complicated or more risky for a bank, they’re kind of the ideal asset class.

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

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

Shiloh:

So you mentioned that low default rate at triple B. I mean, does that imply though that people would be better off taking a little bit more risk and moving down the cap stack rather than investing in the triple A,  which, and I know they’ve never defaulted, so everybody feels good about that, but would it make sense for a lot of people to take a little bit more risk and maybe get paid for it?

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Disclosure AI:

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

AUM refers to assets under management.

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

Layering refers to placing additional debt with a priority abov3 the first lien term loan.

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

The global financial crisis (GFC) was a period of extreme stress in global financial markets and banking systems between mid 2007 and early 2009.

Credit ratings are opinions about credit risk for long-term issues or instruments. The ratings lie on a spectrum ranging from the highest credit quality on one end to default or junk on the other.

A AAA is the highest credit quality. A C or D, depending on the agency issuing the rating, is the lowest or junk quality. Leveraged loans are corporate loans to companies that are not rated investment grade broadly.

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

Middle market loans are usually underwritten by several lenders with the intention of holding the investment through its maturity spread is the percentage difference in current yields of various classes of fixed income securities versus treasury bonds or another benchmark bond measure.

ETFs are exchange traded funds.

Offset is a refinancing and extension of A CLO investment. 

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

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

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

RMBS stands for Residential mortgage-backed securities.

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

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

General Disclaimer Section

References to interest rate moves are based on Bloomberg data. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of or potential or actual portfolio changes related to securities of those companies unless otherwise noted. All discussions are based on US markets and US monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice, projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole.

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Disclaimers regarding JAAA and JBBB:

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

JAAA Fact Card

JBBB Fact Card

The CLO Investor Podcast, Episode 7

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

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

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

Then there’s no haircut on that.

Patrick:

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

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

Shiloh:

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

Patrick:

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

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

Shiloh:

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

Patrick:

Thanks. Always great to chat.

Disclosure AI:

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

Definition Section: 

AUM refers to assets under management

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

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

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

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

Up tiering refers to placing additional debt with a priority above the first lien term loan. 

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

The global financial crisis, GFC was a period of extreme stress in global financial markets and banking systems between mid 2007 and early 2009. 

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

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

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

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

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

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

ETFs are exchange traded funds.

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

Reset is a refinancing and extension of a CLO.

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

Intex is software that CLO practitioners use. 

General Disclaimer Section: 

References to interest rate moves are based on Bloomberg data. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of or potential or actual portfolio changes related to securities of those companies unless otherwise noted. All discussions are based on US markets and US monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice, projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole.

Any such views are subject to change at any time based upon market or other conditions and Flat Rock Global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research, or investment advice. It is not a recommendation offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global Speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment related course of action as neither Flat Rock Global nor its affiliates are undertaking. To provide impartial investment advice, act as an impartial advisor or give advice in a fiduciary capacity. This broadcast is copyright 2024 of Flat Rock Global LLC. All rights reserved. This recording may not be reproduced in whole or in part or in any form without the permission of Flat Rock Global. Additional information about this podcast along with an edited transcript may be obtained by visiting flatrockglobal.com.

The CLO Investor Podcast, Episode 6

Shiloh:

Hi, I am Shiloh Bates and welcome to the CLO Investor podcast. CLO stands for collateralized Loan obligations, which are securities backed by pools of leverage loans. In this podcast, we discuss current news in the CLO industry and I interview key market players. Today I’m speaking with Paul Nikodem, CLO researcher at Nomura Securities. Paul’s job is to provide CLO market commentary and analysis to CLO investors like myself. Our primary discussion revolved around evaluating CLO managers at Flat Rock. We do not manage CLOs, we just invest in CLO Securities. Each CLO has a manager. Their job is to pick the loans for the CLO and to keep the CLO passing its many tests. According to Creditflux, the five largest CLO managers are Elmwood, Credit Suisse Asset Management, Blackstone, Neuberger Berman, and Octagon. But CLO investors have over a hundred different managers they can choose from. Our conversation also tackled declining CLO financing costs. And now my conversation with Paul Nikodem. Paul, welcome to the podcast.

Paul:

Thanks, Shiloh. It’s good to be on. Appreciate you having me.

Shiloh:

Why don’t you tell our listeners a little bit about your background and how someone becomes a CLO researcher?

Paul:

Sure. To be honest, I didn’t start off as a CLO researcher. I’ve been covering securitized products as a research analyst since 2003, but I started my career covering mortgages and housing for the first decade. So it was a really interesting time to cover both of those markets. Obviously saw the large runup pre global financial crisis and then the whole mortgage market and the housing market imploded and then that was followed by the recovery trade aided by a lot of government support and just a slow rebuild of the mortgage market. So it was a really interesting time to think about scenarios and how to stress test bonds and just experience both the boom and the bust cycle. And then after 2010 or 2011, it was really the recovery trade where we saw government support come back to the housing market and private capital and GSEs really start to slowly expand the underwriting box.

And the mortgage market slowly came back until the housing market accelerated and then it was boom times for much the next decade. So as we covered RMBS and housing during that decade post GFC and we expanded our coverage, we started looking at other sectors as well within the securitized products research arena. One of the sectors that stood out to us was the CLO sector that was starting to gain its footing and starting to grow pretty rapidly at the time. And it was really interesting for us as research analysts to look at the performance during the GFC. Now, the mortgage market clearly did not do well and it was really housing led, but CLO market did quite well surprisingly well when we started looking at the data. And it was really interesting to see how these structures held up in this first stress scenario that we started to take a look at.

And basically around that time, our firm Nomura also decided to make a commitment to grow in the CLO business, starting with the secondary trading and followed by the primary business as well. And we started to cover the sector from a research perspective. So the idea was that we had really great technology that we built up from the residential mortgage research arena looking at loans and mortgage servicers and intext data. First thing we did is we took a look at those systems and applied them to the CLO market where we had managers and we had individual loan issuers. We tried applying similar technology to see what we can find. And it was a really interesting time to start to look at a very micro level at the CLO market to see differences in manager performance and loan performance and issuer performance. And that’s how we got started.

We were in the right place at the right time and we were able to transfer some of that technology from R and BS to really hit the ground running on the CLO side. And since then, the market has obviously grown dramatically. It’s one of the key sectors within the securitized markets and it’s very fascinating to look at the market both from a very macro perspective where we look at the buyer base and overseas investors and just supply demand dynamics and also at a very micro level looking at manager selection and loans and recoveries and drilling in very, very deep. So it’s been a very exciting time to be a CLO research analyst over this past decade.

Shiloh:

So for your research, is it that you put out a different piece each week that goes to a number of clients telling them whatever you think is interesting that’s happening in the market?

Paul:

Exactly. So we try to respond to what questions are on investors’ minds at every week, sometimes more frequently than once a week depending on what’s going on in the market. But we try to combine some of the micro interesting data analysis and manager analysis with some of the broader macro observations that we find in our research.

Shiloh:

I know Nomura has a CLO banking team and a CLO trading team. Why don’t you talk about the other things that Nomura is doing with CLOs?

Paul:

So starting in 2015-2016, we started off by having a very strong secondary trading effort. So our firm is the most active trading desks in most scenarios in CLO BBs and equity and me in general, we speak with all the key investors that are active in the space and we have a very strong franchise there. A couple years later, we also made an investment in the primary business where we deal with many of the largest, most established managers in the space and we’ve really built a top 10 business in that space. So part of it is timing and getting the timing right. Part of it is investing in talent and investing in balance sheet as well as research. So our firm has really decided to make an investment in this business.

Shiloh:

So what is it about CLO equity and CLO double Bs that’s of particular interest to your firm?

Paul:

It’s a very data intensive, research intensive product where there’s a lot of differentiation and performance across managers and deals and vintages. With the right tools in place and the right investment in place, we have developed a way to find a niche and an edge in identifying opportunities. There’s a lot of dispersion in performance, so that’s one. These products trade very differently depending on the profile and requires a lot of analysis and insights into the market to figure out how to generate alpha for our clients as well as run a successful trading business. And part of it is connectivity to our primary business as well, where a lot of what’s going on in the market today has to do with optionality for issuers and equity holders to refi or reset or call these deals. So having an insight into what investors want to do both on the primary and the secondary side and what are the outs for these deals has a large impact on valuations, especially given that most of the market is trading at a premium now. So the timing of that refi reset is also crucial. We feel like we’ve developed an edge in that as well.

Shiloh:

Interesting. So one of the things I wanted to focus on today was just how to evaluate a CLO manager. So if we’re talking about broadly syndicated CLOs, which is around 90% of the market, I think there’s a hundred different active CLO managers. What do you think the first step is in identifying a CLO manager that’s going to outperform?

Paul:

From a research perspective, we’ve developed a large variety of metrics to evaluate manager performance over a long period of time. So in the past I’d say that bill was the most relevant metric that we used.

Disclosure AI:

Note par build refers to the CLO manager growing the par balance of the loans. This can sometimes be thought of as loan gains.

Paul:

To benchmark and compare manager performance over a long period of time. Although in recent months and quarters, it’s become a less useful metric by itself given that a lot of managers have been focused on risk reduction and defending against tails, whether it’s downgraded loans or lower price loans picking up. And the stats have been skewed based on the par build metric alone. So we’ve done a couple of things to try to identify who’s outperformed in recent years. Number one is we’ve tried to improve on the par build metric. And what I mean by that is we’ve created a new sub metric within par build to try to decompose the two effects that drive par build. One is original portfolio quality or credit selection, how has that original portfolio performed over time, absent any subsequent trading activity and also the value add of trading. So we have a metric, we like to call it active versus passive par build. So we decompose that performance by manager. That gives a lot of interesting insights. First being that original credit selection matters a lot more than trading activity and driving performance for many managers over the past two years. So that’s one observation that we rely on from this metric.

Shiloh:

So is what you’re saying here that the CLO begins its life with 400 million or 500 million of loans and it’s really that initial loan selection that’s going to be the key driver of returns over time? That’s your view?

Paul:

In the last two years, that was the primary driver of differences in performance, not necessarily true in previous episodes of distress, but over the past two years, definitely the case. Another thing is looking at how CLO managers manage tails. So on the surface you could take a look at what’s the triple C concentration by manager, and that’s one thing that the market does tier for. But looking under the hood, there’s some managers that don’t sell a lot of triple Cs and they might have a credit view that some of these loans might recover and the market prices are too low at the time and you have other managers that might be very aggressive in selling. And then you also have the other dimension of high downgrade rates to triple C and lower downgrade rates to triple C. So I think it’s also very important to decompose and think about what are downgrade rate differences across managers and how does that interact with trading as well?

So sources of triple C and how managers are handling that through the cycle also matters quite a bit. And finally, just thinking more broadly, consistency matters quite a bit. So in terms of thinking about who’s done well in the past, there’s obviously no guarantee that past performance will lead to future success. So we like to look over a long time period at consistency throughout different cycles and consistency and style. But for example, some metrics we like to take a look at are unlevered returns on the underlying portfolio over time. So how does it look every calendar year going back five or 10 years depending on the 10 of managers we’re taking a look at? So consistency is important. If you’re a debt investor, you do not want to see large drawdowns necessarily equity investors, you might have a little bit more tolerance for that if you see more upside in certain years, but it all depends on where you sit in the capital stack. So consistency in general matters quite a bit as we think about forward outlook.

Shiloh:

So one of the things from my C is that the metrics that you used, I could obviously see the attractiveness of using them, but each metric is a little bit incomplete in some way. So for example, you mentioned the par balance of the loans and is it growing? So the shortfall of that metric is just, well, are the loans price at par or 90 or some other number? And then if we’re looking at CCC balances, CCC loans are certainly at higher risk of default. But one of the first experiences I had with CLO managers, I went to a prominent one and he was telling me about his philosophy on triple CCCs and he just basically said, Hey, listen, I’m just buying good loans for the CLOs and if a rating agency has a loan at ccc, it’s important to know that for the functioning of the CLOs many tests.

But at the end of the day he’s like, I just want to buy good loans. He trusted his credit team a lot more than the rating agency assessment of the risk in the loan, and he told me he might buy a CCC loan because it has a high spread or because it has a low dollar price. So sometimes the rating agencies are a little bit lagged in terms of their downgrades or upgrades. So that’s the downside to using the CCC balance as a prominent metric. And at the end of the day, really the question with CCCs are just are they going to repay at par or not?

Paul:

Yep, exactly. I think that’s very consistent with a lot of our thoughts as well. I think that speaks to original credit selection mattering a bit, and obviously you want to have a manager that’s at least aware of some of the triggers and tests and the structural constraints of A CLO versus just managing a loan portfolio as it relates to certain stress scenarios or the ability to have good metrics so that they’re able to continue to raise capital in the future. But at the end of the day, I completely agree it’s loan selection and having a good credit team definitely matters quite a bit. Those with better selection ability over the last couple of years have definitely outperformed in our metrics versus those that might be optimizing par build for example.

Shiloh:

So I think the first cut for CLO manager analysis, what we would do is just pull up their deals in Intex

Disclosure AI:

Note Intex is software market participants use to model CLO securities

Shiloh:

And look for deals that are two to three years old and see what’s happening with the loan portfolio and really just ask yourself, are these CLOs where I would’ve wanted to participate from inception? I think that’s a good way to start the analysis. One of the things that I think is everybody’s looking for the loss rate on the loans. So one manager might have 40 basis points of annualized loan losses, another might have 60 and somebody say, okay, well the 40 is better than the 60, but what you really need to do is normalize for the income or spread of the loans. So if one CLO manager has a 20 basis points of incremental loan losses, but their loans provide 40 basis points of incremental loan income, then that’s the better manager in our view.

Paul:

For equity holders, that’s definitely a valid way to look at it. I think that for example, our unlevered return metric handles that maybe not directly, but it goes in that direction where if you have a higher spread on the portfolio that’ll contribute to the returns and be offset against the market value drawdowns. So we don’t explicitly count defaults separately from market value moves. It’s counted together. And that’s a very good point for equity that you have some more cushion if you have a higher spread portfolio. So yes, absolutely, I would definitely consider that as well.

Shiloh:

If you were just going to use one metric and one metric only to evaluate a CLO manager, would it be the unlevered return of the loans versus the Morningstar loan index? So that’s just the performance of the loans outside of the CLO structure

Paul:

Over the long term in terms of identifying upgrade candidates and just thinking big picture. Yes, absolutely.

Shiloh:

So I mentioned earlier that there’s downsides to each way of measuring performance, and if you’re looking at the performance of the loans only, you’re not capturing any of the skill that’s needed to manage CLOs and the CLOs. Many tests and then also some CLO managers are just going to have more conservative loan portfolios. So those might underperform the Morningstar loan index, but with the leverage provided by the CLO structure, the returns there could still be quite favorable.

Paul:

I mean, one thing I would say for that is we tend to look at a cluster a two by two scatterplot, if you will, of returns versus standard deviation of returns versus some other risk metric. We’ve played around with a few to risk adjust those returns to do some comparative analysis. So for the higher return, lower standard deviation managers look at a quartile, for example, on this two by two grid, which managers are outperforming their peers. I agree with you. On average there are some biases to looking at it that way and it might not fully capture the equity returns, but we’re thinking more in terms of upgrade candidates or which smaller managers are outperforming some of their bigger manager counterparts and are deserving of an upgrade for equity managers. I think that definitely would look at different metrics more so in terms of leverage and distributions and cushions, but that unleveled return versus appears is more for a holistic view on upgrade potential and small versus big managers and who’s trending in what direction.

Shiloh:

So maybe the takeaway is just that there’s a number of different ways to evaluate CLO managers and you probably need to use all of them to really get a complete picture. So the result of CLO manager analysis is a tiering of CLO managers into tier one through four with one being the best. So I think starting at tier four, would you put anybody in tier four? I’m not necessarily looking for names at this point, but are there a handful of managers that have really underperformed

Paul:

In terms of underperformance? Yeah, there’s probably isn’t a quarter of all the managers outstanding. It’s probably not the bottom quartile. Maybe it’s the bottom decile of, as you mentioned, managers that haven’t issued and some of them might be trying to rebrand themselves and have much cleaner portfolios and switch their style, but there’s definitely a few that clearly have underperformed in the past and clearly have par holes or underperformed during past stress periods that are just not treated well in secondary at all. There’s stats reflect that. The other tier is just new managers in general, which we give them the benefit of the doubt and wait two to three years to see a track record before really taking on a view. To your point earlier that everything looks clean on day one, but it seems like it takes at least two to three years of history before we could start to differentiate who are the better and the worse of the new managers. And basically who deserves an upgrade to tier one or tier one and a half faster than others. That’s how we’re thinking about it.

Shiloh:

Okay. So who do you think is in the top tier if you’re able to share a few names with us?

Paul:

Sure. So top tier, the way we think about it internally, there’s a couple of different metrics, whether you’re the top, you’re the bottom of the stack, part of it’s performance, part of it is AUM, part of it is number of deals and primary spread tiering, and it’s a little bit of a circular argument. We don’t really love it as research folks, but it makes sense that managers that have been around longer who have consistently traded tight primary have better liquidity. So there’s a better refi reset optionality to get out if spreads tighten without as much extension risk and they’re going to trade better in secondary if you see another Covid scenario and spreads blow out, for example. So there’s some self-fulfilling prophecy to that. Our first blush would just be to rank by primary spread tiering as well as just AUM in general. So you’d see a lot of the usual names there, but to put a couple names out there in terms of overlaying a research view on performance and who’s been cleaner and who’s navigated through credit cycles better than others, some names that stand out within that tight spread and high AUM top quartile would be, for example, Elmwood, CS, Oak Hill, I guess BlackRock, CISC, Allstate are some names that come to mind.

Shiloh:

So do you think that most people on the market would agree with the tier one distinction for the guys you mentioned, or is it that CLO investors like myself that we are just using totally different inputs into our CLO manager analysis that would result in a different tiering?

Paul:

So at the top of the stack, I think it’s pretty self-evident given the AUM and primary spread tiering, which tends to be very sticky. And part of it has to do with the fact that larger anchor buyers tend to just set up their list and they tend to switch less frequently, although we have seen a shift in the AAA buyer base. So there’s some impetus for change, although not as rapidly as at the bottom of the stack. So at the double B and at the equity part of the stack, I think there’s a lot more opinions, especially of if a manager has tails that are increasing or has cleaned up quite a bit, the market could tier very, very differently pretty quickly after seeing some of the performance differences. Or they might tier a manager differently for vintages two years ago versus four years ago based on differences in performance. So it feels like down the stack that tiering is a lot more responsive and there’s a lot more opinions about who’s improving, who’s trending, who’s getting worse, et cetera.

Shiloh:

So from my perspective, it looks like a tier one status at the top of the stack for the AAA for example, a lot of that seems to be just based on name recognition rather than the performance of the underlying loans. And once you have that tier one AAA investor base, I think it tends to be pretty sticky. So these guys just continue to do your deals year after year and maybe aren’t looking to put new entrants on their list. And in CLO equity is totally different. So you’re daring any loan losses, it’s an issue for you. So name recognition doesn’t really pay the bills. The other part of CLO manager tiering and manager selection is just that there could be managers out there that we really like, but at the end of the day, if they can’t get good debt execution, then there’s really nothing for us to talk about because that’s the key ingredient for good CLO equity returns. So Paul, let me ask you this. It seems like every year there’s five to 10 new CLO manager entrance to the market. Have you seen any of those be particularly successful? I think it’s a pretty tough business to break into.

Paul:

This may not be the newest of managers, but Elmwood was probably the first one that stuck out. Obviously the PM came from BlackRock and the performance was pretty similar early on and conservative, but they’ve performed very well and are clearly tier one and nobody would call them a new manager, but they’re probably the first one that we would think of in terms of that upgrade cycle. But more recently, I guess Birchgrove white box stand out to us as also going down that positive trajectory.

Shiloh:

So one of the changes we’ve seen in terms of CLO management style is that pre Covid managers were doing loans with LIBOR spreads from 330 basis points all the way up to 400 basis points. And during Covid, when loan losses were elevated, a lot of the loan losses were actually in the high spread names, which makes sense. So it was really the conservative loan pools that outperformed during covid. And it seems a lot of CLO managers are really now just sticking to the lower spread pools. Is that something you’re seeing in your research?

Paul:

I’m hearing more of the latter, but as a research analyst, another thing that I point out is that a few years ago, if you take a look at a scatter plot of WAS versus performance

Disclosure AI:

Note WAS stands for, the weighted average spread of the loan portfolio

Paul:

High WAS tends to outperform. In good scenarios, they tend to have large drawdowns and bad scenarios, unsurprisingly, but more recently, over the past two years that correlation has broke down and it’s not obvious that high was has underperformed in the cycle. In fact, we’ve seen some lower spread managers that have had a small number of loans that have gone bad and unfortunately the recoveries have been so low that they’ve taken pretty big par hits. So the correlation between high and low spread and performance has really broken down in recent years and it’s hard to really show that relationship. Recently just given the market environment, the defaults have been low and just the loan recovery has been just very idiosyncratic. So anecdotally, it does feel like we’ve seen a number of higher spread managers previously that are trying to go into lower spread, more conservative portfolios rather than the other way around. But it’s not clear that that has a difference, an impact on performance as of right now over the longer run, in theory it’s supposed to have a correlation, but in the last two years it has not.

Shiloh:

Well, one of the reasons that we favored the low spread loan pools was that with the low spread portfolio, you can still generate very healthy distributions to the equity, but you’re taking less risk on the underlying loans. And if the loan pool stays strong over time, then the option value of doing resets and refis in the future is greater. Whereas if you just have the higher spread portfolio, that to me implies more risk and the higher spread loans do create more income for the CLO equity that comes quarterly and of course that’s nice, but you don’t really need to reach for the higher spread loans to get very good CLO equity returns is our view.

Paul:

Yeah, I think that makes a lot of sense. I remember I think five or six years ago, this is where we saw a switch where before that the lower spread managers didn’t necessarily have great distributions and a lot of them were shunned by the market. But after that there started to be a transition where some of the lower spread managers had really tight funding costs and they avoided a lot of the hiccups in 2017, 2018, 2019, whether it’s retail or some of the idiosyncratic issues that showed up in the loan market and they really outperformed, at least some of them started to outperform. And I think that trend has continued. So I think that makes a lot of sense.

Shiloh:

So changing topics, one of the things we’ve seen this year is that the CLO financing costs have come in really dramatically. And curious if you think the trend’s going to continue or if there’s some floor level to SEAL Lewis spreads that we may hit at some point?

Paul:

That’s a great question that we often have received recently. I feel like spreads will continue to oscillate down, but the issue is that every time you tighten a few bps, you could see another wall of refi reset supplied pickup, and that could temporarily cause spreads to widen before they tighten again. But the general direction continues to be tighter. So across all the securitized products assets that I cover now, the conversation is really spreads are pretty close to post pandemic tights or near two year tights. And now take a look at where spreads were before the pandemic and look at that comparison. And CLOs are not in a vacuum by any means. I don’t think that there’s anything preventing CLOs to go into the low to mid one-thirties by year end with a couple of fits and starts where spreads might temporarily widen with refi reset supply.

But there’s a couple of important factors here. One, just from a broader macro environment, we think the macro environment will be relatively benign and fund flows will be positive and insurance and annuity flows will be positive and more importantly, bank demand for securities has gradually picked up and we think that trend will continue going into year-end positive for CLOs just given the duration profile and the floating rate nature. But I think all the major investor groups are either investing quite a bit or rising as a share of buyers in terms of the CLO market and broader securitized products. Also, net issuance is very, very limited for CLOs and even more limited for triple eight given that amortization speeds are elevated and most of the amortization happens at the AAA part of the stack. So to give some context, CLO AAA net issuance is barely above zero year to date, whereas overall CLO net issuance is about 15 billion year to date.

So the net amount of growth and the AAA part of the market is pretty close to flat and that’ll probably continue for the remainder of the year. Taking a look at some of the bank data, banks have been roughly flat down in terms of their holdings over the last quarter and they could pick up a little bit. ETFs obviously are growing and accelerating, especially at the top of the stack, and it doesn’t take much of ETF or bank flows to really push AAAs tighter given that they’re not really creating new AAAs. A lot of it is recycling from short to long and amortization. But in general, we think the technicals should be positive, think the macro environment should be positive. We think the Fed first rate cut, we’re calling for July with some risk that it gets pushed to September, but we’re calling for two cuts this year, possibly slightly less, but at least one cut this year. Even if some of the inflation prints are a little bit hotter in the near term, it does feel like a risk on environment and general spread tightening environment. So we are positive at the top of the stack continuing to tighten.

Shiloh:

Do you think that spread tightening is really a function of the fundamental performance of the underlying loans or is it more technical in nature?

Paul:

I think it’s very technically driven recently, so a year ago agency spreads at 180 bps was certainly an impediment to CLOs tightening given that you saw some crossover buyers look at both, that issue has gone away. Agencies have tightened in quite a bit and we think they are slightly below where fair value is right now. So that’s one. The technical environment of issuance is very, very limited and the buyer base has expanded tremendously. Used to be a couple of anchor buyers in Japan and a couple of domestic banks sponsoring the majority of deals. Now you have deals that are syndicated, you have money managers, you have insurance, you have ETFs, so you just have much more players, especially in retail sponsoring the sector. And on the fundamental side, we see no issues at the AAA part of the stack. It’s as positive as ever. So we think that all signs point to continue tightening

Shiloh:

Well. I think the higher base rate has certainly attracted a lot of people to our market, the science CLO equity. The other really important security to me is the CLO double B. So by our math, there’s been about 25 basis points of annual defaults there over the last 30 years. And s and p publishes a stat on that. I think there’s about 35 different names that have defaulted. So it’s a pretty small number. Given the size of the overall market. Do you think that the favorable risk adjust returns of BBs will continue here or is there any reason to think that the default rate will pick up from the 30 year history?

Paul:

We’re very positive on double Bs. We think it’s a very stable structure. We don’t think that default rates will materially pick up. Obviously there’s a manager bias where if you take a look at some of the deals that have taken write downs or have not paid principal in the past or have been downgraded to default in the past, they tend to be some of the smaller managers, maybe managers that have taken on more of the risk, but not necessarily in the large top tier managers that have had more of a defensive posture and an active trading posture in general. So overall on a model basis, it’s extremely hard to break double Bs. You need to annualize the fall rate of at least five, maybe seven or 8% per year for life depending on your other assumptions. And it’s like a GFC scenario extrapolated multiple times, but we know that averages don’t tell the full story. And for the deals that have taken losses in the past, they were unlucky with concentrated bets in the wrong sectors multiple years through multiple cycles. And we just don’t see that happening with many of the large managers with diversified portfolios and experience and dedication managing these structures. So in general, we’re very positive on double B credit and just the structure itself, especially with rising credit enhancements over time. So we see no reason for that to get worse compared to those historical stats.

Shiloh:

Yeah, well the stats that I quoted, by the way, those are for the last 30 years, but that doesn’t account for is that post financial crisis, there’s actually more equity in CLOs than there was prior. So the newer double Bs are actually the more conservative ones. And at Flat Rock we like to invest in middle market double Bs where you get 12% equity in the CLO instead of the 8% or so in broadly syndicated CLOs. So if we’re talking about a default rate requirement to break a deal to miss a dollar of interest or principal, we’d see that as a 15% annualized default rate. So as a result, we’re very bullish on middle market BBs.

Paul:

Absolutely.

Shiloh:

So one other question I wanted to ask you is just around what are investors reaching out to you on these days? What are the key topics? I assume refis and resets are the biggest, but is there any other topics that are worth mentioning?

Paul:

I think that’s a lot of it just refis and resets how to model optionality both for equity and for double Bs in light of high reset volumes. What are the characteristics driving refis and resets expectations for investor demand, whether it’s bank regulation, whether it’s overseas, whether it’s ETFs or insurance, some thoughts on that. Other than that, a lot of it’s macro and thinking about interest coverage ratios and when and how much will the Fed cut. You obviously have a large share of issuers with rate hedges on that are probably going to expire in early to mid 2025, or in other words you could say that the median issuer probably has a three-ish percent base rate right now net of hedges in terms of SOR for the loans. So depending on where SOFR and FED funds will be in mid-2025, if they don’t cut, that’s five and three eighths and that’s an issue. We think that the terminal fed funds rate can get down to something like three and an eighth. Within about two years. The Fed could cut quarterly potentially next year once they start cutting and they have confidence to cut. But where that fed funds and SOFR rate is in early to mid 2025 will have a large impact on credit and potential downgrades as these hedges are rolling off. So doing analysis on that and trying to monitor that situation in light of macro is another question we get pretty often

Shiloh:

For CLO equity. If a deal is coming off period in say six months and the capital stack is in the money, so meaning you could refinance it today, if you could at a lower rate, in your experience, would a secondary buyer, would they be willing to pay up for that optionality or is it more of a optionality where the owner of CLO equity has to execute on our refinancing or reset really to get any value?

Paul:

That’s a really interesting question. I feel like if you asked me that three or four months ago, the answer would be very different than now. But right now it feels like most of that optionality is pretty fully priced in for anything soon to roll off from no-call or past, no-call, but a few months ago the market was starting to lean into those assumptions but wasn’t really paying for it. So yeah, so a lot of the valuation in secondary equity is based on executing that refi reset and realizing those spread savings. Otherwise, the returns are definitely going to suffer

Shiloh:

For us looking for good candidates where there’s a refi or a reset coming, that’s certainly something we would focus on. But on the other hand, if it’s potentially six months off, I think you’re willing to pay something for the optionality, but you’re certainly not going to buy CLO equity under the assumption that when a on-call date rolls off, that magically the manager is going to be able to get a deal done on that date. Potentially there’s a deal ahead of you or spreads may move wider in the interim. You don’t know, so you really can’t bet on it. I agree people are starting to value the optionality more certainly in the current marks and where things trade, but for a long time I would just say there was really no value given to the optionality in these deals. So you were highly incentivized to look around in the market and find deals where you think something favorable could happen in a shorter period of time.

Paul:

I think that’s right.

Shiloh:

Well, Paul, is there anything else happening in CLOs that we haven’t covered today?

Paul:

Not really. I think we covered a lot of what we’ve done in our research and what’s interesting to investors minds in terms of our

Shiloh:

Great. Well, Paul, thanks so much for coming on the podcast.

Paul:

Great. Thanks for having me, Shiloh. I enjoyed it.

Disclosures:

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

Definition Section

AUM refers to assets under management

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

A government-sponsored enterprise (GSE) is a type of financial services corporation created by the United States Congress.

The global financial crisis (GFC) was a period of extreme stress in global financial markets and banking systems between mid 2007 and early 20093.

Credit Ratings are opinions about credit risk. For long-term issues or instruments, the ratings lie on a spectrum ranging from the highest credit quality on one end to default or “junk” on the other. A triple-A (AAA) is the highest credit quality. A C or D (depending on the agency issuing the rating) is the lowest or junk quality.

Par build refers to building the par balance of the CLO loans where each that hasn’t defaulted is counted at its par value.

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

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

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

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

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

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

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

Spread tiering refers to different CLO managers being able to finance their CLO at different rates.

RMBS are residential mortgage-backed securities.

Morningstar Loan Index serves as the market standard for the US leveraged loan asset class and tracks the performance of more than 1,400 USD denominated loans.

A LIBOR spread is the difference between the highest and lowest rate of the London Interbank Offered Rate

General Disclaimer Section

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

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

It is not a recommendation offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment related course of action as neither Flat Rock Global nor its affiliates are undertaking. To provide impartial investment advice, act as an impartial advisor or give advice in a fiduciary capacity. This broadcast is copyright 2024 of Flat Rock Global LLC. All rights reserved. This recording may not be reproduced in whole or in part or in any form without the permission of Flat Rock Global. Additional information about this podcast along with an edited transcript may be obtained by visiting flatrockglobal.com.

The CLO Investor Podcast, Episode 3

Shiloh:

Hi, I am Shiloh Bates and welcome to the CLO Investor podcast. CLO stands for collateralized loan obligations, which are securities backed by pools of leverage loans. In this podcast, we discuss current news in the CLO industry, and I interview key market players. Today I’ll be joined by David Williams, one of our industry’s prominent CLO bankers. A CLO banker, sometimes referred to as a CLO arranger, is the person responsible for bringing a CLO to life. That includes arranging all of the financing for the CLO and mediating the negotiations between the CLO’s many constituents. A CLO banker earns a fee when the CLO is created and that usually ends their involvement in the CLO. Some of the topics for today’s podcast include strong CLO issuance, refis and resets, CLO profitability and opportunities and challenges in the CLO market. Now let’s get started. David, welcome to the podcast.

David:

Really appreciate the opportunity to speak to you.

Shiloh:

I know we’ve known each other for over a decade now, but why don’t you take a few minutes and just give our listeners an overview of your background.

David:

I’ve been in the structured credit space for just under 20 years. I recently joined Scotia Bank, actually almost coming up on my one year anniversary, in May of last year. Before that I was at Natixis, and at Natixis, I was running the credit group and also global syndication for structured credit within Natixis. That included CLOs, both middle market and broadly syndicated and financing business.

Shiloh:

Okay, and what does a head of syndicate do in the CLO business?

David:

Well, before I was the head of syndicate, I was actually doing more of the day to day where I was basically the intermediary between sales and banking and I helped liaise between the manager and the banking team to help get CLOs basically up and down and priced and source interest up and down the capital structure for the deals to be able to get best execution for our managers so we can get repeat transactions.

AI:

Note in CLO jargon, CLO notes, CLO liabilities, and the CLO stack all refer to the same thing. These are the multiple securities that are issued by the CLO to finance itself.

Shiloh:

So is that a little bit like herding cats?

David:

There’s a lot of herding cats and you have to make both sides happy at all times. So investors and managers, it’s a delicate balance and not always the easiest, but I find that if you can be successful and you can find that medium there, hopefully that leads to a successful repeat business and you want to come out where everybody is happy, not too happy because that means you did something poorly on one side or the other. So you want everyone to be moderately happy I think.

Shiloh:

So now you’re at Scotia and there’s a lot of CLO bankers out there. So how do you guys differentiate your platform?

David:

I think that we were able to be quite successful at my former shop. That being said, Scotia is really giving us a lot of tools here to build out the franchise the way that we collectively see how to build a successful business. At the end of the day, I think you need a bank that has the appropriate risk tolerance and by risk tolerance we are par lenders to par lenders. So I don’t think we’re doing anything abnormal, but you certainly need to have a balance sheet. You need to have the capital from a personnel perspective, from a distribution perspective, and you also need a bank that is going to be supportive in good and bad times and very relationship oriented. And since I’ve gotten here a year ago, Scotia has not only been supportive from a balance sheet perspective and helping us giving the tools and risk and really developing the credit franchise, but also from a personnel and to make sure that we mitigate all execution risks and that we are bringing the right deals to market and giving our new risk group not new risk group to Scotia, but the risk group with regards to structured credit comfort there.

We do things a little bit differently at Scotia and some other banks are certainly I think following suit or taking this business model. But back to your core question, I think that there are a lot of CLO arrangers out there. I think that we’re going to differentiate ourselves with being involved both in the private debt middle market side of the landscape and also on the broadly syndicated side and basically come with creative solutions from a financing perspective to our clients. And I think that’s hugely important.

Shiloh:

So what I’ve seen, especially on the middle market side, is that the banks that have the most success are really also the banks that like to lend against the loans. So before the CLO is formed, often a CLO warehouse is put in place to acquire loans. If a bank actually wants to provide the leverage in a warehouse, that’s very useful for the CLO formation. And if the bank doesn’t like that risk for whatever reason, then it’s hard to be at the top of the middle market league tables.

David:

I think that’s a great point. Fortunately I think Scotia has a great DNA with regards to lending and lending to the right partners, and I think picking those partners are hugely important. You really need to eat your own cooking in the sense that you are living with these loans prior to a full CLO coming to fruition and you need a bank that is going to be supportive with lower diversity with regards to funding those assets prior to having enough diversity to go into a CLO. So there needs to be a real comfort with the underlying assets but also the platforms across the board and you have to make sure that you are banking the right partners and you’re aligned in all of your interests.

Shiloh:

So the CLO industry is really off to a really strong start this year. So in terms of new issues, we’ve seen about 60 billion already as we’re talking here, at the end of April, and 50 billion of refi and reset, reset being just an extension of the life of the CLO, what do you think the key drivers of all the CLO business is today?

David:

I think that the CLOs have been around for I guess upwards of 20 years now and really taken a life of its own I would say since the mid-teens. And as CLO creation happens, there are different markets and liabilities are issued at different times, assets are aggregated at different times. We’re seeing a massive wave of refinancings right now and a lot of that is from legacy transactions that either have come out of reinvestment period and that are amortizing that are paying down. And sometimes that is because they have very attractive costs of debt and liabilities right now, but at some point in time the manager and the equity wants to extend that and doesn’t want to lose the assets. And then on the other side you have deals that were done at called the last 12, 18, 24 months where the liabilities in the CLO debt was at much wider levels and you’re seeing an opportunity to really decrease your cost of funds and decreasing your cost of funds will ultimately lead to, and these are actively managed portfolios as long as you avoid significant defaults of the portfolio, that should all be accretive to your equity investors.

So we’re seeing a huge wave of refinancings from both legacy deals that were coming out of reinvesting period, and then also more recent deals with higher liability costs on top of the new issue wave.

Shiloh:

So we’ve seen the cost of the AAA come down substantially over the last year. What do you think’s driving that? Is it just the banks were on strike for the last two years and now with economic conditions improving, their appetite for the top of the CLO stack has come back or you’re talking to these banks, so why don’t you give us some insight there?

David:

I think it’s a mix. I think most recently we’ve certainly seen a handful of the US banks who are the largest and Japan is the close second, and if you actually mix the two, the Japanese and the US banks are the largest buyers of AAA CLOs. But we’re also seeing new investors come into this space from different regions. And it’s not just geographic locations, it’s different types of investors. It’s asset managers and insurance companies and pension funds that historically may not have been comfortable with the three letter acronym because it’s been also associated with the CDO world. I think that that’s worn off after 14 years now finally, and we’re also seeing a lot of ABS investors I think just realize on a relative value basis, CLOs has historically priced substantially wide to that of the ABS market and these are certainly floating rate products.

Floating area products in high rate environments should be attractive to more investors and you’re not locked into the same rate risk securitization can be used in many different ways, but at the end of the day, CLOs are pools of corporate credit both on the private credit middle market side to the broadly syndicated world, so small, medium, large, mega types of corporates on the underlying. And these CLOs have proved to be resilient over the years and it’s now a 20 plus year market where you can actually look at data all the way from equity to AAAs. And I think that the performance as an asset class has been quite strong and investors globally, whether it’s banks, hedge funds, asset managers, pension funds are recognizing this. And while some have been in this product since day one, there’s a handful of investors that were a little bit slow to get comfortable with the CLO world.

 That certainly changed. It doesn’t hurt that it is a floating rate product. Floating rate products and higher interest rate environments are certainly attractive. That being said, higher interest rate environments historically have also led to higher default environments. This doesn’t seem to be the case as of now. We’ll see how that plays out. But at the end of the day, these structures have just proved quite resilient and given the floating rate nature, it is an extremely attractive return versus some of the other asset classes that we’ve seen on a relative value basis. A lot of crossover from traditional flow EBS investors that are now looking at the CLO world because of that performance history.

Shiloh:

And as you talk to the investors in the top part of the stacks, banks and insurance companies, obviously the CLOs cost of debt has been declining, but is that a trend that you would expect to continue throughout the year or is there some type of spread over SOFR where beyond that it’s hard to push?

David:

It’s hard to say that there’s a concrete level. We are probably, or I shouldn’t say probably, but we’re roughly 25 bps. If you look at the LIBOR, so far adjusted spreads about 25 bps wide of the absolute tights of where we got. So there likely is room to run versus historical spreads, but they always look at this asset class as a relative value where they’re seeing elsewhere and I think that they’re every handle.
So right now, let’s say AAAs for top tiers at one 50, when I say handle, they say that’s a five to get to the four. There is some psychological barriers to investors. So if you’re able to break that, usually more deals follow and it’s the next shoe to drop so to say. And I think it’s always hard to push to get to those absolute tights and I don’t know if we should be in those absolute tights because there are macroeconomic considerations that we all need to take into account now, and there always were, but more so now we are in a higher rate environment and historically higher rate environments have led to more stress portfolio. So there are concerns, but the performance has been pretty decent and at the end of the day, CLOs have continued to be wide of other fixed income products. So we will and we continue to see demand at these tighter levels.

Shiloh:

Well, from the perspective of a CLO equity investor, I’m definitely going to cheer you on in looking for lower handles on the triple-A cost in terms of stories of higher for longer on rates, it seems like every month or so we have to reset our expectations and fed cuts continue to get pushed out. How does that affect either the AAA rate or your business in general? Just the trend for higher for longer here…

David:

It really goes to how we pick our credit managers and who we’re working with. At the end of the day, these are actively managed goals. If we had a crystal ball, we said that everything was going to be where it was today and not have any significant stress on the portfolios at these rate environments, I think everybody would’ve called us crazy. We understand that there are problems within every portfolio At the same time it goes to a question on how rapid these increases will potentially get or are we going to see substantial decreases From a lending perspective, it seems to be for us a pretty attractive entry point, but there’s always portfolio considerations I think with higher rate environments that you have to be thoughtful and maybe not go all in at once, so to speak.

Shiloh:

So one of the trends we’ve seen in the market over the last two years is that for newly issued CLOs, a lot of times the equity is being bought by the manager themselves and an internal fund rather than going out to a third party equity investor like us. And the reason is that new issue, the initial profitability expectation of CLOs, we call that the ARB has been really poor over the last two years, but in spite of the poor ARB, I guess managers take the deals anyways and I guess we’ll see how those returns work out for them. Is the arbitrage improving here in April of 24 with the cost of CLOs financing coming in?

David:

ARB is hard. There are situations where the ARB might not necessarily look attractive to all CLO investors, but there’s opportunities that present itself that may still make the equity attractive where you can maybe aggregate a portfolio. It might still be lower spread on the asset side, but lower dollar price, so it can be a pull to par trade.

AI:

A pull to par CLO investment is one in which the initial loans are bought at discounts to par. The CLO equity investor expects to benefit from both the cash flows of the CLO as well as price appreciation on the underlying loans.

David:

Some equity investors do take a strong view that they are able to potentially reset these transactions at post and on-call period after one or two years. I think liabilities certainly tightening help. The arb, I think that dealers, not to speak our own book, but we are getting compressed on fees substantially. That doesn’t hurt the ARB at all when you have lower costs. Maybe lawyers have had to compress their fees as well. I think the costs for the overall structure have ultimately gotten more efficient. So all these factors with the cost of CLO creation with tighter liabilities to enhance the overall. Over the past few months, we’ve definitely seen more loan creation, but the competitiveness on the asset side seems to be quite fierce and spreads have compressed to a good amount. So we’ll see what that ultimately does for the yard. But I think you need to be ready from an arranger and from an equity perspective to act when there’s any hiccup in the market and be decisive because even a 25 or a 50 basis point sell off in loans creates opportunity with a levered vehicle. And if you’re able to lock in, attract AAAs or have a structure that is ready to go in short order, those tend to create the best arbitrage opportunities on the CLO side.

Shiloh:

What we’ve found interesting over the last two years really was I think the initial before middle market deals in the primary was attractive. So we were active there and then we also saw pretty interesting opportunities in secondary CLO LO equity, which had sold off quite a bit for broadly syndicated CLOs in the primary. I thought that was a little bit of a tougher trade. The initial returns there would’ve probably projected to be maybe double digits. To your point, you could invest in A CLO like that and if you’re able to do the CLO refinancing or extension in a year or two, then all of a sudden the profitability expectation would increase substantially, but it’s just hard to put all your eggs in that basket. So we weren’t particularly active in those.

David:

I think that what’s really interesting you touched on in the beginning is on the middle market side, I think these portfolios, since they’re originated assets, they take a long time to aggregate the assets. So it could take anywhere from nine months to two years. So right now if you have a portfolio that has call protection and you were able to source that over the trailing called 12 to 18 months and you can go securitize those assets into a CLO at the current middle market spreads, the ARB should work out quite well. Whereas on the broadly syndicated side, you’re aggregating these assets at a much faster pace, mostly in secondary. We have seen the new issue pipeline pick up historically you’ve been able to build portfolios over a longer period of time. I think we’ve also seen a little bit of migration away from the banks with the size of the overall private debt managers out there eating the dinner of some of the banks to an extent and playing in what were previously broadly syndicated CLOs. 

So I think that all takes into account how do you make that our work on the forward pipeline because even with market, a lot of these portfolios, once they get securitized and they’ve been originated for the past 12 to 18 months, there’s a lot of competition on that side too. And maybe those spreads have compressed 50 or a hundred plus basis points. So we’re going to need to see further tightening I think on the liability side on both broadly syndicated in the middle market to make sure that that ARB is still attractive. But I do think that historically the mid-teens on the broadly syndicated and the high teens is where you needed to be to source that third party equity bit.

Shiloh:

Are you seeing new demand for middle market equity or double Bs?

David:

Yeah, so middle market equity I think you know very well and you’ve been extremely successful with your fundraise and with the way that your platform has evolved over time, and I think you’ve seen value for a long period of time in that space. Being able to write a substantial minority ticket alongside the manager is going to allow you to source those opportunities in greater bulk. A lot of these managers, they are financing traits, so they don’t always sell the equity. There’s nothing more important in middle market than alignment of interest. So there are opportunities where you can get majority equity in the middle market, but you know better than everyone that you want that manager having a say in the underlying loans, controlling those loans across all their portfolios, making sure that there’s that a true alignment if anything goes wrong, they are originating these assets, making sure that they have the risk retention structures in place for European investors for US compliance, et cetera. So the barriers to entry and being able to source middle market equity and even double BS can be challenging and you have to be patient, but if you are patient and you have the right partners, it’s proven that you tell us how that straight has worked out.

Shiloh:

So it’s definitely worked out great. But I think I would add to the barriers of investing in middle market equity or double BS for newer guys is that the securities are really only available to onshore investors. So if you’re not dominant out here, it’s going to be pretty tricky to get involved in some of these transactions.

David:

It’s a hundred percent right. There is less than a handful of managers that have seasoning vehicles and it’s very cumbersome to set that up.

AI:

Note a seasoning facility buys middle market loans from the CLO manager and holds them for a brief period of time before they are purchased by the ccie. LOA seasoning facility enables offshore investors to participate in middle market CLO equity and double B rated notes.

David:

If you have onshore money like yourself, it gives you a massive competitive advantage to source these opportunities. And there’s not very many with the deeper pockets like yourself. And you don’t want 20 equity investors in a middle market CLO or frankly, probably even in the broadly syndicated CLO. You want to know who your partners are and the ability to have onshore money really sets you apart I think from the rest of the investor base and you’ll get first looks on transactions. That goes a long way.

Shiloh:

Yeah, I think we’re fortunate in that setup. So you’re a banker, you’re putting the deals together. Once the CLO closes, you guys get paid a fee and then from there on it’s really the CLO manager managing the structure and investors like us getting our cut of the economics, whatever we’ve signed up for. But I know you also sit at a ton of meetings where the CLO manager is talking to investors like us and describing what they think the credit quality of the loans is going in. I was wondering if you could just give us some insights there. Well,

David:

It’s a new business for Scotia and I think Scotia has hopefully we’ve gotten comfortable with the asset class, but also I think the managers need to do, and these are actively managed vehicles, they have to take a proactive view and sure, they don’t seem too fuss. You have to always be wary at that time, but they are evolving in the way that they think about it. I think from time to time, industries go in and out of favor and you need to be thoughtful in higher rate environments. Okay, what are those industries that potentially are going to be more stressed or what industries are going to outperform or perform well in higher rate environments? So I think we’ve seen managers pivot not necessarily on their strategy, but evolve in the way that they think about certain industries. I think for a long time, technology and software was definitely an area that people tried to shy away from and things can change.

Over the past handful of years we’ve seen that part of the market outperform others and not all technology and software companies are created equal, but a lot of them are quite substantial in size and you can even see it in the equities market if significantly outperformed. Some of the blue chips that we’ve been accustomed to thinking are the best and biggest companies out there. And same goes for CLO managers. I think that they’ve evolved and the way that they’ve thought about industries and as actively managed portfolio managers, they’ve had to give some thought on what these rate environments and different environments in general are going to have an impact with regards to their portfolios.

Shiloh:

I think the biggest evolution I’ve noticed from the managers is just that for oil and gas, which was 5% of these portfolios back in 20 15, 20 16, we’re just really not seeing a lot of these energy names in portfolios anymore. And the reason is that it’s just this one risk that’s unquantifiable as a result. I think secured lenders just do not have a lot of appetite for these companies. So you do see some double digit industry exposure in technology, for example, in healthcare, but when you delve into it, it’s literally dozens of different business models. So there’s not one risk that it’s all correlated to like there was in oil and gas years ago or so. I think one other thing I’d point out is that whenever we’re talking about the risk in the loans, what we’re doing really is unique from other loan investing in that every CLO investor I imagine that you talk to for equity for example, is running a 2% default rate through the portfolio.

We know we acknowledge upfront that not all of the 200 loans in the CLO are going to work out as expected, and so we’re budgeting to take losses and we’re still targeting what we think are mid-teen or higher returns net of those loan losses where in other vehicles people are investing, they may look at a yield from a loan fund or a bond fund and they mistake, in my opinion, in that yield for future return. And it’s roughly correct as long as no loans or bonds default, but unfortunately that isn’t the world of high yield credit.

David:

It’s a great point. I think you need to really take into account, you have to change your assumptions, you have to take into consideration what these higher rate environments are going to do for your default assumptions. Also, when the credit markets are quite hot, you have to look at prepayment rates as well, and that’s going to go into the overall economics to your investment. At the end of the day, if you have a portfolio that was originated in a very attractive timeframe and those portfolio companies and those assets are performing quite well, there’s a high likelihood posted on-call period that you’ll get refinanced as soon as they can out of those assets and you need to take into consideration all of these dynamics when you’re looking at any of these investments.

Shiloh:

So after being in the CLO space for 20 years, what’s the one thing you find most interesting about our industry?

David:

I think that it’s still somewhat of a clubby market. It’s evolving. I think I love that we’ve seen an evolution of, call it middle market private credit CLOs, the receptiveness of investors now willing to dive into that part of the market where they never were the stepchild of the market for a long period of time and just the way that the CLO market evolves. You can use CLO technology in a lot of different ways and you’re not going to your job every day and it’s the same thing in and out. You got to be on your toes and you got to really be thoughtful with regards to who you’re working with, who your partners are, and it’s a long game. It’s a long nine innings, and the market ebbs and flows in times of stress, sometimes creates the best opportunities and sometimes when the markets are seemingly great, it tends to be exceptionally slow. You never know what you’re necessarily going to get. But I think working with good people, having new investors, new managers, and even the evolution of the retail market with ETFs, I have my aunts and uncles asking me about various CLO ETFs and interval funds, and I think it’s exciting when the Flat Rocks of the world are able to issue and given different products to investors that historically have not been able to enter this part of the market. And it’s certainly creating for more interesting conversation and makes your job interesting.

Shiloh:

I think it definitely is maybe surprisingly a relationship business. When I started going to CLO conferences a little bit over 10 years ago, the middle market CLO panel was really, if there were 10 or 15 people in the audience, you’d be lucky, and a few of those would’ve been people that were just working on something from the last presentation and didn’t get the cue that it was time to get up and go. And then now the middle market panel is probably as busy as the CLO equity panel. I do think relationships are huge in the space, and one of the things that I like about it is that sometimes we’re buying bonds in the secondary, so the CLO LO already exists and you’re just trying to get a price and it’s a zero sum game, so we’re sometimes buying CLOs that way, but in the primary market is totally different. It feels more like this team process where everybody’s working. You other equity investors, everybody’s pushing for the best steel and it’s somewhat of a team effort to get it over the finish line. And so doing that with people that you, I can respect, I find that very rewarding.

David:

I can’t agree with you more. I can’t remember ever working with a single equity investor one time or a single manager one time. I think you’re all working to a common goal, whether it’s working with the investor side, the manager side, collectively, I think that we are all in this together. We see a long-term future in this product, and relationships are immensely important to getting everything done in the collective success of having a fluid market for the long-term. It’s important for managers to have a liquid illiquid to have both buckets, especially in times of stress, to be able to play in liquid markets that are less liquid. To have a view there to be able to go anywhere with assets just in general is helpful. Yes, there’s certain managers that have not done as well as others in terms of differentiating the platform, and I think that’s hugely important. But if you’re not well capitalized, I think going forward and just the CLO landscape both on BSL and middle market, you’re in for a tough ride. There’s no reason for 150 managers anymore.

Shiloh:

CLO management is a scale business and either you have the capital to do deals in favorable markets and not favorable markets, or you’re just not going to be relevant. And if you’re out of the market for a while and you come back, then your CLOs cost of debt’s going to be elevated and somebody’s got to bear that additional cost from the equity seat. That’s a manager problem. But I think you need to be able to do three or more deals a year with outside capital or not to be relevant in the space

David:

Three deals a year, but tying them appropriately. You don’t want to do a deal just to do a deal, but you couldn’t say better. If you’re not in the marketing a consistent basis, you’re not going to get the right liability pricing if you don’t get the right liability pricing, the equity doesn’t work. So whether it’s three new issues or if it’s two new issues in a reset, I think just having enough transactions to be relevant to your end investor base, that’s going to certainly just improve the cost of financing and the CLO execution going forward.

Shiloh:

Well, thanks again, David. This is really above and beyond the call of duty.

David:

Thank you for having me Shiloh. Really appreciate it.

AI:

The content here is for informational purposes only and should not be taken as legal business tax or investment advice or be used to evaluate any investment or security. This podcast is not directed at any investors or potential investors in any Flat Rock Global Fund definition section. The secured overnight financing rate software is a broad measure of the cost of borrowing cash overnight. Collateralized by treasury securities, leveraged loans are corporate loans to companies that are not rated investment grade broadly. Syndicated loans are underwritten by banks, rated by nationally recognized statistical ratings organizations, and often traded by market participants. Middle market loans are usually underwritten by several lenders with the intention of holding the investment through its maturity. A collateralized debt obligation. CDO is a structured finance product that is backed by a pool of assets other than leveraged loans. Securitization divides cash flows amongst different investors in a pool of assets.

Global financial crisis or GFC refers to the banking downturn in 2008 and 2009. Asset backed securities are securitizations, usually backed by non-first lie and loan collateral. Par lender is a lender focused on buying loans that are not in stress. Risk retention is when the CLO manager acquires securities in its CLO to meet regulatory requirements. Junior capital is financing that has a lower priority claim in debt repayment to a secured term loan spread is the percentage difference in current yields of various classes of fixed income securities versus treasury bonds, or another benchmark bond measure yield is income returned on investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investments cost, current market value or face value. The Flat Rock Global CLO equity index and its legal disclaimers are available on the Flat Rock Global website.

Amortization is the process by which the CLO repays its financing after the reinvestment period ends ETFR, exchange traded funds. General disclaimer section references to interest rate moves are based on Bloomberg data. The credit quality of fixed income securities and a portfolio is assigned by a nationally recognized statistical rating. Organizations such as Standard and Pores, Moody’s or Fitch as an indication of an issuer’s credit worthiness ratings range from triple A highest to D lowest bonds rated Triple B or above are considered investment grade credit ratings. Double B and below are lower rated securities, also known as junk bonds. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of or potential or actual portfolio changes related to securities of those companies unless otherwise noted. All discussions are based on US markets and US monetary and fiscal policies.

Market forecasts and projections are based on current market conditions and are subject to change without notice, projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and Flat Rock Global Disclaims, any responsibility to update such views. This material is not intended to be relied upon as a forecast, research, or investment advice. It is not a recommendation offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global Speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered.

None of the information provided should be regarded as a suggestion to engage in or refrain from any investment related course of action as neither Flat Rock Global nor its affiliates are undertaking. To provide impartial investment advice, act as an impartial advisor or give advice in a fiduciary capacity. This broadcast is copyright 2024 of Flat Rock Global LLC. All rights reserved. This recording may not be reproduced in whole or in part or in any form without the permission of Flat Rock Global. Additional information about this podcast along with an edited transcript may be obtained by visiting flat global.com.

The CLO Investor Podcast, Episode 2

Shiloh:

Hi, I’m Shiloh Bates, and welcome to the CLO Investor podcast. CLO stands for Collateralized Loan Obligations, which are securities backed by pools of leveraged loans. In this podcast, we discuss current news in the CLO industry and I interview key market players. Today I’ll be joined by my colleague at Flat Rock, Derek Russo. Some of the topics for today’s podcast include what we enjoy the most about our niche CLO market, CLO issuance, re-fis/resets, loan recoveries and CLO equity returns. Now let’s get started. Derek, welcome to the podcast.

Derek:

Thanks for having me.

Shiloh:

Why don’t you take a few minutes and go through your background for our listeners?

Derek:

Sure. Had a pretty interesting start to my career. I came into the finance industry the summer of 2008, joined UBS there and floated around at the firm for the first 18 months or so, while the great financial crisis was playing out, ultimately ended up finding my way onto the high yield bond desk covering the gaming, lodging and leisure sector. I did that for a couple of years and then moved to a Business Development Corporation of America, where I was working with you, Shiloh, and our founder here at Flat Rock Bob Grunewald, doing leveraged loan underwriting. So for direct originated private credit transactions, I also spent some time at that shop doing aviation finance. So we built a bit of an internal portfolio of aircraft equity and ABS securities. From the BDC, moved into the operating role in the aviation finance side directly, and worked with that aviation team for a number of years before thinking back up with you and Bob here at Flat Rock. And now I’m doing CLOs.

Shiloh:

And so is it about two years that you’ve been solely focused on CLOs?

Derek:

So I think it was right around the beginning of 2022 that we joined back up. Yeah. And it’s been great.

Shiloh:

It’s great to have you. What do you find most interesting about the CLO space?

Derek:

I kind of gained my first exposure to structured finance products through the aircraft ABS sector, and it really turned out, you know, in the aircraft ABS, the underlying assets. So first off, they’re diversified but still exposed obviously to the commercial aviation sector. And as we saw with Covid, right, having exposure to one specific sector can really be a problem when that sector experiences a black swan event like a global pandemic. And I think one of the most interesting things looking at CLOs for me was just the broad diversity of the underlying collateral in the asset base and what that means in terms of resilience for the product. So we’ve seen CLOs perform very well through numerous economic cycles, and I think a lot of that has to do with the fact that you’re getting exposure to basically a broad swath of the US economy via the types of underlying loans in the CLOs. Another really interesting thing is just really how inefficient the market is was very surprising to me when I stepped in, and I think it’s still a pretty opaque market where you can generate a lot of alpha by having good connections and knowledge in the sector.

Shiloh:

I agree with that. I mean, each CLO equity tranche might be 50 million in size. And it’d be very surprising to a lot of people to know that even in the primary market where CLOs are created, a lot of times people are actually buying that security at different prices. And then in the secondary market, things do kind of trade all over the place. So I think if you’re a sophisticated investor in this space, you should be able to outperform peers

Derek:

What do you find most interesting about the CLO space?

Shiloh:

Well, I think the CLO self-healing mechanism is one of the most interesting things about the asset class and, as you know, how that works is that the loans in a CLO are constantly prepaying at par. And during the CLO reinvestment period those par proceeds are used to buy more loans.  And if you find yourself in economic conditions where defaults on the loans are picking up for you, that’s, you know, negative as a CLO investor. In recessionary times, leveraged loans should trade down in price. And that gives the CLO manager the opportunity to buy discounted loans.

And so from the perspective of a CLO equity investor, it’s not just loan losses that you care about. It’s really net loan losses. And the CLO should be able to book some gains on loans bought at discounted levels. 

If you look at any CLO fund’s marketing deck, I’m sure they’ll have the famous 2007 vintage CLO in it. And 2007 was a long time ago, but that’s a vintage where if you would have bought CLO equity right before the GFC, what you would have experienced is a default rate on loans significantly higher than you would have ever expected when you bought the CLO equity, and, like other asset classes, it would have traded down dramatically in price during the GFC.

But again, as the loans in the CLO prepaid, new loans were bought often at substantial discounts during the GFC, and that resulted in IRR in the high 20s for CLOs that started their lives right before the financial crisis.

For me, that highlights the resilience of the asset class and a favorable outcome for that vintage of CLOs. 

Derek, isssuance is off to a tear this year, both for new issue and for refinancings or resets, which are, as you know, an extension of the life of the CLO. What do you think’s driving that?

Derek:

When I joined flat Rock at the start of 2022, we were coming off of a year of very strong issuance in 2021 for CLOs and very quickly entered into sort of this post Ukraine environment, where liabilities for CLOs blew out dramatically and it became much more challenging to issue CLOs economically. There were, though, a lot of investors that were still in warehouses that had been opened prior to the invasion of Ukraine, as well as a number of managers had raised captive equity funds prior to the invasion, and a combination of those that were sort of stuck in these warehouses and managers that had access to equity capital continued to drive the new issuance market. The issuance was down in 2022 and 2023, but they were still respectable years in terms of new issuance. What we really did see largely evaporate was deals that were seeded by new third party equity. The arbitrage just really stopped making sense when liabilities widened out. And there were a few deals that we call print-and-sprint deals, where equity investors were trying to capture a dislocation in the loan market and, you know, sort of play for price appreciation and the underlying loans. But by and large, third party equity kind of fell away from the space. And really that continued almost until I guess the start of the start of this year and sort of now we’re seeing liabilities kind of tighten up to the point where it’s starting to make sense again for third party equity investors.

The other part of the market that really shut off during the last couple of years was the refi and reset market. So with liabilities so wide deals that had printed prior to 2022 with attractive cap stacks just really didn’t have the incentive to refinance into a much wider market. So now with again, with liabilities starting to tighten up, we’re seeing a lot more of this refi and reset activity coming back to the market. We’ve also seen some interesting transactions recently with the top of the cap stack. So rather than resetting the entire transaction, maybe the equity will have the triple-A get repriced. And when short dated, it gets very good execution at the top of the stack. So we’re seeing some pretty tight Triple-A prices.

Shiloh:

So let me expand on one of the key drivers for good CLO debt execution.

At the top part of the capital stack, which are securities rated AAA to single A. Those are usually bought by banks and insurance companies around the world.  And in 2022, a lot of the banking regulators said to the banks, instead of buying new CLOs, why don’t you keep the cash on hand for a rainy day and we’ll see how economic conditions play out. And so now, economic conditions have improved and the probability of a recession has receded in a lot of people’s minds. And the result is that banks have really strong demand for Triple-A. And for CLOs, that’s the most important funding cost for the market.

Lower Triple-A rate means higher equity distributions over time. And the market is really moving fast. And so a lot of deals are becoming refi/reset candidates. Even for the 2021 vintage of CLOs, which got great debt execution, even some of those deals are beginning to look like refinancing candidates, given where spreads have gone.

So I think the setup for CLO equity at the beginning of this year is really pretty favorable.

Derek, you’re the keeper of the famous Flat Rock CLO Equity Index. Could you talk a little bit about how that’s put together?

Derek:

One of the things that we’re often asked is to sort of compare the asset class to a benchmark. There was no benchmark before we created the CLO Equity Index that really measured directly how CLO equity has performed over time. And it’s a really hard thing to pin down. Right? Because this is, as I mentioned before, an opaque asset class that really there you don’t get a lot of trading color out of the market. But what fortunately, we are able to see is where some of our competitors and ourselves that file publicly have to release, where they have their CLO equity positions marked on a quarterly basis, and we can use that, plus our knowledge of what payments have come in during the quarter and the size of the equity tranche to triangulate how those positions have moved over time. And what we do is we look through to five different owners of CLO equity that file publicly, and we look at how those transactions have moved. And on a quarterly basis, we roll all of that up into an analysis that results in a proxy for the CLO equity index as a whole. We mark something close to 500 separate line items in the index right now. And unfortunately, we have to work on a quarterly lag because we’re waiting for filings to be published. But that’s roughly how the index is formulated.

Shiloh:

And when does the index start?

Derek:

The Index: We looked back as far as we could get reliable data. It starts in 2014 and has quarterly numbers through, I guess most recently, the end of 2023.

Shiloh:

Have CLO Equity investors made any money?

Derek:

Yeah so it’s an interesting question. I think the index, just by nature of starting in 2014, has a little bit of a handicap in the sense that we missed out on some strong years coming out of the GFC that just unfortunately aren’t in the data set. But if we look back to the starting point, annualized returns since inception of the index are 7%, five year returns are 9%, three year returns are 11.9, and last year the index did 22.1%.

Shiloh:

Okay, so last year’s return was very good. What would you attribute that to?

Derek:

The year before 2022 when we saw rate increases throughout the year, CLO equity actually performed fairly poorly as an index. The index was down 11.6%. That was driven by degradation in the underlying loans. So the Morningstar Loan Index was down significantly during the year, trough somewhere in the 92 area. And in 2023, we saw that basically rally back, particularly in the back half of the year. So that 22% really was the back half of the year story, and that largely driven by the idea that we may be entering into a soft landing and sort of less fear over an imminent default spike. I think that those were some of the big factors.

Shiloh:

I think the other thing happening for the negative returns for 2022 was just that the required rate of return for CLO equity increased. Prior to that year, we were targeting CLO equity returns of mid-teens. And then as spreads widened really across all asset classes that year, the required rate of return for that equity was more like very high teens. As a result, the fair market values of CLOs across the board was written down.

The big picture, though, is that I think CLO equity came into last year priced for a pretty substantial downturn in the economy, and that just wasn’t realized. And with CLOs paying high teen distributions and, you know, not seeing a big uptick in loan losses made for a really good year.

And as we’re in talking today in the end of March, is the trend continuing into Q1?

Derek:

Uh, definitely. So I think there’s less room to the upside given that the loan index has traded up significantly. But what we’re seeing now are this wave of, uh, refis and resets that we talked about before that I think could be very material to equity returns going forward. And I think, you know, !Q numbers at least should look very strong as we’re approaching the end of the quarter here. And I don’t see anything kind of slowing the trend down.

Shiloh:

Well, I also see the trend continuing. I was on a panel recently where someone asked if private credit was a bubble, My answer to that is of course no. And one of the biggest reasons I point to is that the loans that go into CLOs start their lives with a 40% to 50% loan to value. And so, you know, occasionally the loans do default. But at the end of the day, there’s a lot of junior capital supporting these businesses. And so as long as the wheels don’t fall off the cart, the loans really should be money good at the end of the day.

The CLO’s loans need to pass tests that come from the rating agencies, you know, for weighted average rating and maximum CCC loan exposure. And so, the rating agencies certainly haven’t relaxed their rating standards for the loan. So I feel pretty good about the credit quality of what’s going in.

I’d also point out that our asset class is different from others and that it’s not a zero loss expectation that we have. By that I mean, if there’s 200 different loans in a CLO, and I’ve never met a CLO manager that goes 200 for 200. Right? So there’s always going to be some cats and dogs that default. Fortunately, the loans are first lien and senior secured, and usually the recoveries are high. We’re generally budgeting for a 2% loan default rate. I think that is the market standard, actually. And that’s really different from other asset classes. If you invest in a loan fund directly, when a loan defaults, there is no loan loss reserve. If you invest in a BDC and a loan defaults, there’ll be a decline in the share price. But again there’s no loan loss reserve. So I think that’s something unique and attractive about the asset class.

Derek:

Yeah, same. And then I’m going into this rally that we saw there was sort of the expectation on the street of significantly higher than average levels of defaults. I think those expectations are starting to be moderated down. And the other big topic that people are, you know, discussing in the market right now is where recovery rates will ultimately end up being. So historically, the types of loans that are in CLOs have recovered 65 to $0.70 on the dollar. Last year we saw that materially inside. So something more in the 40s to $0.50. Shiloh where do you see that sort of going over the next few years here?

Shiloh:

Yeah. So I think that’s certainly been a headwind for CLO equity. There have been some defaults with very low recoveries in some cases. That was because the loan documentation was written in a way that gave the lender less options in downside scenarios, and not all the business’ collateral was available to back the term loan. 

But one of the things that I think is important to know is that if you see a headline number for defaults or a headline number for recoveries on Bloomberg or in the Wall Street Journal or wherever, it’s important to know that that’s usually for the overall loan index. CLOs own a very conservative slice of that index. Some of the recoveries that came in very low were for companies that it really wouldn’t have never been in CLOs in the first place. Some of them were called chapter 22 where the business already did one chapter 11, and it’s coming back for another one. And so those are the kind of assets that would be targeted by a CLO manager.

So whenever I see a headline with the default rate or recovery rate that looks negative, My next question is “what’s happening just in CLOs?” And then obviously much more important to me is “what’s happening in my CLOs?”.

One of the reasons that we favored middle market CLOs over the past few years is that in the middle market, the loan documentation is more favorable to the lender. And as a result, I would expect loan losses in middle market clos to outperform broadly syndicated CLO portfolios.

And so this year, again, we talked about refis and resets. But I think even in a market where there is an uptick in loan losses, I think some very attractive things can happen with the CLO liabilities.

Derek:

Yeah. And another thing is we assume sort of the average, or if you look back at the average loan loss rates over the life of the leveraged loan, and leveraged loan market, it’s not a straight line. Right? So what we’ve seen happen is when there are periods of higher than normal defaults, that’s often followed by long periods of lower than normal defaults, which is the environment that we were in pre Ukraine. So I think it tends to even itself out over time.

Shiloh:

Right. So the industry standard modeling assumption is a 2% loan default rate per year. And so obviously some years it’s going to be higher than 2%. And, in recent past, it’s been much lower than the 2%. So let me tell you a story that highlights how the loan loss reserve works in practice. During the Covid period, we were calling around to our CLO managers trying to get an update on the loan portfolios and one of the managers that we work with a lot, Blackrock, we had them on the phone. The manager was giving me a very favorable update on the loan portfolio, actually more favorable than I really would have expected during the depths of Covid. So what I wanted to do is take it from a qualitative description of the loans to something more quantitative. So I said to them, we run a 2% loan default rate through all of our modeling and profitability assumptions. How would you expect your portfolio to compare to that this year? (This year being 2020.) There was a really long pause. I didn’t really know what how they were going to respond. But the answer was, “you know, Shiloh, after all these years of us working together, I cannot believe that you’re still running my deals with a 2% loan default rate.” And so that was a very funny experience from the 2020 year. And their CLOs were a highlight in terms of CLO performance.

Derek, let’s spend a minute talking about the arbitrage and CLOs. So that’s the natural profitability, or expected profitability, the CLO equity investor is signing up for over the last two years. I mean we have seen a fair amount of CLO issuance. But the equity investors have not been traditional third parties like us. Could you talk about that?

Derek:

Yeah. So a couple of things driving that I think. So some people found themselves stuck in warehouse facilities where they had ramped a portfolio of assets prior to the CLO liability market widening out. And after a certain period of time, they just had to sort of bite the bullet and print a deal that maybe didn’t look quite as attractive as they expected it to look initially. And another thing that we’ve seen is sort of a proliferation of CLO managers raising captive equity funds where they actually have a fund themselves that they can use to seed the equity in their deals. The managers are in the business of printing deals and managing assets. So what we’ve seen is some transactions that got done where the equity returns may not have been attractive enough to attract third party equity, and historically that might have meant that the deal didn’t get done. Since these managers have these captive funds now, though, they were able to continue printing deals in a market that was less attractive for third party investors. One contrasting point I’ll make though is for middle market CLOs. The arbitrage actually continued to make sense through the cycle, at least for select deals, and we found that just the wider spreads on the assets in those structures were able to overcome the higher liability costs. We saw some transactions that we found attractive even through the last couple of years through this wider liability cycle. The arbitrage actually continued to make sense through the cycle, at least for select deals. We found that it’s just the wider spreads on the assets in those structures were able to overcome the higher liability costs. And we saw some transactions that we found attractive even during the last couple of years through this wider liability cycle. And now in the broadly syndicated space, the market is really starting to come back a bit as well. With debt costs coming down, we’re starting to see broadly syndicated CLO equity come back on sides.

Shiloh:

Could you spend a few minutes talking about you know the process for underwriting, I don’t know, CLO Equity and double-Bs, and if it’s different for the different type of security.

Derek:

For CLO Equity, we’re really focused on just the top-tier managers. We’re really focused on outperformance on defaults as the key driver of CLO returns. When we look at double-Bs, it’s a little bit different.

We have significant equity subordination below us absorbing the first loss. And as a result of that, we may be happy with managers that have historically performed at that average 2% default rate. And to the extent that we’re able to pick up a little bit of excess spread for going to a tier two manager, that may be something we would consider when we’re looking at a double B, we probably wouldn’t do equity in that same transaction, and that’s just one of the sort of differences in how we focus on equity versus double B.

Shiloh:

So for the typical double B, how bad would defaults have to get on the CLOs loans such that you’re not money good at the end of the day?

Derek:

So I’ll throw a little bit of a distinction here between broadly syndicated CLOs. So CLOs backed by large syndicated deals, you know, $1 billion-plus  in size versus middle market CLOs where the loan pool there looks more like a private credit loan pool. The reason for the distinction is in the broadly syndicated CLO markets, you know, 90% of the current outstanding CLO market, the CLO starts its life with 8% equity below the double B, whereas in the middle market CLO, the double B will have 12% equity below it. And those yield two fairly different results. Generally speaking, a typical broadly syndicated CLO will start its life and be able to survive 7% annual defaults, and a middle market CLO will start its life with the double B being able to survive 15% annual defaults. And when I say survive here, what I’m really talking about is receive all of its expected interest in principal. It’s not a zero IRR thing. It’s really at those levels of defaults you’re getting full payments.

Shiloh:

Well how do the default rates that you just mentioned, how do those compare to what we experienced during the GFC and during the Covid period?

Derek:

During the GFC, we saw the highest level of defaults that we’ve seen in the leveraged loan market. It spiked to about 8% and stayed around that level for about a year. Uh, well they quickly kind of fell off of that and then normalized even below that 2% level. During Covid, we saw a spike up to around 5% and again, a very quick drop down. So we’ve never seen an economic environment that looks anything even remotely like even a 7% annual default rate sustained over a long period of time. And that might beg the question, so how these Double B’s performed. And the answer is we’ve seen very, very low default rates in the sector. So if you include the entire universe of Double B’s, both broadly syndicated and middle market, uh, the annual default rate has been about 22 basis points per year. And if you look just at the middle market, so the CLOs that have more equity subordination, we actually haven’t found any of those that have defaulted.

Shiloh:

One last question for you. What are the interesting opportunities in the spring of 2024?

Derek:

We here at Flat Rock have had a middle market bias, or I would say since the founding of the firm, and we continue to find the middle market sector on both the equity and double-B side, maybe even increasingly attractive going forward. So we talked a little bit about recovery rates before. Sort of the House view is that middle market collateral will outperform broadly syndicated collateral in the future as a result of stronger documentation. And the arbitrage for middle market CLO equity has remained strong. We’ve seen continued sort of high teens returns coming out of out of that asset class. Middle market double Bs have tightened significantly since their wides sort of at the beginning of last year. And you’re still picking up a significant premium over broadly syndicated double B notes there. And with base rates, you know, still over 5%, those have offered attractive returns and we think continue to offer attractive returns.

Shiloh:

Great. Well, thanks so much for being on the podcast, Derek. We’ll talk to you soon.

Derek:

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

Definitions 

The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. 

Chapter 11 is the process by which companies are reorganized under bankruptcy law.

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

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

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

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

Securitization divides cash flows amongst different investors in a pool of assets.

Global Financial Crisis or GFC refers to the banking downturn in 2008 and 2009.

Asset backed securities are securitizations usually backed by non first lien loan collateral.

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

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

Yield is income returned on investment such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment’s cost, current market value, or face value.

The Flat Rock Global CLO equity index, and its legal disclaimers are available on the Flat Rock Global website.

General Disclaimer

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

Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of, or potential or actual portfolio changes related to, securities of those companies.

Unless otherwise noted, all discussions are based on U.S. markets and US monetary and fiscal policies.

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