Author: Shiloh Bates

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 Double Bs 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 5

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. On May 15th, I attended
the Creditflux CLO Symposium in London. Creditflux is one of the papers of record for the CLO industry and their annual conference in London is always, for me, a must-attend event. It was great to see lots of familiar faces and the panel guests were really top notch. Some of the themes of the conference were the rise of middle market CLOs and declining CLO financing rates. Usually my podcast is me interviewing other market participants, but in this episode I’m posting a fireside chat I did at the conference with Credit Flux Managing
director Tom Davidson. Credit Flux also has a podcast that I’d highly recommend. It’s called The Last Tranche, and I was a guest there a while back.  Some of the topics we discussed were CLO education, current opportunities in the CLO market and CLO equity risk adjusted returns, which I emphasize are more important to me than total returns. And now my conversation with Tom Davidson.

Tom:

Welcome, Shiloh. Before we get going on the fireside chat,
maybe if you just want to introduce yourself with your main job.

Shiloh:

Hi everybody, I’m Shiloh Bates. I’m the CIO of Flat Rock
Global. We manage about a billion of AUM. We focus on CLO equity and CLO double Bs. And then within those two asset classes we have a preference for middle market CLOs, as you know.

Tom:

Great. Now for those of you who called the first fireside
chat, my colleague Lisa Lee and Jane Lee, Lisa upped the ante on us by announcing that Jane is an award-winning documentary film producer. Luckily enough, Shiloh also
has a side gig, which is as an author. I’ve got a copy of his book here. We also have a few more copies if anyone’s interested. This is CLO Investing with an Emphasis on CLO Equity and Double B notes. So maybe we should talk a bit about the book. Why did you decide to become an author?

Shiloh:

There’s a saying that it’s great to have written a book, but
it’s not great to be writing a book. The genesis though, really is in 2020 I had some free time on my hands and so I wrote a 60 page just kind of like manual, or the way I go about approaching investing in CLO equity. And we put
that on our website. I was really surprised at how many people read it and my competitors mentioned it to me, CLO managers and people that were just kind of interested in the space, they read it. And so that gave me the idea to just go ahead and do the bigger book. It’s about 220 pages, but a lot of what’s written in the book is stuff that I’m constantly as part of my job educating investors. And so some slides from our pitch decks are in the book.

I’m frequently answering their one-off questions for
investors. And so I came up with the outline for how I wanted to tell the story of CLOs. And at the end of the day, there’s really like maybe four concepts that make CLOs different from other asset classes. So I would agree it’s not
as, especially in equity, it’s not as straightforward as investing in a high yield bond or a leveraged loan directly or certainly a stock. If you want to learn about CLO equity and Double Bs, one option is a book obviously, but if you didn’t do that, you can spend a lot of time Googling and finding different articles and you can kind of put together the information you need. But the idea with the book was to put it all as kind of like a one-stop shop for your CLO needs.

Tom:

And it’s an amazing read if you haven’t had a chance to read
it. As I say, we have a few copies, it’s come out, so come and find us. I think one of the interesting things is obviously you wrote this a few years ago now, the market’s changed pretty dramatically in a lot of ways since then. What would you change now? What do you wish you’d written in the book?

Shiloh:

In the segment about double Bs in the book, I make the point that if the MVOC, so if the market value of all the loans in the portfolio plus the cash, that if that does not cover the full balance of the CLOs debt, AAA to
double B, that means you have an MVOC of less than a hundred percent. So it might be 98 or 99, something like that. And a point that I made in the book was that you can very comfortably buy bonds that are not covered and still expect a payout. And the reason really is twofold. So one is that if the loans don’t perform well, the CLO will not pay the equity and that profitability will be trapped in the CLO and ultimately that will benefit the double B. But then the
other part of it was just that the loan index was trading at discount of the levels.

And so at the end of the day, loans are either worth par or
they default and get some recovery, but there’s no in between. That’s kind of the binary thing. And our view was that most loans trading at discounts, it was really a function of heightened risks in the market, political risks, economic
risks, and that at the end of the day, there would definitely not be enough defaults to really impair a lot of the double Bs. That part has actually paid out, I think very few double Bs. Definitely very few have defaulted. I would expect very few to default in the future, but today a double B that’s not
covered by its fair market value given how much loans have traded up, is a much higher risk situation than it would’ve been last year at this time.

Tom:

Great. You are obviously very passionate about this investor
education piece. I know as well as the book, you have a new podcast as well. I have a podcast as well. Welcome to the space. It’s always great to see some competitors joining in. Tell me about the podcast.

Shiloh:

The new podcast is called the CLO Investor, and basically in
the first episode I just talk a little bit, I do a CLO 101 and just talk about the market to establish that foundation for people who need it. And then in the second podcast I interview a colleague, we talk about our strategy in
the market and what we find interesting. The third and fourth podcast, which we will drop soon, one is an interview with David Williams, who’s a CLO banker at Scotia who I know you know. And then Evo Turkejiev is a broadly syndicated CLO manager at New Mountain Capital. From the perspective of writing the book and the podcast, I try to approach it as from the angle of somebody who’s an investor
in the space, and I hope people will find it beneficial as once you figure out how to be a podcaster, when you have good guests on, they do all the work. You just have to think of the questions that they do all the talking, and then you talk for an hour and then hopefully it’s a quality product that people like.

Tom:

Absolutely. Let’s get into the equity investing side. And I
think one of the things which I find interesting is it’s actually quite hard to unpack for people looking at equity investing. How well is CLO equity performing as an asset and how much is added on by the alpha from managers? And
I think this is something you’ve done some work on.

Shiloh:

Well. Yeah, so one of the things that we put together
starting about four years ago was a CLO equity index. And it’s available on our website, it’s public. If you invest in any of the debt securities, double B to AAA, JP Morgan has great indices for that. Palmer Square does as well. And on any
day you can see, oh, how did double Bs do today or single A whatever you’re interested in. But with equity, you really can’t do that because there’s just not enough trades in the market. So what our idea was in putting together the
CLO equity index was to take information from what’s called public filers in the US. And so I’m a public filer myself, meaning that every quarter I tell our investors, these are all the CLO equity pieces I own. This is where I mark them
at 3-31 or 12-31.

I have a number of competitors who do the same. And so if
you know that somebody owned 10 million of a specific CLO security and they had it marked at this price a quarter ago and this price, now you just need to figure out what was the payment received on the equity in the interim, and you
can calculate a return in that way. And so our index construction basically matches a Cliff Water direct lending index. They do the same analogy or the same methodology where you’re looking at other public filers figuring out what
they owned, what the specific return was in quarter. And I feel really good about the results because all those marks are marks that are coming from managers who are registered investment advisors. So there’s a lot of regulation. It’s not just people really thought about the mark, it’s not
just something that just came at thin air.

That’s kind of the regulatory setup there. And so we’re able
to mark about 500 different CLO equity tranches using this methodology. And one of the things that’s not ideal about it is that I have to wait to put the index together. So for 3-31, so for March 31st, I don’t know yet what the CLO equity return was. I need to wait for everybody to file with the SEC, and that takes 60 days for a lot of folks. But if you look at the index, one thing, the returns really for the last few years have looked very good. So last year, CLO equity did 22%, which I think people were pretty excited about. And then if you look at a three-year annualized rate, it’s about 12. And if you go back five years, it’s like nine. So the more recent performance of CLO equity has been the better.

Tom:

I think it’s interesting you can compare and contrast that
with on the credit flux side, we track fund performance a lot of CLO equity funds. And as you say, last year, I mean I guess all of the returns were above 20%. And that makes sense now because almost anything you bought would’ve
delivered that. But equally, some investors are producing returns much higher than that, more than that 30%. I think some of them were hitting 40%. So clearly there is also a lot of alpha you can add as an equity investor as well.

Shiloh:

So the way I think about it and how we approach things at
Fire Rock is it’s not, your awards are a total return award. And how I think about it is we’re going for the best risk adjusted returns. So a lot of times at Flat Rock, we’re looking at CLO equity pieces or double Bs where we think the outcome will be very favorable and the return opportunities are quite high. But there’s also just an amount of risk that goes along with the securities that’s just kind of above and beyond what our investors would want to sign up for. Internall, we would look at some of these deals and say, oh, that’s something I would do in my PA if I could. But it’s not something we’re doing with shareholder money. And so what we try to do in equity is to provide a low double digit net return to investors with a high focus on reducing the downside risk. I’m guessing that for people who hit a 30% return for last year, they probably, the trade to get there would’ve been to buy single Bs at a discount or equity that was potentially a risk of missing payments. And both of those would’ve worked out to your point. But investors in those funds are signing up for a level of potential volatility that mine are not.

Tom:

So turning to your investor hat away from the education hat,
what’d you like at the moments out there? What are you buying?

Shiloh:

We have really, since the inception of Fire Rock CLO, middle
market equity is kind of the core of what we’ve been focused on at the beginning of the year. We saw some pretty interesting opportunities there, and in the last two months we’ve seen some middle market issuance, but there really
hasn’t been a ton of new loan creation in the middle market. And so that’s been a hindrance to CLO issuance. And then we’d also seen recently that sometimes the manager takes all the equity themselves and they even take the double B
sometimes, which is another security that we would want if they would sell it. And so a lot of the recent issues or issuances have been middle market CLO where the securities offered are triple A to single A or triple B. That’s not where I’m playing. The two things that really we’ve liked about middle market equity and continue to like are the natural arbitrage in the deals, it’s more favorable.

There’s more profit in the CLO, you get higher cash
distributions each quarter one. And then through this conference today, a lot of what panelists have been talking about are a liability management exercises and low loan recoveries. Well, these are not really an issue in the middle
market. So in the middle market, it’s private market. There’s no distressed hedge funds buying the loan. And the secondary, if the loan does get into issues, usually it’s just one to three lenders who need to figure out a way to
move forward. And so in the middle market, I would expect recoveries to be around the 70% area. That is what we put into all of our modeling projections. And then broadly syndicated, the consensus is for lower recoveries. Certainly
those are the two benefits for CLO equity. We’ve, I think, benefited from that historically. And the trend should continue as well.

Tom:

And obviously, I guess from your side, its liability spreads
do keep coming in is actually good from an equity investor perspective.

Shiloh:

On the last panel, I learned that the spread between the
broadly syndicated AAA and the middle market AAA, I’ve always thought about it as about 50 bps over 10 to 12 years. That’s kind of what it’s been, but now it is certainly moving tighter. And I am all for tighter middle market aaas. I
also invest in middle market double Bs where I don’t need those to trade any tighter. And then for the equity, anything that trades tighter creates more profitability for the CLO and better equity distributions.

Tom:

Yeah. And then I thought the other interesting part of that
panel was a talk about improvements in liquidity in the secondary, and we were talking about this, the guys there were very positive about some of the work which has been done on transparency in middle market CLOs. I’m not sure we necessarily agree that it was quite there yet.

Shiloh:

When we look at a middle market equity or double B piece, for example, the middle manager sends us a list of the 200 or so loans that are going to go into the CLO, and they’ll give us some metrics around the loan, what’s the leverage, the interest coverage, the loan to value. And usually we
find seven or eight loans where they’re of particular interest or they stand out for one reason or another. And so we get the CLO manager on the phone and we talk through those credits. And usually there’s a very satisfactory answer
for why these kind of few loans stood out, if you will. And then after that, I think middle market reporting is a little bit mixed. So if you pull up the deals in Intex, sometimes you’ll see a mark for all the loans that’s relatively recent. For other CLO managers, you might see only loans that are rated triple
CA mark.

If the loan’s defaulted, there has to be a mark. Also, the
best thing for a CLO manager to produce is a mark for every one of the 200 loans. I realize it may be a quarterly mark, it may be stale, but if the manager reports the information in that way, they’re going to find that their bonds are much more liquid in the secondary market, and that will lead to
better pricing for them in the primary as well. So that’s something that they should care about. I think there’s some challenges for the managers in that if you have a publicly traded BDC, you don’t want to put out loan marks for the
same loan that’s in A BDC in another fund kind of ahead of when the BDC might be reporting. There are some challenges there, I admit, but the more current marks and percentage of loans marked is better for all the investors in the deal.

Tom:

Great. We’re pretty much out of time now, shall I? So in
fact, we are exactly out of time. Thank you so much. Thank you for joining me.

Disclosure AI:

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

AUM refers to assets under management. 

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

The London Interbank offer rate (LIBOR) was a broad measure of the cost of borrowing cash overnight for banks on an unsecured basis, leveraged loans or 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 obligation (CLO) is a structured finance
product that is backed by a pool of assets other than leveraged loans. 

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 yield is income returned on investments 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 amortization is the process by which the CLO repays its financing after the reinvestment period ends. CLO equity missing
payments happens when there are too many triple C rated loans or defaulted loans in the CLO 

The Flat Rock Global CLO equity index can be found on the Flat Rock Global website.

Liability management exercises or LME are an out of court
restructuring of a company’s debt in which the lenders take a haircut on the principal balance of their loans. 

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 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 4

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 Ivo Turkedjiev, a broadly syndicated CLO manager at New Mountain Capital. The CLO manager is the entity that picks the initial loans for the CLO and keeps it fully invested during its reinvestment period. The CLO manager also works to ensure the CLO passes all of its many tests. New Mountain manages approximately 40 billion of AUM, of which 10 billion is in credit products, both middle market and broadly syndicated loans. I asked Ivo to join me today because of the strong performance of the CLOs he manages. Some of the topics for today’s podcast include New Mountain’s approach to credit investing, loan recoveries, and the path to building a successful CLO management platform. Now let’s get started. Ivo, welcome to the podcast.

Ivo:

Thank you so much for having me, Shiloh.

Shiloh:

Great. Well, you and I have known each other for quite some time now. Why don’t you take a little bit of time and tell our listeners a little bit about your background?

Ivo:

Sure. I got involved in the leverage loan space. It was my first job out of college. Started in 2001 at Lehman Brothers in the leveraged finance group, underwriting leveraged loans and hired bonds. Timing was somewhat challenging Two months after I was on the job. Nine 11 happened, we didn’t even have an office, worked out of a hotel for several months until Lehman bought a building from Morgan Stanley and moved to the current bar building in Midtown. So yeah, it was very interesting because in those days, obviously 2000, it was the telecom bust, the tech bust were kind of happening, the NASDAQ was trading down massively and the nine 11 happened and there was this expectations almost that all markets are shut and are we even going to be working? Yeah,

Shiloh:

I remember

Ivo:

Lo and behold, two months after nine 11, I worked on a bond deal out of a hotel room in Midtown and the market opened rates were coming down and what was a pretty small institutional leverage loan market at the time, it was about 150 billion. It was really an emerging market really started growing as lower rates and more activity from private equity sponsors really boosted the market. But the other thing that was really boosting the market, and I didn’t know much at the time, was the emergence of a CLO product, which was really expanding. The technology was proven at that point and when more managers were getting involved and expanding what was a pretty tiny market.

Shiloh:

And so how did you end up at New Mountain?

Ivo:

So as Lehman, I actually moved to the buy side in 2003, worked for a shop called GSC Group, and I was hired because we were doing our first a regular way CLO at that time at GSC group and we’re looking to grow the business and I started as an analyst and then pretty quickly got involved in trading and portfolio management and just in time in 2008 for the financial crisis to happen and have to say at that point I really learned a lot about CLOs, how CLOs work on the spot kind of thrown in the line of fire. 2008, once Liman filed, leveraged loan prices declined in a very substantial way. Every other loan was triple Co almost. That’s how it felt. So the CLOs got really stressed and it’s interesting adults times, very few people, I mean there was some doubt in the market whether CLOs can survive the stress of a Lehman because that’s not what was modeled at the time.

And pre Leman CLOs actually were more levered than they are today. There was more risk in the structure. The equity cushions were thinner and there was more leverage through every tranche all the way down to the bottom of the stack. Yet the deals did very well. I think to the surprise of a lot of people, the self-healing mechanism, the ability to buy cheap collateral. What ended up happening is a lot of the 2060 2007 vintage deals ended up being great deals, which nobody could believe me because at the time I remember everyone thought that these transactions would fail and they didn’t. And I think post Leeman C market really took off. So actually prior to joining New Mountain, I spent almost a decade at Invesco where had various roles, but one thing that I led the CO liability investment book, we managed over a billion of CO liability investments across a couple of different strategies. So that showed me a different aspect of the CO world, not just as a manager, but also as an investor. So that was a very interesting experience. And then in 2019, I joined New Mountain to start the seal of business here at New Mountain.

Shiloh:

And so what attracted you to New Mountain?

Ivo:

New Mountain at the time when I joined the company had been around for almost 20 years. I actually got involved in the credit business right after Lehman as well, seeing an opportunity to buy loans of companies. That New Mountain, which the core private equity firm started as a private equity firm, a lot of accumulated sector knowledge and company knowledge. So when the ability to buy loans of companies that were fully underwritten at 60 cents on the dollar appeared, that was viewed as a very attractive opportunity. That portfolio allocation from a private equity fund at the time later on when to become our publicly traded BDC, new Mountain Finance Corporation, NMFC, that’s how the credit business started. And at the time when I joined New Mountain, had a really good track record of really protecting the downsides, the defensive growth mentality that we employ across all our strategies had really translated to a very low defaults rates and net gains in some of the broadly syndicated portfolios. So I thought that the firm had a really differentiated strategy and ability to analyze credit and there are over a hundred CLM managers out there, but not all of them have differentiated strategies. And I thought that I had an opportunity to create a CLO manager with the firm’s backing that was differentiated and could provide an alternative to investors.

Shiloh:

I think one of the things that appealed to me about your platform besides the track record is just that my understanding is that a lot of the loans, their LBOs were your private equity folks. They’re probably not the buyer of the company, but maybe they participated in the auction, they did due diligence on the company there, and so you have real deep expertise by the time the loan gets to you. The company’s already been circulating as an idea around New Mountain,

Ivo:

Certainly for art of the investments. That is true. But I think what we’ve done here at New Mountain, we’ve been tracking sectors. Again, we invest in defensive growth and the way we define defensive growth is we’re looking for companies and sectors that have really good medium to long-term growth trajectories, good tailwinds in their back and within those sectors, we seek to identify companies that are a cyclical that can grow and do well no matter what the general economic cycle to get there. We spend a lot of time studying industries, developing relationships within industries, getting to know companies, getting to know players, bringing a lot of executive talent from those industries as part of the New Mountain Network, in addition to companies that we’ve evaluated directly at some point in the past, we also have the ability to reach out to this broad network that we have developed and really help our credit team verify the thesis, make sure that we’re not missing stuff. You can talk to people that are operating in the industries we’re investing in day to day, and that can help us really identify potential pitfalls and risks that just sitting at the desk here in Manhattan, our analysts might not be able to identify. I think that’s really the differentiation that we’re bringing. Again, combined with sector thesis, avoiding deeply cyclical sectors where our view is that companies don’t ultimately control their own destiny.

Shiloh:

So a broadly syndicated loan. If Bank of America or JP Morgan is the underwriter, let’s say it’s a billion dollar loan, and they have to decide who they’re going to allocate that to today, a lot of times the loan’s oversubscribed, so there’s more demand for the loan than supply. Could you talk a little bit about how you think you guys are treated in that process by the banks and if you kind of punch above your weight in terms of the allocations that you get?

Ivo:

Great question. In a market like today, pretty much every new issue, loan transaction, this oversubscribed, there’s a lot of demand for loans right now on the market’s been really ripping higher for the last six months and new issue loans tend to be attractive. They come at a slight ID slight discount to par in a market where a large portion of the loans trade above par, that’s pretty attractive. So as a result of that, there’s a lot of demand as you mentioned for new issue allocations. I think the way we differentiate ourselves and punch above our weight as you put it, we do have really good relationships with sponsors. We do have a direct lending private credit business where we cover sponsors, develop relationship with these sponsors. So

Disclosure AI

Note in CLO jargon, a financial sponsor refers to a private equity firm.

Ivo:

That certainly is helpful when looking for favorable allocations. But in addition, as a sponsor ourselves, we’re active in the market financing our portfolio company. So that leads to some pretty good relationships. Our capital markets desk has really good relationships with the banks, with the underwriting banks as well, and we’re often making calls to these desks on our behalf to get a better allocation. But yes, it’s a market in which everyone is looking for their little advantage and we believe we have a couple in our pocket.

Shiloh:

So you’re in the process of building out the CLO platform there. Could you talk a little bit about just some of the challenges to getting a CLO platform up and running and how you guys have tackled those?

Ivo:

So in 2019 when I joined, we had to build the business from the ground up. What was helpful is we already had a credit business, as I mentioned earlier. So we had back office, middle office functions in place, compliance functions I benefited from a lot of the groundwork was there, but we had to set up OSCE business from scratch. What we chose to do is we chose to outsource certain functions, especially middle office, back office functions. We had to hire a team, grow the team to make sure that we have the expertise to cover all the 200 plus loans that typically go into A CLO origination and trading. Other areas where we had to expand. We hired a couple of folks that used to be CLO bankers joined me to help with structuring deals and monitoring existing transactions. So it’s a lot of work. Those first 18 months felt like the workday never ended, but pretty happy with the way things turned out. And of course my timing this time also was not great. We were six months into it when covid happened, so that threw a little bit of a range. But again, the CLO market rebounded pretty quickly and in October of 2020, we issued our first transactions. We were the first new manager to come to market after Covid and after Covid, the market came back as robust as ever. So the good thing about CLOs is it’s a market that again, has withstood the test of multiple events and

Shiloh:

have a lot of challenges,

Ivo:

A lot of challenges and keeps coming back.

Shiloh:

So at some point I imagine you’re going to want to be on all the approved lists in Asia where a lot of times you get the best debt execution there. And from my perspective as a CLO equity investor, good returns are generated both by returns on the assets that you’re managing, but also getting good debt execution. So what’s the process like in kind of educating these investors about the merits of your platform?

Ivo:

Sure. I agree a hundred percent with you that getting good debt execution is crucial to getting good equity returns and building the platform. As a newer manager, it was very important for us to get our story out and that requires a lot of investor outreach. Last month I’ve been to both Asia and to Europe speaking with investor, selling the new mountain story, showing our performance and our differentiation and sharing views on the market. That’s a repetitive process. Again, once you get on investor screens, they want to follow your performance for some time. But I think again, with more differentiated story and good performance, good performance has certainly been very helpful in getting on more and more investors approved lists, which again is crucial to tightening the spread on the liabilities and creating better equity arb for our investors.

Shiloh:

What do you think the biggest metrics the Asian investors are looking for on the debt? It seems to me that the approved lists, there are a big function of just name recognition, so that’s certainly helpful, but are they focused on the equity residual value at deals? Are they focused on how many defaulted loans or triple C rated loans? I mean, there’s tons of metrics, right? So are there any that they are particularly focused on?

Ivo:

I think some of the metrics that probably Japanese investors care a little bit more about, they care about the size of the platform. You often hear that three or 5 billion number of a UM is a minimum for an investment for a lot of the larger banks over there. In addition, track record linked of the track record three to five years track record is also very important. In addition to all the other metrics that you mentioned that I think most investors pay close attention to diversity of the portfolios, the average rating as well as Triple CS downgrades. These are all metrics that investors often ask about. They want to understand the strategy of the manager and as well as Triple CS downgrades. These are all metrics that investors often ask about. They want to understand the strategy of the manager and

Disclosure AI:

Note the range of CLO management strategies include how much diversity there is in the loan pool, if the spread on the CLO loans is low or high, and whether the CLO manager purchases second lien loans or bonds subject to the constraints of the indenture,

Ivo:

They do want to make sure that you’re following the strategy. I think as an investor, when I was investing, the last thing that I wanted to see was a manager who changed strategies Often that made the investment less predictable and it wasn’t easy to evaluate because if you’re investing, if a manager fits one strategy within a broader portfolio and then shift to a different strategy, that’s something that as an investor I did not appreciate. So I think that’s something that investors are focused on as well.

Shiloh:

I’ve never bought a aaa, but I imagine that from that perspective, none of ever defaulted. So that’s great. But you do have things that you care about would be is there a risk that I get downgraded to aa maybe that matters for capital charges around the bank. And then there’s also just kind of the platform risk where, I don’t know, a couple of senior guys leave and there’s a transition and a for aaa, I mean it’d be worse for the equity, but at the aaa, they want to see some stability, a big platform with a deep bench where whoever bought the AA isn’t going to have to explain anything kind of up the chain at the bank they’re investing from. I guess that’s the priority for those guys.

Ivo:

Yeah, no, I certainly agree with that.

Shiloh:

So I think CLO equity has had a very good last year, 2023, and then this year the trend’s continuing. So we feel good about that. I think there’s a lot of upside coming this year in terms of refis and resets, but the one headwind really I think has been loan recoveries. And so your deals have performed very well. But across the market there have been some recoveries where I guess the first lane lenders found out that they weren’t as senior and secured as they expected to be at the end of the day. So could you talk a little bit about recovery rates, where you see that going and what you do to make sure that you’re in deals where the legal documentation is up to par, if you will?

Ivo:

Sure. It’s a great question. Obviously I think this is something that we spend a lot of time talking about internally, and it’s been a big topic in the market. I think several factors are really driving the decline in recovery rates that we have seen in the last couple of years. I think from my perspective, the first defaults that we saw in 2223, once we saw rates go up and companies struggling to make their interest payments combined with the inflationary challenges that we had in the economy, supply chain disruptions, et cetera. The first companies that really defaulted were companies that in some cases should have defaulted a long time ago that had kicked the can down the road. And vision is probably the name that comes to mind as a poster child for that. Companies that had restructured multiple times in attempts to create more runway for the company when the reality was the debt burden was never sustainable and the headwinds, the secular challenges that they were facing made it impossible to grow out of the capital structure. So the recoveries in those situations ended up looking worse than they should have been because again, we had a situation where more and more debt kept coming into the business to provide a runway and ultimately impacting layering existing layers and impacting recoveries.

Disclosure AI:

Note, the layering of debt refers to the company taking on additional debt with a higher seniority than the existing debt layering is not permitted in most first lien loan credit agreements.

Ivo:

The second driver for me was you saw a lot of the secularly challenged businesses. Also the fault movie theaters is probably another poster channel for that. The business that with technological innovation became apparent that the long-term outlooks for that business are not good and the valuation kept coming down and as a result, the recoveries did not look good. The third factor and the one that we’re spending a lot of time on is the new liability management exercises that have really started to define restructurings in the loan market. Perhaps for listeners who are less familiar with the markets, with loans, the loan documents, you have a first lien package and on almost all assets typically, however, in good markets like we had in 2021 where we had a lot of money chasing deals, the covenants deteriorated and sponsors got a lot of leeway to layer debt to do things without lender approval.

Those openings created the ability for investors to come in, take advantage of these loopholes, layer the existing debt and impact negatively recoveries. It’s an unfortunate development in the market, one that we’ve been vocal against, but that certainly has impacted recoveries. And that leads, to answer your question, your initial question, how do you protect from the ace, the good deals, the deals that everybody wants? Kind of as you mentioned earlier, the oversubscribed deals, they’ll understand they have not a lot of leverage pushing back on covenants and the loan docs. So that’s necessitate really strong views on credit. Kind of going back to the way we believe we protect our investors is really by doing a lot of work upfront and making sure that we invest in businesses that have low probability of having to use these buckets, having to use these liability management exercises that ultimately could impact recoveries.

So I do think that over the next couple of years, the defaults that are going to come will have better outcome because I do think that those defaults will really be driven by good businesses that have bad capital structures that got a little overlevered when rates were zero, that could not stay prolonged 5% interest rates. So FR levels and as a result, need to restructure the balance sheets to rightsize the debt. So I do think the recoveries there will be better, but the one wild card is again, the direction in which these liability management exercises will take, and that provides a little bit of uncertainty.

Shiloh:

I think most CLO equity investors assume there’ll be a 70 cent recovery at the end of the day. Should we think of that as a number from the past or is that still attainable if you’re with the right manager and in the right deals?

Ivo:

I do think it’s a number that’s still obtainable, but I think as a market, I do expect recoveries to come a little bit lower than the historical average. I remember 10 years ago we were using 80, that kind of went down to 70. So we’ll see if time will tell what the right numbers. But with the emergence of more loan only structures and some of the leeway in the documents and these liability management exercises, which reduce recovery is kind of upfront, I do think that it’s reasonable to assume that the numbers should be a little bit lower than 70.

Shiloh:

One of the things we’ve seen in just how default rates and recovery rates are reported is that usually what makes it into the journal or to Bloomberg is the defaults and recoveries of the overall loan index. And that could be an interesting number, but what we kind of care about is the default and recovery rate in CLOs, which have a more conservative slice of that index. And then beyond that, hopefully your CLO investor is able to add value and be with managers where it’s even a more favorable cut of the loan universe. So some of the loan recoveries that were low just weren’t in CLOs anyways, so it was like a interesting headline, but more of an issue for maybe a distressed semester or A BDC. So that’s what we saw there.

Ivo:

I can say managers have gotten very sophisticated and generally manage downgrade risk and manage the fault risk before it happens. So what we do is when we see deterioration in quality and performance, we look to usually pare down the positions, seeing that we might’ve gotten the initial underwrite slightly wrong, or the company just underperformed something in the market changed. And I do think that with a lot of the restrictions that CLO indentures put on managers, most managers are very focused on protecting the downside and tail risk within their portfolios.

Shiloh:

So then there’s significant upside of my opinion for the equity coming this year from refis and resets. So we basically have mapped out all of our deals when a on-call period comes off, if there’s something to do, it could be a refinancing, it could be a reset, it could be nothing. It could be we’ve already got a good capital structure and we’re just going to take it forward. So how do you guys think about the optionality and maybe some modeling you do to kind of determine what you think the best path is for your CLOs? After the on-call expires,

Ivo:

Once the deal is out of the on-call period, we’re regularly evaluating what are the options, where is the capital structure and the money, or do we have a chance to reset the capital structure, lower the cost of liabilities, extend the deal, et cetera. So that’s part of just a regular monitoring process, and it’s always the questions once the perfect time to do it. If you wait for the absolute perfect moment, you risk the market moves away. So that’s something that factors into that decision as well. Yeah, sure, the market could tighten another 10 bips from the liabilities, but I also might miss my window of opportunity here. So it really is on the case by case basis. We look at where the deal is from a par perspective, the portfolios, how reset all the portfolios, are there any assets that have to be excluded, talk to our equity investors, get their thoughts on what the optimal timing is as well.

But it’s an ongoing process for sure, and what you’re seeing right now is I think a lot of the deals that are coming for Visa were the deals that were done in 22 and 23 that have higher cost of liabilities, where the reset is what I would describe as a no-brainer. You’re able to lower the cost of liabilities in many cases by 40 50 bps, creating a much better outcome for the equity or older deals that were done pre covid that are towards their reinvestment period. But if you have a clean portfolio, you have the ability to do something creative with the deal and reset it and extend it, or in some cases just refinance the liabilities, lower the cost of capital and keep the arbitrage going longer.

Shiloh:

One of the things we’ve seen for the 2021 vintage where we got really good debt execution, I think kind of a misconception in the market is that when the reinvestment period ends, the CLOs done reinvesting, and that’s really pretty far from the case. It’s actually true in middle market CLOs, it’s different, but in broadly syndicated, there’s so much flexibility to reinvest after the reinvestment period ends. So that typical indenture says the reinvestment period’s up, but if any loan optionally prepays, you can reinvest it subject to some constraints there. But the point is that every loan repayment almost is unscheduled. So we’ve seen a lot of deals continuing to invest two years post the reinvestment period ending. So I think that kind of ties a little bit into the refined reset conversation in that just because the reinvestment period is ending, if you have a good AAA or cost down the stack, you might be able to keep the CLO pretty full for B or plus, depends on prepayment rates and other things. If you have that good debt execution, there’s no rush to move into something else.

Ivo:

Great. I think the flexibility is there, and again, certain managers are more aggressive than others on reinvesting proceeds, but it definitely needs to study the doc as an investor, especially if you’re investing up the stack. If you’re a AAA investor, that becomes a very important part of the conversation.

Shiloh:

Yeah, if you’re a AAA from 2021, you just want your money back as soon as possible and you could reinvest it wider spreads today. So wanted to also ask, what’s one or two things that you find interesting about the CLO business? I mean, you kind of mentioned self-healing, which would be at the top of my list, but what’s one or two other things that are unique and fun about CLOs?

Ivo:

I think the clo o markets, as a manager, as an investor I guess as well, you’re always chasing the perfect arbitrage and there’s always, again, a lot of things have to align for that to happen, and it’s a very dynamic ative process of trying to pick the best timing. So that’s something that I enjoy. What is the perfect timing to come to the market with a deal and that process, creating the transaction lighting everything up, I find pretty exhilarating. The other thing that I find very fascinating about the asset class is that I think that’s something that you had mentioned before on your podcast is that the 2007 transactions that everyone thought would be real duds ended up being great deals, and that I think every market offers an opportunity even it would maybe consider to be a bad market. You have the ability to buy loans very cheap, create real principle appreciation within the portfolio, which could really drive returns in a really good market. You have the ability to lock in cheap liabilities, which create a lot of optionality to take advantage of market dislocations over the reinvestment period. So again, a dynamic product that every deal is kind of unique. Every deal has its own dynamics, and every market offers an opportunity.

Shiloh:

I started buying CLO equity about 12 years ago, and the arbitrage has always been kind of a funny concept for me. So if you study finance in grad school, you learn arbitrage is riskless profits. You buy a stock in one market and sell it in another and you make money and CLOs arbitrage is not riskless at all. That’s definitely not the business. But for 12 years, I think people have described the arbitrage as poor, and so it was poor when I started. That’s how people described it. And then it got worse from there for the most part, with the exception of 2021, I think people thought the arbitrage in 2021 was pretty good because you had lib IBOR floors and the money that was adding a nice bit to equity returns.

AI Disclosure:

Note LIBOR floors on loans protected the loan investor at times when LIBOR was near zero. LIBOR floors increased CLO income, but CLO note investors do not receive floors on the base rate. The market has transitioned from a LIBOR base rate to a SOFR base rate.

Shiloh:

Now I think it’s improving. So I think there’s more and interesting opportunities in the primary market. One of my observations also is just that whenever you hit a period where risk is up on the loans, the discounts that they trade to is never what’s realized in terms of loan losses. So for example, when I’m buying a CLO equity piece and there’s loans trading below 90, you’re going to make some adjustments there in terms of the price you’re going to pay. But the reality is all those reserves that people take when they’re buying CLO equity, in my experience, the actual loan losses tend to be much less than what people are actually reserving for, and the result is favorable returns over extended periods of time.

Ivo:

Yeah, I think if the manager continues to get credit rates and take appropriate risk, that’s a big driver. Sometimes. I think the worst thing is a manager in my experience that you can do is faced with a loss on a loan, try to replace it, buy something else at a discount to mitigate the loss, which ends up being a worse loan than the one you initially had. Then kind of create more losses, but that also again, creates, I think there’s majors who have done very well buying loans at a discount and replacing some of the losses in the portfolio over time and rebuilding the portfolios to a healthy state.

Shiloh:

Yeah, it’s been a very resilient product. So Ivo, thanks so much for coming on the podcast. Really enjoyed chatting with you and good luck building out the platform.

Ivo:

Shiloh, it was a real pleasure. Thank you for having me and good luck with the podcast.

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 investors 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. 

The London Interbank offer rate (LIBOR) was a broad measure of the cost of borrowing cash overnight for banks on an unsecured basis. 

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. 

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 amortization is the process by which the CLO repays its financing after the reinvestment period ends. 

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

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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 a 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.

Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions and Flat Rock Global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research, or investment advice. It is not a recommendation, offer, or solicitation to buy or sell any securities, or to adopt any investment strategy. Neither Flat Rock Global, nor the Flat Rock Global speaker, can be responsible for any direct or incidental loss incurred by applying any of the information offered. None of the information provided should be regarded as a suggestion to engage in, or refrain from, any investment-related course of action as neither Flat Rock Global, nor its affiliates, are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. 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 1

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. During this podcast series I’ll cover a CLO 101, relevant topics in the CLO industry and interview key market players. I’ll put a heavy emphasis on CLO equity and BB rated securities as those are the securities I find most interesting.

By way of background, I’m the Chief Investment Officer of Flat Rock Global. I’ve spent two decades in the CLO market, working for CLO managers, and investing in CLO securities. And in 2023 I wrote a book on CLO investing. As CLOs are gaining in popularity, I believe investment professionals of all varieties will benefit from understanding this unique market.

Now, let’s get started.

Our first episode is CLO 101. But first off, let’s discuss why the CLO market is important today.

When I started my career, there were around $6 billion in CLO assets under management and a handful of CLO managers. Today there are over one trillion in CLO assets under management and over one hundred different CLO managers.

CLOs, in my opinion, can offer attractive risk adjusted returns for numerous investors with different risk and return profiles. CLOs issue securities rated AAA and sell them to banks and insurance companies, while investors who can handle more risk and might be targeting double-digit returns invest in CLO BB Notes and CLO Equity.

CLO securities are floating rate so there is almost no interest rate duration. The income from CLO securities varies based on the Secured Overnight Funding Rate or SOFR, which is tied closely to the Fed Funds rate. In recent years CLO investors have benefitted from Federal Reserve Interest Rate increases.

I don’t think any MBA programs offer courses in CLOs, but I think they should. The CLO market sits at the intersection of leveraged buyouts, high yield bonds, leveraged loans, credit analysis and securitization.

I like to say that CLOs are a little complicated but in a fun way. And I believe investors who take the time to understand them can be rewarded.

Lots of people enjoyed the movie, The Big Short, and I’ve read the book a few times. In fact, Michael Lewis is one of my favorite authors. But that movie is about CDOs not CLOs. The nomenclature is similar, but the results for investors were not. Both CLOs and CDOs use securitization, which takes a pool of assets and repackages them into other securities. Securitization is a powerful tool, but the quality of the underlying assets is key. CLOs own highly diversified pools of senior secured loans to large US businesses. CDOs from the financial crisis often owned portfolios of subprime mortgages of dubious credit quality. CDOs, as a result, saw defaults on securities rated initially AAA. For CLO equity, which takes the most economic risk, those securities ended with realized IRRs in the high 20% area. If they make a movie about CLOs, I believe it would have a happy ending.

In 2003, there were $16BN of new CLOs created. Twenty years later, in 2023 there were $116BN. During the 2008-2009 Global Financial Crisis CLO, issuance dried up. Excluding this time period, CLO issuance has been on a two decade upswing. The two primary drivers, in my opinion, are investors seeking exposure to actively managed portfolios of first lien loans combined with the performance of CLO securities over extended periods of time.

Let’s get into the CLO structure. The easiest way to think about a CLO is that it’s a simplified bank in one business line, commercial lending. The typical CLO has approximately $500M of assets. The assets are first lien loans that float based on SOFR. The loans are generally secured by all the assets of the company, both physical and intangible. Assets pledged to the lender would usually include cash, accounts receivable, inventory, physical plant, real estate, and any other assets. If a loan were to go bankrupt, the first lien lenders are the first in line for any recovery. These loans are created in leveraged buyouts. Imagine that a private equity firm is buying a company. They might put up half the purchase price in equity. The remainder could be a first lien term loan. The private equity firm wants to lever its investment, because it believes the businesses its acquiring will grow revenue and cash flow over time. In a typical CLO there might be 200 plus of these types of loans. In fact, a requirement to form a CLO is a highly diversified loan portfolio.

The loans in a CLO are actively managed and there are over 100 CLO management firms in the market. Realistically, we have more CLO managers than we could possibly need. The largest publicly traded alternative asset managers all have large CLO management teams. They earn 40 to 50 basis points annually to pick the initial loans that go into the CLO and keep the CLO fully invested during its reinvestment period. The CLO manager’s job is also to keep the CLO passing its many tests.

Many of the leveraged loans that can be found in CLOs were issued by businesses that may be familiar to you. Asurion, for example, is the company that does insurance contracts for Apple and Samsung phones. Cablevision, Virgin Media, and McAfee are a few more familiar names. My gym in New York, Equinox, has a term loan owned by many CLOs and they have great yoga classes too. While these are large companies, you aren’t going to find many of these companies in the S&P 500. Companies like Apple and Google are rated investment grade and borrow at rates too low to be included in a CLO. The borrowers in CLOs are ”speculative grade” with an average rating of single B or B2 from Standard and Poor’s or Moody’s. Fortunately, these loans default rarely, and when they do default, recoveries are usually high. The attraction of lending to speculative grade companies is they pay attractive interest rates to the lender, in this case the CLO. It’s important to note that the pool of loans in a CLO is not random; the borrowers in a CLO are, for the most part, owned by sophisticated private equity firms that did lots of due diligence on the borrower before acquiring it. And the credit quality of the loan is acceptable to the CLO’s manager.

Earlier I mentioned that a CLO might have $500 million of assets. To finance itself, a number of securities will be issued including ones rated AAA, AA, A, BBB, BB and Equity. Of the seven securities, three will be the most important for this podcast. The AAA is critical because it makes up 65% of the CLO’s financing and provides the CLO’s most favorable funding cost. The CLO BB is usually the junior most CLO debt tranche and therefore offers the highest projected CLO debt security return. The CLO equity receives the quarterly profitability of the CLO but takes the first loss risk on any of the CLO loans. CLO equity investors target mid to high teen returns net of expected loan defaults. Similar to my bank analogy, CLO equity returns are generated because the CLO’s assets earn a higher interest rate than the CLO’s financing cost. The result is distributions to the CLO equity are made quarterly.

The beginning of the CLO is often a CLO warehouse, which is used to acquire loans prior to the formation of the CLO. When the CLO begins its life, all of the CLO debt securities that were issued start accruing their interest expense. From the CLO equity investor’s perspective, it’s best to start a CLO with minimum cash, which would be a drag on returns. Once a majority of the CLO’s loans have been purchased in a warehouse, the CLO’s arranger, which are some of the largest US investment banks, find buyers for the CLO’s securities. An indenture is negotiated that details the rules the CLO will follow. The CLO’s reinvestment period usually runs five years. During that time, loans are frequently repaying at par, and the CLO manager is buying new loans with the proceeds. After the reinvestment period ends, when loans repay at par, new loans are not purchased. The cash proceeds are used to repay the AAA CLO debt until it is fully retired. Then proceeds will go to the AA, etc. As the CLO’s highest rated debt repays, so goes the CLO’s lowest cost of capital. From the CLO equity investor’s perspective, as the CLO delevers, the profitability of the CLO is reduced. At some point the CLO’s equity investors will decide the CLO should be called. Calling a CLO means selling all the CLO’s loans and repaying the CLO’s debt securities. After that the remining proceeds are distributed to the CLO equity.

The debt the CLO issues usually has a two-year non-call period on it. That means the rate on the AAA for example cannot be changed. However, after the non-call period, the CLO equity may attempt to refinance the CLO’s debt at lower costs and or extend the reinvestment period of the CLO, this is called a reset. Both of these transactions can be accretive for the CLO equity investor. I’ll do a future podcast on this subject as refinancings, and resets are prevalent in the market today.

A key concept in CLO investing is the value of the self-healing mechanism. In periods of economic stress, defaults on loans pick up. This is negative for CLO equity investors and the other debt investors in the CLO. However, the CLO’s assets, its leveraged loans, are constantly repaying at par. And during the CLO’s reinvestment period, those par proceeds are used to buy new loans. If defaults on the CLO’s loans are picking up, it’s likely that many leveraged loans will be trading at discounts to par value. Purchasing these discounted loans, if they end up paying off at par, provide loan gains that can be a valuable offset to any uptick in loan losses. This is the CLO self-healing mechanism, and it’s powerful.

Why would someone invest in CLO Equity? It provides exposures to actively managed pools of senior secured loans, but with attractive long-term financing attached. CLO equity pays high current income, today in the mid-to-high-teens area.¹

Many Investors get exposure to leveraged loans using loan funds or BDCs. In these structures investors take a loss whenever a loan defaults. Usually, I think this is a good risk to take. However, investors in CLOs generally budget for a loan loss reserve using a 2% default rate. If the default rate ends up below this number, it’s likely the CLO equity can outperform the buyer’s base case returns projections. CLO equity projected returns are quoted net of loan losses.

CLO equity has low correlation to other asset classes like high yield bonds or the S&P 500. That means investors can potentially increase overall returns and lower the overall risk of client’s portfolios by including CLO equity. Finally, one of the reasons I’ve gravitated to CLO equity as an asset class is that it’s an inefficient market, and an experienced investor can outperform peers.

For CLOs issued between 2002 and 2019, the average CLO equity tranche returned 21% – not too shabby. ²

CLO BBs, on the other hand, which take less risk, returned 9.5% since 2012, which isn’t bad considering how low interest rates were during much of the time period.³ Again, CLO BBs and most of the other CLO’s financing is floating rate.

Now why would someone buy a CLO AAA? Well, none have ever defaulted, so that’s nice. Banks and insurance companies buy them to make a return on a security that requires little regulatory capital, given its high rating. CLO AAAs are, of course, floating rate, and the performance was in sharp contrast to the investment grade bonds that traded down substantially when interest rates increased 2022. I’ve actually never bought a AAA rated CLO Note and probably never will. BBB is the most senior note I’ve owned. The reason is that the CLO’s junior-most tranche, the BB Note, default rarely but pay much higher returns that the AAA. The 30-year default rate on CLO BBs is around 20bps per year, so defaults on these securities are exceedingly rare.⁴

Many financial firms have gotten into trouble because their assets are of longer duration than their liabilities. The banking crisis of the spring 2023 is one prescient example. If the assets are illiquid and the financing market isn’t open when liabilities come due, it can be a big problem. CLOs are structured with financing longer than the expected life of all the CLO’s leveraged loans. There should never be a time when a CLO is a forced seller of assets in a depressed market.

CLOs have historically been an asset only available to large institutional investors. Given what I believe are the attractive risk/return characteristics of CLOs and CLO equity and BB Notes in particular, I believe retail investors will increasingly want access to the asset class. And recent years have seen the launch of CLO focused closed-end funds, interval funds and exchange-traded funds or ETFs. The key question for investors is what CLO security best fits their targeted return and risk profile.

So, that is your CLO 101 in a nutshell. Throughout the podcast series I’m going to delve deep into the concepts I discussed here. And in the interim, there are also numerous educational resources that can be found on the Flat Rock Global website. Until next time, thanks for listening.

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 Section:

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

Leveraged Buyout is the acquisition of a company using debt as an important funding source.

High Yield Bonds are debt investments, usually unsecured and fixed rate, that are rated below investment grade.

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

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

Credit Analysis is the process of evaluating the creditworthiness of a borrower.

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

Delever is the process by which an asset becomes financed more with equity and less with debt.

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.

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 organization (such as Standard & Poor’s, Moody’s, or Fitch) as an indication of an issuer’s creditworthiness. Ratings range from AAA (highest) to D (lowest). Bonds rated BBB or above are considered investment grade. Credit ratings BB 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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Source:

1. Flat Rock Global Market Analytics
2. Nomura CLO Research
3. Palmer Square BB Index
4. Standard and Poor’s

Ted: Hello, I’m Ted Sades and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content@capitalallocators.com.

All opinions expressed by Ted and podcast guests are solely their own opinions and do not reflect the opinion of capital allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of capital allocators or podcast guests may maintain positions and securities discussed on this podcast.

Ted: My guest on today’s sponsored insight is Shiloh Bates, the Chief Investment Officer at Flat Rock Global, an alternative credit manager specializing in the junior tranches of CLOs. Last year, Shiloh published CLO investing, a comprehensive review of the structure, payoff rules and historical performance of the space. Our conversation covers shiloh’s 25 years spent in and around the space, an overview of the market characteristics of CLOs, attractiveness of CLO equity relative to other credit opportunities and flat rock’s approach to investing in CLO Equity and double Bs before we get going. It’s springtime in New York and that means it’s time for Yankee Baseball. Like each of the last 53 years, I’ve started dreaming about a perfect season with the Yankees finishing 162 and oh, now that’s never come remotely close in the history of Major League baseball and it never will. But after watching the Yankees sweep the Astros on the road, the first four games of the season, thanks to the Fielding and hitting exploits of star Signi, Juan Soto, I’ll quote the great comedian Jim Carrey in the movie Dumb and Dumber.

So you’re saying there’s a chance it’s highly likely by the time you’re listening to this that the perfect season will have ended, but in this moment I’m still dreaming. So as the weather turns and you find yourself outside enjoying the sunshine, but a little sad that your baseball team, hopefully the Yankees won’t be perfect again this year. At least you can turn to that podcast app on your phone and listen to Capital Allocators for about as perfect an hour as you can get each week. Thanks so much for spreading the word. Please enjoy my conversation with Shiloh Bates. Shiloh, great to see you. Thanks for doing this with me.

Shiloh: Yeah, great to be here with you.

Ted: Why don’t you take me back to your background and how that brought you into the world of structured credit?

Shiloh: Sure. So I went to Graduate school at Harvard and after graduating I went to work for Wells Fargo as an investment banking analyst, and then at Wells Fargo, basically I think somebody in HR takes a pool of a hundred different investment banking analysts and just assigns them to different groups. I was in financial institutions and one of my initial projects in the group was to work on a financing for a CLO manager. And then two years later actually found myself working for that same CLO manager in Los Angeles. So I worked as a most banking analyst for just a little bit and then quickly transitioned to the buy side.

Ted: When was that?

Shiloh: 1998 when I graduated from grad school and started in the business

Ted: What did the CLO world look like in 98?

Shiloh: So it was a very small little niche of finance. So there was basically about 6 billion in a UM when I joined, and there was six different CLO managers. And today there’s really over a trillion in CLO AUM and about a hundred different active CLO managers.

Ted: So within the 1 trillion of CLO assets. How big is the CLO equity tranches across the industry?

Shiloh: A trillion of CLO AUM The CLO equity tranche is about 10% of the CLO’s financing, so it’s a hundred billion asset class for CLO equity in particular.

Ted: So what was your early experience like in that niche market at the time?

Shiloh: So basically I was a credit analyst picking loans for the CLOs. So there might be 10 or so different loan opportunities that would come across your desk in a month, and your job is to sort through the best opportunities. So the typical loan that goes into A CLO is going to be a first lien and senior secured loan. Today, the loans pay around SOFR plus three and a half to 4%. And basically the idea is that if you’re investing in first lien loans, you’re starting off with a loan to value of around 40%. So you’re not so sensitive to whether or not the economy grows at 2% or 3% or even shrinks a little you’re exposed to is really the situation where the wheels fall off the cart in terms of the company’s business model. So loans with a 40% initial loan to value, they do default, rarely, fortunately. Usually it’s due to some regulatory or technological change or loss of big customers. But as the credit analyst job to sort through the downside risks of the loans that go into the CLO and figure out the ones that survive really, and if there’s a pretty substantial downturn in the economy.

Ted: So from that early experience, looking at a very niche market at the time, what did you see in the evolution of CLOs alongside the rest of structured credit between then and when you started Flatrock?

Shiloh: The growth of CLOs has really been driven by a few factors. So one is that investors, they find lien loans very attractive today, the yield on these loans are close to 10% or higher. So people look at that and say, Hey, if I can get an equity like return and I’m the top of the capital structure, I’m first lien and I’m secured, that’s an opportunity I want to participate in. So in CLOs, people are looking for actively managed exposures to these pools of loans. And then the CLO O securities really up and down the stack have performed very well over the last 30 years. So a lot of people have seen the movie The Big Short, the CLO industry is sometimes painted with the brush of the performance of CDOs, where during the GFC you’d saw defaults really all the way up to AAA securities and initially rated AAA.

Shiloh: And then if you were in Contrast and investor in CLO equity through the financial crisis on a buy and hold basis, a lot of the equity in those deals return high 20% returns, and the debt in the CLOs defaults rarely as well. So performance has been very good over the last 30 years, so that’s going to attract a lot of investors. And then I think the final thing is that pretty much every security in the CLO market is floating rate. So we’ve been benefiting as the federal reserves have been increasing rates, and when you buy A CLO security, you just don’t have the interest rate duration that you might have if you’re buying a high yield bond or an investment grade bond. If you look at the banking crisis of the spring of last year, look, if banks would’ve owned AAA rated CLOs instead of some of the bonds that might be in the Bloomberg aggregate bond index, CLO aaas might’ve traded to 97 cents on the dollar or something like that. Investment grade IG bonds traded into the eighties and sometimes lower. So I think it’s a confluence of all those factors drawn people to the asset class and the reason that I think it’ll continue to grow.

Ted: What was your path from that early experience alongside those cycles in ls?

Shiloh: So initially my job was again, just picking the loans that go into the CLOs. So I did that for about 10 years and then I had opportunity to start investing instead of the loans investing in CLO securities directly. So I started buying CLO double B notes, which are backed by pools of leveraged loans, and then eventually made my way to investing in CLO equity, which is the riskiest part of the CLO trade, if you will. And then the firms that I work for fortunately just saw a lot of growth and that enabled me to expand my skillset and to be one of the larger players in this space over time. So that’s been a lot of fun and I’ve been fortunate in that.

Ted: What was the genesis of writing a book on CLO investing?

Shiloh: So in my role, I spend 80 or 90% of my time investing, but I do need to do some investor education. And during the covid period where I had some extra time on my hands, I decided to just write a little ebook that was 60 pages and we put it on my firm’s website and it described how I go about CLO equity investing. And after I did that, I was really surprised by how many people read it. It was widely circulated in the market, and that gave me the idea of doing a full book. So the book’s, 220 pages, a lot of the writing from it at least initially just came from stuff that we use to educate investors in our pitch decks or our q and as with them. And at the end of the day, it’s like a trillion dollar asset class market now there should be a book. So we wanted to lead with that, and I wrote it in a way where I think people that are familiar with financial concepts, no CLO knowledge is required, just the basic financial concepts, and I think people can benefit from it, and it’s all in there. If you wanted to learn about CLOs a different way, you could do Google searches and there’s tons of different articles, but I tried to make this book the one-stop shop, if you will, for all your CLO knowledge needs.

Ted: I’d love to dive in a little bit maybe through your book about what these investment opportunities are today. So we talked about what the assets are in these pools. Why don’t you talk some about what is involved on the right hand side of these balance sheets?

Shiloh: So the easiest way to think about A CLO is that it’s a simplified bank. So if you buy a share of, for example, bank of America or JP Morgan stock today, basically you’re going to get exposure to maybe 20 or 30 different lines of business. But in ACL O, it’s really just a pure play lending vehicle. So the CLO might have 500 million of assets in it. Again, the loans are almost exclusively first lien floating rate loans. And then to finance that pool of loans, there’s long-term financing and it’s sold in tranches, which are rated AAA at the top, and that’s most senior and secured. And then down to double B, which is the junior most CLO debt tranche. And then there’s the CLO equity, similar to my bank analogy. The loans that the CLO owns its assets, they pay much higher rate than the CLO O’S financing costs.

Shiloh: So that means each quarter there should be a nice amount of profitability that flows to the CLO equity. After all the CLOs debt has been paid and there’s a CLO manager as well that earns a fee, take a look after all the loans in the CLO. So if you’re an investor in CLO equity today, you’re targeting returns in the mid to high teens and basically you’re exposed to any loss on the CLOs loans. So the risk that you’re taking is loans in the CLO default, but fortunately it’s not a unquantifiable risk. It’s you can look back 30 years and by our estimate, the default rate in CLOs is about 2%. So whenever somebody buys a CLO equity tranche, we budget in a 2% default rate into all of our profitability projections. So in ACL O, you might have 200 different loans in there. I’ve never met a CLO manager who goes 200 for 200 unfortunately.

Shiloh: So you kind of budget in a 2% default rate. That’s the game in CLO equity, and that’s supported by very high quarterly cash distribution. So unlike owning SOC and the s and p 500 where you’re counting on capital appreciation maybe as being the biggest part of the return you get in CLO equity, it’s actually the quarterly distributions that come to you right away. So that’s the equity trade in a nutshell. We’re also investors in BB rated notes that works differently. That’s just a debt security where all the loans in the CLO are pledged to you as collateral. There are other debt investors in the CLO that are ahead of you, but if you look back over 30 years, the default rate on CLO BBS is around 20 basis points. So if you compare that to high yield bonds or to levered loans, if you’re just talking about the default rates of indices in general, not what’s in CLOs in particular, but high yield bonds default to like 3% per year loans, and the loan index defaults around 3% per year. So this is really just a small fraction of the default rate. And then today, because C double Bs are floating rate, and because the Fed has hiked so much, we’re getting yields in the 12% plus area and defaults have been really, really minimal. So that’s a pretty compelling opportunity that we’re going after today.

Ted: How do you pencil out? On the one hand, most of that 30 year history was in a declining rate environment. It’s a pretty stable economic environment with lower defaults, so that could be a negative if defaults go up. On the other hand, with rates going up and you own floating rate paper, you’re going to have a higher yield. How do you think about going forward, the balance of those two foror an owner of the underlying loans?

Shiloh: Higher rates is great to the extent that the borrower can make the payments. How we think about that is, well, the initial loan to value, it’s around 40%, maybe 50% at the max. So there’s a lot of junior capital and equity that supports the business. So these loans are created in leveraged buyouts where a large private equity firm, they’re buying a company and they might put up, call it half of the equity or purchase price from the perspective of the borrower, they can either make their interest in principal payments or they can toss the lenders the keys. Those are really the only options. So because the loan to value starts off, we think pretty attractive place, even as rates have gone up, borrowers still have the capacity to make the payments, and even if they didn’t, from the perspective of the private equity firm that owns the company, they’re looking at a future interest rate environment that should be decreasing.

Shiloh: At least that’s what the SOFR forward curve would say. So they would be highly incented to support a business that has decent prospects, that has a good business model, help them make the higher interest payments rather than just turning over the keys to the lender. So that’s for the underlying loans that are in the CLO, depending on the pool of loans in the CLO, you’re still going to see interest coverage ratios. So that compares the amount of cashflow the business produces each year to its annual interest expense. For the most part, the loan pools are going to be above two times, which is still pretty comfortable.

Ted: What are some of the nuances in investing in this space that led you to select the areas that you?

Shiloh: One of the things that’s interesting to me about CLOs and why I gravitated to this segment of the leveraged finance market is it’s very quantitative. In graduate school, I studied statistics among other things when we’re buying a double B note, instead of asking ourselves, Hey, is this one loan a great loan? Is it a defensible business model? Does it have a good management team? Does it have a good competitive position? These are things that we could debate you and I for hours. I don’t know if there’d be a right answer, wrong answer at the end of it, but in CLOs is very different. Hey, I have this pool of first lane senior secured the loans, and as long as seven or 8% of the loans don’t default each year for the next seven or eight years, I’m going to be money. Good. That’s the analysis you can do as a debt investor in CLOs, and I’ve always found that the analysis of pools rather than one specific outcome to be more interesting to me.

Ted: You mentioned at the onset that there are now a hundred different managers of CLOs. I’d love to map out what this investment universe looks like. So of these hundred that create these and manage the CLOs, who are these organizations?

Shiloh: So the biggest alternative asset managers are all going to have large CLO groups. So Blackstone, BlackRock, KKR, Aries, they all have CLO management teams. They earn call it 30 to 50 basis points to put together the initial loan portfolio to keep the CLO fully invested during its reinvestment period, and really to make sure the CLOs passing all its tests. So the CLO managers are competing amongst themselves for capital from people like me. So they do that by having the best performance of the underlying loans in their CLOs, and they also do it by getting the best debt execution on their CLOs. So for me, that’s the two things. Those are two really of the key ingredients that make for good CLO equity returns and also for a nice stable performance of BB rated notes.

Ted: What drives the ability of the manager to get attractive financing?

Shiloh: So the best financing for CLOs comes out of Asia. It’s large Japanese banks and insurance companies that like to buy the aaa and basically they have approved lists, so they have 10 or 15 guys that have somehow made it onto the list. A lot of the criteria it looks to me like from afar is just name recognition. So if it’s a big household name, then that puts them pretty close to the top. But then if you’re not on the list in Asia issuing CLOs is a much harder business because your initial cost of capital is higher, and that means less equity distributions over time. So A CLO management firm might say, Hey, I didn’t get a good debt print for the CLO O, but I’ll cut my management fee or I’ll do something else for you. But the good debt execution really puts the top quartile of managers significantly ahead of anybody else who’s in the business or trying to enter the business.

Ted: When the manager goes to the market to create one these, how do they address the buying market beyond what say that most senior tranch is coming from Asia?

Shiloh: So to form a CLO, really the first thing you need is a CLO equity investor like myself. So without the equity, there’s really not much that can be done. Maybe the manager can put up the equity themselves. Sometimes it’s going to be part of the CLOs permanent financing. Other times it’s maybe a bridge until they locate a third party CLO equity investor like myself. But once you have the equity, then you can set up what’s called the CLO warehouse, and that’s used to acquire loans prior to the formation of the CLO. And then you start marketing the CLOs debt. So the AA then is the most important, and then the other CLO securities, the ones rated AA down to double B, those are important, but less so the AAA is 65% of your funding costs, so you need to get good debt execution there. And then later in the process, the other tranches get filled out. So each CLO has a CLO arranger. They have a team that puts together an indenture which has the rules that the CLO is going to follow, and that negotiates economics with people up and down the CLO capital stack.

Ted: So when you’re looking at the CLO equity and you want to know that they have that attractive debt financing, it sounds like there’s a chicken and egg. If you’re supplying the equity before you know what the terms of the debt will be, how do you resolve that in your research?

Shiloh: The equity needs to be first, but the AAA is probably on deck and there’s probably already been a number of conversations there. So that’s part of it. But another thing is that in my market, it’s very transparent as to which managers are getting the best debt execution. A CO manager might come to me and just say, Hey, I print the tightest AAA in the market. I did it last month and three months before that and I was talking to a Japanese bank, and they seem pretty interested. And so that gets the conversation going. But the other part of this is once you have the equity, you’re in a CLO warehouse and you’re buying loans prior to the formation of the CLO, you have three to six months to figure out the full commitment on the aaa. So if it comes back maybe wider than you might like as an equity investor, you can always just stay in the warehouse and just wait for a better time or better execution.

Ted: What does the universe of the initial equity providers,

Shiloh: So I think there’s about 15 of us. One of the common jokes in the CLO industry is that you go to CLO conferences, of which there’s many, and it’s a common theme that, oh, there’s new investors coming into the market and you kind of always hear this, but really I see the same 15 guys. We are often sharing in the same deals, we’re speaking at conferences together. It is a niche asset class, although it’s grown to be a trillion and it’s just a little bit more complicated than owning a high yield bond directly or a s and p 500 stock or a mutual fund. So it does take a little bit of learning to get up the curve. I think for people who spend the time, I think the risk adjusted returns are very favorable.

Ted: So when you are discussing the value of CLO equity relative to other alternatives of someone who’s looking for a certain type of risk return profile, how do you compare it to the other ways people might get exposure to credit markets?

Shiloh: Great question. So if we’re comparing private credit owned predominantly unlevered, a lot of times you’re going to get in a CLO exposure to the same underlying loans. But the difference is in the CLO, we’re employing this long-term attractive funding cost that comes along with the CLO vehicle. So if you own traded the loans they might pay today, call it a yield of around 9%. So if you’re in an unlevered fund, that’s the yield. Then what investors would get would be less management fees and some loan losses. Now if you’re investing in CLOs, the CLO O comes with attached leverage to it. So it might be the same underlying pool of loans, but you have seven to nine times leverage associated with that. So that’s the leverage that would be similar to US Bank today. So in my business, whenever you see a diversified pool of loans, usually somebody is financing against it.

Shiloh: And the reason is that banks and insurance companies and CO AA investors will give you such attractive financing against a diversified pool of loans. They usually people take it. So it’s that leverage in the CLO that bridges you from the unlevered return to the levered one. And we think for an investor that can have a little bit more volatility on their nav, that at the end of the day doing it with leverage is probably the best way to do it. I think the attraction of CLO equity is that the returns that we’re expecting to earn should pretty much rival what we think you get from the s and p 500, but we also think that you can get the returns with a lot less risk. So somebody putting together a diverse portfolio of assets would find CLO equity can push out their efficient frontier or just have a portfolio with better returns and lower risk.

Shiloh: So I think that’s the selling point for CLO equity is that the distribution of returns around what I’m targeting should be I think a pretty tight distribution. So if you invest in CLO equity, you’re never going to triple your money unless you’re buying something very distressed in a real severe downturn. But at the same time, the probability that you have a negative IRR is extremely low. So by our math, it’s about 6% of CLOs that have had negative IRR. So it’s for somebody who wants to be in the mid to high teens and then not have as much downside risk as they might if they just own individual stock, I think it’s a compelling opportunity for them.

Ted: I’d love to dive into how you go about implementing the investment strategy. How do you start to filter what you’d like to have in your portfolios?

Shiloh: So if you want to buy a CLO equity tranche, your options really are to do it in the primary market where CLOs are being created or you can buy CLOs in the secondary market. So broker dealers, they make markets in these securities. The securities also trade in auction processes. So for example, the seller of CLO equity might put out a notice to the market that says, Hey, in two days I’m going to sell these three securities and I’m looking for the best bids. And people put in bids through broker dealers for that. So the first thing that you need to decide is just where you’re seeing more interesting opportunities for the primary or the secondary market. So what we do is we basically have a tracking sheet which has every CLO opportunity that we’ve ever been shown in it. And the first screen is just, well, you buy A CLO equity tranche very simply, you put in the price and you put in your 2% expected default rate on the loans, and then you’re screening highest to lowest return opportunity.

Shiloh: But it’s much more complicated than that. So if the CLO equity has a higher return associated with it, then you need to delve in and be like, okay, well what’s the reason? And sometimes it’s reasons that are good and that are going to lead to pursue the opportunity, and then other times it’s just not going to be an opportunity that you want to chase. Great reasons to get a high IRR would be I’m buying at a good price, I have good debt execution out of Asia, the CLO manager is working for a reasonable fee. There’s some deal specific things if the CLO equity offers high returns, but the reason is that the loan pool is very spread, well that means, okay, that’s nice for the equity, but a higher spread loan portfolio could result in higher loan defaults over time. So that’s the opportunity that we would screen out.

Ted: As you’re diving into any one of those opportunities, you’ve got a different capital stack on the right hand side of the balance sheet of the CLO, and then you’ve got say, 200 loans on the left hand side. How do you go about doing your research to determine whether you think it’s an attractive opportunity?

Shiloh: So one of the things that we don’t do is deep dive due diligence on the underlying loans. And the reason for that is a few. So one, there’s going to be 200 or 300 different loans in the portfolio. Usually the max loan size is going to be 1% of a UM or thereabouts. And then if we’re talking about broadly syndicated CLOs, the loans are traded. So you could do due diligence on underlying loan, it’s 50 basis points of the loan portfolio, and then you found out three months later the CLO manager traded it and replace it with another loan. So you’re not really going one by one through loans and asking the CLO manager to explain themselves. So there’s some big picture details that are reported by the CLO that would be of interest. So one is the amount of defaulted assets in there, which usually there are going to be the amount of triple C rated assets, so those are loans that you have much higher risk to default.

Shiloh: And then another metric would be the amount of loans trading below a $90 price. So we usually think of loans that are worth 91 cents or higher as being worth par and loans that likely default at that 2% rate. But if the loan at 80 might not have defaulted yet, it might not even be ccc, but you would never buy a CLO with a loan trading at 80 and not make some kind of adjustment in terms of the price you’d be willing to pay. Another thing that we would shy away from is often there’s very high returns offered for CLO equity securities that are short. So the CLO equity might have an eight year life, and if you want to step into that in the secondary with one year to go or something like that, usually you can buy that at returns that would at least model to be very attractive, but that would be the most risky CLO equity securities you can buy because sooner or later the loans will be liquidated and the CLOs debt gets repaid and the equity gets what’s left. And if you’re only really signing up for that last part of the CLO O or you’re not getting a lot of distributions along the way and you’re just interested in the outcome of a liquidation, that’s not a trade that would work for us.

Ted: Along that type of example, how do you think about the active management component by the CLL manager?

Shiloh: So I think active management is very important. You’re paying them 40 basis points on average, and for that, you’re not just getting somebody who’s picked an initial portfolio of loans and then just let us sit there. The CLO managers, the good ones, they’re actively trading their portfolio in the loan market. How that works is, for example, if JP Morgan or B of A is underwriting a new leverage loan, they price that in a way to really incentivize buyers of the loan to come in in the primary transaction. So a new loan might come at a price of 99 cents on the dollar, but it was underwritten in a way that after it was allocated that it’s worth 99 and a quarter or 99 and a half. Some little bump in economics is what you get by playing in the primary market for loans. So a lot of the time, some successful strategies and leveraged loan management would be to be very active in primary where you’re getting loans that trade up incrementally and over time rotating out of loans that might be more risky or just be more seasoned.

Shiloh: So those are some of the strategies they do, but the amount of churn CLO equity investors are definitely looking for managers with more churn of the loan. So that implies active management. Now, it needs to add alpha. It’s not just rotating in and out, but I think that’s a metric that people in my seat are going to focus on. I think there’s also a qualitative component to this, which is I’ve been investing with the same CLO managers for 10 plus years. So when we’re looking at a new CLO in the primary, you can do so much analysis on the underlying loans and how they performed, but qualitatively you’ve already done a few deals with the guys and you can just pull up the CLO positions that you already own with them. And I think that’s obviously something that you need to wait in your decision process.

Ted: You have what sounds like just a massive data. So all of these CLO managers over 10 years, each CLO having 200 names in it, the performance of all those, how do you process all of that information that’s coming in?

Shiloh: A lot of the big investment banks, they have CLO research teams, they’re analyzing the data as well as we are. So they’ll put out a stat that says something like, Hey, in the last year, these are the top 15 managers who have grown the par balance of their loans. Or another bank might say, Hey, these are the managers who reduce their triple C loan exposure. And when you look at that is one of the challenges in evaluating A CLO managers that there’s so many different metrics that you could choose. I could list a dozen of them. At the end of the day, what it really adds up to is what I care about and what our investors care about is the IRR of their deals. But pretty much every market participant I think uses software called intex, which models CLOs very quickly. You can pull up your portfolio and see how it compares to the other CLOs out there. There’s this qualitative element once you’re having a good experience with a CLO manager, it probably would be hard for a newer CLO team to wiggle themselves into the list of people that you’re looking to work with.

Ted: How do you think about putting together your portfolios of CLO equity and debt securities?

Shiloh: So the 90% of the CLO market is broadly syndicated CLOs. So if you look in there, you’re going to find companies who borrow a billion dollars and up basically. And so our focus though at Fire Rock is really middle market CLOs where your typical borrower is going to be 200 to 400 million of revenue. It’s not going to be a company that you’re going to read about in the Wall Street Journal or anything like that, but still going to be a business that provides material product and service in the economy. So what we found is that portfolios of middle market loans, they both pay higher rates to the lender lender, but they also have more favorable loss statistics over time. And on top of that, middle market loans tend to be much less volatile than broadly syndicated loans. And as a result of that, the volatility that you see on middle market, CLO double Bs and middle market CLO equity is just going to be more favorable to that of what you see in the broadly syndicated CLO market. And so that’s where we’re focused is roughly this 10% of the market niche and in this part of the market, instead of there being a hundred managers, there’s about 15 or so that work working with. In a typical year,

Ted: When you build a portfolio, what does it look like in terms of the number of positions or line items that you’ll have

Shiloh: To be diversified in the CLO market? I would say it’s something like having max positions of around 5% of the portfolio. Each CLO again is going to have 200 or 300 different loans in it. You would not need a hundred CLO equity tranches to be diversified. And then two, a lot of the CLOs are going to own similar loans. So for example, Asurion is the largest loan in CLOs today. They do contracts for iPhone and Samsung phones. The insurance contracts, if you go out and buy ACL O, you’ll probably find them in there. I think having call it 20 different CLO equity tranches would result in a pretty diversified portfolio. The one thing you want to be diversified though is just the life of the CLO. So in a diversified CLO fund, you wouldn’t want to own 20 CLO equity tranches all bought in 2021.

Shiloh: We’d want the CLOs bought at different times. And that’s important because the CLO starts its life with a two year no-call period during which the rate on the AAA down to double B, it’s all fixed and you can’t really monkey around with it. But after the two year no-call period comes off. If it’s to the advantage of the equity, you can go into the market and refinance the CLOs debt at lower rates. You can extend the life of the CLO or you can decide to call the CLO O and that’s just liquidating all the loans and getting your money back.

Ted: When you own this portfolio of the 20 CLO equity pieces and you’re getting distributions along the way, what are the structures that you put together look like that you offer to investors that can match the right liquidity that you’d need to optimize how you want to manage this portfolio with the experience of your investors? On the other side,

Shiloh: What we do at Flatrock is we have three different interval funds. They work similar to a mutual fund, so people can buy them with the ticker through an RAA. Actually they’re not available just to the public. Contrast to a mutual fund is that the securities we’re investing in are pretty illiquid. So we’re not in a position to give anybody daily liquidity if they want out. So what we can do is have these 5% quarterly tender periods where people want to tender their shares to us, the fund will buy them back. So this is a great structure I think for CLO equity because the CLO equity does pay these high cash distributions quarterly. So a common question I get asked from our investors is, well, if you’re tendering for 5% of shares, where does the cash come from? And the first answer is, well, the CLO equity pays very high cash distribution. So you have that on hand and then backup answers would be, yes, I also have a line of credit from a bank or I can just borrow or there’s cash on the balance sheet. The interval fund structure is one where I see it taking market share over time. One of our three funds was initially a private BBC, and we converted that into an interval fund because we believe so much in the structure. And then if you’re an investor in an interval fund, it’s the same SEC reporting is mutual fund.

Ted: What are the advantages of that structure compared to say A BDC or even just a portfolio of the loans?

Shiloh: If you contrast it to A BDC, I think one of the challenges for BDC investors is on the one hand, the BDC is like a close end fund. The shares trade around all day, so you can get liquidity really at any time. But the BDC can trade at a premium or discount to book. Unfortunately for BDC investors, usually it’s a discount. So an investor in those shares, they have both the volatility of changes in the underlying prices of securities, but on top of that, the volatility of just the difference between where the funds trade in the market versus the underlying nav. So the end result of that is BDCs are wildly volatile and in a period like Covid for example, that downturn a lot of BDCs cut in half. And well, if that can happen from a portfolio of predominantly secured loans that pay a dividend yield of nine or 10%, the risk reward there I think would feel funny to a lot of people. So I think that’s one of the reasons that people would prefer the interval fund over the BDC.

Ted: And how about compared to just a private credit vehicle?

Shiloh: The primary difference is going to be in liquidity. How the 5% tenders work is that if every single investor tendered at the same time, you’d get back 5% of your money, but realistically, only a small percentage of your investors should be tendering. At the same time, if you want to tender your shares, you should get back a lot of your money from these tenders. If you’re in A-G-P-L-P fund, you’re committed to lockup capital seven plus years. I think it’s becoming pretty tricky for a lot of large institutional investors to make commitments that are that long in duration.

Ted: What is your research team look like to implement the strategy?

Shiloh: We have an investment committee, which is three folks, myself, our CEO and our CFO, and then people who are working on the CLO team. There’s three of us, and CLO investing is not similar to the team structure. You might see at a private equity firm or even a private credit firm, for example, CLOs are modeled in software that everybody uses. So to get a good sense of what’s happening, you pull it up and literally in 10 minutes you have a pretty good idea of what you’re looking at and if it’s interesting. So in CLO LO investing, as you become more senior in your career, you don’t start flying over from 10,000 feet and making broad pronouncements about the market or managers. All the details are super relevant. I’ve been doing this 20 plus years and I’m still reading in dentures and modeling CLOs and involved in all the negotiations that go with putting a CLO together to contrast it with loans.

Shiloh: For example, if you buy a first lien loan with a 40% loan to value, and for some reason there is an error in the model, at the end of the day, you still land at 40% loan to value and you’re probably getting your money back. CLOs and CLO equity in particular, that’s not the case. So CLOs are going to produce a stream of cash flows over time, and then there’s one payment at the end when the CLO is liquidated and people get whatever cash remains, there’s no par payout at the end. A lot of times you’re getting back 40 cents, 50 cents on the dollar. Now over the eight year life of the CLO, you’ve got these very large distributions along the way. Hopefully it nets to a nice return for you, but you don’t get far back at the end. So the modeling of it really needs to be a hundred percent accurate because every dollar is going to be part of that IRR. There’s no magical a hundred cents that comes back to you at the end.

Ted: What does happen at the end as the manager is unwinding the CLO?

Shiloh: So the typical CO is going to have a five-year reinvestment period. And during that time, loans are constantly prepaying at par. The CLO managers going out into the market and they’re buying new loans with the proceeds. Then after the reinvestment period ends, for the most part, that stops. So when a loan prepays at par, instead of buying a new loan, that cash is used to repay at the AAA security first. Then when that’s fully retired down to the aa, so after the reinvestment period ends, the CO is losing its most attractive financing cost. So the CLO equity distributions are declining. Whoever owns 50% or more of the CLO, when they decide that they’ve delivered enough and want their money back, they can notify the CLO manager and tell them to put all the loans out for sale. So the thinking once you get past the end of their reinvestment period, for somebody like me, there’s a few variables that would determine how long the CLO should go.

Shiloh: So one is if you’ve got a really good financing cost, aaa, even if you’re losing it partially over time, it may make sense to just keep it. And then the other function in there would be the liquidation value to the equity. So if for example, we’re in a period where loans have traded down, then there might not be a high liquidation value for the equity. And in that case, you’re not incentive to call a deal if you’re an investor in double bbs, you’re basically trying to figure out what the equity might do. So a lot of the bbs we buy are later in their life and we buy double Bs at discounts to par almost all the time. So the quicker you can get repaid, the better. So when we’re buying double B securities, we’re figuring out, hey, which of these CLOs are interesting call candidates? Which ones would we call if we were the equity? And that’s part of our decision making and how we filter out the double Bs that we buy.

Ted: If you look at the drivers of your return over time, how much of it is the year over year yield that accrues down to the double equity and how much of it comes from the unwinding of the portfolio?

Shiloh: So one of the things that’s interesting about CLOs is that I mentioned they have this two year no-call period on them in which you can’t really tinker with your AAA and double B or what they are. But after that, what we hope to do with a lot of our CLOs is really have them as permanent capital vehicles. So I mentioned that the reinvestment period might be five years, but if you go out five years and the CLO has performed well, your incentive to just try to go back into the market and extend the CLO O’S life and add another five year reinvestment period to it. So by doing that, you skip two to three years of potential de-leveraging and receiving lower cash flows. Instead of having that period, you just stay fully invested and keep going. So a transaction like that would be very accretive for the equity.

Ted: What are some of the other nuances of how you can drive returns for your investors through the structures?

Shiloh: Let me give you an example of some of the upside that I think exists in these deals that we try to take advantage of as an equity investor. So I mentioned there’s refis, there’s CLO life extensions every quarter after the reinvestment period ends, the CLO equity investors looking to maximize their returns. It may be the case that a call one year after the reinvestment period is the ideal one for the equity and it could go as long as four years. So that’s some other upside that comes to us. I think another source of potential outperformance for equity fund, something that I’ve done and I think our competitors have done to some extent as well, is that if I rewind the clock to the spring of 2020 CLO securities are trading at really discounted levels. So if you’re an investor in CLO equity, you don’t have a crystal ball for how quickly the economies going to recover.

Shiloh: So equity feels a little bit scary, especially when some of the underlying businesses in the CLO aren’t even open for business. That’s obviously not good. But at the same time, what we did is we looked at CLO double B notes that were trading in the market in the sixties, seventies, and eighties. And in looking at those, you just ask yourself, okay, well what percentage of the underlying loans would have to default such that I’m not money good on this double B? And even during covid, we saw double BS as securities that we expected to be really rock solid. So we are a CLO equity fund, and I put equity in quotes now because after COVID started, we were buying double Bs. We felt like, hey, you can get equity-like returns here or better and be more senior and de-risk yourself. Why wouldn’t you do that? So a lot of times people who are investors in CLO equity are looking to the double B as a potential alternative. And when those are trading at discounts, that can be a pretty compelling place to look for a turn rather than your more traditional trade.

Ted: So you’ve experienced an incredible growth in the industry you’re participating in for a long time. What do you think happens from here over the next five or 10 years in this part of the market?

Shiloh: I think the market continues to grow probably at a mid single digit clip. I think that we talked earlier about drivers being people wanting exposure to first lien loans, the performance of CLO securities over time. And I think it’s partially just an education process. So when we’re marketing our funds to investors, a lot of the times they’re not familiar with private credit, they’re not familiar with CLOs or even traded loans. There’s a lot of education. I think that’s what’s being done. SOFR is a little bit less than 5.5% today. If you’re lending, again, 4% above that, people are going to find that to be a pretty attractive yield that I think is just going to pull more and more people into the space.

Ted: Closing before your hobby or activity outside of family,

Shiloh: Almost every night I go to the jiujitsu studio and train that with the guys. What I really like about it is it’s both a mental challenge and also physically exhausting. There’s the comradery of training with the same team every day. But the other part of it is that in Jiujitsu, you are 100% present. You’re just really in the moment trying to deal with the immediate problems. And it also teaches you how to learn and acquire new skills and really think about the best way for you to learn new movements and tricks. I find it to be really enjoyable.

Ted: What’s one fact you find interesting that most people dunno about you?

Shiloh: So once I started working, I did two years on the sell side and then transitioned, I think I worked for six years on the buy side in Los Angeles. And then after that, that would’ve been a time where a lot of people in my position would’ve maybe gone back to school and gotten an MBA. But I had already done the CFA and I had a master’s in public policy where there would’ve been some overlap with an MBA. So what I decided to do is I took a sabbatical and traveled the world for two years. So I visited over 20 countries, learned Spanish, I learned Portuguese, I still speak Spanish, Portuguese is gone. Unfortunately, I also did a lot of surfing. So I’m from a lower middle class family, and we didn’t have the opportunity to take a lot of vacations when I was younger, and I took that two years to see the world and really enjoy life.

Ted: What’d you learn most from that experience?

Shiloh: One of the standout experiences for me was living in Rio where a lot of people are living in favelas or slums and they’re living on maybe $5 a day or something or less. But when you meet these people, when you spend time with them, they’re some of the happiest people in the world. They’ve got the Brazilian flag painted inside their home, they’re playing soccer on the beach, they’re swimming in the ocean. And if you compare that to a lot of guys who might have a corner office on Wall Street, the contrast is just so stark, and I think it just shows you the value of being fulfilled or being happy with what you have and thinking about ways to live your life in a way that you can get that enjoyment and satisfaction.

Ted: What’s your biggest pet peeve?

Shiloh: My biggest pet peeve at work at least, is where people reach out to you trying to sell you something, but don’t really have anything that they’re offering back. So let me give you the example from the perspective of how we do fundraising. One way would be to call a bunch of RAs and family offices and say, Hey, we want you to invest in our fund. Okay, we want that. Why should they want that? The better way to do it is to offer something instead of to ask. So what we offer is education, education on private credit, on CLOs. We have the clo o investing book that I wrote and other resources. So we’re reaching out to people. We want something, but we have something to offer. And I think it’s important that people try to think about framing what they want in a way where maybe something’s coming back to the other person.

Ted: Which two people have had the biggest impact on your professional life?

Shiloh: So I think the two biggest people are going to be the two people in HR who took an Excel spreadsheet with a hundred names on it of people from different universities and decided which industries they were going to cover. So I think we like to go through life thinking. We’re in charge of everything that’s happening to us, what’s happening around us as a result of our hard work or lack thereof or of the smart calculated risks that we’re taking. But in reality, there’s a lot of random things that affect our life in huge ways and assigning me to the financial institutions group, that’s what resulted in us chatting here today. It could be in another universe. I could have been in the telecom group and who knows where I’d be. Unfortunately, I’m pretty happy with how it worked out.

Ted: What’s the best advice you’ve ever received?

Shiloh: So one of the things that I do, and one of the things I think we try to do as a firm is to take the most generous interpretation of what’s happening in a situation where you feel like you’re not being treated well or you don’t like what the other person’s doing. Instead of jumping to the conclusion, oh, assigning the worst motivations to the person, instead really assigning the best. Somebody shows up late to a zoom call. The worst impression would be, okay, this is somebody who’s not motivated or didn’t care or didn’t prioritize this, and the best is, Hey, you just don’t know what other people have going on in their life. I make an effort daily to go with the generous one. And start with that.

Ted: What life lesson have you learned that you wish you knew a lot earlier in life?

Shiloh: I found that I really like learning. So I have three different master’s degrees. I studied public policy at one point, financial mathematics and statistics, and then after graduate school, instead of learning in the academic environment where you’re really spoonfed information to try to learn things as an adult. So just like I go to the gym multiple times a week and I’m working out whatever muscle group, I try to treat my brain the same way. So I’m constantly learning new things. So piano, I mentioned jujitsu. I try to stay current with Spanish and just always finding mental challenges. I think that’s, at least for me, it’s a key to feeling good during the day, and I think it might keep you a little younger as well.

Ted: Shiloh, thanks so much for sharing this incredible education on CLO investing.

Shiloh: Thanks for having me, Ted. That’s great.

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