Author: Shiloh Bates

Shiloh:

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

Drew, thanks so much for coming on the podcast.

Drew:

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

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

Shiloh:

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

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

Drew:

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

Shiloh:

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

Drew:

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

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

Shiloh:

So that’s the Credit Suisse loan index.

Drew:

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

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

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

Drew:

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

Shiloh:

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

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

Drew:

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

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

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

Shiloh:

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

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

Drew:

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

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

Shiloh:

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

That’s how to think about it.

Drew:

Yes.

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

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

Drew:

They did.

Shiloh:

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

Drew:

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

Shiloh:

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

Drew:

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

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

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

Shiloh:

This is the broadly syndicated loan market.

Drew:

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

Shiloh:

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

Drew:

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

Shiloh:

You need a loose stock,

Drew:

financial stress,

Shiloh:

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

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

Drew:

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

Shiloh:

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

Drew:

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

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

Shiloh:

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

Drew:

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

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

Shiloh:

So how do you protect yourself from lower loan recoveries?

Drew:

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

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

Shiloh:

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

Drew:

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

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

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

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

Shiloh:

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

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

Disclosure AI:

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

Shiloh:

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

Drew:

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

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

Shiloh:

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

Drew:

Agreed.

Shiloh:

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

Drew:

Thank you. Thanks for having me.

Disclosure AI:

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

AUM refers to assets under management

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

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

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

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

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

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

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

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

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

ETFs are exchange traded funds.

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

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

An add back would attempt to adjust EBITDA for non-recurring items.

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

General Disclaimer Section

References to interest rate moves are based on Bloomberg data.

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 disclaim, 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 offer. 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 Globla LLC. All rights reserved.

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

Disclaimers related to TCW

This material is for general information purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any security.

TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained may include preliminary information and/or forward-looking statements, Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. Copyright TCW 2024.

The CLO Investor Podcast, Episode 8

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

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

Shiloh:

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

John:

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

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

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

Shiloh:

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

John:

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

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

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

Shiloh:

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

Disclosure AI:

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

Shiloh:

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

John:

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

Shiloh:

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

Disclosure AI:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

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

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

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

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

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

Shiloh:

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

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

John:

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

Shiloh:

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

John:

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

Shiloh:

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

John:

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

Disclosure AI:

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

AUM refers to assets under management

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

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

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

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

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

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

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

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

ETFs are exchange traded funds.

Offset is a refinancing and extension of A CLO investment. 

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

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

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

RMBS stands for Residential mortgage-backed securities.

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

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

General Disclaimer Section

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

Any such views are subject to change at any time based upon market
or other conditions, and Flat Rock Global disclaims any responsibility to
update such views. This material is not intended to be relied upon as a
forecast, research, or investment advice. It is not a recommendation offer or
solicitation to buy or sell any securities or to adopt any investment strategy.
Neither Flat Rock Global nor the Flat Rock Global speaker can be responsible
for any direct or incidental loss incurred by applying any of the information
offered. None of the information provided should be regarded as a suggestion to
engage in or refrain

from any investment related course of action as neither Flat Rock Global nor its affiliates are undertaking To provide impartial investment advice, act as an impartial or give advice in a fiduciary capacity. This broadcast is copyright 2024 of Flat Rock Global LLC.

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

Disclaimers regarding JAAA and JBBB:

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

JAAA Fact Card

JBBB Fact Card

The CLO Investor Podcast, Episode 7

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

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

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

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

Shiloh:

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

Patrick:

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

Shiloh:

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

Patrick:

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

Shiloh:

Then there’s no haircut on that.

Patrick:

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

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

Shiloh:

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

Patrick:

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

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

Shiloh:

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

Patrick:

Thanks. Always great to chat.

Disclosure AI:

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

Definition Section: 

AUM refers to assets under management

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

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

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

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

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

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

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

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

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

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

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

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

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

ETFs are exchange traded funds.

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

Reset is a refinancing and extension of a CLO.

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

Intex is software that CLO practitioners use. 

General Disclaimer Section: 

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

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

The CLO Investor Podcast, Episode 6

Shiloh:

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

Paul:

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

Shiloh:

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

Paul:

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

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

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

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

Shiloh:

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

Paul:

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

Shiloh:

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

Paul:

So starting in 2015-2016, we started off by having a very strong secondary trading effort. So our firm is the most active trading desks in most scenarios in 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.

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

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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