Author: Shiloh Bates

Shiloh Bates is a Partner and Chief Investment Officer at Flat Rock Global. Prior to joining Flat Rock Global in 2018, Mr. Bates was a Managing Director at Benefit Street Partners, where he worked on corporate acquisitions. Prior to joining Benefit Street Partners in 2016, Mr. Bates was the Head of Structured Products at BDCA Adviser, where he was responsible for investments in collateralized loan obligations (“CLOs”) and publicly traded business development companies (“BDCs”) as well as structuring the firm's credit facilities. He has worked at several CLO managers including Canaras Capital Management, Four Corners Capital Management and ING Capital Advisors. Mr. Bates began his career as an investment banker at First Union Securities. Mr. Bates has invested over $1 billion in CLO securities since 2013.
17 Oct 2023
Educational Videos Shiloh Bates 0 comment

Video: Interval Fund Basics

What is an interval fund? How is an interval fund different from other investment vehicles? Flat Rock Global CIO Shiloh Bates explains interval funds and why he thinks interval funds are growing in popularity.

Hi. I’m Shiloh Bates and I’m the CIO of Flat Rock Global.

Today I want to talk to you guys about interval funds and why we think they’re growing in popularity.

To purchase an interval fund is the same, simple funding mechanism as a U.S. mutual fund. It’s point and click; there is no paperwork. Now there is a daily share price, or NAV, net asset value, and that’s calculated by a third party. That’s the price at which investors can purchase shares of the fund. Now if investors want to sell shares, there’s a process by which they can tender those shares to the fund. And the fund agrees to a repurchase of at least 5% of shares per quarter, or 20% per year.

Now, practically speaking, an investor who wants to tender shares should get back much more than the contractual minimum. That’s because it’s very unlikely that all investors would tender at the same time.

The interval fund structure enables the fund to invest in illiquid assets that have a return premium associated with them. The premium is then passed along to the fund’s investors as dividends over time.

Interval funds make less-liquid asset classes typically reserved for institutional investors available to retail investors without the accredited or qualified investor limitations.

There are four primary reasons we believe interval funds will increasingly take share from private funds or closed-end funds. First, when you decide to invest in an interval fund, you can do it on that business day. You fund it to a portfolio where there’s already assets earning you return. There’s no concept of capital calls. There’s no setting aside cash, waiting for the capital calls to come in. You’re just fully invested on day one. Second, interval funds are SEC-registered and governed by the 1940 Act. And there’s a lot of regulation that goes along with that. For example, you’ll get annual reports, prospectuses, portfolio holdings, and caps on fund leverage, to name a few. But basically it’s the same regulation as a U.S. mutual fund. Third, in the interval fund structure, there’s no concept of trading above or below NAV. And that’s important because, for example, many closed-end funds, including BDCs, perpetually trade below NAV. In closed-end structures, changes in the fund’s discount in premium only adds to the overall share volatility. In the interval fund structure, it’s just not a concept. Fourth, for financial reporting, an investor in an interval fund receives a 1099. There’s no K1. And that’s going to make financial reporting much simpler.

So those are a few of the reasons we’re excited about interval funds. If you have any questions, feel free to reach out.

13 Jul 2023
Insights Shiloh Bates 0 comment

Common Mistakes in CLO Equity and BB Note Investing

Collateralized Loan Obligation (CLO) Equity is the riskiest tranche of a CLO, but also has the highest return potential, while notes rated BB are usually the CLO’s junior-most debt tranche. Both securities have attractive fundamentals, but it’s important to realize that these securities have some distinct features from other asset classes. Several key differences revolve around market illiquidity, conflicts of interest, CLO structural features, and market size. Below are a few lessons learned from our time in these asset classes:

1. CLO Equity investing, in particular, is not a great investment for investors that do not already have deep relationships in the market.

Imagine a CLO arranger has a $50 million equity tranche to sell in a new CLO. Who gets the first look? Given the investment size, the arranger generally cannot show the deal to multiple potential investors at the same time. That’s because each investor may want a majority of the equity, and if they all want the deal, many will be disappointed. So, the arranger starts with one account, and if that account passes, he moves on to the second. The pecking order is established by who does the most business with the arranger, among other factors. People new to the CLO asset class are going to find themselves last in line and will only see CLO opportunities that multiple others have passed on.

Similarly, it’s important that an investor sees other relevant market trades before making an investment. If you see a one-off trade from a broker dealer, it may end up being a fine investment, but you need to make sure you paid a fair price that is in line with recent market transactions.

2. An investor in CLO Equity should approach the market with the broadest possible mandate.

Many investors who want exposure to CLOs invest with one CLO manager in a GP / LP fund format that will invest in the next several CLO Equity tranches managed by that same manager1. This is an easy but inefficient way to invest. The investible universe of CLO Equity tranches is over 1,600 deals. The options are as follows: 

Primary CLOs – the financial market in which investors purchase newly-issued CLO securities

Secondary CLOs – where investors can buy and sell previously issued CLOs from other investors

CLO Warehouses – short-term financing vehicles provided by an investment bank to CLO managers to accumulate a pool of leveraged loans that will eventually be securitized into a CLO 

Middle Market CLOs – CLOs  with underlying collateral consisting of middle market loans rather than broadly syndicated loans

An investor in a GP / LP manager fund will be targeting the smallest fraction of the investible market, and there will be high overlap of the leveraged loans in each of the CLOs. Slowly waiting for the GP / LP fund to call capital may also be undesirable.

3. A CLO manager may not make the best CLO Equity Investor.

Many CLO Equity investors are also CLO managers, and they effectively market their CLO management skills as being useful in picking CLO Equity investments. However, this can quickly result in some conflicts of interest. Is the CLO Equity investor really looking at the whole market for the best opportunities, or is he simply helping the home team by investing in his firm’s CLOs? Let’s say the CLO Manager has syndicated almost all the CLO Notes for a new deal, but a few unsold parts of the capital structure remain. Perhaps those unwanted securities will end up in the CLO Equity Fund?

4. CLO BB Notes are robust, even when the market value coverage (market value of leveraged loans and cash / CLO debt through the BB Note) is less than 100%.

When the leveraged loan market sells off, potential returns in BB Notes can be equity-like. On its face, it seems very risky to invest in a CLO BB Note when, if the CLO was hypothetically liquidated, the proceeds would not result in full repayment. But, very few CLO BBs have defaulted, and there are two ways that the market value coverage likely ends above 100%, which is a requirement to get a full repayment on the CLO BB Note. First, many of the CLO’s leveraged loans will repay at par, thus increasing the market value coverage over time, as the fair value of the leveraged loans typically are below par. Second, if the CLO’s leveraged loans materially underperform, the diversion of cash flow that would have otherwise gone to the equity will also benefit the market value coverage. Do not underestimate the value of this CLO structural protection for the BB Note. 

5. Allocation to Middle Market CLO Equity and BB Notes has the potential to reduce overall portfolio risk. 

Middle Market CLOs offer exposure to a unique set of levered loans that aren’t represented in other CLOs. Projected equity returns are comparable to CLOs backed by broadly syndicated loans, but middle market loans tend to retain their value better in down markets. Changes in fair value of Middle Market CLO Equity are primarily driven by the actual performance of the underlying levered loans as opposed to technical factors influencing the broadly syndicated leveraged loan market.

1) GP / LP refers to a private fund structure where the General Partner (GP) typically manages assets on behalf of Limited Partners (LPs) who have contributed investment capital. GP / LP funds are not regulated under the investment Company Act of 1940.

DISCLOSURES

Past performance is not indicative of future results.

This Insight article is not an invitation to make any investment or purchase shares in any fund and is intended for informational purposes only. Nothing contained herein constitutes investment, legal, tax or other advice, nor is it to be relied on in making an investment or other decision. Nothing herein should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment, or to engage in any other transaction.

23 Apr 2020
US CLO Issuance
Insights Shiloh Bates 0 comment

The Underperformance of CLO Risk Retention Funds

On October 21, 2014, the final rules implementing the credit risk retention requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act were issued (the “U.S. Risk Retention Rule”).  U.S. Risk Retention Rule required a CLO manager or affiliate to retain not less than 5% of the credit risk of the assets collateralizing the CLO.  This could be achieved by the CLO manager owning approximately 50% of the CLO’s equity or a 5% vertical slice of all the CLO’s securities rated AAA down to equity.  It was expected that CLO issuance would be negatively affected by these new requirements, but the opposite turned out to be true.  CLO managers were successful in raising risk retention funds from their largest institutional investors, which was used to satisfy the new requirements.

The risk retention requirement ended on April 5, 2018, when it was successfully challenged in court.  However, risk retention funds continue to exist.  The business agreement between the CLO manager and the fund’s investors will likely continue until all the fund’s capital is called. 

US CLO Issuance

Source: Wells Fargo Research, January 2020

Risk retention funds enabled investors to participate pro-rata in a CLO manager’s next several years of issuance, with the largest managers issuing around four new CLOs a year.  The risk retention fund’s investors were often given management fee rebates to entice them into the fund.  However, management fee rebates have been available in the CLO market for a long time and participation in a risk retention fund isn’t required to benefit from them.    

It is our belief that investors in these funds will be disappointed with their returns.  It’s not because CLO equity doesn’t offer favorable risk-adjusted returns.  It’s because the way the funds approach the market is fundamentally flawed. 

To contrast, for an independent investor in CLO equity, the market is large at approximately $60 billion.1  There are over 100 managers issuing new CLOs and over 1,000 existing CLOs that could be invested in.1  Also, many independent investors buy the junior debt securities issued by CLOs when those securities offer high rates.  An independent investor may invest in the primary market when CLOs are created or invest in a CLO that began its life in 2014.  Most independent investors would want to be diversified by CLO manager and by the year of CLO issuance. 

For the the risk retention funds, the investment universe is quite small – subsequent CLOs issued by a single manager.  All other managers and the entire secondary market for CLO equity tranches are excluded.  The pre-selected investment universe is less than 1% of the overall market!  This is a recipe for underperformance. 

In 2019, the debt costs for new CLOs were elevated.  And the difference between the interest earned on the CLO loans and the interest paid on the CLO’s debt (the “arbitrage”) was at multi-year lows.1  At the same time, CLOs issued prior to 2019 were available in the secondary market that provided attractive risk-adjusted returns; that is where many independent CLO investors saw the best value.  However, the risk retention funds continued to call capital and create new CLOs that arguably should not have been formed.  Because the manager of a risk retention fund gets paid on assets under management, the incentive for the manager is to keep creating new CLOs.      

CLO market participants like to break managers into different tiers. For example, a CLO manager that has a large investor following and good historical returns is considered a tier one manager, while a newer CLO manager might be a tier three or four manager.  Since relative returns are constantly changing, managers’ categorizations are changing as well.   An investor in a risk retention fund may find that its long-term commitment is to a CLO manager whose reputation isn’t what it once was.  The independent CLO investor can quickly invest away from underperforming managers.      

Risk retention fund investors may recognize these issues.  At CLO conferences their strategy is discussed with incredulity on various panels.  If these funds truly marked their holdings to market, fund investors would have put pressure on the managers to stop calling capital a long time ago.     

While the CLO market can be difficult to understand for someone who doesn’t work in it daily, I often find it helpful to give analogies to the equity market.  Imagine being approached for a new equity fund with this pitch: “Invest in our fund today, and we will do the next six IPOs underwritten by investment bank X.  We don’t care about the company’s profitability, business model, management team, etc.  We are doing the next six deals!”  It’s hard for me to imagine this being a successful strategy, but that is the equity-equivalent to risk retention fund investing.  

(1) The CLO Market Monthly Overview, February 2020, Wells Fargo Securities

      For further information feel free to email info@flatrockglobal.com

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