Author: Shiloh Bates

Hi everybody, I’m Shiloh Bates. I’m the CIO of Flat Rock Global, and today I’m going to walk you guys through an educational presentation on CLOs. We call it CLO 101, and we’re not going to talk about our funds today, just the basics of CLOs. So just by way of background, for those of you who I haven’t met in the past, I started my career, it’s a little bit over 20 years ago, and in the CLO space, I’ve invested over 1,500,000,000 in CLO securities with Bob Grunwald, my firm’s founder. We’ve done that over the last 10 years, but basically my entire career is either working for CLO managers, picking the loans that go into CLOs or investing in CLO securities, debt and equity directly. And I recently wrote a book on CLO investing that’s available on Amazon.

So why learn about CLOs? Well, one thing today is it’s a $1 trillion AUM market. When I joined, it was about 6 billion of AUM, so it’s grown quite a bit. And one of the key reasons is that the market offers what I think is pretty attractive risk adjusted returns and people interested in CLOs can find investment opportunities from AAA rated notes, which are going to be the safest investments to CLO equity, which has the potential for mid-teen returns or better and takes more risk in the CLO market. Pretty much everything is floating rate. So it floats based in the past on LIBOR and now on three months SOFR. And the floating rate’s been very beneficial obviously in the last two years. And I describe CLOs as just a little bit complicated, but in a fun way. That’s how I think about it.

So one thing to know is that CLOs are very different from the failed CDOs of the past. So for example, I loved Michael Lewis’s book, the Big Short, but CLOs have their collateral is first lien senior secured corporate loans. And in contrast, the CDOs had subprime mortgages or mortgages of dubious credit quality In there securitized number of different, and the easiest way to think about it is if you’re securitizing quality assets, the outcomes over time can be quite favorable. And if you’re not securitizing good assets, there’s really nothing that securitization can do to improve the outcome in Closs. There’s lots of transparency in terms of how they report to us. And the CLOs are managed by really the largest US asset managers out there. The underlying loans tend to not be correlated because each CLO O is going to have a number of different industries represented in it and lots of different borrowers. And historically, as I mentioned, returns have been favorable, really up and down the CLO stack from AAA to equity. In the case of CDOs, you had defaults even in the investment grade tranches.

So annual CLO issuance, you can see that the trend has been up over time during the GFC there were just a few is issued. But what’s been driving this in my opinion, is really a few things. So one is the attractive returns that CLO investors have received over time and investors’ willingness and desire to get exposure to portfolios of first lien senior secured loans. That’s what’s driving this. And what ends up in CLOs are loans made to US companies that have usually undergone a leveraged buyout. So are private equity firms buying a company and they need, firstly in debt to finance part, usually half of the acquisition and a lot of those loans become the fuel for CLO. So as private equity a UM has grown. So too has CLO AUM.

So the typical broadly syndicated CLO structure, it is going to be about 500 million of assets. So these are first lien loans, again, floating rate. They’re secured by all the assets of the company. So that could be property plan and equipment, inventory, accounts receivable, intangible assets, it’s all in there pledged to the lenders. And again, these loans are created usually in leverage buyouts. And then the CLO is finance with investment grade debt that’s rated triple A down to triple B, it sold to insurance companies and banks primarily. We were actually not an investor in the investment grade part, but we do invest in double B notes. So these are the junior most debt that’s issued by the CO. And we’re also an investor in first loss equity. And basically if you’re an investor in the equity, the CLO is going to distribute to you very high quarterly income. And when I say high mean high teens and it comes to you each quarter and then you’re on the hook if and when loans default, you’re on the hook. But fortunately that risk isn’t like an unknowable risk. And I’ll talk through how we think about that as an equity investor. But simplistically, this is just like a pure play US bank. All it’s doing is lending the rate on the assets is higher than the CLO is financing costs in that creates some inherent profitability in the CLO.

So the biggest CLO managers today, Blackstone, Palmer Square, Elmwood, PGM, which is Prudential to name a few. So these guys are paid 40 to 50 basis points to manage the CLOs loans during the CLOs life and keep the CLO on sides with all the CLOs. Many tests. So at Fire rock, we’re investors in double Bs and equity. We don’t manage the underlying pools of loans. That’s a function that’s outsourced to the guys here in this ranking from Creditfluxx. So the typical loans in A CLO are going to start their lives with about a 50% loan to value. So there’s going to be a lot of equity capital, some junior debt capital in there as well. And what that means is that for one of these companies to default, defaults really are not going to be caused by just an increase in interest rates or some supply chain issues, inflationary costs that are not passed along to the end investor. What really causes default is a fundamental change in a business that comes from left field. So that could be a technological change, a regulatory change, a loss, an unexpected loss of a top two or three customers, stuff like that can put you into a default. But generally, as long as the business lose 50% of its enterprise value, then you should expect full repayment when the loan comes to.

So if you look into a broadly syndicated CLOs today, you’re going to see some names that may be familiar to you. So Asurion is a provider of wireless handset insurance. So they do that for iPhones and some Samsung phones as well. And then there’s other names here, which Cable Vision, Virgin Media, McAfee to name a few. So there’s some large US businesses that are represented in CLOs today, and each CLO though is going to have 200 different loan issuers in it. So historically, when loans default, you’ve gotten back close to two thirds of your money. And this is JP Morgan data. It goes all the way back to 1990. And how they measure the recovery is they take the trading price of the loan 30 days after default. They call that the recovery. Well, in ACL O, the CLO manager is not required to sell defaults.

Usually they work through the default. Typically, a loan might be restructured into a new loan of smaller size with some equity warrants attached to it. And so the recovery really plays out over time. And the expectation from the CLO manager’s perspective would be to get a recovery that’s higher than what’s shown here. But this is just the trading price 30 days after, and it’s much higher than high yield bonds. So high yield bonds are basically a promise to pay. They’re unsecured and the bond doesn’t get a recovery unless the first lien loans are made whole generally. And then the second liens, same thing. The second liens is only getting a recovery if the first lien is made whole generally.

So this is the lifecycle of a CLO. There’s a lot on here. But basically before the CLO is formed, usually an investment bank with an equity investor decide to open a CLO warehouse, and the warehouse is used to acquire loans prior to the formation of a CLO. And that’s true because when the CLO begins its life, the AAA down to the double B, all that debt starts accruing its interest. And so when the CLO starts its life, you want to have many loans purchased as possible so that you don’t have a negative cash track. And so the warehouse period might be four to six months where the CLO manager is slowly acquiring loans, then there’s what’s called the CLO pricing date, that’s the date at which financing is secured for the CLO. And investors have agreed on all the terms once the CLO closes, that’s really kind of the CLO formation date.

And then shortly thereafter, the CLO is going to start paying distributions to the debt and to the equity for the first, call it two years of the CLO’s life, there’s a no-call period on the CLO’s debt. And what that means is that during that time, the rate on the AAA, for example, it is what it can’t be changed for the benefit of the equity. But after two years, if it’s possible to go into the market and get a better financing rate for the AAA or the double B or whatever it is, the equity investors are going to want to do that. And similarly, if it’s in the interest of the equity to do a CLO life extension, which is also called a reset in the market that just extends the CLO’s life, it extends its reinvestment period. Those are things that can happen after the no-call period.

And then the reinvestment period ends. This is generally five years after the CLO closes and before the reinvestment period ends, every time the loan prepays a par, the CLO manager just goes into the market and buys a new loan with those proceeds. So the CLO is fully levered during its entire life through the well during their reinvestment period is. And then after the reinvestment period ends, when loans prepay a par, that cashflow is used to first repay the AAA, then the AA. And so slowly the CLO just naturally delvers and the CLO de-leveraging results in lower distributions for the equity. And so at some point, the equity’s going to decide to call the deal, and that is basically selling all the loans, repaying all the debt that’s left, and the remaining proceeds would be distributed to the equity. So all this could take eight years for the CLO, maybe another half year for the warehouse. If you do any CLO life extensions, that would add another five years to the CLO. So these are vehicles that are going to be around for quite some time.

So if you’re an investor in CLO BBs versus CLO equity, there’s some things that are very different in terms of the profile of these securities. And let me just kind of go back up here to show you the CLO diagram. So I’m going to compare how to think about the world from the perspective of the double B note here in orange, which is a debt security and the green CLO equity, which just takes the remainder of the cash flows that the CLO receives after all the interest is paid on the C’S debt and after some operating expenses of the CLO.

So if you’re an investor in double Bs, the CLO equity is a buffer against losses. So you’re not expecting to take any losses in the double B because equity has signed up to be that first loss risk. If you’re an investor in CLO double Bs, your return should be the cashflow you receive from the base rate, the floating rate of SOFR plus your spread. But if you’re an investor in CLO equity, again, you just sit at the bottom of the waterfall and whatever payments are left remain to you after the contractual payments, people above you and the waterfall, that’s what you get. You sweep up whatever’s left at the end. If you’re an investor in double Bs, you’re taking lower risk and expecting lower returns than CLO equity. And if you’re in the CLO double Bs, you have really no right to dictate how long the CLO is outstanding. You’re basically along for the ride. And if you’re in the CLO equity, you have certain rights where you can call a deal that’s decide to liquidate all the loans. You can refinance different tranches or reset the CLO after the no-call period. CLO BBSs are pretty liquid in secondary trading. And CLO equity has some liquidity but less than the CLO BB.

So some of the characteristics of CLO equity that I think are unique, one is that it’s an actively managed exposure to a diversified portfolio of these first lean loans. And again, by actively managed, I mean that we’re hiring a CLO manager who’s going to be one of the best and biggest investors in credit in the country. CLO equity offers very high current income. So if you invest in the S and P 500 for example, most of the return you’re expecting is just appreciation in shares. The dividend rate is quite low. Whereas for CLO equity, it’s the opposite. The return that you’re getting is actually coming from the quarterly distributions that you get. CLO equity has the potential for equity like returns, so returns similar to the s and p 500, but with a low correlation to the s and p 500 and to high yield bonds as well.

In each CLO, there’s a loan loss reserve. And basically what that means is that when we buy a CLO equity piece, we see there’s 200 different loans in the CLO for example, we know that no CLO manager is going to go 200 for 200. There’s always going to be some cats and dogs that default. And so what we do is we look back over the last 30 years and we see that there’s roughly a 2% default rate in CLO portfolios. And historically the recovery rate in CLOs is about 70%. And so we put that into all of our projection models. So when we buy a CLO equity piece, we never assume we’re going to go get all the loans par back. That’s not how the business works. But we have this loan loss reserve. And so when loans default, often like how we look at it is, oh, okay, that’s a budgeted default.

And when I talk about the returns that I’m targeting, that’s net of this loan loss reserve. So today, CLO equity investors are targeting high teen returns, and that’s net. That’s after 2% of the loans default and recover 70. And then I think potentially one of the most intriguing and advantageous parts of investing in CLO equity is that in recessionary periods what happens is you would expect that the default rate in your CLOs picks up, but at the same time, really in any market loans are constantly prepaying at par and those par proceeds are reinvested into new loans. And in a recession, the CLO manager should be able to buy new loans at a pretty interesting discount to par value.

If you look at the last almost two years, for example, our usual modeling assumption is that when a loan prepays, a new loan will be bought at 99 cents on the dollar. Well, for the last two years, the Morningstar loan index has had an average price of around 95. And so each time a loan repaid, presumably the collateral manager bought a new loan at a nice discount. And those discounted loans have the potential to increase profitability of the CLO over time. And it’s also a very valuable offset to any increased loan losses that you take in our recessionary period. Then finally, it’s an inefficient market with a potential for alpha. So each CLO equity tranche is about 50 million. There’s a couple of different holders of it, and our view is that if you’ve been around for a while and know what you’re doing, there’s a potential to really outperform your peers.

The one way to think about CLO equity returns simplistically is just what’s the chance that I have a negative IRR? And so we looked at deals from 2002 to 2020 and saw that less than half percent, less than 5% had negative IRRs. And the ones that were negative were basically mildly negative, negative 5%, negative 10, stuff like that. And there’s a few reasons for this. So one is that when the CLO begins its life, it starts making these very large equity distributions right out of the gate. And so in your first year you might get 20% of your investment back, and in the second year you’re at 40. And so just over time you’re just kind of naturally de-risking yourself. So that’s really helpful. The CLO self-healing mechanism that I described earlier where the CLO manager has the potential to buy discounted the loans in recessionary periods, that’s valuable. And then the other part of it is just the general quality, the high quality of the first lien loan portfolios that you can find in CLO o. So I think all these combined result in this pretty favorable positive distribution.

In terms of CLO self-healing, let’s go into this in some detail. So usually the loan market is trading around 99 cents on a dollar. So that’s the Morningstar loan index that you see here in Orange, and that’s where it ended. 99 is basically where it ended the year 2021. Well as risk premium went up throughout 2022 and into this year, the loan index sold off. And during this time the prepayment rate on loans is around 10 to 15%. So it wasn’t a very high prepayment rate number, but still loans were slowly repaying in the CLO and each time that happened, a discounted loan was bought with those proceeds. Now the CLOs are generally going to buy loans that are a little bit more conservative than the loan index. So if the loan index is at 95, they might be buying loans at 97 or something like that. But this has been an extended period where CLO managers have been able to buy discounted loans, and this has the potential to materially increase CLO equity returns over time. And it’s also beneficial to the debt investors and the CLO as well because if you’re buying discounted loans that ultimately mature par, that’s going to be more collateral that backs the position of the AAA down to the double B.

So one way to think about CLO equity returns is just to look at vintages. So this is the start date of A CLO and in this dataset, we stopped it at 2017 because for 2018 and beyond, the CLOs are still outstanding. So there’s not a realized return yet to show you, but we think those CLOs are doing well and are going to result in returns that are kind of comparable to previous vintages. But one of the things that really stands out here is the 2007 vintage CLO. And this is really surprising to a lot of people. So if you bought a CLO equity piece right before the financial crisis, you ended up with almost a 30% IRR. So why would that be? So imagine again, you bought this, you’re like the CLO analyst who is buying a unique CLO piece. In 2007, you were assuming a 2% default rate and a 70% recovery rate consistent with history.

And in 2008, you would’ve found in 2009 that the default rate was much higher than you would’ve initially expected. So the default rate peaked at about 8%. And so that’s obviously very negative for CLO equity. But at the same time, the index of loans traded down really into the sixties during the GFC and that enabled CLOs to buy lots of loans at discounts over time. And the loan market remained dislocated for a period of three to four years. And given the amount of discounted loans that were bought by the CLOs over time, that was actually more beneficial to returns than the elevated losses they took during the GFC. So the self-healing mechanism actually net net was positive for CLO equity. And so instead of earning a return of, call it mid-teens, which is probably what was targeted in 2007, it ended up being twice that and that’s the power of the self-healing mechanism.

So here’s a simple kind of income statement if you will for ACL O. So the loan interest rate today certainly elevated because of how SOFR has moved with fed hikes, but basically a 9% rate is floating on the assets, but it’s SOFR plus three and a half percent. The cost of debt is also going to be floating rate seven and a quarter today CLO manager fees on average about 40 basis points. And I mentioned that whenever we buy ACL O, we assume that 2% of the CLOs assets will default. Usually it’s a 30% loss in a default. So that’s the 60 basis points there. And so the levered return, so 75 basis points, so that’s the return that you earn on each turn of leverage, you’re making the 75 basis points. So that’s the loan interest rate, less the cost of debt, less management fees, and the loan loss reserve. And so with the CLO being levered nine times, what you pick up is 6.7, 6.75% in terms of the return. And then you also have an unlevered portion. So the formula there is just the loan interest rate less CLO manager fees and loan loss reserve. There’s no debt tied to one turn of the CLOs financing. And so when you add up the two items at the bottom, the total projected return in this example is 14.75%.

So if you’re interested in looking back at some historical returns for CLO equity, we made an index and it’s available on our website and it goes back to 2014, that’s when we had a sufficient dataset to create the index and we updated quarterly with a little bit of a lag. So now moving back to CLO double Bs. So again, the junior most debt tranche of the CLO, when you buy A CLO double B, that really simple question you’re asking yourself is what percentage of the underlying loans would have to default such that we’re not money good in the BB level? So here I’m going to just go back to the diagram for a quick second. So it’s just again, if you’re an investor here, these assets are your collateral and you just want to know how bad losses could be over here, such that all the equities even through and you start taking losses at the double B level. Really that’s the analysis.

And so we use some software called Intex that that models CLO cash flows to help us figure that out. And on average it’s about a 7% annual default rate per year for seven years to have a CLO double B that’s impaired. When we say impaired, we mean really just not receiving $1 of contractual interest and principal payments. So it’s not like a negative IRR or a total wipe, it’s just losing a little bit of the return that you you’re expecting. And so what we show here is the JP Morgan default rate over time. So you can see in orange, you can see that defaults peaked during the GFC at about 8%, but shortly thereafter, the default rate tends to normalize to the 2% area. You can also see some elevated defaults during the covid period as well. But what the blue line is showing you is that for a double B to default, you need that 7% default rate to happen for seven years, not just retreat quickly to a normalized level. And so what this shows to me is that these CLO double B notes are very robust, and that’s also true for the triple B, which is even more robust and up the stack. And then at Flatrock, we are investors in middle market BBs where there’s even more equity contributed to the deal upfront, and those survive like a 15% default rate annually over the seven year life of ACL O. So both middle market CLOs and broadly syndicated CLO double Bs we think are a very high credit quality.

So if you’re an investor in a double B, there’s a two things that benefit you at the end of the day. One is obviously the equity that signed up to take the first losses on the loan portfolio. But the second is this schematic here, which shows that if A CLO starts to underperform, and by that I mean there’s too many CCCs CCC rated loans or defaulted loans, instead of making the equity distribution, that cash is going to be retained in the CLO, it’s going to be used to buy more loans, which would be more collateral for the double B investor and other debt investors in the CLO or the cashflow could be used to dele the CLO. So both of those are beneficial really to all the debt holders.

And this is a very powerful tool because the equity distributions I mentioned earlier are in the high teens today. So there’s a lot of cashflow that’s available In a downside case, there’s a lot of cashflow that’s available, which could be used for the benefit of the double be holders. Now, the Closs today generally are performing quite well. None of ’em, none really are diverting cash flows in this way, but it’s a potential benefit and a downside case for all the debt holders in the CLO. So historically, high yield bonds have defaulted at about a 3% rate leverage loans at 2.9. Now, this is what I’m quoting here is are the indices. So if you look in CLOs specifically, the default rate for leveraged loans is going to be lower than the 2.9%, but if you compare that to the default rate for CLO double B notes, it’s about 25 basis points is the default rate. And hopefully that kind of jives with this previous slide that showed how robust these are through the GFC through covid. This chart is, I think it really kind says it all in terms of the credit quality here. And then the other benefit obviously is this, the ability to self-heal the CLOs debt tranches. So that’s what’s resulted in a very low default rate for CO BBSs over time, and that’s why we decided to launch a fund that’s dedicated to CO double Bs.

So some of the lessons that I’ve learned in my career investing in CLOs, one is that you really do need deep knowledge on the asset class and you need to have connection with all the investment banks that underwrite these CLOs and that trade CLOs in the secondary market. And one reason for that, it goes back to the size of the CLO tranche. So if an investment bank is working on selling a $50 million equity tranche or a 30 million BB for example, they can’t really go out to the entire world. And the reason is that if a number of people decide they want to do it, then they’re going to have a problem and there’s only 50 million for sale. So they’re going to have a lot of unhappy customers at the end of the day. So especially in equity, the investment banks tend to go to their top clients first for the most interesting transactions. And then if those clients pass on the opportunity, then they’re calling down a list. And if you’re kind of like a tourist to the asset class, if you’re new to the asset class, you’re probably not going to be high on anybody’s list and you’re probably going to miss some of the best transactions out there.

We also think it’s very important to have a broad mandate in CLOs. And so that means specifically that our targeted investments are middle market CLO equity, broadly syndicated, CLO equity, broadly syndicated BBs, middle market double Bs. We invest in CLO warehouses, which again are the vehicles that are used to acquire loans prior to the Closs formation. We do the equity in those, we invest in the primary market where CLOs are created. We invest in the secondary market where Closs that already exist are treated. And over time we see different opportunities across all those spaces and we think it’s best practice to be nimble and be able to move around and capture that value over time.

At Fire Rock for example, we are not a CLO manager, so there’s no kind of in-house team that we’re supporting with our funds. So there’s a hundred different CLO managers out there. We’re not wedded to any of ’em. We have some quantitative and qualitative metrics we use to distill the top a hundred managers to the top quartile or so, but there’s no kind of in-house cooking that we’re putting into the funds. And one of the things I’ve seen in the past is that when a CLO equity team is tied to a CLO manager, when that CLO manager is forming new CLOs, a lot of times there’ll be a few CLO securities that aren’t sold. So maybe there’s 5 million of a AAA that wasn’t sold for whatever reason or parts of a double B, and then the investment bank’s like, Hey, well why don’t you put that into one of your internal funds? There’s obviously a conflict there and we suggest that people try to find managers that avoid that conflict.

We like CLO double Bs, we like them surprisingly, even at times where if all the loans were liquidated today, the double B would not be covered. And that sounds a little bit scary, but if you remember how the double B, the self-healing works is that when the CLO O is underperforming equity, CLO equity distributions get turned off. And so you have, when the distributions are turned off, the nav should be, or the fair market value of the loans should be increasing over time. So that can move you back on sides. And at the end of the day, a lot of times loans trade off the traded loan market often moves with high yield, but at the end of the day, loans either prepay you a par or they default. Those are really the only options. And even when loans have kind of sold off some, usually the end result given they start their lives at a 50% loan to value is that you just get your money back at the end.

So loan might be trading in the mid nineties today, that’s actually where the loan index is, but we’d feel really good about getting a par recovery in most cases. And then we really like middle market CLOs at Fire Rock. So we have one fund that’s primary mandate is middle market loans owned directly on our balance sheet. Middle market loans are unique in that each of the CLOs is going to have a very different collateral pool than CLOs managed by other middle market managers. And there’s some portfolio characteristics that we also think make middle market CLOs very appealing.

So if you’d like to know more, again, I did write a book on CLO investing. It’s available on Amazon and we’re happy to send you a copy if you’d like. But this is written in a way where it’s written from the perspective of an investor. So before this book, you could Google CLOs and there’d be a lot of different information that you could piecemeal together to educate yourself. But what’s different here is that in a lot of parts of it I’m describing really the framework that we use to buy equity and double Bs, the same framework that is used to buy double Bs is also applicable all the way up the stack to aas. It’s the exact same thought process.

Last year I saw an intro to CLOs that was written that went around the market and it was written by lawyers and they started off the book saying, A CLO is a bankruptcy remote vehicle do mess outed in the Cayman Islands with, and they went through the legal ease of it. And I’m reading it, I’m like, okay, well that’s all true. But this book is designed to capture the economics of the trade. And I think with just some basic financial knowledge that it is written for somebody with just some basic financial knowledge and hopefully people will find it interesting and if they read the book and still have additional questions, they should feel free to reach out. So with that, I’m going to stop here. Thanks a lot for joining us today. I really appreciate it. But again, we’re always happy to answer your question, so feel free to reach out to me or your salesperson and hope you have a great afternoon. Thanks.

Hi everybody, I’m Shiloh Bates. I’m the CIO of Flat Rock Global, and today I’m going to walk you guys through an educational presentation on CLOs. We call it CLO 101, and we’re not going to talk about our funds today, just the basics of CLOs. So just by way of background, for those of you who I haven’t met in the past, I started my career, it’s a little bit over 20 years ago, and in the CLO space, I’ve invested over 1,500,000,000 in CLO securities with Bob Grunewald, my firm’s founder. We’ve done that over the last 10 years, but basically my entire career is either working for CLO managers, picking the loans that go into CLOs or investing in CLO securities, debt and equity directly. And I recently wrote a book on CLO investing that’s available on Amazon.

So why learn about CLOs? Well, one thing today is it’s a $1 trillion AUM market. When I joined, it was about 6 billion of AUM, so it’s grown quite a bit. And one of the key reasons is that the market offers what I think is pretty attractive risk adjusted returns and people interested in CLOs can find investment opportunities from AAA rated notes, which are going to be the safest investments to CLO equity, which has the potential for mid-teen returns or better and takes more risk in the CLO market. Pretty much everything is floating rate. So it floats based in the past on LIBOR and now on three months SOFR. And the floating rate’s been very beneficial obviously in the last two years. And I describe CLOs as just a little bit complicated, but in a fun way. That’s how I think about it.

So one thing to know is that CLOs are very different from the failed CDOs of the past. So for example, I loved Michael Lewis’s book, the Big Short, but CLOs have their collateral is first lien senior secured corporate loans. And in contrast, the CDOs had subprime mortgages or mortgages of dubious credit quality In there securitized number of different, and the easiest way to think about it is if you’re securitizing quality assets, the outcomes over time can be quite favorable. And if you’re not securitizing good assets, there’s really nothing that securitization can do to improve the outcome in CLOs. There’s lots of transparency in terms of how they report to us. And the CLOs are managed by really the largest US asset managers out there. The underlying loans tend to not be correlated because each CLO is going to have a number of different industries represented in it and lots of different borrowers. And historically, as I mentioned, returns have been favorable, really up and down the CLO stack from AAA to equity. In the case of CDOs, you had defaults even in the investment grade tranches.

So annual CLO issuance, you can see that the trend has been up over time during the GFC there were just a few issued. But what’s been driving this in my opinion, is really a few things. So one is the attractive returns that CLO investors have received over time and investors’ willingness and desire to get exposure to portfolios of first lien senior secured loans. That’s what’s driving this. And what ends up in CLOs are loans made to US companies that have usually undergone a leveraged buyout. So are private equity firms buying a company and they need, firstly in debt to finance part, usually half of the acquisition and a lot of those loans become the fuel for CLO. So as private equity AUM has grown, so too has CLO AUM.

So the typical broadly syndicated CLO structure, it is going to be about 500 million of assets. So these are first lien loans, again, floating rate. They’re secured by all the assets of the company. So that could be property plan and equipment, inventory, accounts receivable, intangible assets, it’s all in there pledged to the lenders. And again, these loans are created usually in leverage buyouts. And then the CLO is finance with investment grade debt that’s rated triple A down to triple B, it sold to insurance companies and banks primarily. We were actually not an investor in the investment grade part, but we do invest in double B notes. So these are the junior most debt that’s issued by the CO. And we’re also an investor in first loss equity. And basically if you’re an investor in the equity, the CLO is going to distribute to you very high quarterly income. And when I say high mean high teens and it comes to you each quarter and then you’re on the hook if and when loans default, you’re on the hook. But fortunately that risk isn’t like an unknowable risk. And I’ll talk through how we think about that as an equity investor. But simplistically, this is just like a pure play US bank. All it’s doing is lending the rate on the assets is higher than the CLO is financing costs in that creates some inherent profitability in the CLO.

So the biggest CLO managers today, Blackstone, Palmer Square, Elmwood, PGM, which is Prudential to name a few. So these guys are paid 40 to 50 basis points to manage the CLOs loans during the CLOs life and keep the CLO on sides with all the CLOs. Many tests. So at Flat Rock, we’re investors in double Bs and equity. We don’t manage the underlying pools of loans. That’s a function that’s outsourced to the guys here in this ranking from Creditfluxx. So the typical loans in A CLO are going to start their lives with about a 50% loan to value. So there’s going to be a lot of equity capital, some junior debt capital in there as well. And what that means is that for one of these companies to default, defaults really are not going to be caused by just an increase in interest rates or some supply chain issues, inflationary costs that are not passed along to the end investor. What really causes default is a fundamental change in a business that comes from left field. So that could be a technological change, a regulatory change, a loss, an unexpected loss of a top two or three customers, stuff like that can put you into a default. But generally, as long as the business lose 50% of its enterprise value, then you should expect full repayment when the loan comes due.

So if you look into a broadly syndicated CLOs today, you’re going to see some names that may be familiar to you. So Asurion is a provider of wireless handset insurance. So they do that for iPhones and some Samsung phones as well. And then there’s other names here, which Cable Vision, Virgin Media, McAfee to name a few. So there’s some large US businesses that are represented in CLOs today, and each CLO though is going to have 200 different loan issuers in it. So historically, when loans default, you’ve gotten back close to two thirds of your money. And this is JP Morgan data. It goes all the way back to 1990. And how they measure the recovery is they take the trading price of the loan 30 days after default. They call that the recovery. Well, in ACL O, the CLO manager is not required to sell defaults.

Usually they work through the default. Typically, a loan might be restructured into a new loan of smaller size with some equity warrants attached to it. And so the recovery really plays out over time. And the expectation from the CLO manager’s perspective would be to get a recovery that’s higher than what’s shown here. But this is just the trading price 30 days after, and it’s much higher than high yield bonds. So high yield bonds are basically a promise to pay. They’re unsecured and the bond doesn’t get a recovery unless the first lien loans are made whole generally. And then the second liens, same thing. The second liens is only getting a recovery if the first lien is made whole generally.

So this is the lifecycle of a CLO. There’s a lot on here. But basically before the CLO is formed, usually an investment bank with an equity investor decide to open a CLO warehouse, and the warehouse is used to acquire loans prior to the formation of a CLO. And that’s true because when the CLO begins its life, the AAA down to the double B, all that debt starts accruing its interest. And so when the CLO starts its life, you want to have many loans purchased as possible so that you don’t have a negative cash track. And so the warehouse period might be four to six months where the CLO manager is slowly acquiring loans, then there’s what’s called the CLO pricing date, that’s the date at which financing is secured for the CLO. And investors have agreed on all the terms once the CLO closes, that’s really kind of the CLO formation date.

And then shortly thereafter, the CLO is going to start paying distributions to the debt and to the equity for the first, call it two years of the CLO’s life, there’s a no-call period on the CLO’s debt. And what that means is that during that time, the rate on the AAA, for example, it is what it can’t be changed for the benefit of the equity. But after two years, if it’s possible to go into the market and get a better financing rate for the AAA or the double B or whatever it is, the equity investors are going to want to do that. And similarly, if it’s in the interest of the equity to do a CLO life extension, which is also called a reset in the market that just extends the CLO’s life, it extends its reinvestment period. Those are things that can happen after the no-call period.

And then the reinvestment period ends. This is generally five years after the CLO closes and before the reinvestment period ends, every time the loan prepays a par, the CLO manager just goes into the market and buys a new loan with those proceeds. So the CLO is fully levered during its entire life through the well during their reinvestment period is. And then after the reinvestment period ends, when loans prepay a par, that cashflow is used to first repay the AAA, then the AA. And so slowly the CLO just naturally de-levers and the CLO de-leveraging results in lower distributions for the equity. And so at some point, the equity’s going to decide to call the deal, and that is basically selling all the loans, repaying all the debt that’s left, and the remaining proceeds would be distributed to the equity. So all this could take eight years for the CLO, maybe another half year for the warehouse. If you do any CLO life extensions, that would add another five years to the CLO. So these are vehicles that are going to be around for quite some time.

So if you’re an investor in CLO BBs versus CLO equity, there’s some things that are very different in terms of the profile of these securities. And let me just kind of go back up here to show you the CLO diagram. So I’m going to compare how to think about the world from the perspective of the double B note here in orange, which is a debt security and the green CLO equity, which just takes the remainder of the cash flows that the CLO receives after all the interest is paid on the C’S debt and after some operating expenses of the CLO.

So if you’re an investor in double Bs, the CLO equity is a buffer against losses. So you’re not expecting to take any losses in the double B because equity has signed up to be that first loss risk. If you’re an investor in CLO double Bs, your return should be the cashflow you receive from the base rate, the floating rate of SOFR plus your spread. But if you’re an investor in CLO equity, again, you just sit at the bottom of the waterfall and whatever payments are left remain to you after the contractual payments, people above you and the waterfall, that’s what you get. You sweep up whatever’s left at the end. If you’re an investor in double Bs, you’re taking lower risk and expecting lower returns than CLO equity. And if you’re in the CLO double Bs, you have really no right to dictate how long the CLO is outstanding. You’re basically along for the ride. And if you’re in the CLO equity, you have certain rights where you can call a deal that’s decided to liquidate all the loans. You can refinance different tranches or reset the CLO after the no-call period. CLO BBSs are pretty liquid in secondary trading. And CLO equity has some liquidity but less than the CLO BB.

So some of the characteristics of CLO equity that I think are unique, one is that it’s an actively managed exposure to a diversified portfolio of these first lean loans. And again, by actively managed, I mean that we’re hiring a CLO manager who’s going to be one of the best and biggest investors in credit in the country. CLO equity offers very high current income. So if you invest in the S and P 500 for example, most of the return you’re expecting is just appreciation in shares. The dividend rate is quite low. Whereas for CLO equity, it’s the opposite. The return that you’re getting is actually coming from the quarterly distributions that you get. CLO equity has the potential for equity like returns, so returns similar to the s and p 500, but with a low correlation to the s and p 500 and to high yield bonds as well.

In each CLO, there’s a loan loss reserve. And basically what that means is that when we buy a CLO equity piece, we see there’s 200 different loans in the CLO for example, we know that no CLO manager is going to go 200 for 200. There’s always going to be some cats and dogs that default. And so what we do is we look back over the last 30 years and we see that there’s roughly a 2% default rate in CLO portfolios. And historically the recovery rate in CLOs is about 70%. And so we put that into all of our projection models. So when we buy a CLO equity piece, we never assume we’re going to go get all the loans par back. That’s not how the business works. But we have this loan loss reserve. And so when loans default, often like how we look at it is, oh, okay, that’s a budgeted default.

And when I talk about the returns that I’m targeting, that’s net of this loan loss reserve. So today, CLO equity investors are targeting high teen returns, and that’s net. That’s after 2% of the loans default and recover 70. And then I think potentially one of the most intriguing and advantageous parts of investing in CLO equity is that in recessionary periods what happens is you would expect that the default rate in your CLOs picks up, but at the same time, really in any market loans are constantly prepaying at par and those par proceeds are reinvested into new loans. And in a recession, the CLO manager should be able to buy new loans at a pretty interesting discount to par value.

If you look at the last almost two years, for example, our usual modeling assumption is that when a loan prepays, a new loan will be bought at 99 cents on the dollar. Well, for the last two years, the Morningstar loan index has had an average price of around 95. And so each time a loan repaid, presumably the collateral manager bought a new loan at a nice discount. And those discounted loans have the potential to increase profitability of the CLO over time. And it’s also a very valuable offset to any increased loan losses that you take in our recessionary period. Then finally, it’s an inefficient market with a potential for alpha. So each CLO equity tranche is about 50 million. There’s a couple of different holders of it, and our view is that if you’ve been around for a while and know what you’re doing, there’s a potential to really outperform your peers.

The one way to think about CLO equity returns simplistically is just what’s the chance that I have a negative IRR? And so we looked at deals from 2002 to 2020 and saw that less than half percent, less than 5% had negative IRRs. And the ones that were negative were basically mildly negative, negative 5%, negative 10, stuff like that. And there’s a few reasons for this. So one is that when the CLO begins its life, it starts making these very large equity distributions right out of the gate. And so in your first year you might get 20% of your investment back, and in the second year you’re at 40. And so just over time you’re just kind of naturally de-risking yourself. So that’s really helpful. The CLO self-healing mechanism that I described earlier where the CLO manager has the potential to buy discounted the loans in recessionary periods, that’s valuable. And then the other part of it is just the general quality, the high quality of the first lien loan portfolios that you can find in CLO o. So I think all these combined result in this pretty favorable positive distribution.

In terms of CLO self-healing, let’s go into this in some detail. So usually the loan market is trading around 99 cents on a dollar. So that’s the Morningstar loan index that you see here in Orange, and that’s where it ended. 99 is basically where it ended the year 2021. Well as risk premium went up throughout 2022 and into this year, the loan index sold off. And during this time the prepayment rate on loans is around 10 to 15%. So it wasn’t a very high prepayment rate number, but still loans were slowly repaying in the CLO and each time that happened, a discounted loan was bought with those proceeds. Now the CLOs are generally going to buy loans that are a little bit more conservative than the loan index. So if the loan index is at 95, they might be buying loans at 97 or something like that. But this has been an extended period where CLO managers have been able to buy discounted loans, and this has the potential to materially increase CLO equity returns over time. And it’s also beneficial to the debt investors and the CLO as well because if you’re buying discounted loans that ultimately mature par, that’s going to be more collateral that backs the position of the AAA down to the double B.

So one way to think about CLO equity returns is just to look at vintages. So this is the start date of A CLO and in this dataset, we stopped it at 2017 because for 2018 and beyond, the CLOs are still outstanding. So there’s not a realized return yet to show you, but we think those CLOs are doing well and are going to result in returns that are kind of comparable to previous vintages. But one of the things that really stands out here is the 2007 vintage CLO. And this is really surprising to a lot of people. So if you bought a CLO equity piece right before the financial crisis, you ended up with almost a 30% IRR. So why would that be? So imagine again, you bought this, you’re like the CLO analyst who is buying a unique CLO piece. In 2007, you were assuming a 2% default rate and a 70% recovery rate consistent with history.

And in 2008, you would’ve found in 2009 that the default rate was much higher than you would’ve initially expected. So the default rate peaked at about 8%. And so that’s obviously very negative for CLO equity. But at the same time, the index of loans traded down really into the sixties during the GFC and that enabled CLOs to buy lots of loans at discounts over time. And the loan market remained dislocated for a period of three to four years. And given the amount of discounted loans that were bought by the CLOs over time, that was actually more beneficial to returns than the elevated losses they took during the GFC. So the self-healing mechanism actually net net was positive for CLO equity. And so instead of earning a return of, call it mid-teens, which is probably what was targeted in 2007, it ended up being twice that and that’s the power of the self-healing mechanism.

So here’s a simple kind of income statement if you will for a CLO. So the loan interest rate today certainly elevated because of how SOFR has moved with fed hikes, but basically a 9% rate is floating on the assets, but it’s SOFR plus three and a half percent. The cost of debt is also going to be floating rate seven and a quarter today CLO manager fees on average about 40 basis points. And I mentioned that whenever we buy a CLO, we assume that 2% of the CLOs assets will default. Usually it’s a 30% loss in a default. So that’s the 60 basis points there. And so the levered return, so 75 basis points, so that’s the return that you earn on each turn of leverage, you’re making the 75 basis points. So that’s the loan interest rate, less the cost of debt, less management fees, and the loan loss reserve. And so with the CLO being levered nine times, what you pick up is 6.7, 6.75% in terms of the return. And then you also have an unlevered portion. So the formula there is just the loan interest rate less CLO manager fees and loan loss reserve. There’s no debt tied to one turn of the CLOs financing. And so when you add up the two items at the bottom, the total projected return in this example is 14.75%.

So if you’re interested in looking back at some historical returns for CLO equity, we made an index and it’s available on our website and it goes back to 2014, that’s when we had a sufficient dataset to create the index and we updated quarterly with a little bit of a lag. So now moving back to CLO double Bs. So again, the junior most debt tranche of the CLO, when you buy a CLO double B, that really simple question you’re asking yourself is what percentage of the underlying loans would have to default such that we’re not money good in the BB level? So here I’m going to just go back to the diagram for a quick second. So it’s just again, if you’re an investor here, these assets are your collateral and you just want to know how bad losses could be over here, such that all the equities even through and you start taking losses at the double B level. Really that’s the analysis.

And so we use some software called Intex that that models CLO cash flows to help us figure that out. And on average it’s about a 7% annual default rate per year for seven years to have a CLO double B that’s impaired. When we say impaired, we mean really just not receiving $1 of contractual interest and principal payments. So it’s not like a negative IRR or a total wipe, it’s just losing a little bit of the return that you’re expecting. And so what we show here is the JP Morgan default rate over time. So you can see in orange, you can see that defaults peaked during the GFC at about 8%, but shortly thereafter, the default rate tends to normalize to the 2% area. You can also see some elevated defaults during the COVID period as well. But what the blue line is showing you is that for a double B to default, you need that 7% default rate to happen for seven years, not just retreat quickly to a normalized level. And so what this shows to me is that these CLO double B notes are very robust, and that’s also true for the triple B, which is even more robust and up the stack. And then at Flat Rock, we are investors in middle market BBs where there’s even more equity contributed to the deal upfront, and those survive like a 15% default rate annually over the seven year life of ACL O. So both middle market CLOs and broadly syndicated CLO double Bs we think are a very high credit quality.

So if you’re an investor in a double B, there’s a two things that benefit you at the end of the day. One is obviously the equity that signed up to take the first losses on the loan portfolio. But the second is this schematic here, which shows that if a CLO starts to underperform, and by that I mean there’s too many CCCs CCC rated loans or defaulted loans, instead of making the equity distribution, that cash is going to be retained in the CLO, it’s going to be used to buy more loans, which would be more collateral for the double B investor and other debt investors in the CLO or the cashflow could be used to dele the CLO. So both of those are beneficial really to all the debt holders.

And this is a very powerful tool because the equity distributions I mentioned earlier are in the high teens today. So there’s a lot of cashflow that’s available In a downside case, there’s a lot of cashflow that’s available, which could be used for the benefit of the double be holders. Now, the CLOs today generally are performing quite well. None of them, none really are diverting cash flows in this way, but it’s a potential benefit and a downside case for all the debt holders in the CLO. So historically, high yield bonds have defaulted at about a 3% rate leverage loans at 2.9. Now, this is what I’m quoting here are the indices. So if you look in CLOs specifically, the default rate for leveraged loans is going to be lower than the 2.9%, but if you compare that to the default rate for CLO double B notes, it’s about 25 basis points is the default rate. And hopefully that kind of jives with this previous slide that showed how robust these are through the GFC through COVID. This chart is, I think it really kind says it all in terms of the credit quality here. And then the other benefit obviously is this, the ability to self-heal the CLO’s debt tranches. So that’s what’s resulted in a very low default rate for CO BBSs over time, and that’s why we decided to launch a fund that’s dedicated to CLO double Bs.

So some of the lessons that I’ve learned in my career investing in CLOs, one is that you really do need deep knowledge on the asset class and you need to have connection with all the investment banks that underwrite these CLOs and that trade CLOs in the secondary market. And one reason for that, it goes back to the size of the CLO tranche. So if an investment bank is working on selling a $50 million equity tranche or a 30 million BB for example, they can’t really go out to the entire world. And the reason is that if a number of people decide they want to do it, then they’re going to have a problem and there’s only 50 million for sale. So they’re going to have a lot of unhappy customers at the end of the day. So especially in equity, the investment banks tend to go to their top clients first for the most interesting transactions. And then if those clients pass on the opportunity, then they’re calling down a list. And if you’re kind of like a tourist to the asset class, if you’re new to the asset class, you’re probably not going to be high on anybody’s list and you’re probably going to miss some of the best transactions out there.

We also think it’s very important to have a broad mandate in CLOs. And so that means specifically that our targeted investments are middle market CLO equity, broadly syndicated, CLO equity, broadly syndicated BBs, middle market double Bs. We invest in CLO warehouses, which again are the vehicles that are used to acquire loans prior to the CLO’s formation. We do the equity in those, we invest in the primary market where CLOs are created. We invest in the secondary market where Closs that already exist are treated. And over time we see different opportunities across all those spaces and we think it’s best practice to be nimble and be able to move around and capture that value over time.

At Flat Rock for example, we are not a CLO manager, so there’s no kind of in-house team that we’re supporting with our funds. So there’s a hundred different CLO managers out there. We’re not wedded to any of ’em. We have some quantitative and qualitative metrics we use to distill the top a hundred managers to the top quartile or so, but there’s no kind of in-house cooking that we’re putting into the funds. And one of the things I’ve seen in the past is that when a CLO equity team is tied to a CLO manager, when that CLO manager is forming new CLOs, a lot of times there’ll be a few CLO securities that aren’t sold. So maybe there’s 5 million of a AAA that wasn’t sold for whatever reason or parts of a double B, and then the investment bank’s like, Hey, well why don’t you put that into one of your internal funds? There’s obviously a conflict there and we suggest that people try to find managers that avoid that conflict.

We like CLO double Bs, we like them surprisingly, even at times where if all the loans were liquidated today, the double B would not be covered. And that sounds a little bit scary, but if you remember how the double B, the self-healing works is that when the CLO O is underperforming equity, CLO equity distributions get turned off. And so you have, when the distributions are turned off, the nav should be, or the fair market value of the loans should be increasing over time. So that can move you back on sides. And at the end of the day, a lot of times loans trade off the traded loan market often moves with high yield, but at the end of the day, loans either prepay you a par or they default. Those are really the only options. And even when loans have kind of sold off some, usually the end result given they start their lives at a 50% loan to value is that you just get your money back at the end.

So a loan might be trading in the mid nineties today, that’s actually where the loan index is, but we’d feel really good about getting a par recovery in most cases. And then we really like middle market CLOs at Flat Rock. So we have one fund that’s primary mandate is middle market loans owned directly on our balance sheet. Middle market loans are unique in that each of the CLOs is going to have a very different collateral pool than CLOs managed by other middle market managers. And there’s some portfolio characteristics that we also think make middle market CLOs very appealing.

So if you’d like to know more, again, I did write a book on CLO investing. It’s available on Amazon and we’re happy to send you a copy if you’d like. But this is written in a way where it’s written from the perspective of an investor. So before this book, you could Google CLOs and there’d be a lot of different information that you could piecemeal together to educate yourself. But what’s different here is that in a lot of parts of it I’m describing really the framework that we use to buy equity and double Bs, the same framework that is used to buy double Bs is also applicable all the way up the stack to AAs. It’s the exact same thought process.

Last year I saw an intro to CLOs that was written that went around the market and it was written by lawyers and they started off the book saying, A CLO is a bankruptcy remote vehicle do mess outed in the Cayman Islands with, and they went through the legal ease of it. And I’m reading it, I’m like, okay, well that’s all true. But this book is designed to capture the economics of the trade. And I think with just some basic financial knowledge that it is written for somebody with just some basic financial knowledge and hopefully people will find it interesting and if they read the book and still have additional questions, they should feel free to reach out. So with that, I’m going to stop here. Thanks a lot for joining us today. I really appreciate it. But again, we’re always happy to answer your question, so feel free to reach out to me or your salesperson and hope you have a great afternoon. Thanks.