Author: Shiloh Bates

Shiloh Bates, CFA joined Flat Rock Global in 2018 and is a Partner and Chief Investment Officer. Prior to that, he was a Managing Director at Benefit Street Partners. During his 20-year career, Mr. Bates has worked for several CLO managers and has been one of the largest investors in CLO securities. He wrote the book, CLO Investing with a focus on CLO Equity and BB Notes. He is also the host of the CLO Investor Podcast. Shiloh has a BA from Virginia Tech in Political Science, an MA in Public Policy from Harvard University, an MA in Financial Mathematics from the University of Chicago, and an MA in Statistics from Columbia University. He was also a specialist in psychological warfare in the US Army Reserves.
22 Jan 2024
Insights Shiloh Bates 0 comment

Key Questions about Private Credit, CLOs

Is private credit a bubble?

Relevant for: Leveraged loans, CLO BBs, and CLO Equity

We do not believe private credit is a bubble. As a result of Federal Reserve interest rate hikes, middle market loans yields are now in the low double-digits. In the typical corporate capital structure, the more risk you take, the higher the required return. However, middle market loans could offer returns well in excess of where many economists project long-term equity returns to be. Middle market loans are senior and secured and therefore typically offer more downside protection than high yield bonds or equities. Standard and Poor’s estimates that private equity firms have raised $2.5 trillion that has yet to be deployed.1 We believe much of that capital will be used to buy middle market businesses in transactions where the loan will make up less than 50% of the purchase price. A substantial equity contribution from a private equity sponsor provides downside protection for the middle market loan investor. This favorable risk / return dynamic for middle market loans hasn’t existed for the last fifteen years, in our opinion.

Middle market loans are owned in long-term non-mark-to-market funds. The market should not see any forced selling of middle market loans due to margin calls. The result is more stable loan pricing over time.

Middle market lending has never been a zero-loss investment opportunity. Unforeseen events can push some business into default. When we model CLOs, we include a 60bps loss rate on the loans, consistent with the historical loss rate in those portfolios. Prior to the increase in interest rates, we believe most middle market loans were paying a fixed spread of approximately 5.0% over a LIBOR floor of 1.0%. Now, middle market loans pay the spread over the Secured Overnight Funding Rate (SOFR), which finished the year at 5.3%. The additional yield of 4.3% could provide an attractive offset for any increase in loan losses that could result from a slowing economy.

Outside of traditional middle market lending, we see risk in broadly syndicated loans where the loan documentation did not adequately protect creditors’ rights. We also see risk in second lien loans and unsecured debt, where if the loans were to default, recoveries would be much lower than first lien loans.

Can borrowers afford higher interest rates?

Relevant for: Leveraged loans, CLO BBs, and CLO Equity
We believe that most companies that issue leveraged loans will be able to pay the higher rates that have resulted from Federal Reserve interest rate increases. By our estimation, interest coverage ratios of middle market borrowers have declined from ~3.7x at year-end 2021 to ~2.0x at year-end 2023.2 Rate increases were long expected, but the Federal Reserve certainly did not expect that it would have to raise interest rates to current levels to tame inflation. The interest rate markets now expect SOFR rates to normalize in the 3.0% area in 2025.3

Higher interest rates have resulted in less cash flow for middle market businesses, but that has been partially offset by the borrowers growing revenue and profitability. At the end of the day, corporate borrowers either make their contractual interest and principal payments, or the lenders take over the business and work for the best loan recovery possible. Given the average initial loan-to-value for senior secured loans is around 50%, there is significant equity and junior capital financing each borrower. We believe that the private equity firms would rather support their existing portfolio companies for what is expected to be another year or two of higher rates, rather than take a total loss on their equity investment. Higher interest rates have resulted in a favorable shift in economics away from private equity for the benefit of senior secured lenders.

Where we’ve seen borrowers struggle, the cause is usually some input cost pressures that can’t be passed along to customers or the loss of key customers to competitors. If the business is tracking to plan, the higher rates are manageable, in our opinion.

The SOFR forward curve predicts that SOFR will decline by 2.5% over the next two years,3 increasing borrower cash flow and liquidity. Of course, higher for longer has been a smart wager.

When / if refis and CLO extensions will be possible?

Relevant for: CLO Equity
The potential for significant upside could exist in CLO Equity if the CLO can refinance its debt at lower rates, or if the reinvestment period can be extended on favorable terms. Since the beginning of 2022, CLO financing costs have been elevated, and these transactions have been rare. Last year the CLO AAA spread over SOFR declined from 2.1% to 1.6%.4 We believe there can be a significant number of refinancings and reinvestment period extensions this year if AAA CLO spreads decline 0.20% from current levels.

In addition, many CLOs issued in 2022 and 2023 have elevated debt costs, relative to current levels. Many of these CLOs are good candidates to extend their reinvestment periods, even if CLO AAA spreads do not decline further.

CLOs issued in 2021 or before, may go their full lives without refinancing their debt or extending their reinvestment periods. In such cases, the CLO equity could benefit from below market financing costs for the CLO’s 8-10 year expected life.

A CLO reinvestment period extension has the potential to add 2% to our base-case projected returns, assuming no change in the CLO’s cost of debt. The value of refinancing portions of the CLO’s debt at lower rates depends on the magnitude of the cost reduction. A general rule is that 10bps of reduction in the CLO’s cost of debt results in 80bps of incremental cash flow to the CLO equity for a middle market CLO levered 8.0x.

What are the causes and effects of lower loan issuance?

Relevant for: Leveraged loans, CLO BBs, and CLO Equity
Leveraged loans are often created in a Leveraged Buyout (LBO). LBO activity has declined since 2021 due to the inability of private equity sponsors and business owners to agree on a purchase price for the business. Higher interest rates in general have resulted in a compression of acquisition multiples that private equity sponsors will pay and many business owners have been unwilling to sell at these lower multiples. As interest rates decline, we would expect LBO activity to rebound to more normalized levels.

Much of primary activity in the loan market this past year resulted from refinancings, repricings and maturity extensions, rather than new LBOs. While new loan creation was down, the quality of new loans that did come to market was high, in our opinion, both in terms of the projected returns of new loans as well as lender-favorable documentation terms.

The decline in new loan activity resulted in stronger bids for higher quality credits in the secondary market. During 2023, the Morningstar Loan Index (“the Loan Index”) increased from 92 to 96. Higher loan prices were a tailwind for CLO equity and CLO BB returns during the year.

Has there been CLO self-healing over the last two years?

Relevant for: CLO BBs and CLO Equity
CLOs typically start their lives with a 4- to 5-year reinvestment period, during which the CLO can reinvest proceeds from loan repayments into new investments. During periods of market turbulence, loans tend to trade down in price. That enables the CLO manager to purchase discounted loans in the secondary market. These discounted purchases can provide a material offset to increased defaults during economic downturns. Discounted loan purchases can enhance the CLO’s credit profile for CLO Note investors and potentially increase returns for CLO Equity investors. We call this the “self-healing” mechanism of CLOs.

The Loan Index ended 2021 at 99, but during the last two years, the Loan Index had an average price of 95.5 This has provided an opportunity for CLOs to buy discounted loans. However, the loans that CLOs invest in tend to be more conservative than the overall Loan Index. We believe that our CLO managers have been able to invest loan repayments at dollar prices between 97-98 throughout the year. This is accretive to CLO equity returns given our usual CLO modeling assumption of a purchase price of 99.

Is there a trend towards lower loan recoveries in the event of default?

Relevant for: Leveraged loans, CLO BBs, and CLO Equity
Our usual base-case CLO modeling assumption is that 2% of the loans will default each year and the recovery rate will be 70%. This can be considered a loan loss reserve. One of our goals is to invest with CLO managers that outperform on these metrics.

For broadly syndicated loans, recovery rates for 2023 were poor, which was a headwind for CLO equity returns. Fortunately, loans default rarely, and the default rate of 2.0% at year-end 2023 was consistent with our modeling assumptions.6 But across the 52 defaults in 2023 tracked by JP Morgan in the syndicated loan market, the recovery rate was 36.4%.

There are two primary reasons why broadly syndicated loan recoveries have been coming in below our typical CLO modeling assumption of 70%:

1. Initial loan to value was marginally higher than in the past, i.e., less equity and unsecured bonds as a % of the initial financing

2. Loose loan documentation did not adequately protect creditors’ rights

While JP Morgan measures the recovery rate of a loan as the trading price 30 days after the loan defaults, that is not the ultimate recovery value. In a default, the lender often ends up with a restructured term loan and an equity investment. In some cases, the equity upside can be substantial, but it takes time for the recovery to play out.

We view low loan recoveries as unique to the broadly syndicated loan market. In the middle market, we believe loan documentation is still creditor friendly, and initial loan-to-values are below 50%.

We expect the impact of loan defaults to be less pronounced on CLO portfolios than on the loan market overall. CLO managers are actively managing their CLO’s underlying loan portfolios to improve average credit quality and ensure the CLO’s compliance with its many tests. Accordingly, CLOs own loans that are much more conservative than the overall Loan Index.

The other important variables that determine CLO equity returns have been tracking favorably: default rate, interest rate, new loan purchase price, and new loan spread. Additional CLO equity upside could exist in 2024 and beyond if we’re able to refinance our CLO’s debt at lower rates or extend their reinvestment periods.
SOURCES

1) S&P Global Market Intelligence, December 2023

2) Flat Rock Global Assumptions, for a borrower levered at 4.5x EBITDA paying a SOFR + 5% interest rate

3) Chicago Mercantile Exchange SOFR Futures

4) JP Morgan CLOIE Index

5) Bloomberg, LLC

6) JP Morgan Default Monitor December 2023

DISCLOSURES

Past performance is not indicative of future results.

This 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.

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

08 Dec 2023
Insights Shiloh Bates 0 comment

Podcast: Demystifying CLO Myths

Flat Rock Global CIO Shiloh Bates discusses CLOs (Collateralized Loan Obligations) with Macro Hive CEO Bilal Hafeez on the Hive Podcast. Learn more about characteristics of different CLO tranches, CLO issuance, and the self-healing mechanism, to name a few.

Listen Now

DISCLOSURES

The performance data quoted in the podcast represents past performance. Current performance may be lower or higher than the performance quoted in the podcast. lnvestment return and principal value will fluctuate, so that shares, when redeemed, may be worth more or less than their original cost. Past Performance is no guarantee of future results. A Fund’s performance, especially for very short periods of time, should not be the sole factor in making your investment decisions.

Consider the investment risks, charges, and expenses of the Fund carefully before investing. Other information about the Fund may be obtained at https://flatrockglobal.com/flat-rock-opportunity-fund/. Please read it carefully.

Risk: The Fund is suitable for investors who can bear the risks associated with the Fund’s limited liquidity and should be viewed as a long-term investment. Our shares have no history of public trading, nor is it intended that our shares will be listed on a national securities exchange at this time, if ever. No secondary market is expected to develop for our shares; liquidity for our shares will be provided only through quarterly repurchase offers for no less than 5% of and no more than 25% of our shares at net asset value, and there is no guarantee that an investor will be able to sell all the shares that the investor desires to sell in the repurchase offer. Due to these limited restrictions, an investor should consider an investment in the Fund to be of limited liquidity. Investing in our shares may be speculative and involves a high degree of risk, including the risks associated with leverage. Investing in the Fund involves risks, including the risk that shareholder may lose part of or all of their investment. We intend to invest primarily in the equity and, to a lesser extent, in the junior debt tranches of CLOs that own a pool of senior secured loans. Our investments in the equity and junior debt tranches of CLOs are exposed to leveraged credit risk. Investments in the lowest tranches bear the highest level of risk. We may pay distributions in significant part from sources that may not be available in the future and that are unrelated to our performance, such as a returns of capital or borrowing. The amount of distributions that we may pay, if any, is uncertain.

ALPS Control Number: FLT000395

17 Oct 2023
Educational Videos, Insights 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