Credit Trends & CLO Strategies

Hi, I’m Shiloh Bates, and welcome to the CLO Investor Podcast. CLO stands for Collateralized Loan Obligations, which are securities backed by pools of leveraged loans. In this podcast, we discuss current news in the CLO industry, and I interview key market players.

Today I’m speaking with Jonathan Horowitz, Partner and head of structured liabilities at Fortress investment group.  Jonathan is a thirty year veteran of the CLO market and his role at Fortress encompasses arranging CLOs and financing lines for his firm’s loan portfolios.  We discuss the pros and cons of using bank leverage vs. CLOs; credit trends in broadly syndicated and private credit loans and the lack of new issue loan supply in general. We also discuss the effect of Fed rate cuts on our business. 

If you’re enjoying the podcast, please remember to share, like and follow. And now my conversation with Jonathan Horowitz. 

Jonathan Horowitz:

Thank you very much. Thanks for having me.

Shiloh Bates:

So, why don’t we start off with your background and how you ended up at Fortress.

Jonathan Horowitz:

Sure. So, I’m a partner at Fortress and I’m Head of Structured Liabilities. So, what that means is I’m really responsible for the financing of a large portion of our credit assets. CLOs have been a major strategic funding tool for us for the last 20 plus years, and I spent a lot of my time managing the capital market side of our CLO business. Prior to Fortress, I was a portfolio manager in JP Morgan’s chief investment office and I was responsible for the CLO and Consumer ABS portfolios, which in aggregate was about $45 billion at the time. Prior to JP Morgan’s, I ran Morgan Stanley’s CDO Capital Markets desk and I co-headed the CDO structuring and origination business and I started my career at Salomon Brothers. And if you’re old enough to remember, but Salomon Brothers was a predecessor to Citigroup, so I’ve been in the structure credit markets for probably the last 30 or so years.

Shiloh Bates:

So, tell me about Fortress. What do you have in terms of business lines and assets under management?

Jonathan Horowitz:

So Fortress is a $53 billion asset alternative credit manager. So, we have a pretty diversified credit business. A lot of our activity is in corporate credit and real estate, but we also do a lot in asset based finance. We have a litigation finance business and an intellectual property business and a number of other things. So, I think one of the key things that’s different about our firm is that we’re really not beholden to any one sector and it makes it easy for us to pivot when we see better relative value in one sector versus another.

Shiloh Bates:

And how do you see Fortress as being differentiated from peers in the broadly syndicated loan business or the private credit business?

Jonathan Horowitz:

It’s a good question. So, I think there are a few things that are a little different about how we’re set up. So, the first thing is when you think about our CLO business, we have the same credit team for our broadly syndicated loans and our middle market credit. So, basically the way we’re set up is that the analysts are organized, the credit underwriters organized by industry vertical. So, within each industry vertical, they cover all parts of the capital structure and broadly syndicated and middle market credit. So, liquid and illiquid credit in all parts of the capital structure. And we do that deliberately for a couple of reasons. One, what we found is that it really helps us make better relative value decisions when we’re seeing everything. And the other thing is that we find that there are some benefits from information flow. So what happens with middle market credit is that you tend to get reporting much more frequently.

So, it’s typically on a monthly basis and sometimes even more frequent than that. And a lot of times some of the insights that we get can really help inform some trends that will help us make better decisions on our broadly syndicated loans where we’re maybe not getting information quite as frequently. So, that’s one way in which we’re different. I think another thing that’s different is that we have made a really big investment in what we call our asset management group. And this is a group that really touches the loans after we make them on a regular basis, stays in touch with the borrowers and really helps manage our downside risk and take proactive measures. When we do see problems coming, helps us to take measures to protect our capital and prevent problems from becoming bigger problems. And when we do have problems, then it really helps our recovery.

So, our asset management group, it’s about 160 people and that’s across all asset classes and probably 40 or so are dedicated to corporate credit, but we have a lot of people in real estate and an asset-based finance and so forth. But it’s really a big part of the philosophy of how Fortress is set up and we’ve been that way since inception and we think that that shows up when you look at our recovery rates and ultimately our credit losses have been quite low and we think that’s a big reason why. Find that I think when you just look at our CLO business in particular, and I think this is particularly different with our broadly syndicated loan business, is that we use CLOs as a financing tool and this is just how we’ve used it across the platform. So, what that means is that we retain 100% of the equity and I think that’s in middle market loans or middle market CLOs, that’s pretty common. For broadly syndicated loans, it’s a lot less common and I think that’s something that creates an alignment of interest between the debt holders and the manager, which on a benign credit environment, honestly it probably doesn’t matter all that much, but when things are really bad it does matter.

And certainly when I was managing the CLO portfolio at JP Morgan, we saw a lot of behavioral differences during the ’08-’09 period and some of that I think can be ascribed to that.

Shiloh Bates:

So, you guys have diversified portfolios of private credit loans or broadly syndicated loans around your platform and you want to add leverage to increase your return. And I guess the two options are you can either do a securitization, CLO, or you can just borrow from a bank, and you guys do both I presume.

Jonathan Horowitz:

Yeah, that’s right. And I think this is really more of a question for middle market loans. I think while bank financing does exist for broadly syndicated loans, most of the time that financing involves mark to market and oftentimes recourse. For example, in total return swap facilities. And we really don’t like to use that kind of financing. We don’t like mark-to-market and we don’t like recourse. So, for broadly syndicated loans, there aren’t too many other alternatives other than CLOs. For middle market CLOs, I think you have a very robust bank financing market and a pretty robust CLO market and I think there are pros and cons of each. I actually think the two markets are pretty symbiotic and we can talk a little bit about how it’s different and how we think about them.

Shiloh Bates:

So, it sounds like your options for broadly syndicated loans are you’re doing a securitization, you’re doing a CLO for the leverage there and for private credit that’s where you have the two options going to a bank.

Jonathan Horowitz:

That’s right. And when you think about it, for middle market CLOs, the advantages there are you’re getting term financing for the assets so you’re really match funding your assets and liabilities. It’s non-mark-to-market. And the financing is, I think, more stable than the bank financing if any of the assets have problems. So, in other words, you don’t have to re-equitize the portfolio. I think some of the drawbacks of middle market CLOs are that you do tend to have more constraints on the portfolio and there’s less flexibility. And one of the outcomes of that is that the position size is you can have in those facilities are smaller. I think when you contrast that with the bank facilities, the advantages are that they do tend to be a bit more flexible, so not quite as many constraints. Oftentimes you don’t need ratings, although you may want them anyway on the assets in terms of getting credit estimates and that sort of thing, you can have larger position sizes and overall less portfolio constraints.

I think the disadvantages are that you often need asset by asset approval, which you don’t need in CLOs. And if you do have credit issues with particular loans, and an example of that would be like if leverage increases by a certain amount or if there’s a material modification to the loan as it’s defined in the credit agreement, then you may need to put in more equity. So, that’s one consideration. And also I think these facilities tend to give you less leverage than you would get in a middle market CLO. But I think the bottom line is for us, we really think there’s room for both and they are somewhat symbiotic. So for example, you can create capacity in your bank facilities by term financing some of the loans into CLOs and then you can reload the bank facility. So, we really use the two together.

Shiloh Bates:

So, a lot of times it’s a bank financing to start and then once you’ve ramped up a significant portfolio, you term it out with a CLO and then you can start again with a bank line of credit.

Jonathan Horowitz:

That’s right. And something that’s a little different about how we structure our middle market CLOs, I’m not sure if any other manager does this, but we like to have a revolver for a portion of our AAAs. So, it’s usually around 30% of our AAAs are structured as a revolver and that allows us to use the CLO a little more like a bank facility and we can keep dry powder. It becomes less costly for us if we don’t want to remain fully invested and we never want to be in a position where we kind of have a gun to our head where we have to be fully invested at any given time. So this gives us a little more flexibility to avoid that.

Shiloh Bates:

Are the financing rates comparable between the two markets?

Jonathan Horowitz:

It really depends on what time you’re talking about. At this particular time, the CLO market is significantly less expensive than the bank market, but that can change. There are times when the CLO market is more expensive or that the CLO market might be either in brief periods of time when it can become pretty dislocated and it might not be possible to do a new issue deal, but the bank market might be open. So, I think the bank spreads tend to move around a little more slowly than the CLO market does. CUSIP buyers tend to be a lot more reactionary to like macro events and other market movements.

Shiloh Bates:

A CUSIP buyer is a CLO investor because they’re buying a security with that unique identifier?

Jonathan Horowitz:

That’s right.

Shiloh Bates:

Okay. So when you finance your pool, your private credit pool, either it’s a CLO and the CLO has an indenture that sets out all the rules of the CLO upfront. And as long as your portfolio is in compliance with all the rules, you’re reinvesting and you’re paying distributions and the CLO is working as you would expect, or you can, contrasting that with the bank facility, there’s actually a human being that’s approving the loans that go in. You’re dealing with an organization, you might not necessarily have the same fixed set of rules and maybe they’ll be a little bit less predictable in how they act depending on the economic conditions in the market. Is that accurate?

Jonathan Horowitz:

Yeah, I think that’s a very fair characterization. I’ll give you an example. If we’re originating a new loan and we want to figure out how much capacity we have for it, for the CLOs, it’s pretty formulaic. You can figure out pretty quickly how much of a loan you can put in a particular CLO, whereas in a bank facility, you need to do the “mother may I” with a bank, and they have to do a credit review and usually they can turn it around pretty quickly. But depending on the counterparty, sometimes it takes longer than others. I should mention that there are some bank facilities that employ what they call a ‘box structure’, which actually is more rule-based and more like a CLO, but in terms of what you can put in there, it does tend to be a bit more limited. So, having the asset approval, in some ways you could think of it as being more restrictive, but in a lot of ways it can also give you more flexibility. So, that might enable you to get financing on a loan that you wouldn’t be able to finance in a CLO because of some unique feature. So, we’ve always found that there is room for both and there are advantages to both and it’s important to have both types of financing available, but definitely puts and takes with each.

Shiloh Bates:

Do you feel like banks are very active today, they want this business, they’re looking to grow their balance sheets?

Jonathan Horowitz:

Absolutely. I think the common theme from the different bank financing groups that I’ve spoken with going into this year, it seemed like everyone had pretty ambitious growth targets where they might be looking to as much as double their loan book, which is pretty significant. And I think that makes sense. Having worked at a bank or at banks for basically the rest of my career, there are some reasons why that would make sense. I think from a capital perspective, these bank facilities are very, very efficient because they get to use securitization treatment, which really lowers, get to hold a minimum amount of capital against these loans. And I think that from a credit perspective it is extremely safe. The spreads are quite high because it’s in loan form, they don’t really have to worry about mark-to-market, so it doesn’t attract VAR capital. So really it ticks a lot of boxes for them. So when you think about all the different bank businesses and what they might be trying to grow or pull back, it seems like this business is one that every bank seems to want to grow, at least that I’ve talked to.

Shiloh Bates:

Well, it seems like it’s a good deal for banks because when a credit defaults, for example, in private credit, aren’t you guys required to remove the loan from the facility and replace it with a new loan?

Jonathan Horowitz:

Not necessarily to remove the loan, but oftentimes we’d have to re-equitize it and at least at a minimum there’s a conversation. Certainly in some facilities it might fall out of the borrowing base completely. At a minimum there’s going to be discussion about the valuation and you might be required to revalue the asset and that will have an impact on the borrowing base or maybe a discussion on the advance rates. So, it definitely gives the bank a seat at the table and they would basically take some action that if they owned a similar exposure in a CLO, they wouldn’t be able to take.

Shiloh Bates:

So, I guess from the bank’s perspective, I mean if they owned one of the loans, the private credit loans directly on their balance sheet, they would earn a higher spread, but the amount of capital they’d have to reserve for that loan would be quite punitive. Whereas if they’re lending against a pool of loans and a manager like you has put up the junior capital, the capital most at-risk, then maybe if the bank implies some high credit rating and very little capital reserved, that’s basically why they like this business.

Jonathan Horowitz:

Yeah, that’s basically it. It might be something on the order of five times as much capital they’d have to hold against the loan outright versus a loan. So, I think the risk waiting on the loan is something like 20% unless my information’s stale, which it might be at this point versus a hundred percent for the loan outright.

Shiloh Bates:

Oh wow, okay. Quite a difference. So, my understanding is you guys recently started selling private credit or middle market equity to third parties. What was behind that decision?

Jonathan Horowitz:

So, we really started thinking about it. I think it was probably a conversation with you as a matter of fact, but I think we really view this as just another way to raise a separate account. So, instead of raising LP dollars, we raise CLO equity and then that becomes a standalone fund. And then the loans for that fund get financed by a CLO. So, first a warehouse and then ultimately a CLO. So, we’re just viewing this as another way to raise funds to do the exact same thing that we’ve been doing since 2002.

Shiloh Bates:

Got it. So, from the perspective of a CLO equity investor, one of the things that we debate quite a bit, and maybe I’ll ask you your opinion for both broadly syndicated loans and for private credit, but it’s just that if you look at broadly syndicated loan portfolio in a CLO, you’re going to see spreads over SOFR from 3% to maybe 3.3 or 3.4% at the high end. And the higher spread given the leverage in the CLO throws off a lot of incremental cashflow to the equity. So is Fortress, would you be like a lower spread manager in broadly syndicated or average or high?

Jonathan Horowitz:

We’d be at the high end of that. I think if you look at third party dealer research and a lot of them publish statistics about this, you’ll see our spreads probably among the highest.

Shiloh Bates:

Okay. So, do you think broadly syndicated loans, it’s an inefficient market and you can pick up the incremental spread without taking on more risk? Or is there something that I’m giving up by going with a higher spread manager or is it free incremental return to the equity?

Jonathan Horowitz:

So, we don’t think that higher spreads necessarily imply higher loan losses. It might have some implication for liquidity on the underlying loans, and we can talk a little bit more about that. But basically, when we go through our broadly syndicated loan investment process, we go through a pretty detailed and rigorous process, really the same process for broadly syndicated and middle market loans. So, it’s a pretty high bar to get into our portfolios, and I think that’s why if you look at our diversity scores for the broadly syndicated loans, you’ll see they’re lower than the rest of the market. We probably average around 60 or low sixties versus low to mid-80s maybe for the rest of the market. So, one thing I would say is that we’re not indexers and we tend to be pretty deliberate and when we find something we like, we lean in. I think we tend to like to have exposure or we have a larger exposure to smaller issuers.

And there are a few reasons for that. One, we feel like we get more control over documentation and better deal structures, but I think the smaller deals often come with higher spread. So I think we actually find that those loans are actually better protected. So maybe it would lead to lower losses, not higher losses. And I think this is where our investment and asset management resources comes in because that really helps keep our losses low. Our loss rates for broadly syndicated loans have averaged around, this is over a 16 year period or something. It’s around 10 basis points. So we haven’t seen higher loss rates. I think that when I was investing in CLO tranches, that was one of the first things I would look at. If I saw higher spread portfolio, I would want to look into it more so I can understand why people would point to that.

I think that you could argue that liquidity is lower maybe for our broadly syndicated loan portfolios. And I think in a very liquid, well-functioning market, I think we found liquidity to be plenty sufficient for our portfolios. We probably turn over our portfolios less than most managers. If you wanted to turn your portfolio over three times a year, it’d be probably harder to do that with our portfolios. But I think we found that when we want to move out of assets for relative value reasons or whatever, we haven’t any problem doing that. In a dislocated market, everything’s illiquid, so it doesn’t really matter. Even the most benchmark broadly syndicated loan. So, that’s our perspective on it, but others may have a different view. But I think that’s probably what I would point to.

Shiloh Bates:

The experience I’ve had with the higher spread managers, by the way, is that if I rewind the clock to say 2018, when I started investing in CLO equity at Flat Rock. For broadly syndicated, back then LIBOR was the base rate and there were portfolios anywhere from LIBOR plus 330 to LIBOR plus 400 at the high end. And then when COVID hit the loans defaulted, a lot of them were really the high spread loans. And so, coming out of COVID, I think broadly syndicated CLO managers, really a lot of them just really just changed their business and became middle of the run to more conservative spread managers just because of how that played out for them during COVID.

So then, let’s switch to private credit. So, in private credit, there’s portfolios of loans from at the low end SOFR plus four and three quarters all the way up to SOFR plus six. Where would you guys play in that spectrum, I guess first?

Jonathan Horowitz:

Yeah, I’d say if you looked at our existing middle market CLOs, it’s probably closer to, SOFR plus six, if you looked at for new loans that we’re putting on right now, it’s probably 500 to 550. That’s more the market. But I think for middle market loans, there are I think more segments of the middle market than you would really find in the broadly syndicated loan. So for middle market loans, there’s the upper end of that market, which really overlaps a lot with the broadly syndicated market. And I think the deals are bigger. The deal structures look a lot like broadly syndicated loans, A lot of ’em are covenant lite. We tend not to participate there other than very infrequently. So, we tend to focus more on the core middle market and we define that as 25 to a hundred million of EBITDA. So across our portfolios, the median EBITDA is around 60 million. And we’ve found that space to be a little bit less competitive and the pricing is a little bit better, and we tend to get better covenants and deal structures that we like and things that we find pretty important.

So, that’s one reason why if you compare our portfolio to a manager that’s focused more on the upper end of the middle market, our spreads are going to be higher. Some managers focus more on unitranche loans and that’s their origination strategy. We’ll do that from time to time, but that’s not really our focus. Those loans tend to carry higher leverage and higher spreads. Spreads tend to be all over the map with a middle market. The other thing I would say is, and this is different for different managers, so for anyone listening, if you’re looking at investing in middle market CLOs for the first time, and I remember going through this process when I was at JP Morgan, it’s a little daunting to try to get your arm around what does this sector and where do managers fit and how do you look at everybody? But one thing that you could focus on is, does a manager focus on sponsored deals and non-sponsored deals?

And there are some managers that will only do one or the other, and there are merits to both. We do both. We’re probably 70% sponsored, 30% non-sponsored. We actually like the non-sponsored deals a lot because you tend to have a borrower that’s a little bit less sophisticated and that allows you to get paid more. You have better deal structures and better documentation and lower leverage. So you tend to have less problems, but they’re a lot harder to originate. It’s a lot easier to originate the sponsored deals. And if a credit has a problem, if it’s a temporary liquidity problem, sponsors typically going to put in more capital to bridge a temporary liquidity gap, or at least that’s something that we get to the table, it’s the borrower, the sponsor, and the lender can get to the table and work something out. And you don’t really have that degree of freedom as much in the non-sponsored deals. But if the fundamental credit picture has changed, you’re not going to expect to see a sponsor to throw good money after bad. So, we don’t take as much comfort in that as maybe others might.

Shiloh Bates:

Okay, so we’re expecting the fed to cut by another 25 [basis points] before the year ends. Is that going to affect your business in any way?

Jonathan Horowitz:

So, I think our view on this, and we talk about this a lot internally, a rate cut would be from a credit perspective, and I guess there’s the credit piece of it, and then there’s the market piece of it. So the credit piece of it, I think a rate cut is maybe marginally helpful for some of the older vintage loans, so think pre-2022, but for the ones that are still outstanding and over levered at issuance, but I think at this point, most of those structures have already been addressed. So, we don’t think that that’s going to have as much of a credit impact other than just at the margin. But we do think that this could create less demand from floating rate investors and that may reduce retail inflows into loan funds and BDCs. So, I’m thinking more about both broadly syndicate and middle market loans. But I think this could help balance the supply and demand picture. I mean, currently right now we see that there is really too much capital chasing too few loans, so that might help balance the equation a little bit. And I think lower rates might also help support an increase in M&A and LBO activity. So, it’s possible the lower rates will help stabilize spreads by putting the supply and demand more in balance. So that’s a theory we’re not sure, but it’s certainly a scenario. We can only hope.

Shiloh Bates:

I would describe it like this – in CLO equity, if you take your model and you plug in the constant, SOFR and you never cut it, you get more cash flows out of the deal, for sure. But in a rate cutting environment, one, we’re already modeling with the SOFR curve, so we’ve already budgeted for the fact that rates are expected to come down. So, already included, already baked in. And then, yeah, I mean I’m hopeful that a lower SOFR will lead to marginally lower defaults and well, you use the word marginally, but marginally matters for CLO equity. Small differences in default rate can make a difference. And then also I think that, yeah, if people rotate out of floating rate investments into something fixed, yes, hopefully the dynamic of it’ll be less dollars chasing loans. Hopefully that’ll mean wider loan spreads, better documents. I don’t know what that does for the CLO financing side of the equation though. That might move wider too.

Jonathan Horowitz:

Certainly for insurance companies, some of the rate sensitive buyers that could impact mezzanine demand, probably less so for banks, but that’s certainly a possibility.

Shiloh Bates:

When you started at JP Morgan, was that your first direct interaction with CLOs?

Jonathan Horowitz:

I would say my first interaction with CLOs, it was really CBOs at the time was at Citi or at Salomon Brothers and I had done some different things there. I had done investment banking, asset backed finance, and then I found my way into, at the time, what was a fledgling CBO business. And that was back in, gosh, I guess 1998. And then I left there and went to Morgan Stanley where I was there for eight or nine years in the CDO business. So really it was since ’98 that I’ve been in and around this market.

Shiloh Bates:

When you started looking at CLOs, what’s one thing that maybe surprised you or that you found interesting?

Jonathan Horowitz:

I think it’s the importance of alignment of interests. At Fortress when we’re making loans, it’s something we talk about a lot. And I remember, and this really happened when I was at JP Morgan, and I remember this, I don’t want to name the names of managers, but I saw during the financial crisis, managers doing some things that were really maybe a little questionable, certainly from the debt holder perspective. I remember there was one manager that took advantage of some drafting loophole in a waterfall. It was just sloppy drafting that was buried somewhere in the indenture that nobody looked at. And it basically allowed the manager to erode subordination. And when I asked the manager about it, they said, well, we think it’s important to keep our management fee stream going, otherwise we can’t manage the portfolio. And that was sort of eye opening to me like, wow, there are some other motivations here that you really need to think about. So, there have been some other things like that that have come up, but I think really it’s thinking about the motivations of the different parties and why are people doing what they’re doing. That was sort of interesting.

Shiloh Bates:

When I first started investing in CLO equity, I guess this was like 2013, so a little bit over a decade ago, I also came across a drafting error. And the error was the indenture basically permitted unlimited reinvestment after the reinvestment period ended. And for a CLO 1.0, so a pre GFC CLO, they had this amazing financing costs.

Jonathan Horowitz:

Oh my God, they probably had LIBOR plus 25 AAAs or something like that.

Shiloh Bates:

So, that was it. And so their game was they wanted to keep the CLO outstanding as long as possible, and that’s for the benefit of the equity. But the language was just clearly misdrafted in the indenture. And there was another part of the indenture that contradicted the unlimited reinvest, and the manager chose to interpret the indenture in the way that was favorable to the equity, and we owned that equity and that was beneficial to us. But then the CLO AAA investor who’s on the other side of this trade and desperately wants to get repaid as quickly as possible, they reached out to the manager and they said, Hey, one, we might hire a lawyer and we can figure it out in court. And two, if you want to issue CLOs again and you want us to play in your deals, then you should really interpret this in a way that’s definitely not equity. That was, I think, a compelling point to the manager. And that’s the way this indenture reading ultimately got resolved.

Jonathan Horowitz:

Yep. I’ve been involved in all different permutations of those conversations.

Shiloh Bates:

What else is topical in your business? I mean, I think rate cuts is the big one, but it sounds like your portfolios are performing well, I’ll tell you across private credit, I think it’s good performance, but defaults are certainly elevated versus last year and we run a 2% default rate through all of our modeling assumptions. I think that’s the market standard. I think for most private credit it’ll be above that this year. How do you seek the overall conditions in private credit?

Jonathan Horowitz:

Yeah, it’s interesting. When I was thinking about what’s topical, I was actually thinking about some things that are happening in a broadly syndicated loan market. But I guess within middle market credit, I think we’re probably expecting defaults to increase, but really to get to more normalized levels, I don’t think we’re expecting any real massive default spike or anything like that. But I think where there’s a lot more differentiation in performance, what we expect is in the broadly syndicated loan market, and probably the thing that has been most topical and a lot of investors I talk to are always asking about this are the liability management exercises. And that’s really a domain of the broadly syndicated loans. You don’t really see that happening in middle market credit for different reasons, but basically for those not familiar with it, the liability management exercises, it’s basically an out of court restructuring with asymmetric treatment for different lenders.

So, basically what’s happening is you would see a company come to some liquidity problem, broadly syndicated loans that trade in the open market, maybe they start trading down. A private equity sponsor is looking to maybe capture some of that economic discount or benefit for themselves and some restructurings imminent. And so they work out a deal with some of the lenders to maybe provide more capital in exchange for maybe getting some fees rolling up their debt in a more favorable way that can increase their recovery. And ultimately what that translates to is maybe a 30 to 50 point difference in some cases in ultimate recovery between the members of the steering committee or the ad hoc group and the folks that are not in that group. So, we found it really, really important to be proactive in those situations, and fortunately we have the resources to deal with that.

I think another differentiating feature of Fortress, so we have a dedicated restructuring team. We’ve probably been involved in a dozen or a little more LMEs and we’ve been on the steering committee or the ad hoc group. And I think all but one, and I think our outcomes have been quite good. So, it’s something that we’re pretty proud of. And I think when someone asks the question, well, how do you see defaults in broadly syndicated loans playing out maybe for the balance of the year or the next 12 months? I’m not sure that defaults are necessarily going to be all that different, but recoveries we think could be a lot different between different managers. And sometimes I get phone calls from folks, managers and maybe I dealt with in a prior life that have heard that we’re involved in some restructuring process and can I put them in touch?

And if they’re calling me, then that’s the sign of desperation. So, I think that’s something that’s pretty interesting right now, and it’s a dynamic I hadn’t seen before, and when I first heard about it, I was like, wow, I didn’t know this sort of thing could happen. Our restructuring guy, if you ask him about it and he will talk your ear off for hours, he loves it. Our team there is really wonderful. I sit one row away from him, and basically my litmus test for how active that market is is the decibel level that comes from that row, and it’s been pretty high recently. So, the other thing that I think is topical really has to do with the arbitrage. So, for broadly syndicated loans, I think it is particularly challenging right now, and it’s really driven by the low loan supply. And I think the same thing is happening for middle market loans. I was talking to the global head of middle market origination today, and I just was curious like, Hey, are you seeing supply pick up? And he said, well, actually we are seeing supply pick up, but the supply we’re seeing is not that great. But in terms of deal structures, leverage, and the companies that are trying to borrow money, and I think it really boils down to a function of loan supply and what the market will bear.

Shiloh Bates:

So, hopefully there’s a natural correction there where if the profitability of CLOs forming isn’t high, hopefully it attracts less capital and hopefully that pushes the loan prices wider as CLOs are buying most of these loans anyways. So, there is that self-correcting mechanism. That’s not going to happen overnight, but hopefully that’s how it works.

Jonathan Horowitz:

Typically, that’s how it works. It’s gone much more slowly right now than it typically does, but hopefully the correction mechanism will take place.

Shiloh Bates:

Do you think the reason the market’s a little bit out of whack in terms of the difference between where the loans pay the spread over SOFR versus the CLOs financing costs, is that just because if I get spread compression, it’s fine if it’s on both sides, if I lose some on the assets and I pay less on liabilities, that’s okay, but is it just there’s more demand for loans and less demand for CLO debt securities? I guess I’m just not sure why that would be the case.

Jonathan Horowitz:

I’ve wondered the same question because yeah, you would think in an environment that you would have more demand for CLO securities and then the arbitrage gets more in line and then everything works. I don’t know the answer to that. I suspect part of the reason might have to do with all the refi and reset activities. So all the deals done in late 2022 and 2023 in a much wider spread environment for those deals to get refied and reset, you’re increasing the supply of CLO paper without needing the loan supply to fill it. And so, that may be something that has created somewhat of a floor on CLO spreads and prevented the arbitrage from getting more in line. Just a guess.

Shiloh Bates:

So, as a CLO manager, one of your roles is when you’re forming a CLO to choose the bank that you’re going to work with, how do you think about that? How are some of the banks differentiated in your mind?

Jonathan Horowitz:

I think distribution is one element. Some banks tend to be a little more flexible than others are more accommodating when it comes to financing or if you are putting a warehouse in place and something comes up, you need to extend it or whatever. Certain counterparties tend to be a little more flexible than others. I think for something like middle market CLOs, some banks have a lot more experience than others and just have a better call into investors.

Shiloh Bates:

Yeah. So, there’s only four or five banks in private credit CLOs.

Jonathan Horowitz:

Pretty much. Most of the people all came from the same bank.

Shiloh Bates:

And then broadly syndicated, it’s the whole street. It’s 15 different arrangers or something.

Jonathan Horowitz:

The other thing, and this is more unique to us, but I think I mentioned earlier in the podcast that when we do our middle market CLOs, we like to have a portion of the AAA structure as a revolver. So, the underwriting bank would typically take that. And among the banks that are good underwriters, good placement agents for middle market CLOs, only a subset of those can also take the revolver and revolvers are pretty punitive for banks. So, it’s understandable that they wouldn’t necessarily want to take them.

Shiloh Bates:

Nobody wants to own a revolver, including myself. We’re not doing revolvers.

Jonathan Horowitz:

Yeah, we don’t like them either.

Shiloh Bates:

And John, my closing question is always describe as CLO in 30 seconds.

Jonathan Horowitz:

Alright, so I thought that was actually a really thoughtful question and it took me a lot more than 30 seconds to think about this. So let me give it a shot. I would think of a CLO as a simple bank. So, a CLO is making hundreds of loans to below investment grade companies and financing them with CLO notes. So, A CLO is really a structured vehicle that bundles together loans and sells the pieces to different tranches, each with different risks and economics. So, the below investment grade tranches carry the most risk and pay the highest spreads, and then on the other end, the AAA tranches carry the least amount of risk and pay the lowest spreads. So, by doing this segregation, this allows the loan portfolio to be broken up into pieces that fit the risk-return objectives of different types of buyers. So, then the equity, the very bottom of the capital structure, earns the difference between what the loan portfolio earns and what’s paid to the different debt tranches. Not sure how I did with the timing, but pretty close.

Shiloh Bates:

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

Jonathan Horowitz:

Me too. Thanks so much for having me. This is great.

*******

Disclosure AI:

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

Definition Section:

–          Secured overnight financing rate SOFR is a broad measure of the cost of borrowing cash overnight, collateralized by Treasury securities.

–          The global financial Crisis GFC was a period of extreme stress in the global financial markets and banking systems between mid-2007 and early 2009.

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

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

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

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

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

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

–          EBITDA is earnings before interest, taxes, depreciation and amortization. An add-back would attempt to adjust EBITDA for non-recurring items.

–          LIBOR, the London Interbank Offer Rate, was replaced by SOFR on June 30th, 2024.

–          Delever means reducing the amount of debt financing.

–          High yield bonds are corporate borrowings rated below investment grade that are usually fixed rate and unsecured.

–          Default refers to missing a contractual interest or principal payment.

–          Debt has contractual interest, principal and interest payments, whereas equity represents ownership in a company.

–          Senior secured corporate loans are borrowings from a company that are backed by collateral.

–          Junior debt ranks behind senior secured debt in its payment priority.

–          Collateral pool refers to the sum of collateral pledged to a lender to support its repayment.

–          A non-call period refers to the time in which a debt instrument cannot be optionally repaid.

–          A floating rate investment has an interest rate that varies with the underlying floating rate index.

–          RMBS, our residential mortgage-backed securities.

–          Loan to value is a ratio that compares the loan amount to the enterprise value of a company.

–          GLG is a firm that sets up calls between investors and industry experts.

–          Payment In Kind, or PIK, refers to a type of loan or financial instrument where interest or dividends are paid in a form other than cash, such as additional debt or equity, rather than in cash

–          A covenant refers to a legally binding promise, or lender protection, written into a loan agreement.

–          Net Asset Value (NAV) – The value of a fund’s assets minus its liabilities, typically used to determine the per-share value of an interval fund or investment vehicle.

–          Dividend Recapitalization (Dividend Recap) – A refinancing strategy where a company borrows to pay a dividend to its shareholders, often used by private equity sponsors.

–          Continuation Vehicle – A fund structure that allows investors to roll their interest in an existing portfolio company into a new vehicle, while offering liquidity to those who want to exit.

–          Equity Cure – A provision that allows private equity sponsors to inject equity into a company to fix a financial covenant breach.

Risks

Risks:

–          CLOs are subject to market fluctuations. Every investment has specific risks, which can significantly increase under unusual market conditions.

–          The structure and guidelines of CLOs can vary deal to deal, so factors such as leverage, portfolio testing, callability, and subordination can all influence risks associated with a particular deal.

–          Third-party risk is counterparties involved: the manager, trustees, custodians, lawyers, accountants and rating agencies.

–          There may be limited liquidity in the secondary market.

–          CLOs have average lives that are typically shorter than the stated maturity. Tranches can be called early after the non-call period has lapsed. 

General disclaimer section:

Flat Rock may invest in CLOs managed by podcast guests. However, the views expressed in this podcast are those of the guest and do not necessarily reflect the views of Flat Rock or its affiliates. Any return projections discussed by podcast guests do not reflect Flat Rock’s views or expectations. This is not a recommendation for any action and all listeners should consider these projections as hypothetical and subject to significant risks.

References to interest rate moves are based on Bloomberg data. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of, or potential or actual portfolio changes related to securities of those companies, unless otherwise noted. All discussions are based on U.S. markets and U.S. monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global Speaker are those of the speaker as of the date of the broadcast, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and flat Rock global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research or investment advice.

It is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered. None of the information provided should be regarded as a suggestion to engage in, or refrain from any investment-related course of action, as neither Flat Rock Global nor its affiliates are undertaking to provide impartial investment advice. Act as an impartial adviser or give advice in a fiduciary capacity. Additional information about this podcast, along with an edited transcript, may be obtained by visiting flatrockglobal.com.