Podcast: The CLO Investor, Episode 11

Shiloh:

Hi, I’m Shiloh Bates, and welcome to the CLO Investor podcast. CLO stands for collateralized loan obligations, which are securities backed by pools of leveraged loans. In this podcast, we discuss current news and the CLO industry, and I interview key market players. Today I’m speaking with John Timperio, the co-head of Dechert’s global Finance practice. Dechert is one of the prominent law firms in the CLO industry and someone that I’ve worked with on many transactions with over two decades of experience. John is a trusted advisor to CLO managers and investors. I asked John to come on the podcast to discuss the exciting topic of CLO regulation. This podcast is going into the weeds, so buckle up. If you’re enjoying the podcast, please remember to share like and follow. And now my conversation with John Timperio. So John, welcome to the podcast.

John:

Thank you for inviting me.

Shiloh:

Are you guys having a busy August at Dechert? It seems there’s a lot going on in the market.

John:

We are as busy as I can remember across our finance practice. So I co-head the finance practice at Dechert and we do CLOs. We do ABS, CMBS, and large loan real estate, and all of those silos are going gangbusters. The CLO piece in particular has just been extraordinarily busy, in particular with private credit CLOs, which continue to enjoy or bask in the spotlight of investor demand.

Shiloh:

Gotcha. So how does somebody become a CLO lawyer?

John:

For me, it was a fairly circuitous path. I’ve been doing this for 33 years out of law school. I started doing real estate that market, this was 1991, was dead, transferred into the bankruptcy group, which was going on, firing on all cylinders at that point. When that slowed down after a few years, given my background and understanding of bankruptcy, remoteness and structures, it was a natural segue into structured credit when I started doing structured credit full time in 1998. It was also an interesting period in the market. It was right at the beginning of the CLO world. So I had at that point moved to Charlotte, North Carolina and was doing a lot of work with a bank, First Union, which was highly focused on middle market credit, middle market CLOs, and was able to get in on the ground floor of doing. And those are still
a huge piece of our CLO business 25 years later.

Shiloh:

There’s a lot of CLO lawyers out there. John, how does Dechert differentiate itself?

John:

Great question. There are a lot of CLO lawyers out there, although if you look across the market, there are probably five or six firms that do a bulk of the work. I think what differentiates Dechert is our platform and I think there are a lot of terrific lawyers that can agree to make collateral management agreement, read an indenture, make comments. I think what differentiates us is in addition to the CLO platform, we have the world’s best Advisors Act practice. And if you’re an asset manager, frequently with your CLOs, you have tons of Advisors Act questions or if you’ve got a BDC, you have all these conflicts and other issues that come up. So we’ve got this great platform which includes terrific advisors act practice. Our tax practice is top-notch in the middle market area, really groundbreaking in terms of their views. The tax issues in the private credit space are a lot more challenging for people to get their arms around because you have someone that’s actually originating a loan.

So you have to figure out a strategy if you have an offshore deal or offshore investors. So those can be more challenging. So we’ve got terrific tax practice. So really I think the reason clients hire us is not exclusively for the CLO piece, but it’s all the other pieces. We’re also the world’s leading rated funds practice, CLO equity fund practice, and when clients are putting all those things together, that’s how I think the calculus is tipped in our favor in some cases and it’s been very helpful. So when we’re chatting with clients, it’s focused around the platform and the resources there, and then the fact that we did close to a hundred transactions last year I think gives them a window into the workings of CLOs that can be very helpful as they try to think about what’s market and we can give them up to date, up to the minute color on, well, here’s how this stip or request from an investor is getting settled at this point in time.

Shiloh:

So if I go to a CLO conference today, they always allocate 45 minutes to have some industry lawyers on a panel to talk about what’s new in regulatory issues for CLOs, is there anything that’s top of mind or important for CLO investors or managers today?

John:

Great question. We at the moment are enjoying a relatively, I wouldn’t use the word benign, but stable regulatory front. So good news, is unlike in the years following the financial crisis, the pace of new regulation has slowed. Right now we primarily work with asset managers. A lot of our asset manager clients are focused on some of the conflict of interest rules, which will go into effect in the middle of next year. And their compliance policies with respect to those rules and those rules prohibit material conflicts of interest between managers and sponsors and investors, and were really designed to prohibit transactions that were designed to fail, which was never a real feature of the CLO market. But 12 years later or now finally going to go into effect and managers have to focus on some compliance there and putting up some information barriers. So we’ve been talking to managers about that.

Shiloh:

So John, as you know, CLO securities have performed very well across the stack from equity to AAA on a buy and hold basis from prior to the financial crisis and forward. So what was the push to have… Why was more regulation needed?

John:

Interesting question. I think the answer just based on the hard data is that the industry did not need additional regulation. As you noted, there really weren’t any CLO tranches, there were not many, at least that went into default or didn’t pay in full. So they’ve had a relatively pristine track record in the financial crisis though there was a conflation between CLOs and a product with a very similar acronyms CDOs, which did experience a lot of problems. What’s interesting now, though, is a decade and a half removed from the financial crisis, I do think regulators understand that CLOs are safe products. We have clients who have ETFs that buy CLO liabilities and we see a lot of interest in CLO equity. So I think regulators understand that this is not a dangerous product.

Shiloh:

So the biggest regulatory change for CLOs post the financial crisis was really, in my opinion, risk retention. So maybe you could give our listeners just a quick overview on risk retention, how it worked, and then the remnants of its implementation, how they continue to effect this even today.

John:

So the US risk retention rules are aimed at requiring a securitizer, which is a party that transfers assets into a ABS transaction and asset backed security, to retain skin in the game. And they calculate that a few different ways, but by and large in the CLO space, it’s either with a vertical strip of 5% of the CLO liabilities or an interest in the most residual tranche. The equity tranche equal to 5% of the fair value of all the notes issued in the CLO and initially in the adopting release, the SEC and the regulators took the position that the collateral manager of A CLO was —

Shiloh:

— the securitizer —

John:

— exactly — very controversial position, which resulted in a lawsuit where the LSTA sued the SEC.

Shiloh:

The LSTA is the loan sales and trading organization, that’s the organizational body for the leveraged loan industry.

John:

So they brought suit and the courts ultimately decided that the clear language of the statute was what governed and the language of the statute was based on a transfer of assets into a CLO. The interesting thing  is it had two implications. One is open market broadly syndicated CLOs no longer had to comply or did not have to comply with US risk retention. And those transactions, which are the 80% of the market, a manager faces the open
market and purchases either in the primary or secondary pieces of loans into
the CLO from third parties. And basically those deals are designed to allow
these asset management platforms, which are your clients as well. And some of the largest, most well-known asset management platforms in the world to gain AUM and management fees. And the track record is pristine, as you mentioned. The other piece of the market are the private credit middle market balance sheet side of the market that is traditionally or historically always been around 10%.

Last year it was 20%. It’s been hovering in that range as there’s been a lot of buzz and focus on private credit CLOs. That part of the market does have to deal with risk retention because in those transactions you do actually have an originator of assets, generally maybe it’s a BDC or an Alts platform. They actually make the loan, they underwrite it, and then they transfer it into a CLO. They use the CLOs as attractive forms of non-market to market leverage, which frees up other capital for them to make loans. And so in those transactions though, we’ve had to comply with risk retention generally in
those deals, interestingly has not been as big an issue because generally the
platforms that originate the loan want to retain all of the equity, or at least
most of it. I know you all also invest in that equity, but it has not been as
big a problem as it would’ve been on the BSL side where you have these BSL
managers who just could never write the amount of checks that would be required to manage 50 CLOs.

Shiloh:

So then the setup today is basically this. If it’s a broadly syndicated loan CLO, there’s no risk retention in the us. So the manager is not required to buy 5% of the AAA down to equity. They’re not required to own 50% of the equity, which I guess would be the other way to satisfy that previous requirement. And you can do that and you can sell the CLO securities in the US and you’re fine, but for that US broadly syndicated CLO security, if you want to sell it to European investors, then there is risk   retention still in place in that continent.

John:

Exactly. What’s been interesting is, as I mentioned, the
middle market CLOs or private credit CLOs, they do comply. There’s some
exceptions, but by and large they comply with US. Sometimes they also comply with European risk retention in order to sell the liabilities to European
credit investors. So sometimes they have dual compliant deals. In the middle
market context, dual compliance is a little more complicated given the type of
reporting that’s required for European compliance. So it’s a little more difficult for them to do that full suite of reporting. But we have a number of clients that have done it and continue to do it. In the broadly syndicated space, even though there’s no US, we frequently have some clients that will set up structures to comply with the European risk retention rules for the same reason it broadens the investor base the liabilities and thereby increases the yield on the equity of their buying equity.

So a lot of what we’ve been doing recently with the managers we set up is set up a structure where they can subsequently use that management company that they’re establishing to hold EU risk retention and thereby satisfy the EU risk retention rules. Interestingly, for BSL CLOs, the reporting is a little easier so that they’re not as troubled, although by that aspect to comply with the European rules, they have to hold 5%. Europe measures it a little differently. They look at 5% of the notional of the portfolio. So it’s a slightly different calculation than the US, but gets you roughly in the same ballpark. So if you think about the market or the landscape private credit, by and large, you do have transfer orders and they do comply broadly syndicated, no US risk retention. They sometimes comply with European in order to facilitate better execution. What’s interesting is there’s another part of the market that’s really picked up steam and that relates to rated feeders, rated note funds, and those are really primarily or exclusively in the private credit space, but they’re initially started out as feeders into private credit funds where people were structuring a feeder so that it had rated debt to facilitate investment by insurance companies.

But now sometimes those deals are very similar to CLOs and the tranching and how they look. But what’s interesting about that market is by and large, because there’s still a lot of fun like aspects to those transactions, people have not treated those as needing to comply with US risk retention. So you do have this other category, and that’s a very burgeoning part of the market on the private credit side.

Shiloh:

Why was it that risk retention was in the US only repealed for broadly syndicated CLOs and not for middle market CLOs?

John:

It was really because the way Congress had drafted the statute was to require a securitizer to hold risk retention, and they define securitizer as the party that organizes and initiates the transaction by transferring assets into the CLO. In a middle market context, you do actually have originators that transfer much like ABS deals. In the broadly syndicated CLO market, the asset managers just acquire from third parties in the open market, much like stock picker of a mutual fund would acquire stocks.

Shiloh:

So though in middle market CLOs, even though risk retention exists, what I see is that the manager of the CLO, they want to own securities in the CLO as well. So they’re required to do it by law, but they want to own a majority of the equity. They often take strips of the senior securities. So it’s not really a burden for them. At least that’s my perception of their business model.

John:

Absolutely. I think what’s been interesting to me, well a few things. One is over the last, I’d say again, 24 months or so, we’ve seen much greater interest in CLO equity and had a bunch of clients raise CLO equity funds. I think that that on the broadly syndicated side, not on middle market, so a number of BSL managers have gone out, dedicated CLO equity funds, and used that money to invest into their own CLOs generally in a way that was EU compliant as well. And that has been something that’s interesting because if you go back five years ago, those who are very episodic, where we might do one or two a year, now, we probably have 10 going on at the moment, people are able
to raise that money. We don’t see that in the middle market space for the
reason you mentioned, the managers really don’t always want to part with that equity and really when they are, they’re going to do it with a strategic
counterparty like a Flat Rock, who they trust and they know they’re going to be a good actor in our transaction.

Shiloh:

So then is there any expected changes to the risk retention framework that exists today? Are there any proposals out there to do it differently?

John:

No expected changes. Certainly there could always be new rule-makings, but nothing we’re aware of in the pipeline. What’s interesting is some of the vehicles that we helped set up in the very early days when people thought it was going to be applicable to both BSL and middle market are still around and in some cases highly successful. The one that comes to mind is Redding
Ridge, which is 25 billion or more in AUM at the moment.

Disclosure:

Note Redding Ridge Asset Management is an independently managed affiliate of Apollo specializing in structured credit.

John:

And that was set up initially as a collateralized manager vehicle, which was an option where you set up an independent company from the main platform and raise capital into that. And that vehicle has been incredibly successful and like I said, still exists and has an AUM that’s very enviable.

Shiloh:

So I guess the punchline is risk retention has gone away, but the manager in the past was able to raise risk retention funds and presumably the funds performed well. So even though the requirement isn’t there today, they keep these funds active.

So then changing topics, I know you guys work on negotiating both middle market and broadly syndicated CLOs. What are some of the key legal differences between the two?

John:

Very interesting, and we were involved with the full evolution of the private credit market and initially those deals emanated out of an ABS-type structure where it was repurchase and all this recourse back to the originator or the assets.

Shiloh:

So an asset backed security, so different from a CLO or what’s the terminology there?

John:

It would be asset backed security. So —

Shiloh:

— securitization of business equipment or aircraft —

John:

— that was the original DNA of middle market CLOs. And then over time they did converge and now the technology is largely the same, but they have a number of characteristics that are different between the two. And first off, the motivations are vastly different. As I mentioned, middle market CLO managers largely use the CLO as just a financing source for collateral, whereas in the broadly syndicated space, they’re really using these as a way of gaining AUM management fees, and as arbitrage vehicles. High level differences as you look at the two first, the collateral obviously middle market CLOs, the collateral is less liquid; generally has credit estimates versus public ratings, and there’ve been the B minus range, whereas the BSL broadly syndicated loan space, it’s a little higher, maybe B/BB minus. Generally middle market CLOs, the loans and middle market CLOs generally have covenants, which in our BSL world is not always the case and most of the collateral will not have covenants.

It’ll be covenant light as we say. Another difference is because the collateral is a little lower rated to begin with, there generally tends to be a higher triple C bucket and middle market CLOs than broadly syndicated CLOs. So generally 17.5% or slightly more in a middle market CLO, whereas in a broadly syndicated CLO, you might have 7.5% and then other differences, there’s a lot less trading that goes on in middle market CLOs, again, both the collateral and liabilities or much less liquid. And this generally with middle market CLOs and there’s lots of exceptions to each of these, but there’s generally not reinvestment, post reinvestment period. So again, the weighted average life will vary from a broadly syndicated CLO. The other thing I’d mentioned, and this would be attractive for investors, is there’s more credit enhancement at all the levels of the tranching. The equity is generally a larger piece of the overall transaction in a private credit middle market CLO than a BSL CLO. So the structures are sturdier than a BSL CLO, which are also  have performed in a terrific way. So not to cast dispersions there.

Shiloh:

So I think one of the things that is newer in CLO documentation today is the ability to protect yourself in a scenario where the underlying loan is being restructured. So the typical CLO would prevent the CLO manager from buying an equity security for example, or participating in inter-rights offering or maybe even buying a debt security that’s currently in default. Those are things that would generally, you think of them as being prohibited. In the past, distress funds would buy up loans of underperforming companies and
they would propose, through the bankruptcy process, a restructuring where a lot of the residual value of the company would come back in equity or warrants or other securities that the CLO couldn’t purchase. And one distressed manager described their business as arbitraging CLOs in this manner. So they buy the discounted loans, they propose an all-equity restructuring, that would result in CLO managers dumping even more of the loan to their advantage. And a distressed fund probably has no issue in buying equity and restructured companies. So the distressed funds were really taking advantage of the CLO’s strict rules, and over the last few years, there’s been a real effort to true that up so that CLOs can play on an equal footing in a restructuring process.

John:

Look, that was an interesting moment where as you pointed out, you had distressed and investors realizing that CLOs were limited in what they could purchase and really trying to take advantage of that. As you note though, over the last couple of years, by, I would say consensus of the market, really all the investors, those limitations or prohibitions or risks to CLO investors have been largely mitigated primarily through allowing the CLOs to purchase workout loans, which may include some securities as part of the package. Additionally, CLOs do now have, because of changes in the Volker rules, an ability to buy permitted loan assets, which had historically been a problem prior to the changes in Volker, there was a restriction where CLOs could not buy securities, equity securities, unless they were received in part of a restructuring, and that created a lot of risk for the CLOs.

Now they can actually own permitted non loan assets. So you’ve got a confluence of things along with an ability to contribute money for permitted uses, which includes buying workout loans and equity securities, that really have closed out loophole. But it was an interesting moment because you
saw these creative distressed fund managers all realizing that there was this
problem, and CLOs obviously own two thirds of the leveraged loan market, and it was very frustrating time for our clients. A number of those older CLOs were amended, and now the new deals do have a bunch of mechanics to address that.

Shiloh:

Well, one of the, I think easiest, mechanics is just that if the CLO manager wants to buy workout loans or other loans, that would generally be prohibited. The solution is you can buy them, but you just need to use cashflow that would’ve otherwise gone to the equity. So that’s a win-win
for everybody because the equity wants to make that investment because it’ll
improve the loan recoveries and that benefits the debt investors in the stack
and doesn’t come out of their pocket. So I think that’s one workable solution
there for everybody.

John:

Absolutely. And we see that uniformly with these
supplemental reserve accounts, which are prior to the distributions to equity.
People having an ability to put money in there and use it to fund workout loans and the like. So I agree with you, very helpful. The other thing you see is, now with permitted uses and contributions, equity can also make a contribution. So it’d be on a date other than a payment date to acquire the equity securities.

Shiloh:

So then when indentures are coming together today, what do you see as top few negotiated items, items where maybe the AAA and the equity have different views, or maybe the manager and some of the investors have
different views? What are you seeing being highly negotiated in docs?

John:

It obviously varies a bit from the perspective of who’s making the request. A lot of times the AAA investors are going to be focused around consent rights to lots of different things in the documentation. There’ll be a lot of negotiation around when you have to go get controlling class consent. They may also be focused a little bit around some of the concentrations and some of the buckets. So it varies a bit. I think what’s been interesting is recently with the changes in Basel III and improved regulatory capital treatment at the AAA level where they reduced it from 20% to 15, we’re now seeing greater interest amongst bank investors. And that’s been interesting and
driven a lot of changes with loan classes and the like, and certainly been a
positive change for the market to have the banks come back at the AAA level.
The other thing we’re seeing a lot of focus on, at least at the moment, is it
seems like people are very, I wouldn’t say concerned, but focus on PIKing
assets and the treatment of PIK assets and how they impact various tests like
the overcollateralization tests. And if you have a PIKing asset that is paying
a certain coupon, making sure that that is not haircut for OC tests. So it
seems like a lot of clients the moment are a little bit nervous around assets
that may defer some interest.

Shiloh:

So a PIK loan is one in which the loan is not paying interest or partially not paying interest. So the interest that would’ve been paid is capitalized into the par balance of the loan, which is growing over time. So I guess the question there is for the purposes of the par tests or the OC tests, higher PIKed balance of the loan, or is it the initial balance of the loan? That’s what we use in that ratio, is that correct?

John:

Absolutely.

Shiloh:

So I guess the reason that it’s maybe a negotiated point. On the one hand, why wouldn’t you use the current par balance of the loan? That would make a lot of sense. On the other hand, the loan is PIK presumably because the borrower doesn’t have the capacity to pay in cash. So it’s probably a principal balance of a loan that might be more at risk than a different loan that’s just making its contractual interest and principal payments each quarter.

John:

That’s right. Another thing I think we’ve seen more of this year, or at least recently has been truly private credit CLOs. So private credit CLOs where there’s no offering circular, just a handful of investors negotiating with a manager originator. And that’s been interesting. Again, it just shows the interest level and a lot of times you have insurers buying the rated liabilities there, so there’s been an uptick of those types of transactions as well.

Shiloh:

Is there anything else interesting happening in the CLO world today?

John:

I would say the one other thing that’s been really fascinating, I mentioned all the creativity in the rated fund rated feeder space, that space not exist five years ago. And since then there have hundreds of transactions in that space, and I think we have 30 going on in some fashion at the moment at Dechert. So red hot space. Also an area where a lot of creativity going on the box is not as narrow because you’re not solving for CLO ratings methodology. They use closed end fund methodology and lower tranche attachment points. So there’s a lot of flexibility there. But the other area that has been interesting to me has been the growth of joint ventures. This is again on the private credit side, joint ventures between middle market originators, managers,
and banks. And again, if I look at it historically, I’d say, well, we had
historically done maybe one a year, one every two years.

Now we’ve seen, and you’ve seen in the press, a number announced of these joint ventures where basically you have banks who will originate private credit loans and source them to middle market originators. Sometimes the bank JV Partners will also provide back leverage to the private credit manager on that portfolio. Sometimes they set up a private credit vehicle jointly and invest into it. So there are all these different permutations there, but that area has been proliferating. And it’s an interesting thing too because if you look at what is the proper role of banks, banks have trouble holding lots of leverage loans in their balance sheet, but they can be great syndicators of credit and earn very rich sourcing fees in that process. So you have the banks dealing with this long-term secular issue of they can’t hold leveraged loans, and for the first time being creative and saying, well, we may not be able to hold them, but we can source them and earn these fees. And then you have these private credit managers who are able to utilize the boots on the ground that these banks have. So it’s a win-win situation, and that’ll be interesting as those loans eventually make their way into CLOs, but that’s been a development that is quite novel.

Shiloh:

Interesting. John, thanks for coming on the podcast. Really enjoyed our conversation.

John:

Absolutely, and thank you for inviting me.

Disclosure:

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

Definition Section

AUM refers to assets under management.

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

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

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

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

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

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

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

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

Spread is the percentage difference in current yields ofvarious 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.

ETFs are exchange traded funds.

CMBS are commercial mortgage backed securities.

A BDC is a business development company.

Basel III is a regulatory framework for banks.

The source for middle market CLO issuance percent is JP Morgan CLO research.

General Disclaimer Section

References to interest rate moves are based on Bloomberg data. Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merit of or potential or actual portfolio changes related to securities of those companies unless otherwise noted.

All discussions are based on US markets and US monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole.

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