Shiloh Bates:
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 Pratik Gupta, the CLO research head at Bank of America Securities. For publicly traded stocks like Apple and Google, investment banks publish research on the company that may have a Buy or a Sell rating. In CLO research, analysts don’t put ratings on particular CLOs. Rather, they write about the overall CLO industry. And because each CLO reports monthly, there’s lots of data to analyze. I think Pratik and I hit pretty much everything topical happening in CLOs today. Of particular interest to me was our discussion about how CLO securities outperform corporate debt with better returns and lower defaults. And within CLOs, private credit CLOs outperforming those backed by syndicated loans. If you’re enjoying the podcast, please remember to Share, Like, and Follow. And now my conversation with Pratik Gupta.
Pratik, thanks for coming on the podcast.
Pratik Gupta:
Shiloh, thank you so much for having me. It’s a real honor. I appreciate it.
Shiloh Bates:
So why don’t we start off with your background and how you became a CLO researcher?
Pratik Gupta:
Sure, thank you for that. So I joined the industry as an RMBS. That is a legacy subprime, the very securities which created the great financial crisis. I started my career as a research analyst covering those securities back in 2012, October. And I really enjoy covering that sector. I still cover that sector. I think it’s a fascinating market. And in 2013/2014, I realized that market is not really coming back in the same way it used to exist during the 1.0 days. And I had to diversify away from mortgage backed securities. That’s the time when I decided to take the plunge into CLOs. At that point of time, it was an emerging asset class, there were people covering it, but I felt that we could make a mark here in this particular sector. And I’m very glad that we did it. We were certainly very lucky and fortunate to do so.
It was also that point of time when we had the energy crisis happening back in 2015. That’s exactly when we started really covering it officially and we applied the same way, which we used to do for RMBS analysis, that is apply a bottoms-up approach, that is look at each and every loan separately and then understand how does a CLO portfolio work. And I think that really made a big difference to us because that was exactly the time when the energy crisis started creating these interesting dispersions in CLO portfolio returns and performance. And I think our approach certainly caused a lot more investors to look at our stuff and talk to us and we learn from them even more as a result.
Shiloh Bates:
So why don’t you tell our listeners what they can find in the research that you publish weekly and monthly?
Pratik Gupta:
As a data-oriented research shop, we want to make sure that investors have access to reliable data, which can help them analyze their portfolio-making decisions. For us, that is really our core strategy. If an investor is looking at a CLO market, or the RMBS market, whatever data we can provide to them which will help them analyze the sector better is where we basically want to excel at. And that is our first and foremost goal. Our next step is to provide our own analysis of the data and tell them what we think about the market based on the data we have on hand. And investors can agree or disagree with us. As research analysts, we are fully cognizant of the fact that we are not the ones who have capital to put to risk. It’s really the investor and we fully respect that. And it’s our job to ensure that we provide them with transparency we can from our side for them to just make the decision in the best possible manner.
Shiloh Bates:
So do investors use your research to distill who the best CLO managers are?
Pratik Gupta:
I would hope so. I think some investors certainly do that and it’s not just us. To be fair, I think the entire street does a really good job of providing data on manager performance and CLO performance metrics. We are certainly one of them, but everybody else does it too. And where we think we would like to provide value is giving them different insights as to how to evaluate managers. As times have evolved, the way we analyze manager performance has also changed. We have entered through different credit cycles, admittedly not very big ones, but certainly many, many credit cycles, since 2012. And understanding how managers have reacted to these credit cycles, what has been the core strategy for each manager to mitigate risk, I think, has been very unique. And there are probably around 160 to 170-odd CLO managers with a CLO outstanding. But if you look at the number of active managers in any given year, they’re close to a hundred, 100 to 111. And I think understanding which manager brings a unique insight into the performance style is something which we try to look at on a regular basis.
Shiloh Bates:
So for an investor that plays down the stack in mezz and equity, what are the key metrics that you would suggest that an investor focus on?
Pratik Gupta:
I think, looking at the data so far, and this is including the energy crisis all the way to now, I think the biggest alpha generator is being loss avoidant. So the ability to recognize loans, which can, really could, decline in price significantly and selling them early or not holding them in the first place has probably been the biggest differentiator across CLO managers. And it sort of makes sense because if you look at the loan market and where CLOs are created at, it’s fair to say most loans are purchased very close to par, so your upside risk is going to be just a coupon and getting paid off in full at some point of time. Your downside risk, though, is pretty significant, especially if the loan does not perform and the recovery rates can be very low. Really the alpha generator has been in recognizing these losses, or risks of losses, early on, getting out of them early on, and simply not holding them in the first place.
And that has been a consistent theme across these mini credit cycles, which we have been observing over time. I think the second part of the trade, and I think that’s equally important, is to continue to hold a loan if you have conviction in the eventual payoff story. And I think during Covid, that was a critical mode of outperformance. So obviously during Covid we saw significant CCC downgrades and the loan market did sell off, but we did see significant dispersion in how managers reacted to that risk. Some managers basically sold a lot of those CCC downgraded names through Covid at a very steep low price, and that really had significant deterioration on the performance for a portfolio. And there are certain managers who held onto that loan through that cycle, and they were justified in doing so in the end, because you saw those loans pay off in full by 2021, 2022. There, the dispersion portfolio returns could be explained by your conviction in that name and your ability to ride these credit cycles over time. So I think it’s a combination of these two factors. The sweet spot is somewhere in the middle.
Shiloh Bates:
When you meet with CLO management teams, do you feel like there’s some secret sauce in the market where some managers do have a repeatable, let’s call it alpha, that they add? Or is it just defaults are random and sometimes one manager is getting tagged with them and not others? How do you see that?
Pratik Gupta:
That’s a great question and it’s honestly tough to say. I think a lot of it has to be predicated upon the process and structure the CLO management teams have in place. I think it’s fair to say not every manager is perfect and they will be tagged with mistakes and how you react to those mistakes is essentially what differentiates some versus the others. And in hindsight, obviously anybody can say that if we had done this it would’ve been better. But there’s a consistent approach in certain managers in reacting to these mistakes and you can see that in those portfolio performance metrics. I think that’s what probably helps them stand out in particular.
Shiloh Bates:
So one of the questions I get asked frequently as a manager of both CLO equity and CLO double Bs is just, we’re recording this at the beginning of March, which set of securities provides the best opportunity for this year? And just curious if you have a view there.
Pratik Gupta:
That’s a very tough question and interesting one. I think the timing of the trade really matters a lot for double B and equity. In my view, the best time to buy CLO equity is when loans are cheap and that’s when a 10 times levered instrument in a loan portfolio investment can make wonderful returns because you’re buying loans pretty cheaply. It doesn’t matter where the liability stack is struck in my view. And if you look at the data it shows through. The best performing equity return was probably that of the 2020 vintage, when liabilities were struck at extremely wide levels, but you were also buying loans at probably one of the widest levels ever in the 2.0 time period. You could also argue the same for 2022/2023 vintage where once again, even though liabilities are wide, you are actually buying loans at one of the local wides in general from a priced perspective.
So I feel the right time to buy equity is exactly when loans are cheap. The double B trade is very interesting. The double B trade basically provides investors with a very low variance but significantly high returns over a longer period of time. Now the problem with CLO double Bs is that it can be mark to market volatile. There will be instances where double B bond prices can go much lower and deviate by roughly 20 to 30 points, if not more, in a volatile, high micro-stress environment. If someone is willing to basically go through that time period, and it’s a buy/hold strategy, I think in the current environment, I feel double Bs are marginally better than equity. But if you’re buying new issue CLOs, and you can underwrite your manager very well, I think in that particular instance, new issue CLO equity can outperform CLO double Bs. So it’s a mixed answer and I completely understand it’s not a great answer, given a yes and no perspective, but in my view, in the primary market, if you can buy CLO equity and underwrite it with a very good manager, your returns can be better than what you buy with a CLO BB trade. But in the secondary market, I feel CLO double Bs can still provide better value as a portfolio trade as a whole versus buying the average CLO equity right now.
Shiloh Bates:
So for equity, obviously today the loans are not really trading at significant discounts. Most of the good loans are at par, but we are seeing lots of refis and resets, or extensions, as I call them. Is that as good as buying a CLO at a time where the loans are trading at discounts?
Pratik Gupta:
I think the resets is really what makes a critical difference for CLO equity today because in terms of where you’re striking loans at, there’s not a lot of discount to be captured in this market. So you’re really banking upon the fact that you can extend your CLO at a time when you really want to extend, let’s say three years or four years down the line. And that will really depend upon the performance of the CLO portfolio. If your CLO portfolio has incurred losses through this time period, your ability to reset the deal, or even refinance the deal, can be significantly impaired and that can actually have an adverse impact on an equity return. That is why for the new issue CLO equity today, given that you’re already striking liabilities at one of the tightest parts of the 2.0 market, it is critical to select the right manager where your portfolio losses should be low on a go-forward basis and that will basically allow you to monetize the refi/reset optionality embedded in CLO equity.
Shiloh Bates:
So you mentioned that for the double B, and I think you were talking about broadly syndicated double Bs, they can be quite volatile. By our math, we see the default rate on these double Bs as being almost de minimis, 20 basis points or so over the last 30 years. Given that performance, why would broadly syndicated double Bs be so volatile in a period like Covid or the recessionary fears of 2022 for example?
Pratik Gupta:
Great question. It gets down to the fact that the double B portfolio trade has a limited investor base compared to let’s say the broadly syndicated loan market or the high yield market. Double B CLOs in our space basically trades on this concept of MVOC, and there’s a very high beta across managers based on what the MVOC level is.
Shiloh Bates:
And the MVOC, just for our listeners, so that’s the market value of all the CLO’s loans, plus cash, that’s the numerator, compared to the CLO’s debt through the double B. So a good ratio there, or at least the initial MVOC, as you said, would be
Pratik Gupta:
108/109 for a good quality deal. And yes, to your point, basically what it means is that you have an additional eight points of cushion to support the double B. If you liquidate your loans at market value, you still are left with an eight points of cushion to support a double B tranche. And yes, that’s exactly right, Shiloh. And during volatile time periods of this MVOC level, or the market value over-collateralization ratio level goes below a hundred because loans are trading cheaply, the double B market does trade wider just based on the structural implications of the trade. And I feel the market base is not wide enough. There’s lack of depth in the double B market which can support this kind of volatility and that is why we think prices are volatile. Now to your point, I think it is a great point. The total defaults in CLO double Bs are much less than that of corporates or any other structured product today.
And I think it’s a good time to showcase what the 10 year returns have been in the CLO double B trade. If you look at CLO double B trades, the cumulative return over the past 10 years, or five years, has been either three times or two times that of corporates. So we are talking about a significant form of outperformance versus both high yield and loans over a five-year and 10-year period. And as long as you can withstand that mark to market vol, which we just talked about, I think on a total return basis, it makes absolute sense and we still like that trade for that very reason that there is less variance across managers when it comes to double B portfolio returns. And if you’re able to withstand the mark to market vol, you end up outperforming the high yield and corporate loan market by roughly 300 basis points, which is pretty significant in today’s world.
Shiloh Bates:
So these securities offer historically better returns and have lower, significantly less, defaults. I think part of the driver for the volatility is that when the MVOC that we’ve been talking about, so when the double B would not be covered, in a loan market where loans have traded down, if the CLO was liquidated on that day, yeah the double B would not fully be repaid. And that sounds pretty scary to people, but the thing to keep in mind is the CLO is not going to be liquidated on that day. In fact, it can’t be. So what’s going to happen is either the loans are going to recover, or loans are going to be downgraded and default. And if you have a lot of downgrades and defaults, the CLO is going to trap the profitability of the CLO, it’s not going to make equity distributions, and then there’s just going to be more cash and ultimately more collateral over time that supports the double B. But I do agree that yes, buying a double B that’s not covered currently by the fair market value of the loans does sound like a risky proposition to folks.
Pratik Gupta:
I think, to your point, certainly there’s a great thing here that even though MVOC could be lower, it doesn’t necessarily mean that the double B is not covered. Not every single loan in the market defaults. For example, if you’re issuing a loan at 200 basis points or the tightest in the market and the market is at 500 basis points, naturally the loan will trade lower. But that doesn’t mean that the loan will default. And I think that’s a critical nature of the CLO. It’s a non-mark to market CLO portfolio investment. They are not forced liquidators. And that’s exactly why I think double Bs have traded so well. They have performed so well because of the structural protection which you just described, as well as the fact that managers are not really forced to liquidate loans in an uncertain macro environment.
Shiloh Bates:
So one of the things I’ve seen, you guys have written about a fair amount, is changes to insurance company regulatory capital rules. How I would’ve thought the rules work was that a CLO double B or triple B or even up the stack, it has a rating from Moody’s or S&P, and that would dictate how much capital a financial institution would have to set aside. And we’ve talked about actually how CLO, at least at double B, and this is true up the stack as well, they default less than corporates. So I think the argument would be at least in my mind, for less capital to support a CLO double B versus a corporate. But my understanding is it’s actually going the other way. Could you help us understand that?
Pratik Gupta:
Sure. And honestly, it’s a puzzle which still confuses me as to why that is the case. And again, I think we both share the viewpoint that it is not justifiable based on the data we have seen. But let’s just take a step back and understand why and what the NAIC is trying to do here. So the NAIC is a regulator for the insurance companies in the US, and to be fair to them, they did highlight this issue where the underlying risk-based capital for loans is actually higher than the aggregated risk-based capital for all the CLO bonds, including the equity, put together. So if someone had to buy a portfolio of loans and then structure a CLO where they held each and every tranche, the risk-based capital for that entity will actually be lower versus them holding the loans outright. And I think that is the arbitrage which the NAIC is trying to minimize.
And I think that’s a fair point and I do see why they’re doing it. But if you have to extend this argument for mortgage loans, or CMBS loans, then the same principle of neutrality does not apply. So this is only the loan asset class to which the NAIC is basically applying this change. They’re not really doing this for other asset classes. So that is one area of discrepancy, which I see in the picture. Now obviously in an effort to get to this neutrality point, what the NAIC has done is they have increased the capital charges for CLO equity in the first place, they have increased that on an interim basis from 30% to 45% risk-based capital. And for the rest of the CLO debt stack, they’re basically trying to do this scenario testing approach where they’re going to test several scenarios of varying degrees of stressors.
And the probabilities of those stressors are somewhat yet to be determined. But the effort here is to basically apply these stress-based scenarios. Some of the scenarios are pretty draconian in nature with very high defaults and very low recovery rates. And based on the expected losses the CLO tranches will incur, they will then apply a risk-based capital formula charge. Now the scenarios and probabilities are designed to achieve this neutrality. So needless to say, because they want to achieve neutrality, those stresses are going to be a lot more punitive in nature and those punitive stresses will also have a higher probability in the model which is not conforming to reality. And as a result of those stresses, we feel that CLO double Bs and CLO triple Bs will certainly see higher risk-based capital charges versus what they have been currently. But on the contrary, CLO triple A, double A will actually benefit. CLO double A in particular will see lower risk-based capital because they don’t really incur any defaults, even under this most draconian, severe stress scenario.
And we could see this bar-belling approach where triple A, double As will have lower risk-based capital. Triple A is already at the best point, but even double A will have a lower risk based capital, but the triple B, double B trade will have higher charges. So it might cause some insurance companies to basically invest at the top of the stack and result in some widening for the triple B bonds if this were to be implemented. Now that’s a big if. I think we should also highlight the fact that there’s another group which the NAIC has asked to model CLOs, which is called the AAA, American Academy of Actuaries. And that particular group has said that they don’t really believe in the risk-based capital approach and they’re going with a completely different model to evaluate the risk-based capital for CLOs. So there’s already two forms of thoughts on what the risk-based capital should be for CLO securities. So the jury is still out there, whether or not CLO bonds will see higher RBC especially for the mezzanine bonds, and to what extent. So initially we were expecting this to be completed by 2025 year end, but given the two different thoughts here, I don’t think it’s going to be completed by this year end. We might see more delays.
Shiloh Bates:
Yeah, it seems like this has been a process that doesn’t seem to come to a conclusion very quickly.
Pratik Gupta:
That is right, and I think that’s why we have not seen insurance companies react very adversely to this prospect, yet we still see very strong demand from insurance for triple B bonds despite this pending NAIC development.
Shiloh Bates:
Do you think insurance companies have a lot of double Bs?
Pratik Gupta:
We don’t think so. We think most of the bonds which insurance companies buy are in the single A, double A, and triple B area. In fact, our research suggests that 50% of double A to triple Bs are held by insurance companies. So they’re certainly very prominent for the mezzanine stack. But we have gotten to realize that if you look at the CLO insurance industry as a whole, as a percentage of their total capital, a very small percentage of that is actually invested in CLOs. So even though we are talking about meaningful changes to the CLO market as such, for the insurance companies as a whole, I don’t think it’s a big change because not a lot of their capital is really exposed to CLO double Bs or triple Bs in the first place.
Shiloh Bates:
So changing topics to CLO ETFs, I would say this is probably over the last two years, the biggest maybe change or trend in the market. How do you see the rise of the ETF as affecting our business?
Pratik Gupta:
Great question. Shiloh. I think during the call and when we were just talking about the topics, I think you had mentioned that CLOs have gotten mainstream and I think the ETF market is probably the symbolic designation that why we have gotten mainstream. We have a lot more retail capital now participating in the CLO market via the ETF space. And that has really democratized, I think, the investment opportunity for both institutional and retail investors alike. We count, I think at least 21 active CLO ETFs right now and the total AUM of the CLO ETF industry has exceeded roughly 31 billion dollars. In fact, we think that the CLO ETF market is bigger than the loan ETF market, which if you look at it was pretty staggering because CLO ETFs have really been existence over the past three years. Loan ETFs have been in existence for the past 10 years or so, if not more than that.
So it’s a great point which you bring about. Now clearly because of almost exponential growth the ETF market has seen over the past two years, it has had an impact on where CLO spreads are. And I think the technicals have had a big role to play, especially in last year and this year. So to summarize why this is so important, if you look at the CLO market as a whole, the CLO net supply is something which is pretty important to consider. So even though you may see a lot of CLO issuance, we’ve got to remember that CLOs also see quarterly liquidations, quarterly pay downs, which basically bring money back into the market to be reinvested. So on a net basis, the total net CLO market has not seen a lot of growth, especially through 2024. And in our view, if you look at the AAA market in particular, which is where all the ETFs are focused on, the net supply for CLO triple As was probably close to 54 billion dollars through last year.
But given the fact that you also saw ETFs basically putting roughly 14 to 16 billion dollars of capital of inflows, if we actually think that the non-ETF investors, that is, you’re talking about domestic banks, Japanese banks, insurance companies, money managers, these entities actually saw their AAA holdings decline by a net 12 billion dollars through 2024. And if you look at 2025, it’s been a further decline of 10 billion dollars. So even though the ETF market has grown in strength and size, we are talking about 32 billion dollars of AUM, non-ETF investors have actually seen the AAA holdings decline by roughly 22 billion dollars since the beginning of 2024. Now that’s a pretty significant technical to consider. In a higher for longer environment, CLO securities demand has been pretty strong. I think most of your readers should know this, but if you have to consider the US market, and you want to invest in floating rate AAA bonds, the largest market by far is the CLO AAA market. And in this environment, given the strong track record, there is still a lot more demand across banks, insurance companies, and money managers for CLO triple As. And if you’re seeing a holdings decline by roughly 22 billion dollars since the beginning of 2024, naturally that demand is going to cause spreads to tighten. And that is exactly what we have seen for our market, especially because of the ETF inflows.
Shiloh Bates:
So do you think that from AAA and some of the ETFs are doing down to double B, do you feel like there’s enough liquidity in the underlying such that in a down market if people are redeeming shares, that these funds will be able to function in a market like that?
Pratik Gupta:
That’s a great question, Shiloh. I think the jury is still out there on that one. I do think that the triple A market is actually fairly liquid. We are talking about the CLO triple A market is close to 650 billion dollars in size. And if you focus on just the triple A CLO ETFs, we are probably talking about 25 billion, 26 billion dollars of total ETF volume. So as a percentage we are seeing that the triple A ETF market is probably less than 4% of the triple A outstanding. So that’s still a pretty small percentage of the market. Now in terms of flows, it can be meaningful, but in terms of an outstanding market it is pretty small, and we think that yes, outflows from ETFs will cause near term volatility risk, but can it be handled well by the triple A market? Yes. Now we like to call CLO triple As the best asset class to sell and the best asset class to own.
And the reason why we call it that is because, historically speaking, because it’s so unique in being the only floating rate product, the price stability of triple As has been pretty strong compared to other fixed rate fixed income products/assets. So in times of stress, when investors want to basically sell and raise cash, they tend to sell the product which is trading closest to par and that inevitably tends to be the CLO triple A bonds. So we do think in times of stress when people want to raise liquidity rates, raise cash. And we saw that exactly during Covid. We saw that exactly during the LDI crisis, we saw institutional investors sell triple A bonds because that was the product which was trading closest to par and that at the lowest mark to market loss for them. So we do think if you see vol in this time period, naturally triple A spreads will widen out because of the associated volatility. But you might also see some investors redeem ETFs because they want to raise cash and the closest product to par is the CLO ETF product right now. So I do see that risk and I do think that the triple A market can handle it.
Where I do see some higher risk factors for us is in the triple B, double B ETF market, to your point, I don’t think the liquidity in triple B ETFs is that strong that it can handle significant variations in inflows and outflows. But so far what we have seen is that the outflows have been very, very moderate and they have been able to digest it. There’s also another interesting trend which I would like to highlight to you here. We’ve actually seen investors redeeming loan ETFs and actually putting money into CLO ETFs. That to us is very interesting to look at because if you look at the performance of CLOs over loans, triple A CLO bonds have returned almost the same amount of capital as single B rated loans since the start of Jan 2024.
So the Sharpe ratio has been outstanding here. We are talking about a triple A product returning the same amount of money as a floating rate single B product. And I think that is what’s driven some of the flows too, where investors realize the value of CLO ETFs versus loan ETFs. So they’ve been redeeming capital and this is a good start. In the month of March so far, and we’ve been only a couple of days into March, investors have redeemed 1 billion dollars of loan ETFs and investors have put in 600 million dollars into CLO ETFs. So I think that’s been a very interesting trend for us to observe. CLO ETFs have one of the highest Sharpe ratios across all fixed income ETFs. And I think that’s one factor which has caused a lot of financial advisors to recognize the value these ETFs provide over other alternatives.
Shiloh Bates:
Won’t those Sharpe ratios decline just naturally after you hit a pocket of distress in the market?
Pratik Gupta:
Absolutely. But I think on a relative basis, those Sharpe ratios will still be better versus other credit products.
Shiloh Bates:
So is your outlook then for this year that CLO ETFs are going to continue to raise money, CLOs are going to continue to get called, which will result in the buyers who get repaid on their CLO debt securities needing/wanting more CLO securities to replace them? Is the outlook just for tighter spreads as we get through the year or how do you see it?
Pratik Gupta:
That’s a great question, Shiloh, and I’m trying to frame it in the context of what has been happening recently. Initially we were pretty bullish on the growth of the CLO market and that was predicated upon the loan market growing. I think the risks to that scenario have certainly increased given the macroeconomic uncertainty. We are not so sure if the LBO and M&A volume is going to come back in force even in the second half of 2025. The risks to the downside have certainly picked up. So we don’t see the loan market growing with that strength versus what we were initially projecting. And the second part of the story is that there is still a substantial amount of CLOs which can be liquidated. We count roughly 50 billion dollars of CLOs, which are out of the two year reinvestment period, and therefore are subject to call risk right now given the fact that the probability of them getting reset is much lower.
So the technicals are actually in your favor where CLO formation may not be as strong as one would expect, but there is still a substantial amount of capital which can be returned back to investors, which should be recycled back. So that is one part of the technical which should keep spreads on a pretty strong tailwind. And I think you have seen part of that this year. If you look at what has happened in the high yield and IG market and even the stock market, we have blown past what the election levels were. High yield is wider versus where we were right after elections, but the loan market and the CLO market is still relatively tight versus where the loan market is or the high yield market is. So we are certainly outperformed on that context. Now the second part of the story though still remains is the ETF market, which we highlighted, and the fact that if IG and high yield is widening on this macroeconomic uncertainty, I have no doubt that even the CLO market will respond to that. I think that technicals can be a lot volatile. If ETF markets start seeing outflows, then we will widen out more than what the IG market does. But if the outflows are limited, then I think we outperform versus the corporate market.
Shiloh Bates:
So you mentioned that the CLO market isn’t growing because there hasn’t been a lot of LBO activity, and we saw LBO activity decline significantly in 2022 for obvious reasons. And then, since then, I’ve read lots of stories about dry powder at private equity firms. So capital they’ve raised that hasn’t been deployed and it is at record highs. I think the last number I saw was 1.7 trillion or thereabouts. Here we are in the spring of 2025. What’s it going to take for that capital to get deployed into new acquisitions for these PE firms?
Pratik Gupta:
That’s a good question and I’m not so sure if anyone has the right answer here, but honestly I think it depends upon the growth outlook. If private equity firms, first of all, can exit their credit investments, which will allow them to return capital to their investors and then redeploy some of the dry powder back into the market, first of all, that needs to happen, and that is not happening if there’s a substantial gap between what the buyers and sellers basically agree on the valuation side. For the valuation basically narrowing that gap, growth prospects need to be materially higher versus where we are today. And now rates are higher and it looks like growth might be lower versus what we were initially projecting. So it’s not clear to us if the M&A/LBO machine is going to kickstart anytime soon. I think we’re going to remain in this period where the M&A/LBO volume that you see here will be of basically having incremental add-on happening across the board, which will still create some value for company which are still doing well.
I think we will continue to see dividend recaps. In fact, 2024 saw a record volume of almost a hundred billion dollars of dividend recaps. So that is where we see some growth happening. But the core M&A/LBO volume growth, which you saw in 2021, I’m not so sure we are going to see that anytime soon, especially in this uncertain era. So for that to occur, we think a uncertainty around growth really needs to go away, rates need to be slightly lower, and that is when we’ll start seeing more M&A/LBO volumes tick up.
Shiloh Bates:
Well, I think the economic backdrop was probably a little bit more favorable even two weeks ago than it might be today here in the middle of March. But isn’t it that for the private equity firms, regardless of the economic outlook, they need to either buy companies or return the money and I really can’t imagine them returning the money. So don’t we have to see a pickup?
Pratik Gupta:
I think there’s a great point, and I think this is where we are starting to see an interesting development take place, which is basically the rise of the second fund finance business. I think as you said, if private equity investors have to raise cash and they’re not really selling companies because the buyers out there want a much lower valuation versus what they can offer, a lot of these PE funds are actually raising cash by either raising continuation funds or basically resorting to NAV loans. And that’s been a big driver of some of the activity which we have seen. This is a pretty significant area of growth, especially for private credit where they have been playing a lot more important role in providing these liquidity solutions to many of the PE sponsors you’re seeing today.
Shiloh Bates:
So the continuation fund is basically the PE fund. The specific fund has gone its normal life and there’s still assets that the manager doesn’t want to sell. So they sell the assets to themselves or they keep it in-house, but a new set of investors step up and take the risk. So they need to figure out a price where the asset goes from one set of investors to another. And then the NAV loans would be, instead of lending to a company directly, they’re lending to a holding company that has equity interests and a number of companies. As long as not all of the companies go bad, then the NAV loan gets repaid. So that’s a different kind of lending, at least from what you’d find in the traditional form that you’d find in CLOs. And we’ve seen a pickup in that. So that seems to be a solution that works for some set of investors who want money back from the PE funds that they invested in multiple years ago.
Pratik Gupta:
Absolutely.
Shiloh Bates:
So one thing I saw that you published and something of keen interest to me is just anything related to private credit CLOs. So the majority of my assets are in this little niche. What kind of research are you publishing there and what do you think is topical for investors?
Pratik Gupta:
Thank you, Shiloh. Thanks for asking that question. This has really been another very interesting evolution in the CLO market, in addition to the ETF market, has been the growth in private credit CLOs. Last year we saw a record volume of 40 billion dollars of CLOs being issued. I think this year we’re going to see that volume being breached. We think another 50 billion dollars of private credit CLOs are going to be issued this year. More interestingly, a lot more asset managers or private credit asset managers are looking to use the CLO technology to obtain term financing. That’s been a very attractive form of funding themselves. And that basically creates interesting opportunities for investors in the BSL market to consider the private credit CLO market. One thing which we have noticed is that the structures in private credit CLOs tend to be slightly better in terms of the subordination levels which they offer to bonds.
So a typical BSL CLO will have a lower subordination level versus that of a private credit CLO. So that is one part of it. At the same time though, because ratings are a bit more punitive, the triple C haircuts, that is the threshold beyond which triple C assets are accounted and market price is also higher in private credit CLOs. The typical concentration limit for triple C estimated loans in a CLO would be roughly 17 and a half percent in a private credit transaction versus 7 and a half percent in a BSL transaction. Now having said that, what we have seen is that the downgrade rate that is a CLO tranche downgrade rate or even the impairment rate has been materially less in private grade CLOs versus BSL CLOs, and that includes the Covid time period as well. So the bonds have certainly outperformed versus the broadly syndicated loan CLO market. And I think the equity in private credit CLOs has been materially a better performer versus the BSL CLO equity platform.
So in both aspects, bonds and equity, private credit CLOs have done better. And if you look at the past 12 months data, given the fact that there’s been a lot of news around liability management exercises and BSL loans, the trailing 12 month loss rate in direct lending loans or private credit loans has only been a fraction versus what you see in the broadly syndicated loan market and KBRE estimates that the loss rate in private credit loans has been roughly 80 to 90 basis points versus the BSL market to be close to 3 point 5 points. So that’s a pretty meaningful difference and it tells you why the private credit CLO transaction has done better versus BSLs.
Shiloh Bates:
So from my perspective, you outlined some of the differences in terms of structure. So if you’re at the bottom part of the stack, so the CLO double B, the amount of capital that’s junior to you in middle market is 12 percent or more. And for broadly syndicated, it’s 8. And when I hear those numbers, well 12 and 8 kind of in the same ballpark, but actually it’s not. 12 is 50% more than 8. And that really matters in terms of what default rate you can survive on the loans. But I think that for me, one of the attractions of middle market has been and continues to be just that anytime the loan has issues, those are going to be worked out between one lender, or a club of lenders, and the borrower. And it’s not always a simple process, but that’s a much better way to do things than to have, in broadly syndicated, potentially a hundred different investors in the loan. Maybe there’s other debt securities like a bond or second lien or whatever. If you have a hundred lenders, you probably have 120 opinions on what should happen with the company. And there’s no distressed hedge funds that are buying up middle market loans. In fact, they’re not for sale. They were underwritten to be held to maturity. So you don’t have that crowd buying loans and proposing restructurings that benefit them vis-a-vis other lenders. So it’s not surprising to me that the loss rate on the loans has been better in the middle market.
Pratik Gupta:
And I think that you raise a great point. I feel that will remain the place, especially given the evolution of liability management exercises in the BSL CLO market and the fact that recovery rates are no longer the 75 to 80 percent, which we all used to rely on. I think that has really caused a paradigm shift in how investors look at the private credit or middle market CLO space as a result. Given the new era we are in, I think manager tiering will also start to play an important role in how private credit CLOs are analyzed. The lack of data so far has been a challenge, but given the fact that a lot of these private credit CLO managers also actually are managers of these BDCs, and many of these BDCs do file public filings, you can see their portfolios on a quarterly basis, what they’re marked at, that can give investors an avenue to actually analyze and tier for different managers based on what their preference is.
Shiloh Bates:
Just to present the other side, I mean, the one drawback to private credit CLOs is that the underlying loans are not trading around in the market. So you basically get a quarterly price that’s done on an appraisal by a third party, but it’s more like an appraisal, which is not as valuable as seeing a trade yesterday or a week ago. So how should investors think about that or get comfortable with that set up?
Pratik Gupta:
I think that’s probably very important for investors to consider when they’re looking at, especially, the junior credit tranches. In fact, we did this research where we looked at how the marks of defaulted assets vary across these private credit CLO transactions. I think that’s very important because these defaulted assets are carried at the market price or the recovery price, which each trustee determines based on the opinion from the manager. And the lower the estimate, the higher the haircut, the better protected the debt holders are in that CLO. And we continue to see a significant variance in the marks of defaulted assets for the same asset across a variety of CLO managers in the private credit space. And I think based on how conservative the manager is, that is what investors will really gear towards in terms of their tiering preferences. And I think the market will start to tier across these managers on a spread basis going forward.
Based on that, there will be two driving factors behind this. One is what is the share of assets which are actually defaulting at the particular asset manager? And did you start from both CLO data as well as BDC data, which is public? And the other part is going to be what is the share of assets which are actually PIKing, that is paying their interest in kind, PIK. And that has also seen a significant variance across CLO managers and manager is getting a large share of their income from PIK income that according to us, will be an adverse scenario for an investor and they will deal for that manager accordingly. And the third layer as highlighted is the difference in marks across asset managers for the same defaulted asset. The lower the mark, the more conservative that manager is. I think CLO debt holders would likely go for that manager from a spread perspective.
Shiloh Bates:
Have you guys looked at what percentage of loans in CLOs is paid in kind rather than paid in cash?
Pratik Gupta:
We looked at the BDC data and the share of PIK income that is a share of each BDCs income, which is payable via PIK is still low. It’s close to 9%, but it has grown from roughly 3 to 4 percent a couple of years back. So that has certainly taken a step back. But more importantly, there’s actually a lot of variance across asset managers here. So historically speaking, the share of PIK income was pretty low, but today it has increased, but more importantly, the dispersion has increased even more across asset managers. So you can clearly see certain managers where the share of PIK income remains less than 5 percent, and there are certain asset managers where the share of PIK income is more than 10 percent, so that this person is going to be an important part of how investors value different platforms going forward.
Shiloh Bates:
So I think though the comparison of private credit CLOs to BDCs isn’t exactly apples to apples because the loans in BDCs are going to have much higher rates and they’re going to have probably a 2 percent or more premium spread over SOFR. So PIK loans really don’t work great in CLOs because the CLO’s financing doesn’t PIK. Or if it does PIK, it’s because there’s been too many defaults or downgrades.
Pratik Gupta:
I think it is a great point here, no doubt, the private credit CLO market, because of the structural concentration limits they apply, it’s actually going to be a positively selected cohort of loans from the BDCs because CLOs will not offer a certain percentage of second liens. They will not accept a certain percentage of PIK loans to your point, and they will certainly not accept hybrid instruments which are very common in BDC portfolios. So from that aspect, a CLO will always be a better performing portfolio versus what the BDC has. What we are trying to do here is looking at the BDC as a way to tier for managers as opposed to looking at the CLO in an absolute format is really to understand the differences across platforms and see if we can use that difference as a way to account for spread differentials across different private credit CLOs.
Shiloh Bates:
Pratik, is there anything else that’s topical that we haven’t covered already?
Pratik Gupta:
I think one aspect which I would like to highlight to some of your listeners is there’s been a lot of chatter about banks basically being competitors to private credit. And I feel the data shows the opposite. We’ve looked at this data based on how many banks have been lending to these NDFIs, that is non-depository financial institutions. That particular portfolio of bank lending has actually grown multiple fold to 1.3 trillion today. It’s grown at an annual rate of 14% versus the C and I book, that is commercial and industrial loan book, which is a mainstay of all bank portfolios that has only grown at 4 percent annually. So NDFI lending is really lending to some of these private credit institutions in addition to mortgage and consumer credit intermediaries. And in that aspect, 2025 onwards, the banks were required to disclose their individual lines of NDFI lending, and that actually included lending to private credit and lending to private equity.
And what our research found was banks have actually lent around 220 to 250 billion dollars to private credit firms, and that has actually grown by leaps and bounds over the past five years. So that tells us banks actually view private credit as partners and not necessarily as competitors. And how this data evolves is actually going to be very interesting to observe. And I think that’s been a big role in how and why private credit has grown at such a strong pace versus the broadly syndicated loan market. I think the banks have played a big role here and we continue to see this format where banks have actually been buying not just the BSL CLO triple As, but also private credit CLO triple As. So they’ve been supporting the growth of the private credit CLO market too by actually buying those bonds themselves and some of it actually is just turning their warehouse into CLO triple A and keeping it on their own books.
Shiloh Bates:
Great. Well Pratik, thanks for coming on the podcast. Really enjoyed our conversation.
Pratik Gupta:
Shiloh, this was a great honor. Thank you for having me. I really appreciate this.
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 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, BSL, 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 investment through its maturity.
Spread is the percentage difference in current yields of various classes of fixed income securities versus treasury bonds or another benchmark 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 a non-recurring item.
LIBOR, the London Interbank Offer Rate, was replaced by SOFR on June 30, 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 pledge 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 an underlying floating rate index.
RMBS are residential mortgage-backed securities.
The UK LDI (liability-driven investment) Crisis, triggered by the mini-budget in September 2022, saw leveraged pension funds with LDI strategies struggle to meet margin calls amid rising interest rates, leading to the sale of gilts, and forcing the Bank of England to intervene.
NAV loans are loans backed by several private equity investments.
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. Additional information about this podcast along with an edited transcript may be obtained by visiting flatrockglobal.com.
