#18, Pratik Gupta, Head of CLO Research, Bank of America Securities

Shiloh Bates talks to Pratik Gupta, CLO Head of Research for Bank of America Securities, about CLO securities' performance versus that of corporate debt, CLOs backed by syndicated loans and private credit CLOs, and more in this episode of The CLO Investor podcast.

Episode Transcript

(00:06):
Hi, I'm Shiloh Bates and welcometo the CLO Investor podcast.
CLO stands for collateralizedloan obligations,
which are securities backed by poolsof leveraged loans. In this podcast,
we discuss current news in theCLO industry and I interview key
market players. Today I'mspeaking with Pratik Gupta,

(00:27):
the CLO research head atBank of America Securities.
For publicly traded stockslike Apple and Google,
investment banks publish research on thecompany that may have a Buy or a Sell
rating. In CLO research,
analysts don't put ratingson particular CLOs. Rather,
they write about the overall CLO industry.

(00:49):
And because each CLO reports monthly,there's lots of data to analyze.
I think Pratik and I hitpretty much everything topical happening in CLOs today.
Of particular interest to me was ourdiscussion about how CLO securities
outperform corporate debt withbetter returns and lower defaults.
And within CLOs,

(01:10):
private credit CLOs outperformingthose backed by syndicated loans.
If you're enjoying the podcast, pleaseremember to Share, Like, and Follow.
And now my conversation with Pratik
Gupta.
Pratik, thanks for coming on the podcast.

(01:30):
Shiloh, thank you so much for havingme. It's a real honor. I appreciate it.
So why don't we start off with yourbackground and how you became a CLO
researcher?
Sure, thank you for that. So Ijoined the industry as an RMBS.
That is a legacy subprime,
the very securities which createdthe great financial crisis.
I started my career as a researchanalyst covering those securities back in

(01:51):
2012, October. And I reallyenjoy covering that sector.
I still cover that sector. I think it'sa fascinating market. And in 2013/2014,
I realized that market is not reallycoming back in the same way it used to
exist during the 1.0 days.
And I had to diversify awayfrom mortgage backed securities.
That's the time when I decidedto take the plunge into CLOs.

(02:12):
At that point of time, itwas an emerging asset class,
there were people covering it,
but I felt that we could make amark here in this particular sector.
And I'm very glad that we did it.
We were certainly very luckyand fortunate to do so.
It was also that point of time when wehad the energy crisis happening back in
2015.
That's exactly when we started reallycovering it officially and we applied the

(02:34):
same way, which we usedto do for RMBS analysis,
that is apply a bottoms-up approach,
that is look at each and every loanseparately and then understand how does a
CLO portfolio work.
And I think that reallymade a big difference to us because that was exactly the
time when the energy crisis startedcreating these interesting dispersions in
CLO portfolio returns and performance.

(02:55):
And I think our approach certainly causeda lot more investors to look at our
stuff and talk to us and we learnfrom them even more as a result.
So why don't you tell our listeners whatthey can find in the research that you
publish weekly and monthly?
As a data-oriented research shop,
we want to make sure that investorshave access to reliable data,

(03:16):
which can help them analyze theirportfolio-making decisions. For us,
that is really our core strategy. Ifan investor is looking at a CLO market,
or the RMBS market,
whatever data we can provide to themwhich will help them analyze the sector
better is where webasically want to excel at.
And that is our first and foremost goal.
Our next step is to provide our ownanalysis of the data and tell them what we

(03:36):
think about the market basedon the data we have on hand.
And investors can agree or disagreewith us. As research analysts,
we are fully cognizant of the fact thatwe are not the ones who have capital to
put to risk. It's really theinvestor and we fully respect that.
And it's our job to ensure that weprovide them with transparency we can from
our side for them to just make thedecision in the best possible manner.

(03:58):
So do investors use your research todistill who the best CLO managers are?
I would hope so. I think some investorscertainly do that and it's not just us.
To be fair,
I think the entire street does a reallygood job of providing data on manager
performance and CLO performancemetrics. We are certainly one of them,
but everybody else does it too.
And where we think we would like toprovide value is giving them different

(04:22):
insights as to how to evaluatemanagers. As times have evolved,
the way we analyze managerperformance has also changed.
We have entered through different creditcycles, admittedly not very big ones,
but certainly many, manycredit cycles, since 2012.
And understanding how managers havereacted to these credit cycles,
what has been the core strategy foreach manager to mitigate risk, I think,

(04:44):
has been very unique.
And there are probably around160 to 170 or CLO managers with a
CLO outstanding.
But if you look at the number ofactive managers in any given year,
they're close to ahundred, a hundred to 111.
And I think understanding which managerbrings a unique insight into the
performance style is something whichwe try to look at on a regular basis.

(05:05):
So for an investor that playsdown the stack in mezz and equity,
what are the key metrics that you wouldsuggest that an investor focus on?
I think, looking at the data so far,
and this is including the energycrisis all the way to now,
I think the biggest alphagenerator is being loss avoidant.
So the ability to recognizeloans, which can, really could,

(05:26):
decline in price significantly and sellingthem early or not holding them in the
first place has probably been the biggestdifferentiator across CLO managers.
And it sort of makes sense because if youlook at the loan market and where CLOs
are created at, it's fair to say mostloans are purchased very close to par,
so your upside risk is going to be justa coupon and getting paid off in full at
some point of time. Your downsiderisk, though, is pretty significant,

(05:50):
especially if the loan does not performand the recovery rates can be very low.
Really the alpha generator hasbeen in recognizing these losses,
or risks of losses, early on,getting out of them early on,
and simply not holdingthem in the first place.
And that has been a consistent themeacross 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,

(06:12):
is to continue to hold a loan if youhave conviction in the eventual payoff
story. And I think during Covid thatwas a critical mode of outperformance.
So obviously during Covidwe saw significant CCC downgrades and the loan market
did sell off,
but we did see significant dispersionin how managers reacted to that risk.
Some managers basically sold a lot ofthose CCC downgraded names through Covid

(06:34):
at a very steep low price,
and that really had significantdeterioration on the performance for a
portfolio.
And there are certain managers whoheld onto that loan through that cycle,
and they were justifiedin doing so in the end,
because you saw those loans payoff in full by 2021, 2022. There,
the dispersion portfolio returns couldbe explained by your conviction in that

(06:55):
name and your ability to writethese credit cycles over time.
So I think it's a combinationof these two factors.
The sweet spot is somewhere in the middle.
When you meet with CLO management teams,
do you feel like there's some secretsauce in the market where some
managers do have a repeatable,let's call it alpha, that they add?
Or is it just the faults are randomand sometimes one manager is getting

(07:19):
tagged with them and notothers? How do you see that?
That's a great question andit's honestly tough to say.
I think a lot of it has to be predicatedupon the process and structure
the CLO management teams have in place.
I think it's fair to say not everymanager is perfect and they will be tagged
with mistakes and how you react tothose mistakes is essentially what

(07:40):
differentiates some versusthe others. And in hindsight,
obviously anybody can say that if wehad done this it would've been better.
But there's a consistent approach incertain managers in reacting to these
mistakes and you can see that inthose portfolio performance metrics.
I think that's what probably helpsthem stand out in particular.
So one of the questions I get askedfrequently as a manager of both CLO equity

(08:01):
and CLO double Bs is just, we'rerecording this at the beginning of March,
which set of securities providesthe best opportunity for this year?
And just curious if you have a view there.
That's a very tough questionand interesting one.
I think the timing of the trade reallymatters a lot for double B and equity.
In my view,
the best time to buy CLO equity is whenloans are cheap and that's when a 10

(08:25):
times levered instrument in a loanportfolio investment can make wonderful
returns because you'rebuying loans pretty cheaply.
It doesn't matter where theliability stack is struck in my view.
And if you look at thedata it shows through.
The best performing equity return wasprobably that of the 2020 vintage,
when liabilities were struckat extremely wide levels,
but you were also buying loans at probablyone of the widest levels ever in the

(08:46):
2.0 time period.
You could also argue the same for2022/2023 vintage where once again,
even though liabilities are wide,
you are actually buying loans at one ofthe local wides in general from a priced
perspective.
So I feel the right time to buy equityis exactly when loans are cheap.
The double B trade is very interesting.
The double B trade basically providesinvestors with a very low variance but

(09:09):
significantly high returnsover a longer period of time.
Now the problem with CLO double Bs isthat it can be mark to market volatile.
There will be instances where double Bbond 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 basicallygo through that time period,

(09:29):
and it's a buy/hold strategy, Ithink in the current environment,
I feel double Bs aremarginally better than equity.
But if you're buying new issue CLOs,
and you can underwriteyour manager very well,
I think in that particular instance,
new issue CLO equity canoutperform CLO double Bs.
So it's a mixed answer and I completelyunderstand it's not a great answer,
given a yes and no perspective, butin my view, in the primary market,

(09:51):
if you can buy CLO equity andunderwrite it with a very good manager,
your returns can be better thanwhat you buy with a CLO BB trade.
But in the secondary market,
I feel CLO double Bs can still providebetter value as a portfolio trade as a
whole versus buying theaverage CLO equity right now.
So for equity,
obviously today the loans are notreally trading at significant discounts.

(10:11):
Most of the good loans are at par,
but we are seeing lots of refisand resets, or extensions,
as I call them.
Is that as good as buying a CLO at atime where the loans are trading at
discounts?
I think the resets is really what makesa critical difference for CLO equity
today because in terms ofwhere you're striking loans at,
there's not a lot of discountto be captured in this market.

(10:34):
So you're really banking upon the factthat you can extend your CLO at a time
when you really want to extend,
let's say three years orfour years down the line.
And that will really depend upon theperformance of the CLO portfolio.
If your CLO portfolio has incurredlosses through this time period,
your ability to reset the deal,or even refinance the deal,
can be significantly impaired and thatcan actually have an adverse impact on an

(10:54):
equity return. That is why forthe new issue CLO equity today,
given that you're alreadystriking liabilities at one of the tightest parts of
the 2.0 market,
it is critical to select the right managerwhere your portfolio losses should be
low on a go-forward basis and that willbasically allow you to monetize the
refi/reset optionalityembedded in CLO equity.
So you mentioned that for the double B,

(11:16):
and I think you were talking aboutbroadly syndicated double Bs,
they can be quite volatile. By our math,
we see the default rate on thesedouble Bs as being almost de minimis,
20 basis points or so over the last30 years. Given that performance,
why would broadly syndicated doubleBs be so volatile in a period like
Covid or the recessionaryfears of 2022 for example?

(11:41):
Great question.
It gets down to the fact that thedouble B portfolio trade has a limited
investor base compared to let's say thebroadly syndicated loan market or the
high yield market.
Double B CLOs in our spacebasically trades on this concept of
MVOC,
and there's a very high beta acrossmanagers based on what the MVOC level is.
And the MVOC, just for our listeners,

(12:02):
so that's the market value ofall the CLO's loans, plus cash,
that's the numerator, compared tothe CLO's debt through the double B.
So a good ratio there, or at least theinitial MVOC, as you said, would be.
108/109 For a good qualitydeal. And yes, to your point,
basically what it means is that you havean additional eight points of cushion

(12:24):
to support the double B. If youliquidate your loans at market value,
you still are left with an eightpoints of cushion to support a double B
tranche. And yes, that'sexactly right, Shiloh.
And during volatile timeperiods of this MVOC level,
or the market value over-collateralizationratio level goes below a hundred
because loans are trading cheaply,
the double B market does trade widerjust based on the structural implications

(12:45):
of the trade. And I feel themarket base is not wide enough.
There's lack of depth in the double Bmarket which can support this kind of
volatility and that is why we thinkprices are volatile. Now to your point,
I think it is a great point.
The total defaults in CLO double Bs aremuch less than that of corporates or any
other structured product today.

(13:05):
And I think it's a good time to showcasewhat the 10 year returns have been in
the CLO double B trade. If youlook at CLO double B trades,
the cumulative return over thepast 10 years, or five years,
has been either three times ortwo times that of corporates.
So we are talking about a significantform of outperformance versus both high
yield and loans over afive-year and 10-year period.

(13:27):
And as long as you can withstandthat mark to market vol,
which we just talked about, Ithink on a total return basis,
it makes absolute sense and we stilllike that trade for that very reason that
there is less variance across managerswhen it comes to double B portfolio
returns. And if you're able towithstand the mark to market vol,
you end up outperforming the high yieldand corporate loan market by roughly 300

(13:48):
basis points, which is prettysignificant in today's world.
So these securities offer historicallybetter returns and have lower,
significantly less, defaults.
I think part of the driver forthe volatility is that when the
MVOC that we've been talking about, sowhen the double B would not be covered,
in a loan market whereloans have traded down,

(14:10):
if the CLO was liquidated on that day,
yeah the double B wouldnot fully be repaid.
And that sounds pretty scary to people,
but the thing to keep in mind is the Cis not going to be liquidated on that
day. In fact, it can't be.
So what's going to happen is eitherthe loans are going to recover,
or loans are going to bedowngraded and default.
And if you have a lot ofdowngrades and defaults,

(14:31):
the CLO is going to trap theprofitability of the CLO,
it's not going to makeequity distributions,
and then there's just going to be morecash and ultimately more collateral over
time that supports the doubleB. But I do agree that yes,
buying a double B that's not coveredcurrently by the fair market value of the
loans does sound like arisky proposition to folks.

(14:54):
I think, to your point,
certainly there's a great thing herethat even though MVOC could be lower,
it doesn't necessarily mean thatthe double B is not covered.
Not every single loan in themarket defaults. For example,
if you're issuing a loan at 200 basispoints 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 thatthe loan will default.
And I think that's acritical nature of the CLO.

(15:16):
It's a non-mark to marketCLO portfolio investment.
They are not forced liquidators.
And that's exactly why I thinkdouble Bs have traded so well.
They have performed so well because ofthe structural protection which you just
described,
as well as the fact that managers are notreally forced to liquidate loans in an
uncertain macro environment.
So one of the things I've seen, youguys have written about a fair amount,

(15:37):
is changes to insurancecompany regulatory capital
rules.
How I would've thought the rules workwas that a CLO double B or triple B or
even up the stack, it has arating from Moody's or S and P,
and that would dictate howmuch capital a financial
institution would have to set aside.

(15:59):
And we've talked about actuallyhow CLO, at least at double B,
and this is true up the stack as well,they default less than corporates.
So I think the argumentwould be at least in my mind,
for less capital to support aCLO double B versus a corporate.
But my understanding is it'sactually going the other way.
Could you help us understand that?

(16:19):
Sure. And honestly,
it's a puzzle which still confuses meas to why that is the case. And again,
I think we both share the viewpoint thatit is not justifiable based on the data
we have seen.
But let's just take a step back andunderstand why and what the NAIC is trying
to do here. So the NAIC is a regulatorfor the insurance companies in the US,
and to be fair to them,
they did highlight this issue where theunderlying risk-based capital for loans

(16:43):
is actually higher than the aggregatedrisk-based capital for all the CLO
bonds, including the equity, put together.
So if someone had to buy a portfolioof loans and then structure a CLO where
they held each and every tranche,
the risk-based capital for that entitywill actually be lower versus them
holding the loans outright.
And I think that is the arbitragewhich the NAIC is trying to minimize.

(17:05):
And I think that's a fair pointand I do see why they're doing it.
But if you have to extend this argumentfor mortgage loans, or CMBS loans,
then the same principle ofneutrality does not apply.
So this is only the loan asset classto which the NAIC is basically applying
this change. They're not reallydoing this for other asset classes.
So that is one area of discrepancy,which I see in the picture.

(17:27):
Now obviously in an effort toget to this neutrality point,
what the NAIC has done is they haveincreased the capital charges for sale of
equity in the first place,
they have increased that on aninterim basis from 30% to 45%
risk-based capital. And forthe rest of the CLO debt stack,
they're basically trying to do thisscenario testing approach where they're

(17:47):
going to test several scenariosof varying degrees of stresses.
And the probabilities of those stressesare somewhat yet to be determined.
But the effort here is to basicallyapply these stress-based scenarios.
Some of the scenarios are pretty draconianin nature with very high defaults and
very low recovery rates.
And based on the expected lossesthe CLO tranches will incur,

(18:08):
they will then apply a risk-basedcapital formula charge.
Now the scenarios and probabilities aredesigned to achieve this neutrality.
So needless to say, becausethey want to achieve neutrality,
those stresses are going to be a lot morepunitive in nature and those punitive
stresses will also have a higherprobability in the model which is not
conforming to reality. And asa result of those stresses,

(18:31):
we feel that CLO double Bs and CLOtriple Bs will certainly see higher
risk-based capital charges versus whatthey have currently. But on the contrary,
CLO triple A, double Awill actually benefit.
CLO double A in particular will see lowerrisk-based capital because they don't
really incur any defaults,even under this most draconian,
severe stress scenario.

(18:52):
And we could see this bar-bellingapproach where triple A,
double As will havelower risk-based capital.
Triple A is already at the best point,
but even double A will have a lowerrisk based capital, but the triple B,
double B trade will have higher charges.
So it might cause some insurance companiesto basically invest at the top of the
stack and result in some widening forthe triple B bonds if this were to be

(19:13):
implemented. Now that's a big if.
I think we should also highlight thefact 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 saidthat they don't really believe in the
risk-based capital approach and they'regoing with a completely different model
to evaluate the risk-basedcapital for CLOs.

(19:35):
So there's already two forms of thoughtson what the risk-based capital should
be for CLO securities. Sothe jury is still out there,
whether or not CLO bonds will seehigher RBC especially for the mezzanine
bonds, and to what extent.
So initially we were expecting thisto be completed by 2025 year end,
but given the two different thoughts here,
I don't think it's going tobe completed by this year end.

(19:57):
We might see more delays.
Yeah,
it seems like this has been a processthat doesn't seem to come to a conclusion
very quickly.
That is right,
and I think that's why we have not seeninsurance companies react very adversely
to this prospect,
yet we still see very strong demand frominsurance for triple B bonds despite
this pending NAIC development.

(20:18):
Do you think insurance companieshave a lot of double Bs?
We don't think so.
We think most of the bonds which insurancecompanies buy are in the single A,
double A, and triple B area. In fact,
our research suggests that 50% of doubleA to triple Bs are held by insurance
companies. So they're certainly veryprominent for the mezzanine stack.
But we have gotten to realize that ifyou look at the CLO insurance industry as

(20:38):
a whole, as a percentageof their total capital,
a very small percentage of thatis actually invested in CLOs.
So even though we are talking aboutmeaningful changes to the CLO market as
such, for the insurancecompanies as a whole,
I don't think it's a big change becausenot a lot of their capital is really
exposed to CLO double Bs ortriple Bs in the first place.
So changing topics to CLO ETFs,

(21:01):
I would say this is probablyover the last two years,
the biggest maybe changeor trend in the market.
How do you see the rise of theETF as affecting our business?
Great question. Shiloh.
I think during the call and when wewere just talking about the topics,
I think you had mentioned that CLOs havegotten mainstream and I think the ETF
market is probably thesymbolic designation that why we have gotten mainstream.

(21:23):
We have a lot more retail capital nowparticipating in the CLO market via the
ETF space. And that hasreally democratized, I think,
the investment opportunity for bothinstitutional and retail investors alike.
We count,
I think at least 21 active CLO ETFsright now and the total AUM of the
CLO ETF industry has exceededroughly 31 billion dollars. In fact,

(21:45):
we think that the CLO ETF marketis bigger than the loan ETF market,
which if you look at it waspretty staggering because CLO ETFs have really been
existence over the past three years.
Loan ETFs have been in existencefor the past 10 years or so,
if not more than that. So it's agreat point which you bring about,
Now clearly because of almost exponentialgrowth the ETF market has seen over

(22:06):
the past two years, it has had animpact on where CLO spreads are.
And I think the technicalshave 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 whichis pretty important to consider.
So even though you maysee a lot of CLO issuance,
we've got to remember that CLOsalso see quarterly liquidations,

(22:29):
quarterly pay downs,
which basically bring money backinto the market to be reinvested.
So on a net basis, the total net CLOmarket has not seen a lot of growth,
especially through 2024. And in our view,
if you look at the AAAmarket in particular,
which is where all theETFs are focused on,
the net supply for CLO tripleAs was probably close to

(22:49):
54 billion dollars through last year.
But given the fact that you alsosaw ETFs basically putting roughly
14 to 16 billion dollarsof capital of inflows,
if we actually think that thenon-ETF investors, that is,
you're talking about domestic banks,Japanese banks, insurance companies,
money managers,
these entities actually saw theirAAA holdings decline by a net

(23:11):
12 billion dollars through2024. And if you look at 2025,
it's been a further declineof 10 billion dollars.
So even though the ETF markethas grown in strength and size,
we are talking about 32billion dollars of AUM,
non-ETF investors have actually seenthe AAA holdings decline by roughly
22 billion dollars sincethe beginning of 2024.
Now that's a pretty significanttechnical to consider.

(23:32):
In a higher for longer environment,
CLO securities demandhas been pretty strong.
I think most of yourreaders should know this,
but if you have to consider the US market,
and you want to invest infloating rate AAA bonds,
the largest market by faris the CLO AAA market.
And in this environment,given the strong track record,
there is still a lot more demandacross banks, insurance companies,

(23:55):
and money managers for CLO triple As.
And if you're seeing a holdings declineby roughly 22 billion dollars since the
beginning of 2024, naturally that demandis going to cause spreads to tighten.
And that is exactly what wehave seen for our market,
especially because of the ETF inflows.
So do you think that from AAA and someof the ETFs are doing down to double B,

(24:15):
do you feel like there's enough liquidityin the underlying such that in a down
market if people are redeeming shares,
that these funds will be able tofunction in a market like that?
That's a great question, Shiloh.
I think the jury is stillout there on that one.
I do think that the triple Amarket is actually fairly liquid.
We are talking about the CLO triple Amarket is close to 650 billion dollars in

(24:37):
size. And if you focus onjust 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 thatthe triple A ETF market is probably less
than 4% of the triple A outstanding.
So that's still a pretty small percentageof the market. Now in terms of flows,

(24:57):
it can be meaningful,
but in terms of an outstanding marketit is pretty small and we think that
yes, outflows from ETFs willcause near term volatility risk,
but can it be handled well bythe the triple A market? Yes.
Now we like to call CLO triple As thebest asset class to sell and the best
asset class to own. And the reasonwhy we call it that is because,

(25:17):
historically speaking,
because it's so unique in beingthe only floating rate product,
the price stability of triple As has beenpretty strong compared to other fixed
rate fixed income products/assets.So in times of stress,
when investors want tobasically sell and raise cash,
they tend to sell the product whichis trading closest to par and that
inevitably tends to bethe CLO triple A bonds.

(25:39):
So we do think in times of stress whenpeople want to raise liquidity rates,
raise cash. And we sawthat exactly during Covid.
We saw that exactly during the LDI crisis,
we saw institutional investors sell tripleA bonds because that was the product
which was trading closest to par and thatat the lowest mark to market loss for
them. So we do think if yousee vol in this time period,

(25:59):
naturally triple A spreads will widenout because of the associated volatility.
But you might also see some investorsredeem ETFs because they want to raise
cash and the closest product to paris the CLO ETF product right now.
So I do see that risk and I do thinkthat the triple A market can handle it.
Where I do see some higher riskfactors for us is in the triple B,
double B ETF market. To your point,

(26:20):
I don't think the liquidity in triple BETFs is that strong that it can handle
significant variationsin inflows and outflows.
But so far what we have seen isthat the outflows have been very,
very moderate and they havebeen able to digest it.
There's also another interesting trendwhich I would like to highlight to you
here.
We've actually seen investors redeemingloan ETFs and actually putting money
into CLO ETFs.

(26:41):
That to us is very interesting to lookat because if you look at the performance
of CLOs over loans,
triple A CLO bonds have returnedalmost the same amount of capital as
single B rated loans sincethe start of Jan 2024.
So the Sharpe ratio has been outstanding.
Here we are talking about a triple Aproduct returning the same amount of money
as a floating rate single B product.
And I think that is what'sdriven some of the flows too,

(27:03):
where investors realize the valueof CLO ETFs versus loan ETFs.
So they've been redeemingcapital and this is a good start.
In the month of March so far, and we'vebeen only a couple of days into March,
investors have redeemed 1 billion dollarsof loan ETFs and investors have put in
600 million dollars into CLO ETFs.
So I think that's been a veryinteresting trend for us to observe.
CLO ETFs have one of the highest Sharperatios across all fixed income ETFs.

(27:27):
And I think that's one factor which hascaused a lot of financial advisors to
recognize the value these ETFsprovide over other alternatives.
Won't those Sharpe ratios decline justnaturally after you hit a pocket of
distress in the market?
Absolutely. But I thinkon a relative basis,
those Sharpe ratios will still bebetter versus other credit products.

(27:49):
So is your outlook then for this yearthat CLO ETFs are going to continue to
raise money, CLOs are goingto continue to get called,
which will result in the buyers whoget repaid on their CLO debt securities
needing/wanting more CLOsecurities to replace them?
Is the outlook just for tighter spreadsas we get through the year or how do you

(28:10):
see it?
That's a great question, Shiloh,
and I'm trying to frame it in the contextof what has been happening recently.
Initially we were pretty bullish on thegrowth of the CLO market and that was
predicated upon the loan market growing.
I think the risks to that scenariohave 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

(28:32):
even in the second half of 2025.
The risks to the downsidehave certainly picked up.
So we don't see the loan market growingwith that strength versus what we were
initially projecting.
And the second part of the story is thatthere is still a substantial amount of
CLOs which can be liquidated. We countroughly 50 billion dollars of CLOs,
which are out of the twoyear reinvestment period,
and therefore are subject to callrisk right now given the fact that the

(28:56):
probability of them gettingreset is much lower.
So the technicals are actually in yourfavor where CLO formation may not be as
strong as one would expect,
but there is still a substantial amountof capital which can be returned back to
investors, which should be recycled back.
So that is one part of the technicalwhich should keep spreads on a pretty
strong tailwind. And I think youhave seen part of that this year.
If you look at what has happened in thehigh yield and IG market and even the

(29:19):
stock market, we have blown pastwhat the election levels were.
High yield is wider versus wherewe were right after elections,
but the loan market and the CLO marketis still relatively tight versus where
the loan market is orthe high yield market is.
So we are certainlyoutperformed on that context.
Now the second part of the storythough still remains is the ETF market,
which we highlighted and the fact thatif IG and high yield is widening on this

(29:42):
macroeconomic uncertainty,
I have no doubt that even theCLO market will respond to that.
I think that technicalscan be a lot volatile.
If ETF markets start seeing outflows,
then we will widen out morethan what the IG market does.
But if the outflows are limited,
then I think the outperformversus the corporate market.
So you mentioned that the CLO marketisn't growing because there hasn't been a

(30:04):
lot of LBO activity,
and we saw LBO activity declinesignificantly in 2022 for
obvious reasons.
And then since then I've read lots ofstories about dry powder at private
equity firms.
So capital they've raised that hasn'tbeen deployed and it is at record highs.
I think the last number I sawwas 1.7 trillion or thereabouts.

(30:27):
Here we are in the spring of 2025.
What's it going to take for that capitalto get deployed into new acquisitions
for these PE firms?
That's a good question and I'm not sosure if anyone has the right answer here,
but honestly I think it dependsupon the growth outlook.
If private equity firms, first of all,can exit their credit investments,
which will allow them to return capitalto their investors and then redeploy

(30:49):
some of the dry powder backinto the market, first of all, that needs to happen,
and that is not happening if there's asubstantial gap between what the buyers
and sellers basically agreeon the valuation side.
For the valuation basicallynarrowing that gap,
growth prospects need to be materiallyhigher versus where we are today.
And now rates are higher and it lookslike growth might be lower versus what we

(31:10):
were initially projecting.
So it's not clear to us if the M&A/LBOmachine is going to kickstart anytime
soon.
I think we're going to remain in thisperiod where the M&A/LBO volume that you
see here will be of basically havingincremental add-on happening across the
board,
which will still create some value forcompany which are still doing well.
I think we will continue tosee dividend recaps. In fact,

(31:32):
2024 saw a record volumeof almost a hundred billion dollars of dividend recaps.
So that is where we seesome growth happening.
But the core M&A/LBO volumegrowth, which you saw in 2021,
I'm not so sure we are goingto see that anytime soon,
especially in this uncertainera. So for that to occur,
we think a uncertainty aroundgrowth really needs to go away,
rates need to be slightly lower,

(31:53):
and that is when we'll start seeingmore M&A/LBO volumes tick up.
Well, I think the economic backdropwas probably a little bit more
favorable even two weeks ago than it mightbe today here in the middle of March.
But isn't it that forthe private equity firms,
regardless of the economic outlook,
they need to either buycompanies or return the money and I really can't imagine

(32:16):
them returning the money. Sodon't we have to see a pickup?
I think there's a great point,
and I think this is where we are startingto see an interesting development take
place, which is basically the riseof the second fund finance business.
I think as you said,
if private equity investors have toraise cash and they're not really selling
companies because the buyers out therewant a much lower valuation versus what

(32:37):
they can offer,
a lot of these PE funds areactually raising cash by either raising continuation
funds or basically resorting to NAV loans.
And that's been a big driver of someof the activity which we have seen.
This is a prettysignificant area of growth,
especially for private credit where theyhave been playing a lot more important
role in providing theseliquidity solutions to many of the PE sponsors you're

(32:59):
seeing today.
So the continuation fundis basically the PE fund.
The specific fund has gone its normallife and there's still assets that the
manager doesn't want to sell.
So they sell the assets tothemselves or they keep it in-house,
but a new set of investorsstep up and take the risk.
So they need to figure out a pricewhere the asset goes from one set of

(33:22):
investors to another.
And then the NAV loans would be insteadof lending to a company directly,
they're lending to a holding companythat has equity interests and a number of
companies. As long as notall of the companies go bad,
then the NAV loan gets repaid. Sothat's a different kind of lending,
at least from what you'd find in thetraditional form that you'd find in CLOs.

(33:44):
And we've seen a pickup in that.
So that seems to be a solution thatworks for some set of investors
who want money back from the PEfunds that they invested in multiple
years ago.
Absolutely.
So one thing I saw that you publishedand something of keen interest to me is
just anything related to private credit.
So the majority of my assetsare in this little niche.

(34:07):
What kind of research are you publishingthere and what do you think is topical
for investors?
Thank you, Shiloh. Thanksfor asking that question.
This has really been another veryinteresting evolution in the CLO market,
in addition to the ETF market, hasbeen the growth in private credit CLOs.
Last year we saw a record volume of 40billion dollars of CLOs being issued.
I think this year we're going tosee that volume being breached.

(34:29):
We think another 50 billion dollarsof private credit CLOs are going to be
issued this year. More interestingly,
a lot more asset managers or privatecredit asset managers are looking to use
the CLO technology toobtain term financing.
That's been a very attractiveform of funding themselves.
And that basically creates interestingopportunities for investors in the BSL
market to consider theprivate credit CLO market.

(34:51):
One thing which we have noticed is thatthe structures in private credit CLOs
tend to be slightly better in terms ofthe subordination levels which they offer
to bonds.
So a typical BSL CLO will have a lowersubordination level versus that of a
private credit CLO. So that is onepart of it. At the same time though,
because ratings are a bit morepunitive, the triple C haircuts,
that is the threshold beyond whichtriple C assets are accounted and market

(35:15):
price is also higherin private credit CLOs.
The typical concentration limit fortriple C estimated loans in a CLO would be
roughly 17 and a half percent in aprivate credit transaction versus 7 and a
half percent in a BSLtransaction. Now having said that,
what we have seen is that the downgraderate that is a CLO tranche downgrade
rate or even the impairment rate has beenmaterially less in private grade CLOs

(35:38):
versus BSL CLOs, and that includesthe Covid time period as well.
So the bonds have certainly outperformedversus the broadly syndicated loan CLO
market.
And I think the equity in privategrade CLOs has been materially a better
performer versus the BSL CLO equityplatform. So in both aspects,
bonds and equity, privatecredit CLOs have done better.

(35:58):
And if you look at thepast 12 months data,
given the fact that there's been a lotof news around liability management
exercises and BSL loans,
the trailing 12 month loss rate in directlending loans or private credit loans
has only been a fraction versus whatyou see in the broadly syndicated loan
market and KBRE estimates that the lossrate in private credit loans has been

(36:18):
roughly 80 to 90 basis pointsversus the BSL market to be close to
3 point 5 points.
So that's a pretty meaningful differenceand it tells you why the private credit
CLO transaction hasdone better versus BSLs.
So from my perspective,
you outlined some of thedifferences in terms of structure.
So if you're at the bottom partof the stack, so the CLO double B,

(36:39):
the amount of capital that's junior toyou in middle market is 12 percent or
more. And for broadlysyndicated, it's eight.
And when I hear those numbers,
well 12 and eight kind of in thesame ballpark, but actually it's not.
12 is 50% more than eight.
And that really matters in terms ofwhat default rate you can survive on the

(37:01):
loans. But I think that for me,
one of the attractions of middle markethas been and continues to be just that
anytime the loan has issues,
those are going to be worked out betweenone lender, or a club of lenders,
and the borrower. And it'snot always a simple process,
but that's a much better wayto do things than to have,

(37:23):
in broadly syndicated, potentially ahundred different investors in the loan.
Maybe there's other debt securitieslike a bond or second lien or whatever.
If you have a hundred lenders,
you probably have 120 opinions onwhat should happen with the company.
And there's no distressed hedge fundsthat are buying up middle market loans.
In fact, they're not for sale. They wereunderwritten to be held to maturity.

(37:45):
So you don't have that crowd buyingloans and proposing restructurings
that benefit them vis-a-vis other lenders.
So it's not surprising to me that theloss rate on the loans has been better in
the middle market.
And I think that you raised a greatpoint. I feel that will remain the place,
especially given the evolutionof liability management exercises in the BSL CLO

(38:07):
market and the fact that recovery ratesare no longer the 75 to 80 percent,
which we all used to rely on.
I think that has really caused a paradigmshift in how investors look at the
private credit or middlemarket CLO space as a result.
Given the new era we are in,
I think manager tiering will also startto play an important role in how private
credit CLOs are analyzed. The lackof data so far has been a challenge,

(38:30):
but given the fact that a lot of theseprivate credit CLO managers also actually
are managers of these BDCs, and manyof these BDCs do file public filings,
you can see their portfolios on aquarterly basis, what they're marked at,
that can give investors an avenueto actually analyze and tier
for different managers basedon what their preference is.

(38:51):
Just to present the other side, I mean,
the one drawback to private credit CLOsis that the underlying loans are not
trading around in the market.
So you basically get a quarterlyprice that's done on an
appraisal by a third party, butit's more like an appraisal,
which is not as valuable as seeing atrade trade yesterday or a week ago.

(39:12):
So how should investors think about thator get comfortable with that set up?
I think that's probably very importantfor investors to consider when they're
looking at, especially, thejunior credit tranches. In fact,
we did this research where we looked athow the marks of defaulted assets vary
across these privatecredit CLO transactions.
I think that's very important becausethese defaulted assets are carried at the

(39:33):
market price or the recovery price,
which each trustee determines basedon the opinion from the manager.
And the lower the estimate,the higher the haircut,
the better protected thedebt holders are in that CLO.
And we continue to see asignificant variance in the marks of
defaulted assets for the same assetacross a variety of CLO managers in the

(39:54):
private credit space. And I think basedon how conservative the manager is,
that is what investors will reallygear towards in terms of their tiering
preferences.
And I think the market will start totier across these managers on a spread
basis going forward. Based on that,
there will be two drivingfactors behind this.
One is what is the share of assetswhich are actually defaulting at the
particular asset manager?

(40:14):
And did you start from both CLO dataas well as BDC data, which is public?
And the other part is going to be whatis the share of assets which are actually
PIKing, that is payingtheir interest in kind, PIK.
And that has also seen asignificant variance across CLO managers and manager is
getting a large share of their incomefrom PIK income that according to us,

(40:35):
will be an adverse scenariofor an investor and they will deal for that manager
accordingly.
And the third layer as highlighted isthe difference in marks across asset
managers for the same defaultedasset. The lower the mark,
the more conservative that manager is.
I think CLO debt holders would likelygo for that manager from a spread
perspective.
Have you guys looked at what percentageof loans in CLOs is paid in kind

(40:59):
rather than paid in cash?
We looked at the BDC data and theshare of PIK income that is a share of
each BDCs income, which is payable viaPIK is still low. It's close to 9%,
but it has grown from roughly threeto 4 percent a couple of years back.
So that has certainly taken astep back. But more importantly,
there's actually a lot of varianceacross asset managers here.

(41:21):
So historically speaking, theshare of PIK income was pretty low,
but today it has increased,but more importantly,
the dispersion has increasedeven more across asset managers.
So you can clearly see certain managerswhere the share of PIK income remains
less than 5 percent and there are certainasset managers where the share of PIK
income is more than 10 percent,
so that this person is going to be animportant part of how investors value

(41:42):
different platforms going forward.
So I think though the comparisonof private credit CLOs to
BDCs isn't exactly apples toapples because the loans in
BDCs are going to have much higher ratesand they're going to have probably a 2
percent or more premium spread over SOFR.
So PIK loans really don't workgreat in CLOs because the CLOs

(42:07):
financing doesn't PIK. Or if it does PIK,
it's because there's been toomany defaults or downgrades.
I think it is a great point here, nodoubt, the private credit CLO market,
because of the structuralconcentration limits they apply,
it's actually going to be a positivelyselected cohort of loans from the BDCs
because CLOs will not offer acertain percentage of second liens.

(42:28):
They will not accept a certainpercentage of PIK loans to your point,
and they will certainly not accept hybridinstruments which are very common in
BDC portfolios. So from that aspect,
a CLO will always be a better performingportfolio versus what the BDC has.
What we are trying to do here islooking at the BDC as a way to tier for
managers as opposed to looking at theCLO in an absolute format is really to

(42:49):
understand the differences acrossplatforms and see if we can use that
difference as a way to account for spreaddifferentials across different private
credit CLOs.
Pratik, is there anything else that'stopical that we haven't covered already?
I think one aspect which I would like tohighlight to some of your listeners is
there's been a lot of chatter about banksbasically being competitors to private

(43:11):
credit. And I feel thedata shows the opposite.
We've looked at this data based on howmany banks have been lending to these
NDFIs, that is non-depositoryfinancial institutions.
That particular portfolio of bank lendinghas actually grown multiple fold to
1.3 trillion today.
It's grown at an annual rateof 14% versus the C and I book,
that is commercial andindustrial loan book,

(43:32):
which is a mainstay of all bank portfoliosthat has only grown at 4 percent
annually.
So NDFI lending is really lending tosome of these private credit institutions
in addition to mortgage and consumercredit intermediaries. And in that aspect,
2025 onwards,
the banks were required to disclosetheir individual lines of NDFI lending,
and that actually included lending toprivate credit and lending to private

(43:54):
equity.
And what our research found was bankshave actually lent around 220 to
250 billion to private credit firms,
and that has actually grown by leapsand bounds over the past five years.
So that tells us banks actually viewprivate credit as partners and not
necessarily as competitors.
And how this data evolves is actuallygoing to be very interesting to observe.

(44:16):
And I think that's been a big role inhow and why private credit has grown at
such a strong pace versus thebroadly syndicated loan market.
I think the banks have played a big rolehere and we continue to see this format
where banks have actually been buyingnot just the BSL CLO triple As,
but also private credit CLO triple As.
So they've been supporting the growthof the private credit CLO market too by

(44:37):
actually buying those bonds themselvesand some of it actually is just turning
their warehouse into CLO triple Aand keeping it on their own books.
Great. Well Pratik, thanksfor coming on the podcast.
Really enjoyed our conversation.
Shiloh, this was a greathonor. Thank you for having me.
I really appreciate this.

(44:58):
The content here is for informationalpurposes only and should not be taken as
legal, business, tax,or investment advice,
or be used to evaluate anyinvestment or security.
This podcast is not directed at anyinvestment, or potential investors,
in any Flat Rock GlobalFund. Definition Section

(45:18):
AUM refers to assets under management
LMT or liability managementtransactions are an out of court
modification of a company's debt
Layering refers to placing additionaldebt with a priority above the first lien
term loan. The securedovernight financing rate, SOFR,
is a broad measure of the cost ofborrowing cash overnight collateralized by

(45:40):
treasury securities. Theglobal financial crisis, GFC,
was a period of extreme stress in globalfinancial markets and banking systems
between mid 2007 and early 2009.
Credit ratings are opinions aboutcredit risk for long-term issues or
instruments.
The ratings lie on a spectrum rangingfrom the highest credit quality on one end

(46:02):
to default or junk on the other. AAAA is the highest credit quality.
A C or D, depending on theagency issuing the rating,
is the lowest or junk quality.
Leveraged loans are corporate loans tocompanies that are not rated investment
grade. Broadly syndicated loans,BSL, are underwritten by banks,
rated by nationally recognized statisticalratings organizations and often

(46:26):
traded by market participants.
Middle market loans are usuallyunderwritten by several lenders with the
intention of holding theinvestment through its maturity.
Spread is the percentage differencein current yields of various classes
of fixed income securities versustreasury bonds or another benchmark
measure. A reset is a refinancingand extension of a CLO investment.

(46:49):
EBITDA is earnings before interest taxes,
depreciation and amortization.
An add-back would attempt to adjustEBITDA for a non-recurring item.
ETFs are exchange traded funds.
LIBOR, the London Interbank Offer Rate,
was replaced by SOFR on June 30th, 2024.
Delever means reducing theamount of debt financing.

(47:13):
High yield bonds are corporate borrowingsrated below investment grade that are
usually fixed rate.
An unsecured default refers tomissing a contractual interest or
principle payment.
Debt has contractual interestprinciple and interest payments,
whereas equity representsownership in a company.
Senior secured corporateloans are borrowings from a company that are backed by

(47:37):
collateral.
Junior debt ranks behind seniorsecured debt in its payment priority.
Collateral pool refers to the sum ofcollateral pledge to a lender to support
its repayment.
A non-call refers to the time inwhich a debt instrument cannot be
optionally repaid.
A floating rate investment has an interestrate that varies with an underlying

(48:00):
floating rate index.General Disclaimer Section
References to interest rate movesare based on Bloomberg data.
Any mentions of specific companies arefor reference purposes only and are not
meant to describe the investment meritof or potential or actual portfolio
changes related to securities of thosecompanies unless otherwise noted.

(48:23):
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Market forecasts and projections arebased on current market conditions
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Projections should not beconsidered a guarantee.
The views and opinions expressed by theFlat Rock Global speaker are those of

(48:43):
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Any such views are subject to changeat any time based upon market or other
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such views. This material is notintended to be relied upon as a forecast,

(49:04):
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(49:24):
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(49:48):
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