April 17, 2024 • 31 mins
In the second episode of The CLO Investor, Flat Rock Global CIO Shiloh Bates discusses the CLO (collateralized loan obligation) market, CLO issuance, refis/resets, and more with colleague Derek Russo.
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(00:03):
- Hi, I'm Shai Lou Bates
and welcome to the CLO Investor podcast.
CLO stands for collateralizedLoan obligations,
which are securities backedby pools of leverage loans.
In this podcast,
we discuss current eventsin the CLO industry,
and I interview key market players.
Today I'll be joined by my colleague at
(00:25):
Flatrock Derek Russo.
Some of the topics fortoday's podcast include
what we enjoy the mostabout our niche, CLO market,
CLO issuance, refi's resets,
loan recoveries, and CLO equity returns.
Now let's get started. Derek,welcome to the podcast.
(00:48):
- Thanks for having me.- Why don't you take a few minutes
and go through yourbackground for our listeners.
- Sure. Had a prettyinteresting start to my career.
He came into the financeindustry the summer of 2008,
joined UBS there
and floated around at thefirm for the first 18 months
or so while the great financialcrisis was playing out.
(01:08):
Ultimately ended up finding myway onto the high yield bond
desk covering the gaming,lodging and leisure sector.
Did that for a couple of years
and then moved to a businessdevelopment corporation
of America where I wasworking with with you Shiloh
and our founder here at FlatRock Grunwald doing leveraged
loan underwriting, so
for direct originatedprivate credit transactions.
(01:29):
I also spent some time at thatshop doing aviation finance,
so we built a bit of a internalportfolio of aircraft equity
and a BS securities from theBDC moved into the operating
role in the aviation finance side directly
and worked with that aviationteam for a number of years
before thinking back up withyou and Bob here at Flat Rock
(01:52):
and now I'm doing CLOs.
- And so is it about two years
that you've been solely focused on CLOs?
- So I think it was rightaround the beginning
of 2022 that we joined back up.
Yeah, been great.
- Well, it's been great to have you.
What do you find mostinteresting about the CLO space?
- I kind of gained my first exposure
to structured finance products
(02:13):
through the aircraft EBS sector.
And it really turned out,you know, at aircraft EBS,
the underlying assets.
So first off, they're diversified,
but still exposed obviously
to the commercial aviation sector.
And as we saw with covid,right, having exposure
to one specific sector canreally be a problem when
that sector experiencesa black swan event like
(02:35):
a global pandemic.
And I think one of the mostinteresting things looking at
CLOs for me was just the broad diversity
of the underlyingcollateral in the asset base
and what that means interms of resilient for the,
so we've seen CLO perform very well
through numerous economic cycles
and I think a lot of thathas to do with the fact
(02:56):
that you're getting exposureto basically a broad swath
of the US economy via the types
of underlying loans in the CLOs.
Another really interestingthing is just really
how inefficient the marketis was very surprising
to me when I stepped in
and I think it's stilla, a pretty opaque market
where you can generate a lot of alpha
by having good connectionsand knowledge in the sector.
(03:17):
- I agree with that. I mean,
each CLO equity tranchemight be 50 million in size
and it'd be very surprisingto a lot of people to know
that even in the primarymarket where CLOs are created,
a lot of times people areactually buying the same equity
security at different prices.
And then in the secondary market,
(03:37):
things do trade really all over the place.
And I think if you're asophisticated investor,
you really should be ableto outperform Pierce.
- What do you find mostinteresting about the CLO space?
- Well, I think the CLOcell PL mechanism is one
of the most interestingthings about the asset class.
And as you know,
(03:58):
the loans in A CLO areconstantly prepaying at par
and during the CLOs reinvestment period,
those par proceeds areused to buy moral loans.
And if you find yourselfin economic conditions
where default home loansare picking up for you,
that's negative as a CLO investor.
But in recessionary times,
(04:19):
leverage loans should trade down in price
and that gives the CLOmanager the opportunity
to buy discounted loans.
And so from the perspectiveof a CLO equity investor,
it's not just loan lossesthat you care about,
it's really net loan losses.
And the CLO should be able
to book some gains on the loansbought at discounted levels.
(04:41):
If you look at any CLOfunds marketing deck,
I'm sure they'll have the thefamous 2007 vintage CLO in it.
And 2007 was a long time ago,
but that's a vintage where ifyou would've bought CLO equity
right before the GFC,
what you would've experiencedis a default rate on the loan
significantly higher than youwould've ever expected when
(05:05):
you bought the CLO equity
and like other asset classes,
it would've traded down dramatically in
price during the GFC.
But again, as the loans in theCLO LO prepaid new loans were
bought often at substantialdiscounts during the GFC
and the result was in ahigher R in the high twenties
for CLOs that started their lives right
(05:26):
before the financial crisis.
And for me, that highlights the resilience
of the asset class
and a favorable outcomefor that vintage of CLOs.
Derek issuance is off toa tear this year, both
for new issue and for refinancings
or resets, which are, asyou know, an extension
of the life of the CLO.
What do you is driving, Matt?
(05:48):
- When I joined Flat Rockat the start of 2022,
we were coming off of a yearof very strong issuance in 2021
for CLOs and veryquickly entered into sort
of this post Ukraineenvironment where liabilities
for CLOs blew out dramatically
and it became much more challenging
to issue CLOs economically.
(06:09):
There were though a lot of investors
that were still in warehousesthat had been opened prior
to the invasion of Ukraineas well as a number
of managers had raisedcaptive equity funds
prior to the invasion.
And a combination of those that were sort
of stuck in these warehouses
and managers that had accessto equity capital continued
(06:29):
to drive the new issuance market.
The issuance was down in 2022 and 2023,
but they were still perrespectable years in
terms of new issuance.
What we really did seelargely evaporate was deals
that were seeded bynew third party equity.
The arbitrage just reallystopped making sense when
liabilities widened out.
(06:50):
And there were a few deals thatwe call Clinton sprint deals
where equity investors were trying
to capture a dislocationin the loan market
and you know, sort of play
for price appreciationin the underlying loans.
But in by
and large third party equity kind
of fell away from the space.
And really that continuedalmost until I guess the start
(07:11):
of the start of this year and,
and sort of now we're seeingliabilities kind of tighten up
to the point where it'sstarting to make sense again
for third party equity investors.
The other part of themarket that really shut off
during the last couple
of years was the refi and reset markets.
So with liability, so widedeals that had printed prior
to 2022 with attractive cap stacks,
(07:34):
just really didn't have the incentive
to refinance into a much wider market.
So now with again with liabilitiesstarting to tighten up,
we're seeing a lot more of this refin
and reset activity comingback to the market.
We've also seen some interestingtransactions recently
with a top of the cap stack.
So rather than resettingthe entire transaction,
(07:54):
maybe the equity willhave the AAA get repriced,
and when short dated,
it gets very good executionat the top of the stack.
So we've seen somepretty tight AAA prices.
- Yeah, so let me expandon one of the key drivers
for good CLO debtexecution at the top part
of the capital stack, whichwas securities rated at AAA
(08:16):
to single A, those areusually bought by banks
and insurance companies around the world.
And in 2022, a lot of bankingregulators said to banks,
instead of buying new CLOs,
why don't you keep the cashon hand for a rainy day
and we'll see how economicconditions play out.
And so now economicconditions have improved
(08:38):
and the probability ofrecession has receded in a lot
of people's minds
and the result is that bankshave really strong demand
for AAA and for CLOs
that's the most importantfunding cost for the market.
A lower AAA rate means higherequity distributions over time
(08:58):
and the market's really moving fast.
And so a lot of deals are becoming refi
and reset candidates evenfor the 2021 vintage of
CLOs, which got great debt execution.
Even some of those deals are beginning
to look like refinancing candidates given
where spreads are going.
(09:18):
So I think the setup forCLO equity at the beginning
of this year is really quite favorable.
Derek, you're the keeper
of the famous flat rock CLO equity index.
Can you talk a little bitabout how that's put together?
- One of the things thatwe're often asked is to sort
of compare the asset class to a benchmark.
There was no benchmark
(09:39):
before we created the CLO equity index
that really measured directly
how CLO equity has performed over time.
And it's a really hardthing to pin down, right?
Because this is, as I mentioned
before, an opaque asset class
that really there you don't get a lot
of trading color out of the market.
But what fortunately we areable to see is where some
(10:00):
of our competitors and ourselvesthat file publicly have
to release where they have theirCLO equity positions marked
on a quarterly basis.
And we can use that plus our knowledge of
what payments have comein during the quarter
and the size of the equitytranche to triangulate
how those positions have moved over time.
(10:21):
And what we do is we lookthrough to five different owners
of CLO equity that file publicly,
and we look at how thosetransactions have moved
and on a quarterly basis we roll all of
that up into an analysisthat results in a proxy
for the CLO equity index as a whole.
We mark close
to 500 separate line itemsin the index right now.
(10:43):
And unfortunately we haveto work on a quarterly lag
because we're waiting forbio links to be published.
But that's roughly howthe index is formulated.
- And when does the index start?
- The index? We looked back as far
as we could get reliable data.
It starts in 2014
and has quarterly numbers through,
(11:03):
I guess most recently the end of 2023.
- Have CLO equityinvestors made any money?
- Yeah, so it's an interesting question.
I think the index, just bynature of starting in 2014,
has a little bit of ahandicap in the sense
that we missed out on somestrong years coming out
of the GFC that just unfortunatelyaren't in the dataset.
(11:23):
But if we look back toto the starting point,
annualized returns sinceinception of the index are 7%,
five year returns are 9%,three year returns are 11.9,
and last year the index did 22.1%.
- Okay, so last year'sreturn was very good.
What would you attribute that too?
(11:43):
- The year before 2022,
when we saw rate increasesthroughout the year,
CLO equity actually performedfairly poorly as an index.
The index was down 11.6%.
That was driven by degradationin the underlying loans.
So the Morningstar loanindex was down significantly
(12:04):
during the year tracksomewhere in the 92 area.
And in 2023 we saw thatbasically rallied back,
particularly in the back half of the year.
So that 22% really was theback half of the year story.
And that largely driven by the idea
that we may be enteringinto a soft landing
(12:24):
and sort of less fear overan eminent default spike.
I think that's, those weresome of the big factors.
- I think the other thinghappening for the negative returns
for 2022 was just that therequired rate of return
for CLO equity increased.
Prior to that year we weretargeting CLO equity returns
of mid-teens
(12:46):
and then as spreads widenedreally across all asset classes
that year, the required rate of return
for CLO equity becamemore like very high teens.
And as a result, the fair market value of
CLOs across the board was written down.
The big picture though is
that I think CLO equitycame into last year priced
(13:08):
for a pretty substantialdownturn in the economy
and that just wasn't realized.
And with CLOs payinghigh teen distributions
and not seeing that uptickin loan losses, that made
for a really good year.
And as we're talkingtoday at the end of March,
is the trend continuing into q1?
(13:29):
- Definitely. So I thinkthere's, there's less room
to the upside given
that the loan index hastraded up significantly.
But what we're seeing noware this wave of refis
and resets that we talked about
before that I think could be very material
to equity returns going forward forward.
And you know, one Q numbers atleast should look very strong
(13:49):
as we're approaching theend of the quarter here
and I don't see anything kindof slowing the trend down.
- Well I also see the trend continuing.
I was on a panel recently
where someone asked ifprivate credit was a bubble.
And my answer to that is of course no.
And one of the biggestreasons I'd point to is just
that the loans that go intoCLOs start their lives with a 40
(14:13):
to 50% loan to value.
And as you know, loansoccasionally do default,
but at the end of the day there's a lot
of junior capitalsupporting these businesses.
And so as long as the wheelsdon't fall off the cart,
the wetlands really should be money good.
At the end of the day, aseal of those loans need
to pass tests that comefrom rating agencies
(14:36):
for weighted average rating
and maximum triple C, the loan exposure.
And so the rating agenciescertainly haven't relaxed their
rating standards for the loans.
So I feel pretty goodabout the credit quality
of what's going into the CLOs.
I'd also point out that ourasset class is different from
others and that it's not a zero loss
(14:57):
expectation that we have.
By that, I mean there mightbe 200 different loans in the
CLO and I've never met aCLO manager that goes 200
for 200, right?
So there's always gonna be somecats and dogs that default,
but fortunately the loans arefirst lien and senior secured
(15:17):
and usually the recoveries are high.
We're generally budgetingfor a 2% loan default rate.
I think that's themarket standard actually.
And that's really differentfrom other asset classes.
If you invest in a loan funddirectly when a loan defaults,
there's no loan loss reserve.
If you invest in A BDC
and a loan defaults,
(15:39):
there'll be a declinein in the share price.
But again, there's no loan loss reserve.
So I think that's something unique
and attractive about our asset class.
- Yeah, same. And I'mgoing into this rally
that we saw there was sort ofthe expectation on the street
of significantly higher thanaverage levels of defaults.
I think those expectations are starting
(16:00):
to be moderated down.
And the other big topicthat people are, you know,
discussing in the market right now is
where recovery rates willultimately end up being.
So historically, the types of loans
that are in CLOs have recovered 65
to 70 cents on the dollar last year.
We saw that materially inside.
So something more in theforties to 50 cents shilah.
(16:22):
Where do you see that sort
of going over the next few years here?
- Yeah, so I think that'scertainly been a headwind
for CLO equity.
There've been some defaults
with very low recoveriesin some cases, and that was
because the loan documentationwas written in a way
that gave the lender lessoptions and downside scenarios.
(16:44):
And not all the businessescollateral was available to
to back the term loan.
But one of the things Ithink is important to note is
that if you see a headlinenumber for defaults
or a headline number forrecoveries on Bloomberg
or in the Wall Street Journal
or wherever, that's usuallyfor the overall loan index.
(17:04):
And so CLOs,
they own a very conservativeslice of that index.
Some of the recoveriesthat came in very low were
for companies that reallywould never have been in
CLOs in the first place.
Some of them were called chapter 22,
where a business alreadydid one chapter 11
and is coming back for another.
(17:26):
And those are the kinds of assets
that would never betargeted by a CLO manager.
So whenever I see aheadline with a default rate
or a recovery rate that looks negative,
my next question is what'shappening just in CLOs?
And then obviously much more important
to me is what's happening in my CLOs.
One of the reasons we favoredmiddle market CLOs over the
(17:48):
past few years is thatin the middle market,
the loan documentation ismore favorable to the lender.
And as a result I would expectloan losses in middle market
CLOs to help perform broadlysyndicated CLO portfolios.
And so this year, again, wetalked about refis and resets,
(18:08):
but I think even in a market
where there is an uptick in loan losses,
I think some veryattractive things can happen
with facie liabilities.
- Yeah, and another thing iswe assume sort of the average,
or if you look back at theaverage loan loss rates over the
life of the leveraged loanin leveraged loan market,
(18:30):
it's not a straight line, right?
So what we've seen happenis when there are periods
of higher than normaldefaults, that's often followed
by long periods of lowerthan normal defaults,
which is the environmentthat we were in pre Ukraine.
So I think it tends toeven itself out over time,
- Right?
So the industry standardmodeling assumption is a 2% loan
(18:52):
default rate per year,
and some years it's gonnabe higher than the 2%
and in recent past it'sbeen much lower than
the than the 2%.
But lemme tell you a story that highlights
how the loan loss reserveworks in practice.
During the Covid period,we were calling around
to our CLO managers
and trying to get an updateon the loan portfolio.
(19:14):
And one of the managers thatwe work with a lot, BlackRock,
we had them on the phone
and the manager was giving mea very favorable update on the
loan portfolio,
actually more favorable thanI really would've expected
during the depths of covid.
And so what I wanted to dois take it from a qualitative
(19:34):
description of the loans tosomething in more quantitative.
So I said to them, we run a2% low on default rate really
through all of our CLOs.
How do you think yourportfolio is gonna compare to
that this year?
That year being, you know, 2020?
There was a really longpause, I didn't really know
(19:55):
how they were gonna respond,
but the answer was, you know, Shiloh,
after all these years of working together,
I cannot believe you'restill running my deals
with a 2% loan default rate.
And so, so that was prettyfunny experience from the 2020
year and their CLOs werereally a highlight in terms
(20:16):
of CLO performance.
Derek, let's spend a few minutestalking about the arbitrage
in CLOs.
So that's the natural profitability
or expected profitabilitythe CLO equity investor
is signing up for.
How's that trended overthe last two years?
I mean, we've seen a lot of CLO issuance,
(20:37):
but the equity investors havenot been traditional third
parties like us. Can you talk about that?
- Yeah, so a couple ofthings driving that.
I think some people foundstuck in warehouse facilities
where they had ramped aportfolio of assets prior
to the CLO liability market widening out.
And after a certain periodof time they had to just sort
of bite the bullet and print a deal
(20:58):
that maybe didn't look quite as attractive
as they had expected it to look initially.
And another thing that we'veseen is a proliferation
of CLO managers raisingcaptive equity funds
where they actually have a fundthemselves that they can use
to seed the equity in their deals.
The managers are in thebusiness of printing deals and
and managing assets.
(21:18):
So what we've seen is sometransactions that got done
where the equity returns maynot have been attractive enough
to attract third party equity.
And historically that might have meant
that the deal didn't get done.
Since these managers havethese captive funds now though
they were able to continueprinting deals in a market
that was less attractivefor third party investors.
(21:40):
One contrasting point I'll make though is
for middle market CLOs, thearbitrage actually continued
to make sense through the cycle at at
least for select deals.
And we found that just thewider spreads on the assets
and those structures were able
to overcome the higher liability costs.
But we saw some transactionsthat we found attractive even
during the last coupleof years through this,
(22:01):
through this wider liability cycle.
And now, now in thebroadly syndicated space,
the market really is startingto come back a bit as well.
So with with debt costscoming down, we're starting
to see broadly syndicatedCLO equity come back on
sites. Could
- You spend a few minutestalking about, you know,
talking about the process forunderwriting, I don't know,
(22:23):
CLO equity and bbs
and if, if it's different forthe different type of security
- For CLO equity?
We're really focused onjust the top tier managers.
We're really focused onoutperformance, on defaults as
that the key driver of CLO returns.
When we look at double Bs,
it's a little bit different, right?
So we have significantequity subordination
(22:45):
below us absorbing the first loss,
and as a result of that, wemay be happy with managers
that have historically performed at
that average 2% default, right?
And to the extent that we'reable to pick up a little bit
of excess spread for goingto a tier two manager,
that may be something we wouldconsider when we're looking
at a double B, we probablywouldn't do equity in
(23:06):
that same transaction.
And that's just one ofthe sort of differences in
how we focus on equity versus double B.
- So for the typical doubleB, how bad would defaults have
to get on the CLOs loans such
that you're not money goodat the end of the day?
- Yeah, so I'll draw a littlebit of a distinction here
between broadly syndicated CLOs.
(23:26):
So CLOs backed by largesyndicated deals, you know,
a billion plus dollars insize versus middle market CLOs
where the loan pool therelooks more like a private
credit loan pool.
The reason for the distinction is
in the broadly syndicatedCLO markets, you know 90%
of the current outstanding CLO market,
the CLO starts its life with8% equity below the double B.
(23:50):
Whereas in the middle market, CLO,
the double B will have12% equity below it.
And those yield twofairly different results.
Generally speaking,
a typical broadly syndicatedCLO will start its slice
and be able to survive 7% annual defaults
and a middle marketCLO will start its life
with a double B being able tosurvive 15% annual defaults.
(24:12):
And when I say survive here,
what I'm really talkingabout is receive all
of its expected interest in principle,
it's not a zero IRR thing,it's really at those levels
of default you're getting full payments.
- Well, how did the defaultrates that you just mentioned,
how did those compare to whatwe experienced during the GFC
and during the Covid period?
(24:33):
- Yeah, so during the GFC,we saw the highest level
of defaults that we've seenin the leverage loan market.
They spiked to about 8%
and stayed around thatlevel for about a year.
Well, they quickly kindof fell off of that
and then normalized evenbelow that 2% level.
During covid, we saw aspike up to around 5%,
and again, a very quick drop down.
(24:54):
So we've never seen aneconomic environment
that looks anything even remotely,
like even a 7% annualdefault rate sustained over
a long period of time.
And that might beg the question, so
how have these double Bs performed?
And the answer is we've seen very,
very low default rates in the sector.
So if you include the entireuniverse of double Bs,
(25:15):
both broadly syndicated
and middle market, the annualdefault rate has been about 22
basis points per year.
And if you look just at themiddle market, so the CLOs
that have more equity subordination,
we actually haven't found anyof those that have defaulted.
- One last question for you.
What are the interestingopportunities in the the spring
of 2024?
(25:36):
- We here at Flat Rock havehad a middle market bias,
or I would say since thefounding of the firm,
and we continue
to find the middle marketsector on both the equity
and double B side, maybe even increasingly
attractive going forward.
So we talked a littlebit about recovery rates
before, sort of the house view is
that middle market collateralwill outperform broadly
(25:59):
syndicated collateral inthe future as a result
of stronger documentation
and the arbitrage
for middle market C equityhas remained strong.
We've seen continuous sort ofhigh teens returns coming out
of, out of that asset class.
Middle market double Bs havetightened significantly since
their wides sort of at thebeginning of last year.
(26:19):
And you're still picking upa significant premium over
broadly syndicated double B notes there.
And with base rates,you know still over 5%,
those have offered attractive returns
and we think continue tooffer attractive returns.
- Great. Well thanks so muchfor being on the podcast,
Eric. We'll talk to you soon.
- Yeah, thanks for having me.
(26:42):
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This podcast is notdirected at any investors
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definition section.
The secured overnight financingrate software is a broad
(27:05):
measure of the cost ofborrowing cash overnight
collateralized by Treasury Securities.
Chapter 11 is the process
by which companies arereorganized under bankruptcy law.
Leveraged loans arecorporate loans to companies
that are not ratedinvestment grade broadly.
Syndicated loans areunderwritten by banks, rated
by national recognizedstatistical ratings organizations
(27:28):
and often traded by market participants.
Middle market loans areusually underwritten
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Securitization divides cash flows
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(27:50):
Global financial crisis
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Asset-backed securities aresecuritizations, usually backed
by non-first Leon loan collateral.
Junior Capital is financing
that has a lower priorityclaim in debt repayment
to a secured term loan spreadis the percentage difference
(28:11):
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(28:32):
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and a portfolio is assigned
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(28:53):
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(29:15):
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(29:37):
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and do not necessarily represent the views
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(29:59):
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(30:41):
To provide impartialinvestment advice, act
as an impartial advisor
or give advice in a fiduciary capacity.
This broadcast is copyright2024 of Flat Rock Global LLC.
All rights reserved.
This recording may not bereproduced in whole or in part
or in any form without thepermission of Flat Rock Global.
(31:01):
Additional informationabout this podcast along
with an edited transcript may be obtained
by visiting flat rock global.com.
- Hi, I'm Shai Lou Bates
and welcome to the CLO Investor podcast.
CLO stands for collateralizedLoan obligations,
which are securities backedby pools of leverage loans.
In this podcast,
we discuss current eventsin the CLO industry,
and I interview key market players.
Today I'll be joined by my colleague at
(00:25):
Flatrock Derek Russo.
Some of the topics fortoday's podcast include
what we enjoy the mostabout our niche, CLO market,
CLO issuance, refi's resets,
loan recoveries, and CLO equity returns.
Now let's get started. Derek,welcome to the podcast.
(00:48):
- Thanks for having me.- Why don't you take a few minutes
and go through yourbackground for our listeners.
- Sure. Had a prettyinteresting start to my career.
He came into the financeindustry the summer of 2008,
joined UBS there
and floated around at thefirm for the first 18 months
or so while the great financialcrisis was playing out.
(01:08):
Ultimately ended up finding myway onto the high yield bond
desk covering the gaming,lodging and leisure sector.
Did that for a couple of years
and then moved to a businessdevelopment corporation
of America where I wasworking with with you Shiloh
and our founder here at FlatRock Grunwald doing leveraged
loan underwriting, so
for direct originatedprivate credit transactions.
(01:29):
I also spent some time at thatshop doing aviation finance,
so we built a bit of a internalportfolio of aircraft equity
and a BS securities from theBDC moved into the operating
role in the aviation finance side directly
and worked with that aviationteam for a number of years
before thinking back up withyou and Bob here at Flat Rock
(01:52):
and now I'm doing CLOs.
- And so is it about two years
that you've been solely focused on CLOs?
- So I think it was rightaround the beginning
of 2022 that we joined back up.
Yeah, been great.
- Well, it's been great to have you.
What do you find mostinteresting about the CLO space?
- I kind of gained my first exposure
to structured finance products
(02:13):
through the aircraft EBS sector.
And it really turned out,you know, at aircraft EBS,
the underlying assets.
So first off, they're diversified,
but still exposed obviously
to the commercial aviation sector.
And as we saw with covid,right, having exposure
to one specific sector canreally be a problem when
that sector experiencesa black swan event like
(02:35):
a global pandemic.
And I think one of the mostinteresting things looking at
CLOs for me was just the broad diversity
of the underlyingcollateral in the asset base
and what that means interms of resilient for the,
so we've seen CLO perform very well
through numerous economic cycles
and I think a lot of thathas to do with the fact
(02:56):
that you're getting exposureto basically a broad swath
of the US economy via the types
of underlying loans in the CLOs.
Another really interestingthing is just really
how inefficient the marketis was very surprising
to me when I stepped in
and I think it's stilla, a pretty opaque market
where you can generate a lot of alpha
by having good connectionsand knowledge in the sector.
(03:17):
- I agree with that. I mean,
each CLO equity tranchemight be 50 million in size
and it'd be very surprisingto a lot of people to know
that even in the primarymarket where CLOs are created,
a lot of times people areactually buying the same equity
security at different prices.
And then in the secondary market,
(03:37):
things do trade really all over the place.
And I think if you're asophisticated investor,
you really should be ableto outperform Pierce.
- What do you find mostinteresting about the CLO space?
- Well, I think the CLOcell PL mechanism is one
of the most interestingthings about the asset class.
And as you know,
(03:58):
the loans in A CLO areconstantly prepaying at par
and during the CLOs reinvestment period,
those par proceeds areused to buy moral loans.
And if you find yourselfin economic conditions
where default home loansare picking up for you,
that's negative as a CLO investor.
But in recessionary times,
(04:19):
leverage loans should trade down in price
and that gives the CLOmanager the opportunity
to buy discounted loans.
And so from the perspectiveof a CLO equity investor,
it's not just loan lossesthat you care about,
it's really net loan losses.
And the CLO should be able
to book some gains on the loansbought at discounted levels.
(04:41):
If you look at any CLOfunds marketing deck,
I'm sure they'll have the thefamous 2007 vintage CLO in it.
And 2007 was a long time ago,
but that's a vintage where ifyou would've bought CLO equity
right before the GFC,
what you would've experiencedis a default rate on the loan
significantly higher than youwould've ever expected when
(05:05):
you bought the CLO equity
and like other asset classes,
it would've traded down dramatically in
price during the GFC.
But again, as the loans in theCLO LO prepaid new loans were
bought often at substantialdiscounts during the GFC
and the result was in ahigher R in the high twenties
for CLOs that started their lives right
(05:26):
before the financial crisis.
And for me, that highlights the resilience
of the asset class
and a favorable outcomefor that vintage of CLOs.
Derek issuance is off toa tear this year, both
for new issue and for refinancings
or resets, which are, asyou know, an extension
of the life of the CLO.
What do you is driving, Matt?
(05:48):
- When I joined Flat Rockat the start of 2022,
we were coming off of a yearof very strong issuance in 2021
for CLOs and veryquickly entered into sort
of this post Ukraineenvironment where liabilities
for CLOs blew out dramatically
and it became much more challenging
to issue CLOs economically.
(06:09):
There were though a lot of investors
that were still in warehousesthat had been opened prior
to the invasion of Ukraineas well as a number
of managers had raisedcaptive equity funds
prior to the invasion.
And a combination of those that were sort
of stuck in these warehouses
and managers that had accessto equity capital continued
(06:29):
to drive the new issuance market.
The issuance was down in 2022 and 2023,
but they were still perrespectable years in
terms of new issuance.
What we really did seelargely evaporate was deals
that were seeded bynew third party equity.
The arbitrage just reallystopped making sense when
liabilities widened out.
(06:50):
And there were a few deals thatwe call Clinton sprint deals
where equity investors were trying
to capture a dislocationin the loan market
and you know, sort of play
for price appreciationin the underlying loans.
But in by
and large third party equity kind
of fell away from the space.
And really that continuedalmost until I guess the start
(07:11):
of the start of this year and,
and sort of now we're seeingliabilities kind of tighten up
to the point where it'sstarting to make sense again
for third party equity investors.
The other part of themarket that really shut off
during the last couple
of years was the refi and reset markets.
So with liability, so widedeals that had printed prior
to 2022 with attractive cap stacks,
(07:34):
just really didn't have the incentive
to refinance into a much wider market.
So now with again with liabilitiesstarting to tighten up,
we're seeing a lot more of this refin
and reset activity comingback to the market.
We've also seen some interestingtransactions recently
with a top of the cap stack.
So rather than resettingthe entire transaction,
(07:54):
maybe the equity willhave the AAA get repriced,
and when short dated,
it gets very good executionat the top of the stack.
So we've seen somepretty tight AAA prices.
- Yeah, so let me expandon one of the key drivers
for good CLO debtexecution at the top part
of the capital stack, whichwas securities rated at AAA
(08:16):
to single A, those areusually bought by banks
and insurance companies around the world.
And in 2022, a lot of bankingregulators said to banks,
instead of buying new CLOs,
why don't you keep the cashon hand for a rainy day
and we'll see how economicconditions play out.
And so now economicconditions have improved
(08:38):
and the probability ofrecession has receded in a lot
of people's minds
and the result is that bankshave really strong demand
for AAA and for CLOs
that's the most importantfunding cost for the market.
A lower AAA rate means higherequity distributions over time
(08:58):
and the market's really moving fast.
And so a lot of deals are becoming refi
and reset candidates evenfor the 2021 vintage of
CLOs, which got great debt execution.
Even some of those deals are beginning
to look like refinancing candidates given
where spreads are going.
(09:18):
So I think the setup forCLO equity at the beginning
of this year is really quite favorable.
Derek, you're the keeper
of the famous flat rock CLO equity index.
Can you talk a little bitabout how that's put together?
- One of the things thatwe're often asked is to sort
of compare the asset class to a benchmark.
There was no benchmark
(09:39):
before we created the CLO equity index
that really measured directly
how CLO equity has performed over time.
And it's a really hardthing to pin down, right?
Because this is, as I mentioned
before, an opaque asset class
that really there you don't get a lot
of trading color out of the market.
But what fortunately we areable to see is where some
(10:00):
of our competitors and ourselvesthat file publicly have
to release where they have theirCLO equity positions marked
on a quarterly basis.
And we can use that plus our knowledge of
what payments have comein during the quarter
and the size of the equitytranche to triangulate
how those positions have moved over time.
(10:21):
And what we do is we lookthrough to five different owners
of CLO equity that file publicly,
and we look at how thosetransactions have moved
and on a quarterly basis we roll all of
that up into an analysisthat results in a proxy
for the CLO equity index as a whole.
We mark close
to 500 separate line itemsin the index right now.
(10:43):
And unfortunately we haveto work on a quarterly lag
because we're waiting forbio links to be published.
But that's roughly howthe index is formulated.
- And when does the index start?
- The index? We looked back as far
as we could get reliable data.
It starts in 2014
and has quarterly numbers through,
(11:03):
I guess most recently the end of 2023.
- Have CLO equityinvestors made any money?
- Yeah, so it's an interesting question.
I think the index, just bynature of starting in 2014,
has a little bit of ahandicap in the sense
that we missed out on somestrong years coming out
of the GFC that just unfortunatelyaren't in the dataset.
(11:23):
But if we look back toto the starting point,
annualized returns sinceinception of the index are 7%,
five year returns are 9%,three year returns are 11.9,
and last year the index did 22.1%.
- Okay, so last year'sreturn was very good.
What would you attribute that too?
(11:43):
- The year before 2022,
when we saw rate increasesthroughout the year,
CLO equity actually performedfairly poorly as an index.
The index was down 11.6%.
That was driven by degradationin the underlying loans.
So the Morningstar loanindex was down significantly
(12:04):
during the year tracksomewhere in the 92 area.
And in 2023 we saw thatbasically rallied back,
particularly in the back half of the year.
So that 22% really was theback half of the year story.
And that largely driven by the idea
that we may be enteringinto a soft landing
(12:24):
and sort of less fear overan eminent default spike.
I think that's, those weresome of the big factors.
- I think the other thinghappening for the negative returns
for 2022 was just that therequired rate of return
for CLO equity increased.
Prior to that year we weretargeting CLO equity returns
of mid-teens
(12:46):
and then as spreads widenedreally across all asset classes
that year, the required rate of return
for CLO equity becamemore like very high teens.
And as a result, the fair market value of
CLOs across the board was written down.
The big picture though is
that I think CLO equitycame into last year priced
(13:08):
for a pretty substantialdownturn in the economy
and that just wasn't realized.
And with CLOs payinghigh teen distributions
and not seeing that uptickin loan losses, that made
for a really good year.
And as we're talkingtoday at the end of March,
is the trend continuing into q1?
(13:29):
- Definitely. So I thinkthere's, there's less room
to the upside given
that the loan index hastraded up significantly.
But what we're seeing noware this wave of refis
and resets that we talked about
before that I think could be very material
to equity returns going forward forward.
And you know, one Q numbers atleast should look very strong
(13:49):
as we're approaching theend of the quarter here
and I don't see anything kindof slowing the trend down.
- Well I also see the trend continuing.
I was on a panel recently
where someone asked ifprivate credit was a bubble.
And my answer to that is of course no.
And one of the biggestreasons I'd point to is just
that the loans that go intoCLOs start their lives with a 40
(14:13):
to 50% loan to value.
And as you know, loansoccasionally do default,
but at the end of the day there's a lot
of junior capitalsupporting these businesses.
And so as long as the wheelsdon't fall off the cart,
the wetlands really should be money good.
At the end of the day, aseal of those loans need
to pass tests that comefrom rating agencies
(14:36):
for weighted average rating
and maximum triple C, the loan exposure.
And so the rating agenciescertainly haven't relaxed their
rating standards for the loans.
So I feel pretty goodabout the credit quality
of what's going into the CLOs.
I'd also point out that ourasset class is different from
others and that it's not a zero loss
(14:57):
expectation that we have.
By that, I mean there mightbe 200 different loans in the
CLO and I've never met aCLO manager that goes 200
for 200, right?
So there's always gonna be somecats and dogs that default,
but fortunately the loans arefirst lien and senior secured
(15:17):
and usually the recoveries are high.
We're generally budgetingfor a 2% loan default rate.
I think that's themarket standard actually.
And that's really differentfrom other asset classes.
If you invest in a loan funddirectly when a loan defaults,
there's no loan loss reserve.
If you invest in A BDC
and a loan defaults,
(15:39):
there'll be a declinein in the share price.
But again, there's no loan loss reserve.
So I think that's something unique
and attractive about our asset class.
- Yeah, same. And I'mgoing into this rally
that we saw there was sort ofthe expectation on the street
of significantly higher thanaverage levels of defaults.
I think those expectations are starting
(16:00):
to be moderated down.
And the other big topicthat people are, you know,
discussing in the market right now is
where recovery rates willultimately end up being.
So historically, the types of loans
that are in CLOs have recovered 65
to 70 cents on the dollar last year.
We saw that materially inside.
So something more in theforties to 50 cents shilah.
(16:22):
Where do you see that sort
of going over the next few years here?
- Yeah, so I think that'scertainly been a headwind
for CLO equity.
There've been some defaults
with very low recoveriesin some cases, and that was
because the loan documentationwas written in a way
that gave the lender lessoptions and downside scenarios.
(16:44):
And not all the businessescollateral was available to
to back the term loan.
But one of the things Ithink is important to note is
that if you see a headlinenumber for defaults
or a headline number forrecoveries on Bloomberg
or in the Wall Street Journal
or wherever, that's usuallyfor the overall loan index.
(17:04):
And so CLOs,
they own a very conservativeslice of that index.
Some of the recoveriesthat came in very low were
for companies that reallywould never have been in
CLOs in the first place.
Some of them were called chapter 22,
where a business alreadydid one chapter 11
and is coming back for another.
(17:26):
And those are the kinds of assets
that would never betargeted by a CLO manager.
So whenever I see aheadline with a default rate
or a recovery rate that looks negative,
my next question is what'shappening just in CLOs?
And then obviously much more important
to me is what's happening in my CLOs.
One of the reasons we favoredmiddle market CLOs over the
(17:48):
past few years is thatin the middle market,
the loan documentation ismore favorable to the lender.
And as a result I would expectloan losses in middle market
CLOs to help perform broadlysyndicated CLO portfolios.
And so this year, again, wetalked about refis and resets,
(18:08):
but I think even in a market
where there is an uptick in loan losses,
I think some veryattractive things can happen
with facie liabilities.
- Yeah, and another thing iswe assume sort of the average,
or if you look back at theaverage loan loss rates over the
life of the leveraged loanin leveraged loan market,
(18:30):
it's not a straight line, right?
So what we've seen happenis when there are periods
of higher than normaldefaults, that's often followed
by long periods of lowerthan normal defaults,
which is the environmentthat we were in pre Ukraine.
So I think it tends toeven itself out over time,
- Right?
So the industry standardmodeling assumption is a 2% loan
(18:52):
default rate per year,
and some years it's gonnabe higher than the 2%
and in recent past it'sbeen much lower than
the than the 2%.
But lemme tell you a story that highlights
how the loan loss reserveworks in practice.
During the Covid period,we were calling around
to our CLO managers
and trying to get an updateon the loan portfolio.
(19:14):
And one of the managers thatwe work with a lot, BlackRock,
we had them on the phone
and the manager was giving mea very favorable update on the
loan portfolio,
actually more favorable thanI really would've expected
during the depths of covid.
And so what I wanted to dois take it from a qualitative
(19:34):
description of the loans tosomething in more quantitative.
So I said to them, we run a2% low on default rate really
through all of our CLOs.
How do you think yourportfolio is gonna compare to
that this year?
That year being, you know, 2020?
There was a really longpause, I didn't really know
(19:55):
how they were gonna respond,
but the answer was, you know, Shiloh,
after all these years of working together,
I cannot believe you'restill running my deals
with a 2% loan default rate.
And so, so that was prettyfunny experience from the 2020
year and their CLOs werereally a highlight in terms
(20:16):
of CLO performance.
Derek, let's spend a few minutestalking about the arbitrage
in CLOs.
So that's the natural profitability
or expected profitabilitythe CLO equity investor
is signing up for.
How's that trended overthe last two years?
I mean, we've seen a lot of CLO issuance,
(20:37):
but the equity investors havenot been traditional third
parties like us. Can you talk about that?
- Yeah, so a couple ofthings driving that.
I think some people foundstuck in warehouse facilities
where they had ramped aportfolio of assets prior
to the CLO liability market widening out.
And after a certain periodof time they had to just sort
of bite the bullet and print a deal
(20:58):
that maybe didn't look quite as attractive
as they had expected it to look initially.
And another thing that we'veseen is a proliferation
of CLO managers raisingcaptive equity funds
where they actually have a fundthemselves that they can use
to seed the equity in their deals.
The managers are in thebusiness of printing deals and
and managing assets.
(21:18):
So what we've seen is sometransactions that got done
where the equity returns maynot have been attractive enough
to attract third party equity.
And historically that might have meant
that the deal didn't get done.
Since these managers havethese captive funds now though
they were able to continueprinting deals in a market
that was less attractivefor third party investors.
(21:40):
One contrasting point I'll make though is
for middle market CLOs, thearbitrage actually continued
to make sense through the cycle at at
least for select deals.
And we found that just thewider spreads on the assets
and those structures were able
to overcome the higher liability costs.
But we saw some transactionsthat we found attractive even
during the last coupleof years through this,
(22:01):
through this wider liability cycle.
And now, now in thebroadly syndicated space,
the market really is startingto come back a bit as well.
So with with debt costscoming down, we're starting
to see broadly syndicatedCLO equity come back on
sites. Could
- You spend a few minutestalking about, you know,
talking about the process forunderwriting, I don't know,
(22:23):
CLO equity and bbs
and if, if it's different forthe different type of security
- For CLO equity?
We're really focused onjust the top tier managers.
We're really focused onoutperformance, on defaults as
that the key driver of CLO returns.
When we look at double Bs,
it's a little bit different, right?
So we have significantequity subordination
(22:45):
below us absorbing the first loss,
and as a result of that, wemay be happy with managers
that have historically performed at
that average 2% default, right?
And to the extent that we'reable to pick up a little bit
of excess spread for goingto a tier two manager,
that may be something we wouldconsider when we're looking
at a double B, we probablywouldn't do equity in
(23:06):
that same transaction.
And that's just one ofthe sort of differences in
how we focus on equity versus double B.
- So for the typical doubleB, how bad would defaults have
to get on the CLOs loans such
that you're not money goodat the end of the day?
- Yeah, so I'll draw a littlebit of a distinction here
between broadly syndicated CLOs.
(23:26):
So CLOs backed by largesyndicated deals, you know,
a billion plus dollars insize versus middle market CLOs
where the loan pool therelooks more like a private
credit loan pool.
The reason for the distinction is
in the broadly syndicatedCLO markets, you know 90%
of the current outstanding CLO market,
the CLO starts its life with8% equity below the double B.
(23:50):
Whereas in the middle market, CLO,
the double B will have12% equity below it.
And those yield twofairly different results.
Generally speaking,
a typical broadly syndicatedCLO will start its slice
and be able to survive 7% annual defaults
and a middle marketCLO will start its life
with a double B being able tosurvive 15% annual defaults.
(24:12):
And when I say survive here,
what I'm really talkingabout is receive all
of its expected interest in principle,
it's not a zero IRR thing,it's really at those levels
of default you're getting full payments.
- Well, how did the defaultrates that you just mentioned,
how did those compare to whatwe experienced during the GFC
and during the Covid period?
(24:33):
- Yeah, so during the GFC,we saw the highest level
of defaults that we've seenin the leverage loan market.
They spiked to about 8%
and stayed around thatlevel for about a year.
Well, they quickly kindof fell off of that
and then normalized evenbelow that 2% level.
During covid, we saw aspike up to around 5%,
and again, a very quick drop down.
(24:54):
So we've never seen aneconomic environment
that looks anything even remotely,
like even a 7% annualdefault rate sustained over
a long period of time.
And that might beg the question, so
how have these double Bs performed?
And the answer is we've seen very,
very low default rates in the sector.
So if you include the entireuniverse of double Bs,
(25:15):
both broadly syndicated
and middle market, the annualdefault rate has been about 22
basis points per year.
And if you look just at themiddle market, so the CLOs
that have more equity subordination,
we actually haven't found anyof those that have defaulted.
- One last question for you.
What are the interestingopportunities in the the spring
of 2024?
(25:36):
- We here at Flat Rock havehad a middle market bias,
or I would say since thefounding of the firm,
and we continue
to find the middle marketsector on both the equity
and double B side, maybe even increasingly
attractive going forward.
So we talked a littlebit about recovery rates
before, sort of the house view is
that middle market collateralwill outperform broadly
(25:59):
syndicated collateral inthe future as a result
of stronger documentation
and the arbitrage
for middle market C equityhas remained strong.
We've seen continuous sort ofhigh teens returns coming out
of, out of that asset class.
Middle market double Bs havetightened significantly since
their wides sort of at thebeginning of last year.
(26:19):
And you're still picking upa significant premium over
broadly syndicated double B notes there.
And with base rates,you know still over 5%,
those have offered attractive returns
and we think continue tooffer attractive returns.
- Great. Well thanks so muchfor being on the podcast,
Eric. We'll talk to you soon.
- Yeah, thanks for having me.
(26:42):
- The content here is forinformational purposes only
and should not be takenas legal business tax
or investment advice
or be used to evaluate anyinvestment or security.
This podcast is notdirected at any investors
or potential investors inany Flat Rock Global Fund
definition section.
The secured overnight financingrate software is a broad
(27:05):
measure of the cost ofborrowing cash overnight
collateralized by Treasury Securities.
Chapter 11 is the process
by which companies arereorganized under bankruptcy law.
Leveraged loans arecorporate loans to companies
that are not ratedinvestment grade broadly.
Syndicated loans areunderwritten by banks, rated
by national recognizedstatistical ratings organizations
(27:28):
and often traded by market participants.
Middle market loans areusually underwritten
by several lenders with the intention
of holding the investmentthrough its maturity.
A collateralized debt obligationis a structured finance
product that is backed by a pool
of assets other than leveraged loans.
Securitization divides cash flows
amongst different investorsin a pool of assets.
(27:50):
Global financial crisis
or GFC refers to thebanking downturn in 2008
and 2009.
Asset-backed securities aresecuritizations, usually backed
by non-first Leon loan collateral.
Junior Capital is financing
that has a lower priorityclaim in debt repayment
to a secured term loan spreadis the percentage difference
(28:11):
in current yields of various classes
of fixed income securitiesversus treasury bonds.
Or another benchmark bondmeasure yield is income returned
on investments such
as the interest receivedfrom holding a security.
The yield is usually expressed
as an annual percentage ratebased on the investments cost,
current market value or face value.
(28:32):
The Flat Rock Global CLO equity index
and its legal disclaimers areavailable on the Flat Rock
Global website.
General disclaimer section, references
to interest rate moves arebased on Bloomberg data.
The credit quality offixed income securities
and a portfolio is assigned
by a nationally recognizedstatistical rating.
(28:53):
Organizations such asStandard and Pores, Moody's
or Fitch as an indication
of an issuer's credit worthinessratings range from triple A
highest to D lowest bonds rated Triple B
or above are consideredinvestment grade credit ratings.
Double B and below are lowerrated securities, also known
as junk bonds.
Any mentions of specific companies are
(29:15):
for reference purposes only
and are not meant to describethe investment merits of
or potential or actualportfolio changes related
to securities of those companiesunless otherwise noted.
All discussions are based onUS markets and US monetary
and fiscal policies.
Market forecasts
and projections are basedon current market conditions
(29:37):
and are subject to change without notice,
projections should not beconsidered a guarantee.
The views and opinions expressed
by the Flat Rock global speakerare 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 basedupon market or other conditions,
(29:59):
and Flat Rock GlobalDisclaims any responsibility
to update such views.
This material is notintended to be relied upon
as a forecast, research,or investment advice.
It is not a recommendationoffer or solicitation to buy
or sell any securities or toadopt any investment strategy.
Neither Flat Rock Global
(30:20):
nor the Flat Rock GlobalSpeaker can be responsible
for any direct or incidentalloss incurred by applying any
of the information offered.
None of the information
provided should be regardedas a suggestion to engage in
or refrain from any investmentrelated course of action
as neither Flat Rock Global
nor its affiliates are undertaking.
(30:41):
To provide impartialinvestment advice, act
as an impartial advisor
or give advice in a fiduciary capacity.
This broadcast is copyright2024 of Flat Rock Global LLC.
All rights reserved.
This recording may not bereproduced in whole or in part
or in any form without thepermission of Flat Rock Global.
(31:01):
Additional informationabout this podcast along
with an edited transcript may be obtained
by visiting flat rock global.com.
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