#22, Amir Vardi, Head of Structured Credit, UBS Asset Management

Amir Vardi, Head of Structured Credit at UBS Asset Management, joins The CLO Investor podcast to discuss CLO market inefficiencies, CLO debt versus CLO equity, CLO modeling assumptions, and the economics of CLOs managed by newer market participants.

Episode Transcript

(00:07):
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 newsand the CLO industry,
and I interview key market players.Today I'm speaking with Amir Vardi,
head of structured creditat UBS Asset Management.

(00:29):
He works for one of the best regardedbroadly syndicated loan CLO management
platforms,
and he also invests in CLOsecurities managed by third parties.
We discuss multiple topics includingthe inefficiencies in the CLO market,
CLO debt versus equity,
CLO modeling assumptions andeconomics of CLOs managed by newer

(00:51):
market participants. Ifyou're enjoying the podcast,
please remember to share like and follow.
And now my conversation with Amir Bardy.
Amir, thanks for coming on the podcast.
Yeah, Shiloh, it's a pleasureto be on. Thanks for having me.
So how did you end up in the CLO Industry?

(01:13):
So my background is I'm oneof the very rare people to
be at one firm for my entirecareer. I graduated undergrad,
University of PennsylvaniaBusiness School in 2004,
and my first job was at CSFBas it was called at the time.
It was on the sell side.So in sales and trading,
and I still have a placard on my desk,

(01:36):
which are all the people thatwere in my starting class.
It was a hundred plus a hundred somethingpeople. And if I look through that,
maybe two or three people are still here.
So actually in prep of thispodcast, I literally did that.
I basically took a picture of thisplacard and I fed it to AI and I said,
it has all the names on it. So I said,

(01:57):
how many of these people still work atUBS? And so the initial response was,
given the time elapsed since 2004,
it's very probable that most if not allof these individuals have moved on to
other roles, companies, or evenindustries. And then it went on,
despite a generic answer,
it went on to suggest six names thatmight still be here. I was one of 'em.

(02:17):
So it was right on that.
And then the other file I spotchecked and they're all not geared.
It was incorrect or a different personwith the same name. So any case,
I have been at this firmfor now 21 years started as
CSFB became Credit Suisse.Now it has become UBS.
I've always been aroundthe loans and CLO space.

(02:38):
In 2008 is when I did that switch fromthe sell side to the buy side to this
particular group.
First I was a research journalistfor CLO Bonds picking at that time,
2008 nine single A CLO Bondsin the sixties became a
trader of CLO Bonds in 2009,
and then A CLO issuance came back in 2011.

(02:59):
I remember our first deal back was April,2011. I was helping on that effort.
I was made a portfolio manager in 2012,
and then in 2013 I picked up also theresponsibility for the head of CLO capital
markets. Since then, I've hadessentially that same role,
which is the dual headed role, so bothCLO issuance and CLO trunk investing.
So how do you see CSAM and nowUBS as differentiated amongst your

(03:22):
peers and CLO management?
So one thing that's different than anyof the larger players for us is that
every CLO that we've donehas been homegrown de novo.
So we've never bought a CLO manager.We've never bought CLO contracts.
So most of the otherBigs, if you look at them,
they've gotten to theirsize through acquisitions.

(03:44):
Second thing is just the length oftime that we've been doing this.
So this started before I startedhere. This started in 1997,
John Popp and Andy Marshakstarted this business.
They did three CLOs in 1998 to 1999.
At that point is when CSFB acquired themand before the ink dried on that DLJ

(04:04):
acquired them. Then CreditSuisse acquired DLJ.
So they landed at Credit Suisse in 2000.
And that core team has obviously growna lot, has been here ever since 2000.
So we're now underneaththe UBS umbrella obviously.
But as far as our platform, our team, howwe do business, what our specialty is,
it's really been the same. And CLOis really our bread and butter.

(04:25):
So we have some other assets,but this is 65% of our AUM.
It was probably 90% of our assets.
If you look at 2007, 2008 pre-GFC,
we've really grown it post thatcrisis as far as commingled
funds, separate accounts and so forth.
But this is really at the core of whatwe've done for a long period of time.

(04:47):
Do you spend most of your timeon CLO management or investing in
CLO securities?
So I spend most of my time onthe tranche investing side.
The issuance side I wouldcall a well-oiled machine.
So we built out a team on both sides,
but structuring and issuance teamrelated to those Madison Park CLOs is

(05:09):
well built out. And so I spend, as I said,
maybe 30% of my time there and 75% ofmy time on the tranche investing side.
And it's important to note that we'vebeen investing in tranches going back to
that 1998 inception. So in theolder days, as you know, I'm sure,
but maybe some of thelisteners don't. The 1.0 deals,

(05:30):
so the deals from before2008, had buckets.
They were still mostlyloans, senior secured loans,
but they had buckets for CLO tranches.
So we were investing in those CLOsinto other managers, CLO tranches,
and we also had somefunds that had buckets.
So it's really post 2009-10 that we built

(05:51):
out our dedicated structurecredit business that is funds that are exclusively
investing in, we have all sorts, butit could be European investment grade,
it could be US seniors,it could be equity.
We have a series of CLO equity funds,
but we've been actuallyinvesting since 1998.
Amir, you've been in the marketobviously for a long time.

(06:12):
What's one or two things that you findintellectually interesting about CLOs?
Yeah, it's a good question. Ithink it's a dynamic market.
It changes enough to keepthings interesting. It evolves.
The underlying loan marketevolves. The structures,
meaning the CLOs that sit around theloans evolve. There's new players,
some players go away. There'sM&A. There's consolidation.

(06:33):
I'm a particularly data oriented person.
There's just so much data that you candig into and slice and dice various ways
and do various types ofproprietary research on how different managers are doing
different things,
who does what well and whohas a particular style and stays in their lane and
who veers out of theirlane. There's just so much,
it's almost a never ending amount ofresearch and things that you can do within

(06:56):
this market.
So I've anchored my career tothe CLO market for over 20 years
and still haven't yet gottenbored of it. Have you, Shiloh?
Well, my career is anchoredto CLOs as well at this point.
One of the things I like about CLOs isI just think it's a very inefficient
market.
I went to grad school at University ofChicago where they beat market efficiency

(07:18):
into you, but the reality is the equitytranches I'm buying might be 50 to
70 million in size. The BBtranche might be, I don't know,
around 30 million. And thesesecurities don't trade a lot.
If you know what you're doing,
I think there's a highpotential to outperform peers.
I think I have a lot ofsmart peers in the market,

(07:38):
but if you've got a good gameplan, a good research effort,
I think the potential to earnalpha is certainly there.
Let me just say I totally agree withyou that there's two sides to it.
On the one side, things are gettingmore liquid and more efficient,
and on the flip side,
there's absolutely stillnuance and a reason that

(07:58):
people who are really in the weedsand really close to the market and the
documents and the managerscan really outperform.
Whether that's by how you trade and maybeyou can get better prices or looking
for specific things to document orpicking managers in a different way.
There's so many differentways to outperform.
So I'd say that thereis enough inefficiency.

(08:20):
Certainly AAA liquidity is extremelygood. AA liquidity I'd say is pretty good,
and equity liquidity is spotty, butit's there. You can sell your bond.
There is inefficiency, and I thinkthat I totally agree with you.
So your professors at Universityof Chicago were not wrong,
but it doesn't apply to all markets.
Well,
at the beginning of my career when Iwas doing mostly direct investments in

(08:43):
loans,
I found that the reality there isany loan to a good company made
by a good firm could go bad.
There can always be some change tothe business model that results in a
restructuring. Whereas in our business,
you're dealing with the statisticsreally of the pool. In CLO equity,
you're maybe assuming a 2% default ratethrough the entire portfolio of loans.

(09:06):
You're not betting on any loanin particular to do well or not.
I found that statistical analysis of theentire pool to kind of maybe resonate
more with how I view the world.
Investors often ask, how many line itemsdo you need to have to be diversified?
And to some extent, you could buy one CLO.
You could just sit there with oneCLO and have 300 underlying loans.

(09:26):
I wouldn't stop there. My answertends to be something like 30.
If you buy 30 CLO bonds,
the underlying number ofissuers is around 1500,
which is a large,
it's almost every loan in the market aslong as it's not 30 bonds from the same
manager. 30 bonds from say 20 to 30managers is going to be extremely

(09:49):
diversified. But that startingpoint of even one CLO has
200- 250+ individual companies,
you're in such a better place.
So now that recessionary risks in themarket are up post liberation day,
does UBS as a bank have aneconomist that has a call on what

(10:09):
we should expect over the next year or so?
At the end of the day, it's nota driver of our credit decisions.
Our credit decisions are really made atthe fundamental bottom up level company
by company.
Obviously each industry has its owndynamics and the macro view there is
obviously important.
We might have certain out of favorsectors and in favor sectors,

(10:30):
and those are based on macroviews, but it's really much,
much more about the individual company.
It's business who the sponsor isthat is the owner of the company,
the capital structure being putin place, the credit document.
And those business factorshave our macro view baked in.
But we don't start with saying,we are now because of tariffs,

(10:51):
let's decrease our chemicals exposureacross the board by 2% and let's increase
our telecoms up by 3%. It's reallycompany by company analysis.
So even within an industry,there's so much differences.
We're going to takechemicals for instance,
there's parts of chemicals where likecommodity chemicals that might be very
negatively impacted by oversupplyby some foreign actors.

(11:14):
And then there's other parts,
specialty chems that use that as aninput and therefore to the extent that's
happening, their inputcosts just went down,
but they can still sell at the sameprice. Their margin just went up.
So there's literally a winner and a loserside by side within the same broader
industry.
Does the recent marketvolatility make CLO equity or
BBs more or less attractiveto you or maybe other parts of

(11:38):
the CLO capital stack?
Yeah, I mean equity'stough I guess to answer.
We probably just see bettervalue in debt at the moment,
and I think probably in particular isprobably the most meat on the bone in the
AAA.
And that's just because we tend to lagthat the CLO debt tends to lag the loan
market in all markets.
So I'd say equity was really much more

(12:00):
interesting than it had been,let's say pre-liberation day. So,
end of 2024 into 25, it had been muchmore interesting than it had been.
I'm talking about primarymarkets, so creating a deal,
much more than it was in 2022.So, post-Russia, Ukraine,
invasion of 22-2023.
So you were able to lock inreally tight liability prices,

(12:22):
and that has proven tobe a valuable thing.
But right now the liabilitieswidened, everything widened,
and now everything's comeback in, as you said,
with Trump receding from the initialtariff talks. But the CLO debt has
really lagged. If you see adeal pricing today or tomorrow,
it doesn't mean it's good or bad.
It really depends on theother side of the equation,

(12:43):
which is we're able to buy a bunchof assets in the 97s and 98s.
But on paper, I'd say it's hardto look at CLO equity and say,
this looks great, butfrom a debt perspective,
I think that there's value in AAA.
It's much more attractiverelative to its alternatives,
which is agency mortgages or corporateinvestment grade bonds or any type of

(13:06):
liquid ABS like credit card,student loans, even CMBS.
You're getting betterspread in yield than CMBS,
which has real fundamental issues,
largely tied to post-COVID office,not everyone's returned back.
There's some real stress there.
Well, a lot of what I'm doing asyou know is in private credit CLOs,
but the tarrif volatility, Ithink, for private credit BB's,

(13:29):
really was an opportunitybecause spreads blew out from
650 basis points overSOFR to more like 800,
and we didn't see the tariffsas posing really a risk
to the underlying bonds, but we did wantto benefit from the incremental spread,
so we saw that as an opportunity.And then for CLO equity,
the reality is it's down for the yearand some asset classes have come back.

(13:54):
The S&P 500 is back topositive for the year,
at least when we're recording this.
I think for an investor who's investingnew capital today and thinks that
economic risks are up,which I would agree with.
CLO equity has lagged and it's one of thediscounted opportunities in the market
that people may want to take advantageof. So when you say CLO equity,

(14:16):
I think your words were maybe hardto get a conviction around it today,
what kind of outcome would youexpect from here if it's not of high
conviction to you?
They could be negative. I mean,
it's a highly sensitive assetclass to how the manager performs.
So I'd say from today, ifyou pick a good manager,
a bad outcome should be amid-single-digit-return. So, if you made 5-8%,

(14:37):
that's probably not where you'resupposed to get on equity.
Obviously you should have upside intothe high teens and your base case is
probably 12%, 13%, 14%. But,
I don't see that base casebeing 12%, 13%, 14%. Today,
I see at this exact point in time,
if you went and bought loans today andbasically went and printed a CLO today at
where the debt is,

(14:58):
you are probably lookingat a upside case of
12-14%. So that'severything has to go well.
And there's still ways to get to highteens because there's a lot of options
embedded in CLOs. So for instance,if you look at the 2007 deals,
they probably were modeled to that magicnumber 12 to 14%. Things got really bad

(15:19):
in 2008 and 2009. The 2007vintage was a fantastic vintage,
but it's because the CLOs wereable to go through 2008 and
that severe sell-off in the loan market,
they didn't have to sell loansbecause CLOs don't have a situation
where they're a forced seller of loans.In fact, they were on the other side.
So there were a lot of forcedliquidations by some, not by CLOs.

(15:42):
CLOs were the beneficiary of that becauseif you just had to sell and you were a
CLO manager and you had theguts to say, I like this loan,
I'm going to bid $65 for itor going to bid $55 for it,
and there's a tremendous amount ofvalue creation that took place in 2008.
And then actually also as you go through
2010,
so the credit markets completely frozefor a few years. When they unfroze,

(16:06):
these companies had not had the chanceto extend their term loan maturities
and now they finally did. But of coursespreads were way wider in 2010 and
2011 than they were in 2007. So,
we had these "amends and extends" andyou had a massive amount of increase in
the weighted average spreadof your assets. Meanwhile,
your liability spreads don't change.

(16:28):
You have the ability to take themlower, but they don't go higher.
And that might be a way to explainwhy equity is quite interesting today,
should we have a recession.But, we do sit here Shiloh,
with defaults kind of at 4% and yet loan
prices, the ones you'd want to buyin a CLO are pretty close to par.
So that I think an astute manager canfind some lower priced loans and maybe

(16:52):
navigate well and add some value,
but the starting point is a littlebit more difficult from an equity
perspective. So that's why I say that.
Isn't it one of the challenges for themarket that because a lot of money has
been raised in our asset classfor the loans in particular,
that when recessionary risks are up,
the loan market just doesn't trade downlike it used to and those discounted

(17:15):
loan opportunities that you wantto buy, maybe there are discounts,
but they're not at the same discountsthey would've been in the past.
I do think that the first part that yousaid there, people raised so much money.
I think that's part of the problem.
I think that so many newplayers into the CLO space,
if you're going to be a new player,
you have to come with a lot ofcash to buy your own equity.

(17:37):
No one's buying a newmanager's equity period.
And so many new players and somuch money having been raised for
equity is creating all theseCLOs, but at the same time,
you don't have nearly enough newloans. And the new loan supply,
21 was a better year and since thenit's been just very, very scarce.

(17:57):
So the combination ofnot enough new loans,
but a lot of new players and a lot ofpeople trying to start CLO platforms and a
lot of money being raised by existingplatforms for their own equity in what we
call the captive equity funds, Ithink is really compressing that arb.
You're creating a lot of CLO issuance,
[which] keeps the debt spreadsmaybe wider than they ought to be,

(18:18):
and it's creating a lot of demand forloans and that's caused a significant
spread compression through repricing.
And spreads there are reallyshockingly low, I mean low 300s,
tighter than we've seenin a long, long time.
So your firm's been aroundfor almost three decades.
Why do you think people are giving moneyto the newer CLO managers and taking

(18:40):
that risk?
Just to clarify your question,
is it why are people whoown the company doing that?
Or is it why is someone who'sunaffiliated with the company?
Because it's two different answers.I can answer the first one for sure.
Well, it was actually the latter.That was my question. I mean,
you're a CLO equity investor. Are youinvesting with first time managers?

(19:02):
I assume not.
I don't know if anyone does. Look,
why does someone do the first one andthen why does someone do the second one?
I'll ask you, I don't know,
but why does someone do it inthe context of I own the manager?
It's because yes,
I don't think that those investments ontheir own are particularly interesting
because a new manager is going tohave to pay up because no one knows

(19:26):
them.
So they have to pay up quite a bit ontheir liability costs and yet they're
going out and buying the same loans aseverybody else - SOFR plus low 300s.
So that return profileisn't that compelling. But,
if you do four of thesedeals or five of these deals,
and each of them is a little bit lessbad than the prior one because your debt
costs are getting tighter because peopleget to know you and you're becoming

(19:49):
more of what people call a liquid manager.If you get to the point of
having good pricing, tier-one pricing,so similar to all the top players,
then you can start to attractsome third party equity with
some fee discounts. And then as you goon, maybe there's less fee discounts.
And if you perform well, those fees go up.

(20:10):
And every time youraise third-party money,
even with some fee discount,
that's building the value ofyour enterprise of the manager.
So there's some wild success stories. Ithink the obvious one, so I'll say it,
is Elmwood, which Elliotstarted and got off the ground.
So there's a few success stories.
There's a bunch of people who are tryingto chase that model and build an asset

(20:33):
manager who specializes inCLOs, which is worth a lot.
So that trade hasdefinitely been a good one.
It's not going to work everytime and it really depends,
did you hire the right people,did they pick the right credits,
etc. So, there's a lot of peopletrying to do that right now.
Now the second one, why do you buydeal five from a manager? I mean,

(20:53):
probably you believe in them andprobably you got enough of a manager fee
discount.
At a previous firm, I did someemerging manager investing,
and how we thought about it back thenwas you could get a 15 basis point fee
rebate,
which considering the leverage and thestructure might be worth a percent and a
half to you in terms ofincremental IRR or cashflow.

(21:15):
But to your point,
that doesn't account for the fact thatyour cost of debts can be higher. So,
maybe you give all that up, butif you're with a smaller manager,
you might think, okay, these guys aregoing to be more nimble with the assets.
Maybe they'll get allocations of loansand trade them back to the agent on the
break and make a quarter orthree-eights or something like that,

(21:36):
and slowly build par that way.
Bu,t the actual experience at the timewas that the smaller managers just really
struggled to get allocationsof the loans that they wanted.
And so you didn't have that par build andthe higher cost of debt really weighed
on returns. And now that's justnot a business that we're in.
And there's stats on that. I don't havethe exact number, Shiloh, but the top,

(21:57):
let's say 10 managers, get 80%. That'sthe number that comes to mind. But,
there's a reason that the top managersget disproportionately more of what they
want. So, if you start with the premisethat a loan is well oversubscribed,
there's not enough of it to go around.At the end of the syndication process,
a bank could choose to justallocate pro rata. That sounds fair.
Everybody gets 40% or let's say it'sthree times over, everyone gets 33%.

(22:21):
That is generally not how they do it.
They tend to look around and say thelarge managers get early looks on
deals, and then that gets 'emon their way to syndicating,
let's call it a multi-billiondollar deal. And then at the end,
if it's widely oversubscribed,
because we were helpful inalso putting in a ticket early,
we're going to get maybea high percent of it.

(22:41):
Someone who came in late and put in10 million, they might get 1 million,
they might get 2 million. That'swhat, from my vantage point,
I've seen from an allocation perspective.So from that, yeah, I agree with you.
It does tend to favor the larger players.
Well, it doesn't sound like either ofus are investing equity dollars with new
managers,
but it does seem like new platformslaunch every couple months or

(23:05):
so. Maybe I could see the attraction,
if you're a part investor in the CLOsmanager, maybe that could make sense.
There's so, so many,
and it's always a surprise to me thatsomeone wants to put themselves through
that. There's definitely alight at the end of the tunnel.
Everyone wants to be that Elmwood example,
but maybe four out of five of themdon't get there, and it is a struggle.

(23:26):
Can I bring up one morething about large managers,
which is in the context ofthese new last few years,
everyone talks about liabilitymanagement exercises.
It was already our view,and we're a big manager,
so obviously we'regoing to have this view,
we're going to talk our book - it was ourview [that] that you wanted to be big.
We talked about allocations.
It also helps to have a big enoughplatform that you can afford to have, say,

(23:50):
25 credit analysts. So,
you have a very deep bench thatare very focused on, let's say,
one sector. They get really,really good at that sector.
They know all the companies in the sector,they know all the CFOs and the CEOs,
so they get really, reallygood at their sectors,
and that's really whatdrives credit performances.
It's really what you don't buy,
but it's those research analystskeeping out of the wrong sector.

(24:10):
So if you're big, youcan have a lot of 'em,
you can have good ones because youhave the fee revenue to pay them,
etc. Allocations, size of team, but,
the new thing that's I thinkprobably been talked about quite a
bit, but it's just a very obvious one,
is the liability management exercises.
Yeah, the distressed exchanges.
So, in the last couple years,

(24:33):
companies have been ableto recapitalize their debt.
In some cases, do what'scalled discount capture, so,
reduce the balance oftheir debt. Other cases,
maybe erasing new moneyto extend their runway.
And a lot of times that comeswith pretty juicy economics. And,
typically any one of these typesof transactions, you'll need 51%.

(24:57):
And if you have 51% of your lenders,
you can amend and do whatever you want.
The documents are fairly loose andthe lawyers are very creative. So,
the benefit of being large is,
if you're trying to get to 51% with thefewest number of counterparties to deal
with, you got to look at your lender list,
you'll sort it by thebiggest of the smallest,
and you'll pick the top five that getsyou to 51% of the top X that gets you to

(25:18):
that number. But,
you really want to be in that list.The reason is then the byproduct of these
things is there's the "ingroup" and the "out group".
And there's a very bigdifference in recovery.
It's funny because you see recovery ratesquoted on distressed restructurings,
JP Morgan's got dataout that shows its 65%.
That's the most recent number I justsaw today. But if you think about it,

(25:39):
no one gets 65%. That'san average of two things.
Some people are getting 10 to 20 pointshigher and some people are getting 10 to
20 points lower. There's not always twogroups. There could be three groups,
four groups,
but to be big means that you're much morelikely to be in that "in group". And,
so when things go wrongand the LME happens,
it's very challenging to be in the"in group" when you only own 1% or

(26:00):
2% of the loan.
Makes sense. So coming back to theprevious topic of CLO equity returns,
I assume you were previouslytalking about the primary market,
but I imagine that you're investingin both primary and secondary.
Definitely more so in secondary usually.
And is that because the returnopportunity there is better?
It depends on the time. I guess maybeit's recency bias. In recent years,

(26:24):
we've been much more involved insecondary, up until recently. So,
we play primary when we thinkthere's better value in primary. So,
actually it did flipprobably second half of 2024,
and the first few months of this year,we did see better value in primary.
And actually, what we were doing waswe were basically selling secondary.
Secondary was all north of par,generically speaking, could be par or 101,

(26:47):
par and a half,
but we were finding better pricebecause primary is going to come at 100,
at par. Better price andspread than primary. So,
we were buying that and actually sellingsecondary and doing that rotation in
order to fund those primarypurchases. But, prior to that,
for pretty much all of 2023and almost all of 2022,
we did nearly no primary and we werevery active in the secondary. In 2022,

(27:10):
I'd say 15% of our tradingvolumes were primary,
so 85% secondary. And in2023, it was even more stark.
It was 98% of everything that we tradedin the CLO tranche market was secondary,
2% was primary.
We just saw so much better valuediscount prices on the bonds and
better yield potential.

(27:30):
Well, I think to besuccessful in CLO equity,
you need to look at both primaryand secondary for the best value,
and I think a lot of our competitorsjust approach the market with a primary
only mandate.
And that's one of those inefficiencies,the primary only mandate,
which stems from folks that need alot of time to process. Secondary,

(27:51):
you don't have time. Same day"bwic", next day, at best.
Primary market participantsneed weeks of time
to put together a package to presentit to their investment committee.
They want to have a lot of sayin what the document looks like.
There's a lot of folks that arejust not set up to do secondary.
Primary is cleaner. It's aneasier thing to buy. It's cleaner.

(28:11):
Secondary is a little bit,depending on the bond,
it's going to have a littlebit more seasoning to it.
So it does keep people at bay, and it'spart of what we talked about earlier,
which is part of the inefficiency.
It keeps people away and thereforethere's better value there.
In my opinion,
the captive fund vehicles would bethe worst way to invest in CLO equity.
I mean those are funds where investorshave committed to do the next

(28:35):
four or five deals with the manager.
That manager is going to call the equitycapital and start earning a fee on it
as soon as possible.
The initial profitability or projectedprofitability of the CLO is not
the main driver of CLO creation. And then,
what the end investor getsout of it is four or five CLO

(28:55):
equity investments,
exposure to a minuscule part of themarket in four or five CLOs that have high
loan overlap and are supercorrelated. I think it makes no sense.
So basically,
between captive equity and third partyequity as two distinct strategies where
it seems like you're getting thesame thing, you're buying CLO equity.
I think the third-party equityside of things is better.

(29:17):
It's more opportunistic. You'regetting that diversity across managers.
You're getting diversity across vintagesthat you don't get in captive equity
because you're just going to buy six oreight deals from one manager across one
or two vintages. And they're notever going to buy in secondary.
They're not set up to do that.
So there's no buying insecondary and there's no selling.
If there's inefficiency, sometimes youwant to sell into a really strong bid.

(29:38):
They're just holding it for the life.
One thing that they have on theirside will be that there's not this
feeling of two sets of fees, one at theCLO-level and one at the fund-level.
There's some truth to that,
but I think that the third-partyfunds are probably more than
worth their fees.
I think in the end of the day you'llhave a better net return there than you

(30:00):
will in the captives, butyou're more than worth the fees.
Well, having third partyequity at a minimum will ensure that the management fee
is done at a fair market rate. And thesame thing for the underwriter fee.
That's what I was alluding to as faras I think a sophisticated third-party
investor can push the manager'sfees to what you call market level.

(30:21):
And that moves around with the market,
and it probably moves around with aparticular manager and maybe through time.
But those captive fundshave a set discount and
ostensibly it's X percentdiscount off of full fees. Well,
was that manager getting full fees?
Is this really a discount asyou've been told? So yeah,
I'm a little bit suspect in some cases.

(30:41):
I think some are actually probably prettyattractive and a bunch of them aren't.
Well,
I think this goes back to our conversationabout how inefficient our market is
and how there's a lot of players out therewho are implementing their strategies
in a way that wouldn't makesense to the two of us.
And the conflicts go backto what you said, which is,
you're giving the manager money in a fund,

(31:04):
and the fund doesn't have fees, and theyare the decider of when to do a deal.
And, when they do a deal iswhen they start to earn fees.
When that CLO closes,
they'll start to earn manager feeson the par value of the CLOs assets.
So they'll take $50 million from the fund,
they'll turn it into a $500million CLO, they'll start to make,
let's call it 40 basispoints on the $500 million.

(31:27):
What do you think thatmanager is going to thedo?
I think they're going to print.
And so,
at times you've seen these captiveequity funds creating CLOs with initial
profitability. That's probably worsethan the CLO BB note. And again,
they do that because they want the fees.
I think 2023 was aperfect example of that.
I certainly would've preferredbuying primary BBs. This is generic,

(31:49):
because it's always case by case.
Primary BBs over primary equitywould've preferred secondary
BBs over either of those two things,
and secondary equity probablyabove all three of those things.
But last on that listwould've been primary equity,
which is what a captive equity is doing.
It's buying primary equityin that manager's deals.
For CLO equity,

(32:09):
do you think of there as beinga bid ask spread or is it that
equity often just tradesthrough BWICS or auction
processes where a buyer and sellerare matched up through a dealer
who earns just like a small feefor their time on that transaction?
I think there's a bid-ask spread.
I think it gets asked by investors intoour funds, what's the bid-ask spread?

(32:33):
And I can quote it. If you ask me onAAAs, I'd say it's 10 cents. And then,
in equity, I'll typically go to someoffering runs and look and say, okay,
bid-ask is two points,
but the reality is you'retransacting inside of that.
And that's probably true in every market,but it's very true in this market.
So the real bid-ask thenis not a two-point bid-ask.
It's something like you'd probably skinnyit down to maybe it's half a point,

(32:57):
but I think I understand your question.
Because of the inefficiency of the market,
you might actually be able toflip the bid-ask. In other words,
you can sometimes get bidsthat you feel are very good,
and you're selling it abovetheoretically the offer side,
and sometimes you're able to buy stuffat a level that you think is below what
quote the bid side is. So, yeah,I think that there is a bid-ask.

(33:18):
It's not at all clear whatthat is because unlike
other markets, the CLOmarket is a bit weird.
Each of the tranches is very small,
and so it's not like every single CLOtranche is quoted by a bunch of dealers
every day. They mostly allare not quoted by any dealer,
and they mostly all don'ttrade any given day.
But there's enough things that look alot like them that do trade every day.

(33:41):
So you can get an idea.There's daily marks.
How they're able to do thatis they're able to say, well,
this manager's bond that hadthese features traded at this DM,
and I'll take that DM and apply it toall other bonds that are similar in those
features. So it goes back towhy is this market interesting?
It's not efficient. There's supposedto be an answer to what's bid-ask,
but I think some traders are verygood at being able to invert that.

(34:03):
So you may have heard that we're livingin the golden age of private credit.
So are you managing private creditassets on your balance sheet there
or investing in private credit CLOs?
Is it still the golden nature ofprivate credit or we passed that?
I think we're probably stillin it. It's a gap for us.
We have not ever invested in what weused to call middle market CLOs and now

(34:25):
private credit CLOs. I think there'sa place for that. Obviously you do it.
We've always gotten comfort fromknowing the underlying loans.
So in the area that we traffic, whichis the broadly syndicated CLO market,
we do know 98% of the underlyingloans. We know all the managers.
We're in a lot of the same deals.There's a decent amount of overlap. So,
especially when we're investing in theBBs and equity, we get comfort from that.

(34:49):
Where in the middle market, Ithink if we were to approach it,
we would be very disciplinedwith which managers we work with.
It's so much more about the diligenceof the managers. We just would not know
the underlying companies. Even under NDA,
you'd get the list of names andyou scratch your head and say,
I can understand what they do,but I don't know the company.
We haven't looked at it.
So I get comfort that our researchanalyst team has looked at the name,

(35:11):
so that's kept us away from middle market.
I think it's not nearly as much of anissue at the top of the structure. So,
I think middle market, CLO AAAs are safe,
and you still want to be alittle disciplined with managers,
but you can probably have a broader lensthere. The other aspect is liquidity.
So, because we're an asset manager,
most of our funds have certainlydaily marks but also different terms,

(35:34):
but generally have the abilityfor the client to redeem.
And the tranche market on middlemarket side is less liquid.
It's getting better. You tellme, I'm actually curious,
but my sense is it's less liquid,and so that's kept us at bay.
I think we're probably supposedto take another look at it,
but that's why we're not in that space.
Yeah, so for privatecredit equity and BBs,
they're going to be significantly lessliquid than their BSL counterpart.

(35:58):
But if you're talking about BBsfor example, on the one hand,
less liquid and the underlyingloans aren't traded.
But the positive there is that youget 12% equity initially in the deal
rather than the 8% youget in broadly syndicated.
And that initial equity matters alot in terms of how robust the CLO
BB is to defaults on the underlying loans.

(36:20):
That initial equity is very valuable.
There's no doubt. I meanthe same thing with Europe.
You have bettersubordination, as they say,
at every level and probably even more soin middle markets CLOs than in European
CLOs. And there's value to that.It's just more cushion for mistakes,
more loss absorption capability.Like I said, it's a gap for us.
But that's where it's rooted in. It'sjust knowing and having that comfort of,

(36:43):
I really do know what I'm investingin. And with the middle market space,
I think there's some managers that arereally good there and if you're able to
source their paper. Let me ask you this,Shiloh, are you ever able to buy BB,
secondary? middle marketsBB in the secondary,
or in April you said it got to 800,
you're talking aboutprimary deals done in April?
SOFR + 800 is where thingstraded in the secondary.

(37:06):
So through auction processes ordirectly through broker-dealers
who are trying to earn maybe a50 basis point bid-ask spread.
There is the bid-ask spread in CLOs.
Indeed.
I kind of look at it on paper and thinkthat probably the equity could be very
interesting just because the spreadis so much higher, so much higher,
and then your liability costis only a little bit higher.

(37:28):
The arbitrage should be a lot higher,and yet you're getting less leverage.
But I mean,
on paper it looks like it's a lot juicierof an asset and just not something
we participated in. But hasthat been your experience?
Yeah, so it is my experience. If you'resitting around and you said to yourself,
Hey,
should I do middle market or shouldI do broadly syndicated CLO equity

(37:50):
and you were indifferent to theunderlying assets and you just ran your
projected return case through Intex,
what you'd find is that the middlemarket CLOs spit off a lot more cash,
and that's because theunderlying loans are SOFR + 500,
maybe a little shy of that. And then whenyou look at the CLOs financing costs,

(38:10):
starting with AAA for example,
the AAA in middle market CLOsis 30 bps wide to broadly
syndicated. And as you go down thestack, the basis is going to be higher,
but the natural profitability of the CLO,
which is just the rated earns on itsassets less the CLOs financing cost,
the private credit CLO,

(38:31):
the middle market CLO is goingto be much more profitable.
And so your initial IRRs are higher.
And then you talked a bit aboutliability management exercises.
But in private credit, that'snot really a thing. So,
private credit is one lender or aclub of lenders, they're all friendly.
There's no lender on lender violence.I think the docs are better,

(38:52):
and so I think recoveries,they may not hit 70,
maybe 70 is becoming an antiquated number,
but I would expect them to be muchbetter than broadly syndicated as well.
There's a couple of things that haveworked in our favor on these investments.
Can I ask one thing? I get allthat. It sounds really good.
The one thing I haven't wrapped myhead around is just how do you get out?

(39:14):
What is the exit?
So you're going to cashflow betterand maybe it's not that relevant,
but what do you think going is going tobe how you get out? You're selling it?
It's getting called? There must be someway to get out of the trade in the end.
Sure. So,
the typical middle market CLOhas a reinvestment period of four
years,

(39:34):
and then after that the CLOnaturally delevers and then over
time, all the debt would be repaid,
and the equity would get what remains.
But that's not reallywhat we're hoping for.
We own CLO equity insemi-permanent capital vehicles.
They're interval funds. And basically,
when the CLO's reinvestment period ends,

(39:56):
our goal would be to extend theCLO's life or to do a refinancing.
And if you find yourself in aposition where neither of those are
economical,
then a lot of times instead of justhaving the CLO do a full wind down,
a natural wind down,
the CLO manager will just buy the loansfrom the CLO at fair market value.

(40:17):
So, that would be an appraised valuethat comes from a third party like
Standard and Poor's orHoulihan Lokey. And so,
they can value all the loans that remain,
and from that the manager can giveyou a calc of your liquidation value,
and they might take those loans andput them into a new CLO that's ramping
or a BDC or some otheraccount that they're managing.

(40:41):
It's similar in concept toa [BSL] CLO being called,
but as opposed to the loans being soldin the market at fair market value,
the loans are being taken back bythe manager at fair market value
into some other fund on their platform.
That's correct. So one lastquestion for you, Amir.

(41:01):
When I say 2 and 70 in our business,
people know exactly what that means.
It means 2% defaults and 70% recoveries.
Those are kind of the base case modelingassumptions that I think a lot of
people use.
Is that what you use around the shopor are those numbers a little bit
antiquated?
Those are antiquated. I mean,

(41:21):
I think that is probably what mostpeople use as what they would call a base
case. From an equity investor perspective,
I think most people are probably runninga whole bunch of other scenarios,
and we do that too, but from a basecase perspective, for one thing,
2 and 70. 2 is below theaverage default number,
so a little bit rosy and thenrecoveries aren't 70 anymore.

(41:44):
That's a little bit rosy as well.
So I think the bigger issueisn't that it's too rosy,
it's that it's just antiquated.
I've been thinking about it alittle bit differently. I mean,
if you think of what does 2 and 70 reallymean - it's a loss rate of 60 basis
points. So for the listeners,2% of your portfolio defaults,
70 recovery means 30%you lost on each loan.

(42:05):
So 2% times 30% is 60 basis points.The actual realized
loss will ultimately depend and bevery different based on the manager.
But if you look at that historicallyand back it into a default recovery,
that's fine. I mean, that's oneway to get to that same place,
but there's so much more thatgoes into the actual losses.

(42:26):
At the end of the day,
all of the manager's cumulativedecisions of what credits to buy the
trading that they've done,
lower price loans that they boughtor lower price loans that they sold,
what recoveries they got and bakeLME into that - all that stuff - the
reinvestment price assumption,
I actually think at the same timethat you have 2 and 70, too rosy,

(42:47):
is probably aspects that are tooconservative, like reinvestment,
price assumption. People generallyjust assume it's 99 point half par,
and at times it's lower. And theconstant prepayment rate, which is,
what percent of your loans repay you,
the number people typically use is 20.And the reality is, historically,
it's actually higher than that.
My bigger issue also isn't necessarilywhat numbers you choose to use.

(43:08):
It's that whatever assumptionsyou make going in are not that
correlated to the actual outcome atthe end. There's some research on this,
and we recently ran an analysis onour own deals. The Madison Park deals.
We actually found it wasinversely correlated.
So we took all the deals at issuance.
We basically ran exactlythe same assumption,

(43:29):
so it could be 2 and 70 and 20 andweighted average spread at the current
[level]. We did a veryconsistent thing. We said,
let's just run what this looked like,and then we said what actually happened?
And it was actually slightlyinversely correlated,
not that I can explain why thatis. The R-squared was weak,
but the correlation was slightlyinverted. Weak correlation,

(43:50):
and it's essentially not a greatindicator of what you ultimately will
get because these things are aroundfor so long that in time isn't all
that helpful.
I do think if you were torun like 3% defaults and 50
recovery, you'll never buy equity.We didn't really get into it.
But all those optionsin the CLO structure,

(44:13):
we've talked about extending thedeals, which are called resets,
re-fi'ing the deals. Wementioned 2008, 2009,
there's various waysthat the equity can win,
but you're basically notmodeling any of those things. So,
I get why people choose some rosynumbers because it's sort of like
compensating for all the thingsthat are just impossible to model.

(44:35):
I agree. So the 60 basis point lossrate is probably too optimistic,
but we're probably beingconservative on refinancings,
extensions, and buying loans atdiscounts during recessionary periods.
So I think being too optimistic in oneplace and too conservative in another
probably nets you out tothe right place. Well, Amir,

(44:57):
thanks so much for coming onthe podcast. Really enjoyed it.
No, it was a pleasure to be on. Ialso just wanted to add, Shiloh,
that in our little CLO market,
which isn't nearly as little asit was when we both joined it,
you've been one of the biggestadvocates of this space and
educators, mass-market educatorsthrough your book and your podcast.
So I actually want to really thankyou for that. So thanks, Shiloh.

(45:19):
That's great to hear. Appreciate it.
The content here is for informationalpurposes only and should not be taken as
legal, business, tax, or investmentadvice or be used to evaluate any
investment or security.
This podcast is not directed at anyinvestment or potential investors in any

(45:42):
Flat Rock Global Fund. Definitionsection: Secured overnight
financing rate, SOFR, is a broadmeasure of the cost of borrowing cash
overnight collateralized by treasurysecurities. The global financial
crisis, GFC,
was a period of extreme stress in theglobal financial markets and banking
systems between mid-2007 and early 2009.Credit ratings are

(46:06):
opinions about credit risk forlong-term issues or instruments.
The ratings lie in a spectrum rangingfrom the highest credit quality on one end
to default or junk on the other.
A AAA is the highest credit quality a C or
a D. Depending on the agency,
the rating is the lowest or junk quality.Leveraged loans are corporate loans to

(46:27):
companies that are not rated investmentgrade broadly. Syndicated loans are
underwritten by banks,
rated by nationally recognizedstatistical ratings organizations,
and often traded amongmarket participants. Middle market loans are usually
underwritten by several lenders withthe intention of holding the instrument
through its maturity. Spread is thepercentage difference in current yields of

(46:48):
various classes of fixed income securitiesversus treasury bonds or another
benchmark bond measure. A reset isa refinancing and extension of A
CLO investment.EBITDA is earnings before interest, taxes,
depreciation,
and amortization. An add-back wouldattempt to adjust EBITDA for non-recurring

(47:08):
items.LIBOR, The London Interbank offer rate,
was replaced by SOFR on June 30th,
2024.Delever means reducing the amount of debt
financing. High yield bonds are corporateborrowings rated below investment
grade that are usually fixed-rate andunsecured. Default refers to missing
a contractual interest or principalpayment. Debt has contractual interest

(47:32):
principle and interest payments,
whereas equity represents ownership in acompany. Senior secured corporate loans
are borrowings from a companythat are backed by collateral.
Junior debt ranks behind senior secureddebt in its payment priority. Collateral
pool refers to the sum of collateralpledged to a lender to support its
repayment. A non-call period refersto the time in which a debt instrument

(47:56):
cannot be optionally repaid. A floatingrate investment has an interest rate
that varies with the underlying floatingrate index. RMBS are residential
mortgage backed securities Loan-to-valueis a ratio that compares the loan
amount to the enterprise value of acompany. GLG is a firm that sets up calls
between investors andindustry experts. Risks: CLOs

(48:19):
are subject to market fluctuations.Every investment has specific risks,
which can significantly increaseunder unusual market conditions.
The structure and guidelinesof CLOs can vary deal to deal,
so factors such as leverage,portfolio testing, callability,
and subordination can all influencerisks associated with a particular deal.

(48:40):
Third party risk iscounterparties involved, the manager, trustees, custodians,
lawyers, accountants, and rating agencies.
There may be limited liquidityin the secondary market.
CLOs have average lives that are typicallyshorter than the stated maturity.
Tranches can be called early after thenon-call period has lapsed. General

(49:00):
disclaimer section.
Flat Rock may invest in CLOsmanaged by podcast guests. However,
the views expressed in this podcastare those of the guests and do not
necessarily reflect the viewsof Flat Rock or its affiliates.
Any return projections discussed bypodcast guests do not reflect Flat Rock's
views or expectations. This is nota recommendation for any action,

(49:21):
and all listeners should consider theseprojections as hypothetical and subject
to significant risks.
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 meritsof or potential or actual portfolio
changes related to securities of thosecompanies unless otherwise noted. All

(49:44):
discussions are based on US marketsand US monetary and fiscal policies.
Market forecasts and projections arebased on current market conditions and are
subject to change without notice,
projections should not beconsidered a guarantee.
The views and opinions expressed by theFlatrock global speaker are those of the
speaker as of the date of the broadcastand do not necessarily represent the

(50:05):
views of the firm as a whole.
Any such views are subject to changeat any time based upon market or other
conditions. And FlatRock Global Disclaims,
any responsibility to update such views.
This material is not intended to berelied upon as a forecast, research,
or investment advice. It isnot a recommendation, offer,
or solicitation to buy or sellany securities or to adopt any

(50:29):
investment strategy.
Neither Flat Rock Global nor the FlatRock Global speaker can be responsible for
any direct or incidental loss incurredby applying any of the information
offered.
None of the information provided shouldbe regarded as a suggestion to engage
in, or refrain from anyinvestment-related course of action,
as neither Flat Rock Global nor itsaffiliates are undertaking to provide

(50:51):
impartial investment advice,act as an impartial advisor,
or give advice in a fiduciary capacity.
Additional information about this podcastalong with an edited transcript may be
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