October 13, 2025 • 41 mins
Jonathan Horowitz, Partner & Head of Structured Liabilities at Fortress Investment Group, joins the CLO Investor Podcast to discuss the pros and cons of using bank leverage vs. CLOs, credit trends in broadly syndicated and private credit loans, and the lack of new issue loan supply in general.
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Episode Transcript
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(00:06):
Hi, I'm Shiloh Bates and welcometo the CLO Investor podcast.
CLO stands for CollateralizedLoan Obligations,
which are securities backed by poolsof leveraged loans. In this podcast,
we discuss current newsin the CLO industry and I interview key market players.
Today I'm speaking with Jonathan Horowitz,
(00:26):
partner and head of StructuredLiabilities at Fortress Investment Group.
Jonathan is a 30 year veteran of theCLO market and his role at Fortress
encompasses ranging CLOs andfinancing lines for his firm loan
portfolios. We discussed pros andcons of using bank leverage for CLOs,
credit trends, and broadlysyndicated and private credit loans,
(00:49):
and the lack of new issueloan supply in general.
We also discuss the effect offed rate cuts on our business.
If you're enjoying the podcast, pleaseremember to share like and follow.
And now my conversationwith Jonathan Horowitz.
(01:09):
Jonathan, welcome to the podcast.
Thank you very much. Thanks for having me.
So,
why don't we start off withyour background and how you ended up at Fortress.
Sure. So, I'm a partner at Fortress andI'm Head of Structured Liabilities. So,
what that means is I'm really responsiblefor the financing of a large portion
of our credit assets.
CLOs have been a major strategic fundingtool for us for the last 20 plus years,
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and I spent a lot of my time managingthe capital market side of our CLO
business. Prior to Fortress,
I was a portfolio manager in JP Morgan'schief investment office and I was
responsible for the CLO andConsumer ABS portfolios,
which in aggregate was about $45 billionat the time. Prior to JP Morgan's,
I ran Morgan Stanley's CDO CapitalMarkets desk and I coheaded the CDO
(01:54):
structuring and origination businessand I started my career at Salomon
Brothers. And if you'reold enough to remember,
but Salomon Brothers was apredecessor to Citigroup,
so I've been in the structure creditmarkets for probably the last 30 or so
years.
So, tell me about Fortress.
What do you have in terms of businesslines and assets under management?
So Fortress is a $53 billionasset alternative credit
(02:18):
manager. So, we have a prettydiversified credit business.
A lot of our activity is incorporate credit and real estate,
but we also do a lotin asset based finance.
We have a litigation finance businessand an intellectual property business and
a number of other things. So,
I think one of the key things that'sdifferent about our firm is that we're
really not beholden to any one sectorand it makes it easy for us to pivot when
(02:38):
we see better relative valuein one sector versus another.
And how do you see Fortress as beingdifferentiated from peers in the
broadly syndicated loan businessor the private credit business?
It's a good question. So,
I think there are a few things that area little different about how we're set
up. So, the first thing is whenyou think about our CLO business,
(02:58):
we have the same credit team for ourbroadly syndicated loans and our middle
market credit. So,
basically the way we're set up isthat the analysts are organized,
the credit underwriters organizedby industry vertical. So,
within each industry vertical,
they cover all parts ofthe capital structure and broadly syndicated and middle
market credit. So,
liquid and illiquid credit in allparts of the capital structure.
(03:19):
And we do that deliberatelyfor a couple of reasons. One,
what we found is that it really helpsus make better relative value decisions
when we're seeing everything.
And the other thing is that we findthat there are some benefits from
information flow.
So what happens with middle market creditis that you tend to get reporting much
more frequently.So,
it's typically on a monthly basis andsometimes even more frequent than that.
(03:40):
And a lot of times some of the insightsthat we get can really help inform some
trends that will help us make betterdecisions on our broadly syndicated loans
where we're maybe not gettinginformation quite as frequently. So,
that's one way in which we're different.
I think another thing that's differentis that we have made a really big
investment in what we callour asset management group.
(04:00):
And this is a group that really touchesthe loans after we make them on a
regular basis,
stays in touch with the borrowers andreally helps manage our downside risk and
take proactive measures. Whenwe do see problems coming,
helps us to take measures to protectour capital and prevent problems from
becoming bigger problems.And when we do have problems,
then it really helps our recovery.So, our asset management group,
(04:21):
it's about 160 people and that's acrossall asset classes and probably 40
or so are dedicated to corporate credit,
but we have a lot of people in realestate and an asset-based finance and so
forth.
But it's really a big partof the philosophy of how Fortress is set up and we've
been that way since inception and wethink that that shows up when you look at
our recovery rates and ultimately ourcredit losses have been quite low and we
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think that's a big reason why.
Find that I think when you just lookat our CLO business in particular,
and I think this is particularlydifferent with our broadly syndicated loan
business,
is that we use CLOs as a financingtool and this is just how we've used it
across the platform. So,
what that means is that we retain 100%of the equity and I think that's in
middle market loans or middlemarket CLOs, that's pretty common.
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For broadly syndicated loans,
it's a lot less common and I think that'ssomething that creates an alignment of
interest between the debtholders and the manager,
which on a benign credit environment,
honestly it probably doesn'tmatter all that much,
but when things are really bad it doesmatter. And certainly when I was managing
the CLO portfolio at JP Morgan,
we saw a lot of behavioral differencesduring the '08-'09 period and some of
(05:24):
that I think can be ascribed to that.
So, you guys have diversified portfoliosof private credit loans or broadly
syndicated loans around your platformand you want to add leverage to
increase your return.
And I guess the two options areyou can either do a securitization
CLO or you can just borrow from a bank,
(05:45):
and you guys do both I presume.
Yeah, that's right.
And I think this is really more ofa question for middle market loans.
I think while bank financing doesexist for broadly syndicated loans,
most of the time back financing involvesmark to market and oftentimes recourse.
For example, in totalreturn swap facilities.
And we really don't like touse that kind of financing.
We don't like mark-to-marketand we don't like recourse. So,
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for broadly syndicated loans,
there aren't too many otheralternatives other than CLOs.
For middle market CLOs,
I think you have a very robust bankfinancing market and a pretty robust CLO
market and I think thereare pros and cons of each.
I actually think the two markets arepretty symbiotic and we can talk a little
bit about how it's differentand how we think about them.
So, it sounds like youroptions for broadly syndicated loans are you're doing a
(06:30):
securitization,
you're doing a CLO for the leveragethere and for private credit that's where
you have the two options going to a bank.
That's right. And when you thinkabout it, for middle market CLOs,
the advantages there are you're gettingterm financing for the assets so you're
really match funding your assets andliabilities. It's non-mark-to-market.
And the financing is, I think,
more stable than the bank financing ifany of the assets have problems. So,
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in other words, you don't haveto re-equitize the portfolio.
I think some of the drawbacks of middlemarket CLOs are that you do tend to have
more constraints on the portfolioand there's less flexibility.
And one of the outcomes of that is thatthe position size is you can have in
those facilities are smaller.
I think when you contrastthat with the bank facilities,
the advantages are that they dotend to be a bit more flexible,
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so not quite as many constraints.Oftentimes you don't need ratings,
although you may want them anyway onthe assets in terms of getting credit
estimates and that sort of thing,
you can have larger position sizes andoverall less portfolio constraints. I
think the disadvantages are that youoften need asset by asset approval,
which you don't need in CLOs.
And if you do have creditissues with particular loans,
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and an example of that would be like ifleverage increases by a certain amount
or if there's a material modification tothe loan as it's defined in the credit
agreement, then you may needto put in more equity. So,
that's one consideration.
And also I think these facilities tendto give you less leverage than you would
get in a middle market CLO. But Ithink the bottom line is for us,
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we really think there's room forboth and they are somewhat symbiotic.
So for example,
you can create capacity in your bankfacilities by term financing some of the
loans into CLOs and then you canreload the bank facility. So,
we really use the two together.
So,
a lot of times it's a bank financingto start and then once you've ramped up
a significant portfolio,
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you term it out with a CLO and thenyou can start again with a bank line of
credit.
That's right.
And something that's a little differentabout how we structure our middle market
CLOs, I'm not sure if anyother manager does this,
but we like to have a revolverfor a portion of our AAAs. So,
it's usually around 30% of our AAAs arestructured as a revolver and that allows
us to use the CLO a little more like abank facility and we can keep dry powder.
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It becomes less costly for us if we don'twant to remain fully invested and we
never want to be in a position where wekind of have a gun to our head where we
have to be fully investedat any given time.
So this gives us a little moreflexibility to avoid that.
Are the financing rates comparablebetween the two markets?
It really depends on what time you'retalking about. At this particular time,
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the CLO market is significantlyless expensive than the bank market,
but that can change.
There are times when the CLO market ismore expensive or that the CLO market
might be either in brief periods of timewhen it can become pretty dislocated
and it might not be possibleto do a new issue deal,
but the bank market might be open. So,
I think the bank spreads tend to movearound a little more slowly than the CLO
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market does.
CUSIP buyers tend to be a lot morereactionary to like macro events and other
market movements.
A CUSIP buyer is a CLO investorbecause they're buying a security with
that unique identifier?
That's right.
Okay. So when you finance yourpool, your private credit pool,
either it's a CLO and the CLO has anindenture that sets out all the rules of
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the CLO upfront.
And as long as your portfolio isin compliance with all the rules,
you're reinvesting and you'repaying distributions and the CLO is
working as you would expect, or you can,
contrasting that with the bank facility,
there's actually a human being that'sapproving the loans that go in.
You're dealing with an organization,
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you might not necessarily have the samefixed set of rules and maybe they'll be
a little bit less predictable in howthey act depending on the economic
conditions in themarket. Is that accurate?
Yeah, I think that's avery fair characterization. I'll give you an example.
If we're originating a new loan and wewant to figure out how much capacity we
have for it, for the CLOs,it's pretty formulaic.
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You can figure out pretty quickly howmuch of a loan you can put in a particular
CLO, whereas in a bank facility, you needto do the "mother may I" with a bank,
and they have to do a credit review andusually they can turn it around pretty
quickly. But dependingon the counterparty,
sometimes it takes longer than others.
I should mention that there are some bankfacilities that employ what they call
a 'box structure', which actually ismore rule-based and more like a CLO,
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but in terms of what you can put in there,
it does tend to be a bit more limited.So, having the asset approval,
in some ways you could think ofit as being more restrictive,
but in a lot of ways it can alsogive you more flexibility. So,
that might enable you to get financingon a loan that you wouldn't be able to
finance in a CLO becauseof some unique feature. So,
we've always found that there is roomfor both and there are advantages to both
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and it's important to have bothtypes of financing available,
but definitely puts and takes with each.
Do you feel like banks are veryactive today, they want this business,
they're looking to growtheir balance sheets?
Absolutely.
I think the common theme from thedifferent bank financing groups that I've
spoken with going into this year,
it seemed like everyonehad pretty ambitious growth targets where they might be
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looking to as much as double theirloan book, which is pretty significant.
And I think that makes sense.
Having worked at a bank or at banksfor basically the rest of my career,
there are some reasonswhy that would make sense.
I think from a capital perspective,these bank facilities are very,
very efficient because they getto use securitization treatment,
which really lowers,
get to hold a minimum amountof capital against these loans.
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And I think that from a creditperspective it is extremely safe.
The spreads are quite highbecause it's in loan form,
they don't really have toworry about mark-to-market,
so it doesn't attract VAR capital. Soreally it ticks a lot of boxes for them.
So when you think about all the differentbank businesses and what they might be
trying to grow or pull back,
it seems like this business is onethat every bank seems to want to grow,
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at least that I've talked to.
Well, it seems like it's a good deal forbanks because when a credit defaults,
for example, in private credit,
aren't you guys required to remove theloan from the facility and replace it
with a new loan?
Not necessarily to remove the loan,
but oftentimes we'd have to re-equitizeit and at least at a minimum there's a
conversation.
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Certainly in some facilities it mightfall out of the borrowing base completely.
At a minimum there's goingto be discussion about the valuation and you might be
required to revalue the asset and thatwill have an impact on the borrowing base
or maybe a discussion onthe advance rates. So,
it definitely gives the bank a seat atthe table and they would basically take
some action that if they owneda similar exposure in a CLO,
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they wouldn't be able to take.
So, I guess from the bank's perspective,I mean if they owned one of the loans,
the private credit loansdirectly on their balance sheet,
they would earn a higher spread,
but the amount of capital they'd haveto reserve for that loan would be quite
penalitive.
Whereas if they're lending against apool of loans and a manager like you has
put up the junior capital,the capital most at-risk,
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then maybe if the bank impliessome high credit rating and very
little capital reserved, that'sbasically why they like this business.
Yeah, that's basically it.
It might be something on the order offive times as much capital they'd have to
hold against the loanoutright versus a loan. So,
I think the risk waiting on theloan is something like 20% unless my
information's stale,
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which it might be at this point versusa hundred percent for the loan outright.
Oh wow, okay. Quite a difference. So,
my understanding is you guys recentlystarted selling private credit or middle
market equity to third parties.What was behind that decision?
So, we really started thinking about it.
I think it was probably a conversationwith you as a matter of fact,
(14:08):
but I think we really view this asjust another way to raise a separate
account.
So,
instead of raising LP dollars,
we raise CLO equity and thenthat becomes a standalone
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fund. And then the loans for thatfund get financed by a CLO. So,
first a warehouse andthen ultimately a CLO. So,
we're just viewing this as another wayto raise funds to do the exact same thing
that we've been doing since 2002.
Got it. So, from the perspectiveof a CLO equity investor,
one of the things thatwe debate quite a bit,
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and maybe I'll ask you your opinion forboth broadly syndicated loans and for
private credit,
but it's just that if you look atbroadly syndicated loan portfolio in
a CLO, you're going to seespreads over SOFR from 3% to maybe
3.3 or 3.4% at the high end.
And the higher spread given theleverage in the CLO throws off a lot of
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incremental cashflow tothe equity. So is Fortress,
would you be like a lower spread managerin broadly syndicated or average or
high?
We'd be at the high end of that.
I think if you look at third partydealer research and a lot of them publish
statistics about this, you'll see ourspreads probably among the highest.
Okay. So, do you thinkbroadly syndicated loans,
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it's an inefficient market and youcan pick up the incremental spread
without taking on more risk?
Or is there something that I'm givingup by going wa ith a higher spread
manager or is it freeincremental return to the equity?
So,
we don't think that higher spreadsnecessarily imply higher loan
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losses. It might have some implicationfor liquidity on the underlying loans,
and we can talk a little bitmore about that. But basically,
when we go through our broadlysyndicated loan investment process,
we go through a prettydetailed and rigorous process,
really the same process for broadlysyndicated and middle market loans. So,
it's a pretty high bar toget into our portfolios,
and I think that's why if you look atour diversity scores for the broadly
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syndicated loans, you'll see they'relower than the rest of the market.
We probably average around60 or low sixties versus low to mid-80s maybe for the
rest of the market. So,
one thing I would say is that we'renot indexers and we tend to be pretty
deliberate and when we findsomething we like, we lean in.
I think we tend to like to haveexposure or we have a larger exposure to
smaller issuers.And there are a few reasons for that. One,
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we feel like we get more control overdocumentation and better deal structures,
but I think the smaller dealsoften come with higher spread.
So I think we actually find that thoseloans are actually better protected.
So maybe it would lead to lowerlosses, not higher losses.
And I think this is where our investmentand asset management resources comes in
because that really helpskeep our losses low.
(17:02):
Our loss rates for broadly syndicatedloans have averaged around,
this is over a 16 year period orsomething. It's around 10 basis points.
So we haven't seen higher loss rates.
I think that when I wasinvesting in CLO tranches,
that was one of the firstthings I would look at.
If I saw higher spread portfolio,
I would want to look into it more so Ican understand why people would point to
(17:22):
that. I think that you could argue thatliquidity is lower maybe for our broadly
syndicated loan portfolios.And I think in a very liquid,
well-functioning market,
I think we found liquidity to beplenty sufficient for our portfolios.
We probably turn over ourportfolios less than most managers.
If you wanted to turn yourportfolio over three times a year,
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it'd be probably harder todo that with our portfolios.
But I think we found that when we wantto move out of assets for relative value
reasons or whatever, wehaven't any problem doing that. In a dislocated market,
everything's illiquid, soit doesn't really matter.
Even the most benchmarkbroadly syndicated loan. So,
that's our perspective on it, butothers may have a different view.
But I think that's probablywhat I would point to.
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The experience I've had with thehigher spread managers, by the way,
is that if I rewind the clock to say 2018,
when I started investing in CLO equityat Flat Rock. For broadly syndicated,
back then LIBOR was the base rate andthere were portfolios anywhere from
LIBOR plus 330 to LIBOR plus 400 at the
(18:24):
high end. And then when COVIDhit the loans defaulted,
a lot of them were really thehigh spread loans. And so,
coming out of COVID, I thinkbroadly syndicated CLO managers,
really a lot of them just really justchanged their business and became middle
of the run to more conservative spreadmanagers just because of how that played
(18:46):
out for them during COVID.So then, let's switch to private credit.
So, in private credit,
there's portfolios of loansfrom at the low end SOFR
plus four and three quartersall the way up to SOFR plus six.
Where would you guys play inthat spectrum, I guess first?
Yeah, I'd say if you looked atour existing middle market CLOs,
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it's probably closer to, SOFR plus six,
if you looked at for new loansthat we're putting on right now,
it's probably 500 to 550.That's more the market.
But I think for middle market loans,
there are I think more segments of themiddle market than you would really find
in the broadly syndicated loan.So for middle market loans,
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there's the upper end of that market,
which really overlaps a lot withthe broadly syndicated market.
And I think the deals are bigger.
The deal structures look a lotlike broadly syndicated loans,
A lot of 'em are covenant lite.
We tend not to participate thereother than very infrequently. So,
we tend to focus more on the core middlemarket and we define that as 25 to a
hundred million of EBITDA.So across our portfolios,
(19:52):
the median EBITDA is around 60 million.
And we've found that spaceto be a little bit less
competitive and the pricingis a little bit better,
and we tend to get better covenants anddeal structures that we like and things
that we find pretty important.So,
that's one reason why ifyou compare our portfolio
to a manager that's focused more onthe upper end of the middle market,
(20:14):
our spreads are going to be higher.
Some managers focus more on unitrancheloans and that's their origination
strategy. We'll do that from time totime, but that's not really our focus.
Those loans tend to carry higherleverage and higher spreads.
Spreads tend to be all overthe map with a middle market.
The other thing I would say is, and thisis different for different managers,
so for anyone listening,
if you're looking at investing inmiddle market CLOs for the first time,
(20:36):
and I remember going through thisprocess when I was at JP Morgan,
it's a little daunting to try to getyour arm around what does this sector and
where do managers fit andhow do you look at everybody?
But one thing that you could focus on is,
does a manager focus on sponsored dealsand non-sponsored deals? And there are
some managers that will only do one orthe other, and there are merits to both.
We do both. We're probably 70%sponsored, 30% non-sponsored.
(20:59):
We actually like the non-sponsoreddeals a lot because you tend to have a
borrower that's a littlebit less sophisticated and that allows you to get paid
more.
You have better deal structures andbetter documentation and lower leverage.
So you tend to have less problems,but they're a lot harder to originate.
It's a lot easier tooriginate the sponsored deals.
And if a credit has a problem, ifit's a temporary liquidity problem,
(21:21):
sponsors typically going to put in morecapital to bridge a temporary liquidity
gap, or at least that's something thatwe get to the table, it's the borrower,
the sponsor, and the lender can getto the table and work something out.
And you don't really have that degreeof freedom as much in the non-sponsored
deals. But if the fundamentalcredit picture has changed,
you're not going to expect to see asponsor to throw good money after bad. So,
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we don't take as much comfortin that as maybe others might.
Okay,
so we're expecting the fed to cut byanother 25 [points] before the year
ends. Is that going to affectyour business in any way?
So, I think our view on this, andwe talk about this a lot internally,
a rate cut would be froma credit perspective,
and I guess there'sthe credit piece of it,
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and then there's the market pieceof it. So the credit piece of it,
I think a rate cut is maybe marginallyhelpful for some of the older vintage
loans, so think pre-2022,
but for the ones that are stilloutstanding and over levered at issuance,
but I think at this point, most of thosestructures have already been addressed.
So,
we don't think that that's going to haveas much of a credit impact other than
(22:25):
just at the margin.
But we do think that this couldcreate less demand from floating rate
investors and that may reduceretail inflows into loan funds and
BDCs. So,
I'm thinking more about both broadlysyndicate and middle market loans.
But I think this could help balancethe supply and demand picture. I mean,
currently right now we see that there isreally too much capital chasing too few
(22:47):
loans, so that might help balancethe equation a little bit.
And I think lower rates might alsohelp support an increase in M&A and LBO
activity. So,
it's possible the lower rates will helpstabilize spreads by putting the supply
and demand more in balance. Sothat's a theory we're not sure,
but it's certainly ascenario. We can only hope.
I would describe it likethis - in CLO equity,
(23:09):
if you take your model and you plug inthe constant, SOFR and you never cut it,
you get more cash flowsout of the deal, for sure.
But in a rate cutting environment, one,
we're already modelingwith the SOFR curve,
so we've already budgeted for the factthat rates are expected to come down. So,
already included, alreadybaked in. And then, yeah,
I mean I'm hopeful that a lowerSOFR will lead to marginally
(23:33):
lower defaults and well,you use the word marginally,
but marginally matters for CLO equity.
Small differences in defaultrate can make a difference.
And then also I think that, yeah,
if people rotate out of floating rateinvestments into something fixed,
yes, hopefully the dynamic of it'llbe less dollars chasing loans.
(23:54):
Hopefully that'll mean widerloan spreads, better documents.
I don't know what that does for the CLOfinancing side of the equation though.
That might move wider too.
Certainly for insurance companies,
some of the rate sensitive buyersthat could impact mezzanine demand,
probably less so for banks, butthat's certainly a possibility.
When you started at JP Morgan, was thatyour first direct interaction with CLOs?
(24:19):
I would say my firstinteraction with CLOs,
it was really CBOs at the time was atCiti or at Salomon Brothers and I had done
some different things there.I had done investment banking,
asset backed finance, and then Ifound my way into, at the time,
what was a fledgling CBO business. Andthat was back in, gosh, I guess 1998.
And then I left there and went to MorganStanley where I was there for eight or
(24:41):
nine years in the CDO business.
So really it was since '98 thatI've been in and around this market.
When you started looking at CLOs,
what's one thing that maybe surprisedyou or that you found interesting?
I think it's the importanceof alignment of interests.
At Fortress when we're making loans,it's something we talk about a lot.
And I remember, and this reallyhappened when I was at JP Morgan,
(25:03):
and I remember this, I don't wantto name the names of managers,
but I saw during the financial crisis,
managers doing some things that werereally maybe a little questionable,
certainly from the debtholder perspective.
I remember there was one manager thattook advantage of some drafting loophole
in a waterfall.
It was just sloppy drafting that wasburied somewhere in the indenture that
nobody looked at. And it basically allowedthe manager to erode subordination.
(25:27):
And when I asked the managerabout it, they said, well,
we think it's important to keepour management fee stream going,
otherwise we can't manage the portfolio.
And that was sort ofeyeopening to me like, wow,
there are some other motivations herethat you really need to think about. So,
there have been some other thingslike that that have come up,
but I think really it's thinking aboutthe motivations of the different parties
and why are people doing what they'redoing. That was sort of interesting.
(25:49):
When I first started investing in CLOequity, I guess this was like 2013,
so a little bit over a decade ago,I also came across a drafting error.
And the error was the indenturebasically permitted unlimited
reinvestment after the reinvestmentperiod ended. And for a CLO 1.0,
so a pre GFC CLO, they hadthis amazing financing costs.
(26:14):
Oh my God, they probably had LIBORplus 25 AAAs or something like that.
So, that was it.
And so their game was they wanted tokeep the CLO outstanding as long as
possible, and that's forthe benefit of the equity.
But the language was just clearlymisdrafted in the indenture.
And there was another part of theindenture that contradicted the unlimited
(26:35):
reinvest,
and the manager chose to interpret theindenture in the way that was favorable
to the equity, and we owned thatequity and that was beneficial to us.
But then the CLO AAA investor who'son the other side of this trade and
desperately wants to getrepaid as quickly as possible,
they reached out to the managerand they said, Hey, one,
(26:56):
we might hire a lawyer and we canfigure it out in court. And two,
if you want to issue CLOs againand you want us to play in your
deals,
then you should really interpret thisin a way that's definitely not equity.
That was, I think, a compellingpoint to the manager.
And that's the way this indenturereading ultimately got resolved.
(27:20):
Yep. I've been involved in all differentpermutations of those conversations.
What else is topical in your business? Imean, I think rate cuts is the big one,
but it sounds like yourportfolios are performing well,
I'll tell you across private credit,I think it's good performance,
but defaults are certainly elevatedversus last year and we run
(27:41):
a 2% default rate through allof our modeling assumptions.
I think that's the market standard.
I think for most private creditit'll be above that this year.
How do you seek the overallconditions in private credit?
Yeah, it's interesting. When Iwas thinking about what's topical,
I was actually thinking about somethings that are happening in a broadly
syndicated loan market. But Iguess within middle market credit,
(28:04):
I think we're probablyexpecting defaults to increase,
but really to get tomore normalized levels,
I don't think we're expecting anyreal massive default spike or anything
like that. But I think where there's alot more differentiation in performance,
what we expect is in thebroadly syndicated loan market,
and probably the thing that has been mosttopical and a lot of investors I talk
(28:24):
to are always asking about this arethe liability management exercises.
And that's really a domain ofthe broadly syndicated loans.
You don't really see that happeningin middle market credit for different
reasons, but basically forthose not familiar with it,
the liability management exercises,
it's basically an out ofcourt restructuring with asymmetric treatment for
different lenders.So,
basically what's happening is you wouldsee a company come to some liquidity
(28:48):
problem, probably syndicated loansthat trade in the open market,
maybe they start trading down.
A private equity sponsor is lookingto maybe capture some of that economic
discount or benefit for themselvesand some restructurings imminent.
And so they work out a deal with someof the lenders to maybe provide more
capital in exchange for maybe gettingsome fees rolling up their debt in
(29:09):
a more favorable way thatcan increase their recovery.
And ultimately what that translatesto is maybe a 30 to 50 point
difference in some cases in ultimaterecovery between the members of the
steering committee or the ad hoc groupand the folks that are not in that group.
So, we found it really, really importantto be proactive in those situations,
and fortunately we have the resourcesto deal with that. I think another
(29:32):
differentiating feature of Fortress, sowe have a dedicated restructuring team.
We've probably been involved in adozen or a little more LMEs and we've
been on the steering committee or thead hoc group. And I think all but one,
and I think our outcomeshave been quite good. So,
it's something that we're pretty proud of.
And I think when someoneasks the question, well,
how do you see defaults in broadlysyndicated loans playing out maybe for the
(29:54):
balance of the year or the next 12 months?
I'm not sure that defaults are necessarilygoing to be all that different,
but recoveries we think could be a lotdifferent between different managers.
And sometimes I getphone calls from folks,
managers and maybe I dealt with in aprior life that have heard that we're
involved in some restructuring processand can I put them in touch? And if
they're calling me, then that'sthe sign of desperation. So,
(30:17):
I think that's something that'spretty interesting right now,
and it's a dynamic I hadn't seenbefore, and when I first heard about it,
I was like, wow, I didn't knowthis sort of thing could happen.
Our restructuring guy,
if you ask him about it and he will talkyour ear off for hours, he loves it.
Our team there is really wonderful.I sit one row away from him,
and basically my litmus test for howactive that market is is the decibel level
(30:38):
that comes from that row, and it'sbeen pretty high recently. So,
the other thing that I think is topicalreally has to do with the arbitrage. So,
for broadly syndicated loans, I think itis particularly challenging right now,
and it's really drivenby the low loan supply.
And I think the same thing ishappening for middle market loans.
I was talking to the global headof middle market origination today,
and I just was curious like, Hey, areyou seeing supply pick up? And he said,
(31:00):
well, actually we areseeing supply pick up,
but the supply we're seeing is not thatgreat. But in terms of deal structures,
leverage, and the companiesthat are trying to borrow money,
and I think it really boils down to afunction of loan supply and what the
market will bear.
So, hopefully there's a naturalcorrection there where if the
profitability of CLOs forming isn't high,
(31:20):
hopefully it attracts less capital andhopefully that pushes the loan prices
wider as CLOs are buying mostof these loans anyways. So,
there is that self-correcting mechanism.That's not going to happen overnight,
but hopefully that's how it works.
Typically, that's how it works.
It's gone much more slowly rightnow than it typically does,
(31:41):
but hopefully the correctionmechanism will take place.
Do you think the reason the market's alittle bit out of whack in terms of the
difference between where the loans paythe spread over SOFR versus the CLOs
financing costs, is that justbecause if I get spread compression,
it's fine if it's on both sides,
if I lose some on the assets and Ipay less on liabilities, that's okay,
(32:04):
but is it just there's moredemand for loans and less demand
for CLO debt securities? I guess I'mjust not sure why that would be the case.
I've wondered the samequestion because yeah,
you would think in an environment thatyou would have more demand for CLO
securities and then the arbitrage getsmore in line and then everything works.
I don't know the answer to that.
(32:25):
I suspect part of the reason mighthave to do with all the refi and reset
activities.
So all the deals done inlate 2022 and 2023 in a much
wider spread environment for thosedeals to get refied and reset,
you're increasing the supply of CLOpaper without needing the loan supply to
fill it. And so,
that may be something that has createdsomewhat of a floor on CLO spreads and
(32:48):
prevented the arbitrage fromgetting more in line. Just a guess.
So, as a CLO manager,
one of your roles is when you're forminga CLO to choose the bank that you're
going to work with, howdo you think about that?
How are some of the banksdifferentiated in your mind?
I think distribution is one element.
Some banks tend to be alittle more flexible than others are more accommodating
(33:11):
when it comes to financing or if youare putting a warehouse in place and
something comes up, you needto extend it or whatever.
Certain counterparties tend to bea little more flexible than others.
I think for somethinglike middle market CLOs,
some banks have a lot more experiencethan others and just have a better call
into investors.
Yeah. So, there's only four orfive banks in private credit CLOs.
(33:34):
Pretty much. Most of the peopleall came from the same bank.
And then broadly syndicated,it's the whole street.
It's 15 different arrangers or something.
The other thing, and thisis more unique to us,
but I think I mentioned earlier in thepodcast that when we do our middle market
CLOs, we like to have a portion ofthe AAA structure as a revolver. So,
the underwriting bankwould typically take that.
(33:56):
And among the banks thatare good underwriters,
good placement agentsfor middle market CLOs,
only a subset of those can also takethe revolver and revolvers are pretty
punitive for banks. So,
it's understandable that they wouldn'tnecessarily want to take them.
Nobody wants to own a revolver, includingmyself. We're not doing revolvers.
(34:17):
Yeah, we don't like 'em either.
And John, my closing question isalways describe as CLO in 30 seconds.
Alright,
so I thought that was actually a reallythoughtful question and it took me a lot
more than 30 seconds to think aboutthis. So let me give it a shot.
I would think of a CLOas a simple bank. So,
a CLO is making hundreds of loans tobelow investment grade companies and
(34:38):
financing them with CLO notes. So,
A CLO is really a structured vehiclethat bundles together loans and sells the
pieces to different tranches, eachwith different risks and economics. So,
the below investment grade tranchescarry the most risk and pay the highest
spreads, and then on the other end,
the AAA tranches carry the least amountof risk and pay the lowest spreads. So,
(34:58):
by doing this segregation,
this allows the loan portfolio to bebroken up into pieces that fit the
risk-return objectives of differenttypes of buyers. So, then the equity,
the very bottom of the capital structure,
earns the difference between what theloan portfolio earns and what's paid to
the different debt tranches. Notsure how I did with the timing,
but pretty close.
Well, John, thanks so muchfor coming on the podcast.
(35:19):
Really enjoyed our conversation.
Me too. Thanks so much forhaving me. This is great.
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
(35:43):
FLATROCK Global Fund definition section.
Payment in kind or pick refers to a typeof loan or financial instrument where
interest or dividends are paidin a form other than cash,
such as additional debt orequity rather than in cash.
A covenant refers to a legally bindingpromise or lender protection written into
a loan agreement securedovernight financing rate.
(36:05):
SOFR is a broad measure of thecost of borrowing cash overnight,
collateralized by treasury securities.
The global financial crisis GFC was aperiod of extreme stress in the global
financial markets and bankingsystems between mid 2007 and early
2009.
Credit ratings are opinions aboutcredit risk for long-term issues or
(36:27):
instruments. The ratings lie in aspectrum ranging from the highest credit
quality on one end todefault or junk on the other.
A AAA is the highestcredit quality AC or a D.
Depending on the agency, the ratingis the lowest or junk quality.
Leveraged loans are corporate loans tocompanies that are not rated investment
(36:47):
grade broadly. Syndicated loansare underwritten by banks,
rated by nationally recognized statisticalratings organizations and often
traded among market participants.
Middle market loans are usuallyunderwritten by several lenders with the
intention of holding theinstrument through its maturity.
Spread is the percentage difference incurrent yields of various classes of
(37:08):
fixed income securities versus treasurybonds or another benchmark bond measure.
A reset is a refinancing andextension of A CLO investment.
EBITDA is earnings before interest,taxes, depreciation, and amortization.
An add-back would attempt to adjustEBITDA for non-recurring items. Libor,
the London Interbank offerrate was replaced by SOFR on
(37:30):
June 30th, 2024. Dele means reducingthe amount of debt financing.
High yield bonds are corporate borrowingsrated below investment grade that are
usually fixed rate and unsecureddefault refers to missing a contractual
interest or principal payment.
Debt has contractual interestprinciple and interest payments,
whereas equity representsownership in a company.
(37:51):
Senior secured corporateloans are borrowings from a company that are backed by
collateral.
Junior debt ranks behind seniorsecured debt in its payment priority.
Collateral pool refers to the sum ofcollateral pledge to a lender to support
its repayment.
A on-call refers to the time in whicha debt instrument cannot be optionally
repaid.
(38:13):
A floating rate investment has an interestrate that varies with the underlying
floating rate.
Our residential mortgage backedsecurities loan to value is a ratio that
compares the loan amount to theenterprise value of a company.
LG is a firm that sets up callsbetween investors and industry experts.
A risk retention fund is a third partyfund raised by CLO managers to comply
(38:36):
with the CLO risk retention rules.
The US LO risk retention rule wasintroduced in 2014 under the Dodd-Frank
Wall Street Reform and ConsumerProtection Act requiring CLO managers to
retain not less than 5% of the creditrisk associated with each of their C ls.
In 2018,
the US risk retention requirementreversed for managers after being
(39:00):
successfully challenged in court.
E stands for liabilitymanagement exercises,
which are strategies often used bysponsors or select lenders to restructure
debt obligations of distressed companiesin order to avoid traditional default
proceedings.
Flatrock may invest in CLOsmanaged by podcast guests. However,
(39:21):
the views expressed in this podcastare those of the guest and do not
necessarily reflect the viewsof Flatrock 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,
and all listeners should consider theseprojections as hypothetical and subject
(39:42):
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 discussions are based on US marketsand US monetary and fiscal policies.
(40:06):
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 theFlat Rock Global speaker are those of
the speaker as of the dateof the broadcast and do not necessarily represent the
view of the firm as a whole. Any suchviews are subject to change at any time
(40:27):
based upon market or other conditions.
And Flatrock Global Disclaims anyresponsibility to update such views.
This material is not intended to berelied upon as a forecast, research,
or investment advice.
It is not a recommendation offer orsolicitation to buy or sell any securities
or to adopt any investment strategy.
Neither Flat Rock Global nor the FlatRock Global Speaker can be responsible for
(40:51):
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 any investmentrelated course of action,
as neither Flatrock Global norits affiliates are undertaking.
To provide impartial investment advice,
act as an impartial advisor or giveadvice in a fiduciary capacity.
(41:14):
Additional information about this podcastalong with an edited transcript may be
obtained by visiting flatrock global.com.
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 newsin the CLO industry and I interview key market players.
Today I'm speaking with Jonathan Horowitz,
(00:26):
partner and head of StructuredLiabilities at Fortress Investment Group.
Jonathan is a 30 year veteran of theCLO market and his role at Fortress
encompasses ranging CLOs andfinancing lines for his firm loan
portfolios. We discussed pros andcons of using bank leverage for CLOs,
credit trends, and broadlysyndicated and private credit loans,
(00:49):
and the lack of new issueloan supply in general.
We also discuss the effect offed rate cuts on our business.
If you're enjoying the podcast, pleaseremember to share like and follow.
And now my conversationwith Jonathan Horowitz.
(01:09):
Jonathan, welcome to the podcast.
Thank you very much. Thanks for having me.
So,
why don't we start off withyour background and how you ended up at Fortress.
Sure. So, I'm a partner at Fortress andI'm Head of Structured Liabilities. So,
what that means is I'm really responsiblefor the financing of a large portion
of our credit assets.
CLOs have been a major strategic fundingtool for us for the last 20 plus years,
(01:33):
and I spent a lot of my time managingthe capital market side of our CLO
business. Prior to Fortress,
I was a portfolio manager in JP Morgan'schief investment office and I was
responsible for the CLO andConsumer ABS portfolios,
which in aggregate was about $45 billionat the time. Prior to JP Morgan's,
I ran Morgan Stanley's CDO CapitalMarkets desk and I coheaded the CDO
(01:54):
structuring and origination businessand I started my career at Salomon
Brothers. And if you'reold enough to remember,
but Salomon Brothers was apredecessor to Citigroup,
so I've been in the structure creditmarkets for probably the last 30 or so
years.
So, tell me about Fortress.
What do you have in terms of businesslines and assets under management?
So Fortress is a $53 billionasset alternative credit
(02:18):
manager. So, we have a prettydiversified credit business.
A lot of our activity is incorporate credit and real estate,
but we also do a lotin asset based finance.
We have a litigation finance businessand an intellectual property business and
a number of other things. So,
I think one of the key things that'sdifferent about our firm is that we're
really not beholden to any one sectorand it makes it easy for us to pivot when
(02:38):
we see better relative valuein one sector versus another.
And how do you see Fortress as beingdifferentiated from peers in the
broadly syndicated loan businessor the private credit business?
It's a good question. So,
I think there are a few things that area little different about how we're set
up. So, the first thing is whenyou think about our CLO business,
(02:58):
we have the same credit team for ourbroadly syndicated loans and our middle
market credit. So,
basically the way we're set up isthat the analysts are organized,
the credit underwriters organizedby industry vertical. So,
within each industry vertical,
they cover all parts ofthe capital structure and broadly syndicated and middle
market credit. So,
liquid and illiquid credit in allparts of the capital structure.
(03:19):
And we do that deliberatelyfor a couple of reasons. One,
what we found is that it really helpsus make better relative value decisions
when we're seeing everything.
And the other thing is that we findthat there are some benefits from
information flow.
So what happens with middle market creditis that you tend to get reporting much
more frequently.So,
it's typically on a monthly basis andsometimes even more frequent than that.
(03:40):
And a lot of times some of the insightsthat we get can really help inform some
trends that will help us make betterdecisions on our broadly syndicated loans
where we're maybe not gettinginformation quite as frequently. So,
that's one way in which we're different.
I think another thing that's differentis that we have made a really big
investment in what we callour asset management group.
(04:00):
And this is a group that really touchesthe loans after we make them on a
regular basis,
stays in touch with the borrowers andreally helps manage our downside risk and
take proactive measures. Whenwe do see problems coming,
helps us to take measures to protectour capital and prevent problems from
becoming bigger problems.And when we do have problems,
then it really helps our recovery.So, our asset management group,
(04:21):
it's about 160 people and that's acrossall asset classes and probably 40
or so are dedicated to corporate credit,
but we have a lot of people in realestate and an asset-based finance and so
forth.
But it's really a big partof the philosophy of how Fortress is set up and we've
been that way since inception and wethink that that shows up when you look at
our recovery rates and ultimately ourcredit losses have been quite low and we
(04:42):
think that's a big reason why.
Find that I think when you just lookat our CLO business in particular,
and I think this is particularlydifferent with our broadly syndicated loan
business,
is that we use CLOs as a financingtool and this is just how we've used it
across the platform. So,
what that means is that we retain 100%of the equity and I think that's in
middle market loans or middlemarket CLOs, that's pretty common.
(05:02):
For broadly syndicated loans,
it's a lot less common and I think that'ssomething that creates an alignment of
interest between the debtholders and the manager,
which on a benign credit environment,
honestly it probably doesn'tmatter all that much,
but when things are really bad it doesmatter. And certainly when I was managing
the CLO portfolio at JP Morgan,
we saw a lot of behavioral differencesduring the '08-'09 period and some of
(05:24):
that I think can be ascribed to that.
So, you guys have diversified portfoliosof private credit loans or broadly
syndicated loans around your platformand you want to add leverage to
increase your return.
And I guess the two options areyou can either do a securitization
CLO or you can just borrow from a bank,
(05:45):
and you guys do both I presume.
Yeah, that's right.
And I think this is really more ofa question for middle market loans.
I think while bank financing doesexist for broadly syndicated loans,
most of the time back financing involvesmark to market and oftentimes recourse.
For example, in totalreturn swap facilities.
And we really don't like touse that kind of financing.
We don't like mark-to-marketand we don't like recourse. So,
(06:07):
for broadly syndicated loans,
there aren't too many otheralternatives other than CLOs.
For middle market CLOs,
I think you have a very robust bankfinancing market and a pretty robust CLO
market and I think thereare pros and cons of each.
I actually think the two markets arepretty symbiotic and we can talk a little
bit about how it's differentand how we think about them.
So, it sounds like youroptions for broadly syndicated loans are you're doing a
(06:30):
securitization,
you're doing a CLO for the leveragethere and for private credit that's where
you have the two options going to a bank.
That's right. And when you thinkabout it, for middle market CLOs,
the advantages there are you're gettingterm financing for the assets so you're
really match funding your assets andliabilities. It's non-mark-to-market.
And the financing is, I think,
more stable than the bank financing ifany of the assets have problems. So,
(06:54):
in other words, you don't haveto re-equitize the portfolio.
I think some of the drawbacks of middlemarket CLOs are that you do tend to have
more constraints on the portfolioand there's less flexibility.
And one of the outcomes of that is thatthe position size is you can have in
those facilities are smaller.
I think when you contrastthat with the bank facilities,
the advantages are that they dotend to be a bit more flexible,
(07:15):
so not quite as many constraints.Oftentimes you don't need ratings,
although you may want them anyway onthe assets in terms of getting credit
estimates and that sort of thing,
you can have larger position sizes andoverall less portfolio constraints. I
think the disadvantages are that youoften need asset by asset approval,
which you don't need in CLOs.
And if you do have creditissues with particular loans,
(07:36):
and an example of that would be like ifleverage increases by a certain amount
or if there's a material modification tothe loan as it's defined in the credit
agreement, then you may needto put in more equity. So,
that's one consideration.
And also I think these facilities tendto give you less leverage than you would
get in a middle market CLO. But Ithink the bottom line is for us,
(07:56):
we really think there's room forboth and they are somewhat symbiotic.
So for example,
you can create capacity in your bankfacilities by term financing some of the
loans into CLOs and then you canreload the bank facility. So,
we really use the two together.
So,
a lot of times it's a bank financingto start and then once you've ramped up
a significant portfolio,
(08:18):
you term it out with a CLO and thenyou can start again with a bank line of
credit.
That's right.
And something that's a little differentabout how we structure our middle market
CLOs, I'm not sure if anyother manager does this,
but we like to have a revolverfor a portion of our AAAs. So,
it's usually around 30% of our AAAs arestructured as a revolver and that allows
us to use the CLO a little more like abank facility and we can keep dry powder.
(08:41):
It becomes less costly for us if we don'twant to remain fully invested and we
never want to be in a position where wekind of have a gun to our head where we
have to be fully investedat any given time.
So this gives us a little moreflexibility to avoid that.
Are the financing rates comparablebetween the two markets?
It really depends on what time you'retalking about. At this particular time,
(09:02):
the CLO market is significantlyless expensive than the bank market,
but that can change.
There are times when the CLO market ismore expensive or that the CLO market
might be either in brief periods of timewhen it can become pretty dislocated
and it might not be possibleto do a new issue deal,
but the bank market might be open. So,
I think the bank spreads tend to movearound a little more slowly than the CLO
(09:22):
market does.
CUSIP buyers tend to be a lot morereactionary to like macro events and other
market movements.
A CUSIP buyer is a CLO investorbecause they're buying a security with
that unique identifier?
That's right.
Okay. So when you finance yourpool, your private credit pool,
either it's a CLO and the CLO has anindenture that sets out all the rules of
(09:46):
the CLO upfront.
And as long as your portfolio isin compliance with all the rules,
you're reinvesting and you'repaying distributions and the CLO is
working as you would expect, or you can,
contrasting that with the bank facility,
there's actually a human being that'sapproving the loans that go in.
You're dealing with an organization,
(10:08):
you might not necessarily have the samefixed set of rules and maybe they'll be
a little bit less predictable in howthey act depending on the economic
conditions in themarket. Is that accurate?
Yeah, I think that's avery fair characterization. I'll give you an example.
If we're originating a new loan and wewant to figure out how much capacity we
have for it, for the CLOs,it's pretty formulaic.
(10:30):
You can figure out pretty quickly howmuch of a loan you can put in a particular
CLO, whereas in a bank facility, you needto do the "mother may I" with a bank,
and they have to do a credit review andusually they can turn it around pretty
quickly. But dependingon the counterparty,
sometimes it takes longer than others.
I should mention that there are some bankfacilities that employ what they call
a 'box structure', which actually ismore rule-based and more like a CLO,
(10:53):
but in terms of what you can put in there,
it does tend to be a bit more limited.So, having the asset approval,
in some ways you could think ofit as being more restrictive,
but in a lot of ways it can alsogive you more flexibility. So,
that might enable you to get financingon a loan that you wouldn't be able to
finance in a CLO becauseof some unique feature. So,
we've always found that there is roomfor both and there are advantages to both
(11:16):
and it's important to have bothtypes of financing available,
but definitely puts and takes with each.
Do you feel like banks are veryactive today, they want this business,
they're looking to growtheir balance sheets?
Absolutely.
I think the common theme from thedifferent bank financing groups that I've
spoken with going into this year,
it seemed like everyonehad pretty ambitious growth targets where they might be
(11:39):
looking to as much as double theirloan book, which is pretty significant.
And I think that makes sense.
Having worked at a bank or at banksfor basically the rest of my career,
there are some reasonswhy that would make sense.
I think from a capital perspective,these bank facilities are very,
very efficient because they getto use securitization treatment,
which really lowers,
get to hold a minimum amountof capital against these loans.
(12:00):
And I think that from a creditperspective it is extremely safe.
The spreads are quite highbecause it's in loan form,
they don't really have toworry about mark-to-market,
so it doesn't attract VAR capital. Soreally it ticks a lot of boxes for them.
So when you think about all the differentbank businesses and what they might be
trying to grow or pull back,
it seems like this business is onethat every bank seems to want to grow,
(12:22):
at least that I've talked to.
Well, it seems like it's a good deal forbanks because when a credit defaults,
for example, in private credit,
aren't you guys required to remove theloan from the facility and replace it
with a new loan?
Not necessarily to remove the loan,
but oftentimes we'd have to re-equitizeit and at least at a minimum there's a
conversation.
(12:42):
Certainly in some facilities it mightfall out of the borrowing base completely.
At a minimum there's goingto be discussion about the valuation and you might be
required to revalue the asset and thatwill have an impact on the borrowing base
or maybe a discussion onthe advance rates. So,
it definitely gives the bank a seat atthe table and they would basically take
some action that if they owneda similar exposure in a CLO,
(13:03):
they wouldn't be able to take.
So, I guess from the bank's perspective,I mean if they owned one of the loans,
the private credit loansdirectly on their balance sheet,
they would earn a higher spread,
but the amount of capital they'd haveto reserve for that loan would be quite
penalitive.
Whereas if they're lending against apool of loans and a manager like you has
put up the junior capital,the capital most at-risk,
(13:26):
then maybe if the bank impliessome high credit rating and very
little capital reserved, that'sbasically why they like this business.
Yeah, that's basically it.
It might be something on the order offive times as much capital they'd have to
hold against the loanoutright versus a loan. So,
I think the risk waiting on theloan is something like 20% unless my
information's stale,
(13:47):
which it might be at this point versusa hundred percent for the loan outright.
Oh wow, okay. Quite a difference. So,
my understanding is you guys recentlystarted selling private credit or middle
market equity to third parties.What was behind that decision?
So, we really started thinking about it.
I think it was probably a conversationwith you as a matter of fact,
(14:08):
but I think we really view this asjust another way to raise a separate
account.
So,
instead of raising LP dollars,
we raise CLO equity and thenthat becomes a standalone
(14:31):
fund. And then the loans for thatfund get financed by a CLO. So,
first a warehouse andthen ultimately a CLO. So,
we're just viewing this as another wayto raise funds to do the exact same thing
that we've been doing since 2002.
Got it. So, from the perspectiveof a CLO equity investor,
one of the things thatwe debate quite a bit,
(14:52):
and maybe I'll ask you your opinion forboth broadly syndicated loans and for
private credit,
but it's just that if you look atbroadly syndicated loan portfolio in
a CLO, you're going to seespreads over SOFR from 3% to maybe
3.3 or 3.4% at the high end.
And the higher spread given theleverage in the CLO throws off a lot of
(15:15):
incremental cashflow tothe equity. So is Fortress,
would you be like a lower spread managerin broadly syndicated or average or
high?
We'd be at the high end of that.
I think if you look at third partydealer research and a lot of them publish
statistics about this, you'll see ourspreads probably among the highest.
Okay. So, do you thinkbroadly syndicated loans,
(15:36):
it's an inefficient market and youcan pick up the incremental spread
without taking on more risk?
Or is there something that I'm givingup by going wa ith a higher spread
manager or is it freeincremental return to the equity?
So,
we don't think that higher spreadsnecessarily imply higher loan
(15:57):
losses. It might have some implicationfor liquidity on the underlying loans,
and we can talk a little bitmore about that. But basically,
when we go through our broadlysyndicated loan investment process,
we go through a prettydetailed and rigorous process,
really the same process for broadlysyndicated and middle market loans. So,
it's a pretty high bar toget into our portfolios,
and I think that's why if you look atour diversity scores for the broadly
(16:19):
syndicated loans, you'll see they'relower than the rest of the market.
We probably average around60 or low sixties versus low to mid-80s maybe for the
rest of the market. So,
one thing I would say is that we'renot indexers and we tend to be pretty
deliberate and when we findsomething we like, we lean in.
I think we tend to like to haveexposure or we have a larger exposure to
smaller issuers.And there are a few reasons for that. One,
(16:42):
we feel like we get more control overdocumentation and better deal structures,
but I think the smaller dealsoften come with higher spread.
So I think we actually find that thoseloans are actually better protected.
So maybe it would lead to lowerlosses, not higher losses.
And I think this is where our investmentand asset management resources comes in
because that really helpskeep our losses low.
(17:02):
Our loss rates for broadly syndicatedloans have averaged around,
this is over a 16 year period orsomething. It's around 10 basis points.
So we haven't seen higher loss rates.
I think that when I wasinvesting in CLO tranches,
that was one of the firstthings I would look at.
If I saw higher spread portfolio,
I would want to look into it more so Ican understand why people would point to
(17:22):
that. I think that you could argue thatliquidity is lower maybe for our broadly
syndicated loan portfolios.And I think in a very liquid,
well-functioning market,
I think we found liquidity to beplenty sufficient for our portfolios.
We probably turn over ourportfolios less than most managers.
If you wanted to turn yourportfolio over three times a year,
(17:42):
it'd be probably harder todo that with our portfolios.
But I think we found that when we wantto move out of assets for relative value
reasons or whatever, wehaven't any problem doing that. In a dislocated market,
everything's illiquid, soit doesn't really matter.
Even the most benchmarkbroadly syndicated loan. So,
that's our perspective on it, butothers may have a different view.
But I think that's probablywhat I would point to.
(18:03):
The experience I've had with thehigher spread managers, by the way,
is that if I rewind the clock to say 2018,
when I started investing in CLO equityat Flat Rock. For broadly syndicated,
back then LIBOR was the base rate andthere were portfolios anywhere from
LIBOR plus 330 to LIBOR plus 400 at the
(18:24):
high end. And then when COVIDhit the loans defaulted,
a lot of them were really thehigh spread loans. And so,
coming out of COVID, I thinkbroadly syndicated CLO managers,
really a lot of them just really justchanged their business and became middle
of the run to more conservative spreadmanagers just because of how that played
(18:46):
out for them during COVID.So then, let's switch to private credit.
So, in private credit,
there's portfolios of loansfrom at the low end SOFR
plus four and three quartersall the way up to SOFR plus six.
Where would you guys play inthat spectrum, I guess first?
Yeah, I'd say if you looked atour existing middle market CLOs,
(19:10):
it's probably closer to, SOFR plus six,
if you looked at for new loansthat we're putting on right now,
it's probably 500 to 550.That's more the market.
But I think for middle market loans,
there are I think more segments of themiddle market than you would really find
in the broadly syndicated loan.So for middle market loans,
(19:30):
there's the upper end of that market,
which really overlaps a lot withthe broadly syndicated market.
And I think the deals are bigger.
The deal structures look a lotlike broadly syndicated loans,
A lot of 'em are covenant lite.
We tend not to participate thereother than very infrequently. So,
we tend to focus more on the core middlemarket and we define that as 25 to a
hundred million of EBITDA.So across our portfolios,
(19:52):
the median EBITDA is around 60 million.
And we've found that spaceto be a little bit less
competitive and the pricingis a little bit better,
and we tend to get better covenants anddeal structures that we like and things
that we find pretty important.So,
that's one reason why ifyou compare our portfolio
to a manager that's focused more onthe upper end of the middle market,
(20:14):
our spreads are going to be higher.
Some managers focus more on unitrancheloans and that's their origination
strategy. We'll do that from time totime, but that's not really our focus.
Those loans tend to carry higherleverage and higher spreads.
Spreads tend to be all overthe map with a middle market.
The other thing I would say is, and thisis different for different managers,
so for anyone listening,
if you're looking at investing inmiddle market CLOs for the first time,
(20:36):
and I remember going through thisprocess when I was at JP Morgan,
it's a little daunting to try to getyour arm around what does this sector and
where do managers fit andhow do you look at everybody?
But one thing that you could focus on is,
does a manager focus on sponsored dealsand non-sponsored deals? And there are
some managers that will only do one orthe other, and there are merits to both.
We do both. We're probably 70%sponsored, 30% non-sponsored.
(20:59):
We actually like the non-sponsoreddeals a lot because you tend to have a
borrower that's a littlebit less sophisticated and that allows you to get paid
more.
You have better deal structures andbetter documentation and lower leverage.
So you tend to have less problems,but they're a lot harder to originate.
It's a lot easier tooriginate the sponsored deals.
And if a credit has a problem, ifit's a temporary liquidity problem,
(21:21):
sponsors typically going to put in morecapital to bridge a temporary liquidity
gap, or at least that's something thatwe get to the table, it's the borrower,
the sponsor, and the lender can getto the table and work something out.
And you don't really have that degreeof freedom as much in the non-sponsored
deals. But if the fundamentalcredit picture has changed,
you're not going to expect to see asponsor to throw good money after bad. So,
(21:44):
we don't take as much comfortin that as maybe others might.
Okay,
so we're expecting the fed to cut byanother 25 [points] before the year
ends. Is that going to affectyour business in any way?
So, I think our view on this, andwe talk about this a lot internally,
a rate cut would be froma credit perspective,
and I guess there'sthe credit piece of it,
(22:05):
and then there's the market pieceof it. So the credit piece of it,
I think a rate cut is maybe marginallyhelpful for some of the older vintage
loans, so think pre-2022,
but for the ones that are stilloutstanding and over levered at issuance,
but I think at this point, most of thosestructures have already been addressed.
So,
we don't think that that's going to haveas much of a credit impact other than
(22:25):
just at the margin.
But we do think that this couldcreate less demand from floating rate
investors and that may reduceretail inflows into loan funds and
BDCs. So,
I'm thinking more about both broadlysyndicate and middle market loans.
But I think this could help balancethe supply and demand picture. I mean,
currently right now we see that there isreally too much capital chasing too few
(22:47):
loans, so that might help balancethe equation a little bit.
And I think lower rates might alsohelp support an increase in M&A and LBO
activity. So,
it's possible the lower rates will helpstabilize spreads by putting the supply
and demand more in balance. Sothat's a theory we're not sure,
but it's certainly ascenario. We can only hope.
I would describe it likethis - in CLO equity,
(23:09):
if you take your model and you plug inthe constant, SOFR and you never cut it,
you get more cash flowsout of the deal, for sure.
But in a rate cutting environment, one,
we're already modelingwith the SOFR curve,
so we've already budgeted for the factthat rates are expected to come down. So,
already included, alreadybaked in. And then, yeah,
I mean I'm hopeful that a lowerSOFR will lead to marginally
(23:33):
lower defaults and well,you use the word marginally,
but marginally matters for CLO equity.
Small differences in defaultrate can make a difference.
And then also I think that, yeah,
if people rotate out of floating rateinvestments into something fixed,
yes, hopefully the dynamic of it'llbe less dollars chasing loans.
(23:54):
Hopefully that'll mean widerloan spreads, better documents.
I don't know what that does for the CLOfinancing side of the equation though.
That might move wider too.
Certainly for insurance companies,
some of the rate sensitive buyersthat could impact mezzanine demand,
probably less so for banks, butthat's certainly a possibility.
When you started at JP Morgan, was thatyour first direct interaction with CLOs?
(24:19):
I would say my firstinteraction with CLOs,
it was really CBOs at the time was atCiti or at Salomon Brothers and I had done
some different things there.I had done investment banking,
asset backed finance, and then Ifound my way into, at the time,
what was a fledgling CBO business. Andthat was back in, gosh, I guess 1998.
And then I left there and went to MorganStanley where I was there for eight or
(24:41):
nine years in the CDO business.
So really it was since '98 thatI've been in and around this market.
When you started looking at CLOs,
what's one thing that maybe surprisedyou or that you found interesting?
I think it's the importanceof alignment of interests.
At Fortress when we're making loans,it's something we talk about a lot.
And I remember, and this reallyhappened when I was at JP Morgan,
(25:03):
and I remember this, I don't wantto name the names of managers,
but I saw during the financial crisis,
managers doing some things that werereally maybe a little questionable,
certainly from the debtholder perspective.
I remember there was one manager thattook advantage of some drafting loophole
in a waterfall.
It was just sloppy drafting that wasburied somewhere in the indenture that
nobody looked at. And it basically allowedthe manager to erode subordination.
(25:27):
And when I asked the managerabout it, they said, well,
we think it's important to keepour management fee stream going,
otherwise we can't manage the portfolio.
And that was sort ofeyeopening to me like, wow,
there are some other motivations herethat you really need to think about. So,
there have been some other thingslike that that have come up,
but I think really it's thinking aboutthe motivations of the different parties
and why are people doing what they'redoing. That was sort of interesting.
(25:49):
When I first started investing in CLOequity, I guess this was like 2013,
so a little bit over a decade ago,I also came across a drafting error.
And the error was the indenturebasically permitted unlimited
reinvestment after the reinvestmentperiod ended. And for a CLO 1.0,
so a pre GFC CLO, they hadthis amazing financing costs.
(26:14):
Oh my God, they probably had LIBORplus 25 AAAs or something like that.
So, that was it.
And so their game was they wanted tokeep the CLO outstanding as long as
possible, and that's forthe benefit of the equity.
But the language was just clearlymisdrafted in the indenture.
And there was another part of theindenture that contradicted the unlimited
(26:35):
reinvest,
and the manager chose to interpret theindenture in the way that was favorable
to the equity, and we owned thatequity and that was beneficial to us.
But then the CLO AAA investor who'son the other side of this trade and
desperately wants to getrepaid as quickly as possible,
they reached out to the managerand they said, Hey, one,
(26:56):
we might hire a lawyer and we canfigure it out in court. And two,
if you want to issue CLOs againand you want us to play in your
deals,
then you should really interpret thisin a way that's definitely not equity.
That was, I think, a compellingpoint to the manager.
And that's the way this indenturereading ultimately got resolved.
(27:20):
Yep. I've been involved in all differentpermutations of those conversations.
What else is topical in your business? Imean, I think rate cuts is the big one,
but it sounds like yourportfolios are performing well,
I'll tell you across private credit,I think it's good performance,
but defaults are certainly elevatedversus last year and we run
(27:41):
a 2% default rate through allof our modeling assumptions.
I think that's the market standard.
I think for most private creditit'll be above that this year.
How do you seek the overallconditions in private credit?
Yeah, it's interesting. When Iwas thinking about what's topical,
I was actually thinking about somethings that are happening in a broadly
syndicated loan market. But Iguess within middle market credit,
(28:04):
I think we're probablyexpecting defaults to increase,
but really to get tomore normalized levels,
I don't think we're expecting anyreal massive default spike or anything
like that. But I think where there's alot more differentiation in performance,
what we expect is in thebroadly syndicated loan market,
and probably the thing that has been mosttopical and a lot of investors I talk
(28:24):
to are always asking about this arethe liability management exercises.
And that's really a domain ofthe broadly syndicated loans.
You don't really see that happeningin middle market credit for different
reasons, but basically forthose not familiar with it,
the liability management exercises,
it's basically an out ofcourt restructuring with asymmetric treatment for
different lenders.So,
basically what's happening is you wouldsee a company come to some liquidity
(28:48):
problem, probably syndicated loansthat trade in the open market,
maybe they start trading down.
A private equity sponsor is lookingto maybe capture some of that economic
discount or benefit for themselvesand some restructurings imminent.
And so they work out a deal with someof the lenders to maybe provide more
capital in exchange for maybe gettingsome fees rolling up their debt in
(29:09):
a more favorable way thatcan increase their recovery.
And ultimately what that translatesto is maybe a 30 to 50 point
difference in some cases in ultimaterecovery between the members of the
steering committee or the ad hoc groupand the folks that are not in that group.
So, we found it really, really importantto be proactive in those situations,
and fortunately we have the resourcesto deal with that. I think another
(29:32):
differentiating feature of Fortress, sowe have a dedicated restructuring team.
We've probably been involved in adozen or a little more LMEs and we've
been on the steering committee or thead hoc group. And I think all but one,
and I think our outcomeshave been quite good. So,
it's something that we're pretty proud of.
And I think when someoneasks the question, well,
how do you see defaults in broadlysyndicated loans playing out maybe for the
(29:54):
balance of the year or the next 12 months?
I'm not sure that defaults are necessarilygoing to be all that different,
but recoveries we think could be a lotdifferent between different managers.
And sometimes I getphone calls from folks,
managers and maybe I dealt with in aprior life that have heard that we're
involved in some restructuring processand can I put them in touch? And if
they're calling me, then that'sthe sign of desperation. So,
(30:17):
I think that's something that'spretty interesting right now,
and it's a dynamic I hadn't seenbefore, and when I first heard about it,
I was like, wow, I didn't knowthis sort of thing could happen.
Our restructuring guy,
if you ask him about it and he will talkyour ear off for hours, he loves it.
Our team there is really wonderful.I sit one row away from him,
and basically my litmus test for howactive that market is is the decibel level
(30:38):
that comes from that row, and it'sbeen pretty high recently. So,
the other thing that I think is topicalreally has to do with the arbitrage. So,
for broadly syndicated loans, I think itis particularly challenging right now,
and it's really drivenby the low loan supply.
And I think the same thing ishappening for middle market loans.
I was talking to the global headof middle market origination today,
and I just was curious like, Hey, areyou seeing supply pick up? And he said,
(31:00):
well, actually we areseeing supply pick up,
but the supply we're seeing is not thatgreat. But in terms of deal structures,
leverage, and the companiesthat are trying to borrow money,
and I think it really boils down to afunction of loan supply and what the
market will bear.
So, hopefully there's a naturalcorrection there where if the
profitability of CLOs forming isn't high,
(31:20):
hopefully it attracts less capital andhopefully that pushes the loan prices
wider as CLOs are buying mostof these loans anyways. So,
there is that self-correcting mechanism.That's not going to happen overnight,
but hopefully that's how it works.
Typically, that's how it works.
It's gone much more slowly rightnow than it typically does,
(31:41):
but hopefully the correctionmechanism will take place.
Do you think the reason the market's alittle bit out of whack in terms of the
difference between where the loans paythe spread over SOFR versus the CLOs
financing costs, is that justbecause if I get spread compression,
it's fine if it's on both sides,
if I lose some on the assets and Ipay less on liabilities, that's okay,
(32:04):
but is it just there's moredemand for loans and less demand
for CLO debt securities? I guess I'mjust not sure why that would be the case.
I've wondered the samequestion because yeah,
you would think in an environment thatyou would have more demand for CLO
securities and then the arbitrage getsmore in line and then everything works.
I don't know the answer to that.
(32:25):
I suspect part of the reason mighthave to do with all the refi and reset
activities.
So all the deals done inlate 2022 and 2023 in a much
wider spread environment for thosedeals to get refied and reset,
you're increasing the supply of CLOpaper without needing the loan supply to
fill it. And so,
that may be something that has createdsomewhat of a floor on CLO spreads and
(32:48):
prevented the arbitrage fromgetting more in line. Just a guess.
So, as a CLO manager,
one of your roles is when you're forminga CLO to choose the bank that you're
going to work with, howdo you think about that?
How are some of the banksdifferentiated in your mind?
I think distribution is one element.
Some banks tend to be alittle more flexible than others are more accommodating
(33:11):
when it comes to financing or if youare putting a warehouse in place and
something comes up, you needto extend it or whatever.
Certain counterparties tend to bea little more flexible than others.
I think for somethinglike middle market CLOs,
some banks have a lot more experiencethan others and just have a better call
into investors.
Yeah. So, there's only four orfive banks in private credit CLOs.
(33:34):
Pretty much. Most of the peopleall came from the same bank.
And then broadly syndicated,it's the whole street.
It's 15 different arrangers or something.
The other thing, and thisis more unique to us,
but I think I mentioned earlier in thepodcast that when we do our middle market
CLOs, we like to have a portion ofthe AAA structure as a revolver. So,
the underwriting bankwould typically take that.
(33:56):
And among the banks thatare good underwriters,
good placement agentsfor middle market CLOs,
only a subset of those can also takethe revolver and revolvers are pretty
punitive for banks. So,
it's understandable that they wouldn'tnecessarily want to take them.
Nobody wants to own a revolver, includingmyself. We're not doing revolvers.
(34:17):
Yeah, we don't like 'em either.
And John, my closing question isalways describe as CLO in 30 seconds.
Alright,
so I thought that was actually a reallythoughtful question and it took me a lot
more than 30 seconds to think aboutthis. So let me give it a shot.
I would think of a CLOas a simple bank. So,
a CLO is making hundreds of loans tobelow investment grade companies and
(34:38):
financing them with CLO notes. So,
A CLO is really a structured vehiclethat bundles together loans and sells the
pieces to different tranches, eachwith different risks and economics. So,
the below investment grade tranchescarry the most risk and pay the highest
spreads, and then on the other end,
the AAA tranches carry the least amountof risk and pay the lowest spreads. So,
(34:58):
by doing this segregation,
this allows the loan portfolio to bebroken up into pieces that fit the
risk-return objectives of differenttypes of buyers. So, then the equity,
the very bottom of the capital structure,
earns the difference between what theloan portfolio earns and what's paid to
the different debt tranches. Notsure how I did with the timing,
but pretty close.
Well, John, thanks so muchfor coming on the podcast.
(35:19):
Really enjoyed our conversation.
Me too. Thanks so much forhaving me. This is great.
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
(35:43):
FLATROCK Global Fund definition section.
Payment in kind or pick refers to a typeof loan or financial instrument where
interest or dividends are paidin a form other than cash,
such as additional debt orequity rather than in cash.
A covenant refers to a legally bindingpromise or lender protection written into
a loan agreement securedovernight financing rate.
(36:05):
SOFR is a broad measure of thecost of borrowing cash overnight,
collateralized by treasury securities.
The global financial crisis GFC was aperiod of extreme stress in the global
financial markets and bankingsystems between mid 2007 and early
2009.
Credit ratings are opinions aboutcredit risk for long-term issues or
(36:27):
instruments. The ratings lie in aspectrum ranging from the highest credit
quality on one end todefault or junk on the other.
A AAA is the highestcredit quality AC or a D.
Depending on the agency, the ratingis the lowest or junk quality.
Leveraged loans are corporate loans tocompanies that are not rated investment
(36:47):
grade broadly. Syndicated loansare underwritten by banks,
rated by nationally recognized statisticalratings organizations and often
traded among market participants.
Middle market loans are usuallyunderwritten by several lenders with the
intention of holding theinstrument through its maturity.
Spread is the percentage difference incurrent yields of various classes of
(37:08):
fixed income securities versus treasurybonds or another benchmark bond measure.
A reset is a refinancing andextension of A CLO investment.
EBITDA is earnings before interest,taxes, depreciation, and amortization.
An add-back would attempt to adjustEBITDA for non-recurring items. Libor,
the London Interbank offerrate was replaced by SOFR on
(37:30):
June 30th, 2024. Dele means reducingthe amount of debt financing.
High yield bonds are corporate borrowingsrated below investment grade that are
usually fixed rate and unsecureddefault refers to missing a contractual
interest or principal payment.
Debt has contractual interestprinciple and interest payments,
whereas equity representsownership in a company.
(37:51):
Senior secured corporateloans are borrowings from a company that are backed by
collateral.
Junior debt ranks behind seniorsecured debt in its payment priority.
Collateral pool refers to the sum ofcollateral pledge to a lender to support
its repayment.
A on-call refers to the time in whicha debt instrument cannot be optionally
repaid.
(38:13):
A floating rate investment has an interestrate that varies with the underlying
floating rate.
Our residential mortgage backedsecurities loan to value is a ratio that
compares the loan amount to theenterprise value of a company.
LG is a firm that sets up callsbetween investors and industry experts.
A risk retention fund is a third partyfund raised by CLO managers to comply
(38:36):
with the CLO risk retention rules.
The US LO risk retention rule wasintroduced in 2014 under the Dodd-Frank
Wall Street Reform and ConsumerProtection Act requiring CLO managers to
retain not less than 5% of the creditrisk associated with each of their C ls.
In 2018,
the US risk retention requirementreversed for managers after being
(39:00):
successfully challenged in court.
E stands for liabilitymanagement exercises,
which are strategies often used bysponsors or select lenders to restructure
debt obligations of distressed companiesin order to avoid traditional default
proceedings.
Flatrock may invest in CLOsmanaged by podcast guests. However,
(39:21):
the views expressed in this podcastare those of the guest and do not
necessarily reflect the viewsof Flatrock 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,
and all listeners should consider theseprojections as hypothetical and subject
(39:42):
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 discussions are based on US marketsand US monetary and fiscal policies.
(40:06):
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 theFlat Rock Global speaker are those of
the speaker as of the dateof the broadcast and do not necessarily represent the
view of the firm as a whole. Any suchviews are subject to change at any time
(40:27):
based upon market or other conditions.
And Flatrock Global Disclaims anyresponsibility to update such views.
This material is not intended to berelied upon as a forecast, research,
or investment advice.
It is not a recommendation offer orsolicitation to buy or sell any securities
or to adopt any investment strategy.
Neither Flat Rock Global nor the FlatRock Global Speaker can be responsible for
(40:51):
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 any investmentrelated course of action,
as neither Flatrock Global norits affiliates are undertaking.
To provide impartial investment advice,
act as an impartial advisor or giveadvice in a fiduciary capacity.
(41:14):
Additional information about this podcastalong with an edited transcript may be
obtained by visiting flatrock global.com.
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