#5 Tom Davidson, Managing Editor, Creditflux

Shiloh Bates shares his conversation with Tom Davidson, Managing Editor of Creditflux, in the fifth episode of The CLO Investor. Among other topics, Shiloh talks to Tom about CLO education, current opportunities in the CLO market, and CLO equity risk adjusted returns.

Episode Transcript

(00:04):
- Hi, I'm Shiloh Bates
and welcome to the CLO Investor Podcast.
CLO stands for CollateralizedLoan obligations,
which are securities backedby pools of leverage loans.
In this podcast, we discuss current news
and the CLO industry,
and I interview key market players

(00:26):
On May 15th.
I attended the Credit FluxCLO symposium in London.
Credit Flux is one of the papersof record, the CLO industry
and their annual conferencein London is always for me,
a must attend event.
It was great to see lots of familiar faces
and the panel guestswere really top notch.

(00:48):
Some of the themes of theconference were the rise
of middle market CLOs anddeclining CLO LO financing rates.
Usually my podcast is meinterviewing other market
participants, but in thisepisode I'm posting a fireside
chat I did at the conference
with Credit Flux Managingdirector Tom Davidson.

(01:09):
Credit Flux also has a podcastthat I'd highly recommend.
It's called The Last Tranche,
and I was a guest there a while back.
Some of the topics wediscussed were CLO education,
current opportunities in the CLO market
and CLO equity risk adjusted returns,
which I emphasize are more important

(01:32):
to me than total returns.
And now my conversation with Tom Davidson.
- Welcome, Shiloh.
Before we get going on the fireside chat,
maybe if you just wanna introduce
yourself with your main job.
- Hi everybody, I'm Shiloh Bates.
I'm the CIO of Flat Rock Global.
We manage about a billion of a UM

(01:53):
and we focus on CLOequity and CLO double Bs.
And then within those two assetclasses we have a preference
for middle market CLOs, as you know.
- Great. Now for those of you
who called the first firesidechat, my colleague Lisa Lee
and Jane Lee, Lisa anteon us by announcing
that Jane is an award winningdocumentary film producer.

(02:15):
Luckily enough, Shiloh also has a
sge, which is as an author.
I've got a copy of his book here.
We also have a few morecopies if anyone's interested.
This is CLO investing withan emphasis on CO equity
and double B notes.
So maybe we should talka bit about the book.
Why did you decide to become an author?
- There's a saying that it'sgreat to have written a book,

(02:36):
but it's not great to be writing a book.
The genesis though, really isin 2020 I had some free time
on my hands and so Iwrote a 60 page just kind
of like manual
or the way I go about approachinginvesting in CLO equity.
And we put that on our website.
I was really surprised athow many people read it

(02:58):
and my competitors mentionedit to me, CLO managers
and people that were just kind
of interested in the space, they read it.
And so that gave me theidea to just go ahead
and do the bigger book.
It's about 220 pages,
but a lot of what's writtenin the book is stuff
that I'm constantly as partof my job educating investors.

(03:18):
And so some slides from ourpitch decks are in the book.
I'm frequently answering their one-off
questions for investors.
And so I came up with theoutline for how I wanted
to tell the story of CLOs.
And at the end of the day,
there's really like maybe four concepts
that make CLOs differentfrom other asset classes.
So I would agree it's not as,especially in equity, it's not

(03:43):
as straightforward asinvesting in a high yield bond
or a leveraged loan directlyor certainly a stock.
If you wanna learn about CLO LO equity
and Double Bs, one optionis a book obviously,
but if you didn't dothat, you can spend a lot
of time googling and findingdifferent articles and like,
and you can kind of put togetherthe information you need.
But the idea with the bookwas to put it all as kind

(04:03):
of like a OneStop shop for your CLO needs.
- And it's an amazing read if you
haven't had a chance to read it.
As I say, we have a fewcopies, it's come out,
so come and find us.
I think one of the interestingthings is obviously you wrote
this a few years ago now,
the market's changed pretty dramatically
in a lot of ways since then.
What would you change now?
What do you wish you'd written in the book

(04:24):
- In the segment aboutdouble Bs in the book,
I make the point that if theMVOC, so if the market value
of all the loans in theportfolio plus the cash, that if
that does not cover the fullbalance of the CLOs debt,
triple A to double B, thatmeans you have an MVOC
of less than a hundred percent.
So it might be 98 or99, something like that.

(04:46):
And a point that I made in the book was
that you can very comfortablybuy bonds that are not covered
and still expect a par payout.
And the reason really is twofold.
So one is that if theloans don't perform well,
the CLO will not pay the equity
and that profitabilitywill be trapped in the CLO
and ultimately that willbenefit the double B.

(05:10):
But then the other part of it was just
that the loan index was tradingat discount of the levels.
And so at the end of the day,loans are either worth par
or they default and get some recovery,
but there's no in between.
That's kind of the binary thing.
And our view was that mostloans trading at discounts,
it was really a function ofheightened risks in the market,

(05:31):
political risks, economic risks,
and that at the end of the day,
there would definitelynot be enough defaults
to really impair a lot of the double Bs.
That part has actually paidout, I think very few double Bs.
Definitely very few have defaulted.
I would expect very fewto default in the future,
but today a double B that's not covered
by its fair market value given

(05:53):
how much loans have traded up,
is a much higher risksituation than it would've been
last year at this time.
- Great. You are obviouslyvery passionate about this
investor education piece.
I know as well as the book,you have a new podcast as well.
I have a podcast as well.Welcome for the space.
It's always great to seesome competitors joining in,

(06:13):
but tell me about the podcast.
- The new podcast iscalled the CLO Investor.
And basically in the firstepisode I just talk a little bit,
I do a CLO 1 0 1
and just talk about the marketto establish that foundation
for people who need it.
And then in the second podcastI interview a colleague,
we talk about our strategy in the market
and what we find interesting.
The third and fourth podcast,which we will drop soon,

(06:36):
one is an interview with David Williams,
who's a CLO banker atScotia, who I know you know.
And then Evo Turk Jiv is abroadly syndicated CLO manager at
New Mountain Capital.
From the perspective of writing the book
and the podcast, I try toapproach it as from the angle
of somebody who's aninvestor in the space,
and I hope people will find it beneficial.

(06:59):
As you know, once you figureout how to be a podcaster,
when you have good guestson, they do all the work.
You just have to think of the questions
that they do all the talking,and then you talk for an hour
and then hopefully it's aquality product that people like.
- Absolutely. Let's get stuck into the
equity investing side.
And I think one of the thingswhich I find interesting is
it's actually quite hard to unpick

(07:20):
for people looking at equity investing.
How well is CLO equityperforming as an asset
and how much is added onby the alpha from managers?
And I think this is somethingyou've done some work on as
- Well.
Yeah, so one of the things
that we put together startingabout four years ago was a CLO
equity index.
And it's available onour website, it's public.

(07:40):
If you invest in any of thedebt securities, double B
to aaa, JP Morgan hasgreat indices for that.
Palmer Square does as well.
And on any day you can see,oh, how did double Bs do today
or single as whateveryou're interested in.
But with equity you really can't do that
because there's just notenough trades in the market.
So what our idea was inputting together the CLO equity

(08:04):
index was to take informationfrom what's called public
filers in the us.
And so I'm a public filer myself, meaning
that every quarter I tell our investors,
these are all the CLO equity pieces I own.
This is where I mark them at 3 31 or 1231.
I have a number ofcompetitors who do the same.

(08:25):
And so if you know thatsomebody owned 10 million
of a specific CLO security
and they had it marked, you know,
at this price a quarter ago
and this price now you justkind of need to figure out
what was the payment receivedon the equity in the interim.
And you can calculatea return in that way.
And so our index constructionbasically matches a Cliff

(08:45):
water direct lending index.
They kinda do the same analogy
or the same methodology
where you're looking at otherpublic filers, figuring out
what they owned, what thespecific return was in quarter.
And I feel really good about the results
because all those marks are marks
that are coming from managers
who are registered investment advisors.

(09:06):
So there's a lot ofregulation, it's not just a,
people really thought about the mark,
it's not just somethingthat just came at thin air.
That's kind of the regulatory setup there.
And so we're able to markabout 500 different CLO equity
tranches using this methodology.
And one of the thingsthat's not ideal about it is

(09:26):
that I have to wait toput the index together.
So for 3 31, so for March31st, I don't know yet
what the CLO equity return was.
I need to wait for everybodyto file with the SEC.
And that takes 60 daysfor for a lot of folks.
But if you look at the index,one thing, the returns really
for the last few yearshave looked very good.

(09:47):
So last year, CLO equity did 22%,
which I think people werepretty excited about.
And then if you look at kind
of like a three yearannualized rate, it's about 12.
And if you go back fiveyears, it's like nine.
So the more recent performance
of CLO equity has been the better.
- I think it's interesting you can compare

(10:09):
and contrast that withon the credit flux side,
we track fund performancea lot of CLO equity funds.
And as you say, lastyear, I mean I guess all
of the returns were above 20%.
And that makes sense now becausealmost anything you bought
would've delivered that be equally,
some investors are producingreturns much higher than that,
more than that, youknow, 30%, I think some

(10:30):
of them were hitting 40%.
So clearly there is alsoa lot of alpha you can add
as an equity investor as well.
- Yeah, so the way I think about it
and how we approach thingsat Fire Rock is it's not,
your awards are a total return award.
And how I think about it is we're going
for the best risk adjusted returns.
So a lot of times at FireRock, we're looking at

(10:52):
CLO equity pieces
or double Bs
where we think the outcomewill be very favorable
and the return opportunitiesare quite high.
But there's also just anamount of risk that goes along
with the securitiesthat just kind of above
and beyond what our investorswould want to sign up for.
So internally we wouldlook at some of these deals
and say, oh, you know, that'ssomething I would do in in my

(11:14):
PA if I could.
But it's not something we'redoing with shareholder money.
And so like what we try to do in equity is
to provide a low doubledigit net return to investors
with a high focus onreducing the downside risk.
I'm guessing that forpeople who hit a 30% return
for last year, they probably, the trade

(11:35):
to get there would've been tobuy single BS at a discount
or equity that was potentiallya risk of missing payments.
And both of those would'veworked out to your point.
But investors in those fundsare signing up for a level
of potential volatility that mine are not.
- So turning to your investorhat away from the education
hat, what'd you like at the

(11:56):
moment out there? What are you buying?
- We have really, since theinception of Fire Rock CLO,
middle market equity iskind of like the core of
what we've been focused onat the beginning of the year.
We saw some pretty interestingopportunities there.
And you know,
in the last two months we'veseen some middle market
issuance, but therereally hasn't been a ton

(12:17):
of new loan creation in the middle market.
And so that's been ahindrance to CLO issuance.
And then we've also seen recently
that sometimes the managertakes all the equity themselves
and they even take the double B sometimes,
which is another security
that we would want if they would sell it.
And so a lot of the recent issues
or issuances have been middle market CLO

(12:39):
where the securities offered are triple A
to single A or triple B.
That's not where I'm playing.
The two things that reallywe've liked about middle market
equity and continue to like our one,
the natural arbitrage in thedeals, it's more favorable,
there's more profit in the CLO,
you get higher cashdistributions each quarter one.

(13:00):
And then through thisconference today, a lot of
what panelists have beentalking about are a liability
management exercisesand low loan recoveries.
Well, these are not really anissue in the middle market.
So in the middle market,it's private market,
there's no distressed hedgefunds buying the loan.
And the secondary, if theloan does get into issues,

(13:22):
usually it's just one tothree lenders who need
to figure out a way to move forward.
And so in the middle market, Iwould expect recoveries to be
around the 70% area.
That is what we put into allof our modeling projections.
And then broadlysyndicated, the consensus is
for lower recoveries.
Certainly those are the twobenefits for CLO equity.

(13:44):
We've, I think, benefitedfrom that historically,
and the trend should continue as well.
- Yeah, and obviouslyI guess from your side,
its liability spreads do keepcoming in is actually good
from an equity investor perspective.
- On the last panel, Ilearned that the spread
between the broadly syndicated AAA
and the middle market aa,I've always thought about it

(14:05):
as about 50 bips over 10 to 12 years.
That's kind of like what it's been,
but now it's certainly moving tighter.
And I am all for tightermiddle market aaas.
I also invest in middle market double Bs
where I don't need thoseto trade any tighter.
And then for the equity,anything that trades tighter
creates more profitability for the CLO

(14:25):
and better equity distributions.
- Yeah. And then I thoughtthe other interesting part of
that panel was a talk aboutimprovements in liquidity in the
secondary, and we were talking about this,
the guys there werevery positive about some
of the work which has beendone on transparency in
middle market CLOs.
I'm not sure we necessarily agree
that it was quite there yet.

(14:46):
- Yeah, so when we lookat a middle market equity
or double B piece, for example,
like the middle managersends us a list of the 200
or so loans that are gonna go into the CLO
and they'll give us somemetrics around the loan,
what's the leverage, the interest
coverage, the loan to value.
And usually we find seven
or eight loans where they'reof particular interest

(15:06):
or they stand out forone reason or another.
And so we get the CLO manager on the phone
and we talk through those credits
and usually there's a verysatisfactory answer for why
these kind of few loansstood out, if you will.
And then after that,
I think middle market reportingis a little bit mixed.
So if you pull up the deals in Intex,

(15:28):
sometimes you'll see amark for all the loans
that's relatively recent.
For other CLO managers,you might see only loans
that are rated tripleCA mark if the loan's
defaulted, there has to be a mark.
Also, the best thing for aCLO manager to produce is,
you know, a mark for everyone of the 200 loans.

(15:51):
I realize it may be a quarterlymark, it may be stale,
but if the manager reportsthe information in that way,
they're gonna find that theirbonds are much more liquid in
the secondary market and thatwill lead to better pricing
for them in the primary as well.
So that's something thatthey should care about.
I think there's somechallenges for the managers in

(16:12):
that if you have a publicly traded BDC,
you don't wanna put outloan marks for the same loan
that's in A BDC inanother fund kind of ahead
of when the BDC might be reporting.
There are some challenges there I admit,
but the more current marks
and percentage of loans marked is better
for all the investors in the deal.

(16:33):
- Great. We're pretty muchoutta time now, shall I?
So in fact, we are exactlyoutta time. Thank you so much.
Thank you for joining me.
- The content here is forinformational purposes only
and should not be takenas legal business tax
or investment advice, or beused to evaluate any investment
or security.

(16:53):
This podcast is notdirected at any investors
or potential investorsin any Flat Rock Global
Fund definition.
Section A UM refers toassets under management.
The secured overnight financingrate software is a broad
measure of the cost ofborrowing cash overnight,
collateralized by treasury securities.

(17:15):
The London Interbank offerrate LIBOR was a broad measure
of the cost of borrowing cash overnight
for banks on an unsecuredbasis, leveraged loans
or corporate loans to companies
that are not ratedinvestment grade broadly.
Syndicated loans areunderwritten by banks, rated
by nationally recognizedstatistical ratings organizations

(17:37):
and often traded by market participants.
Middle market loans areusually underwritten
by several lenders with the intention
of holding the investmentthrough its maturity.
A collateralized obligation.
CDO is a structured financeproduct that is backed by a pool
of assets other than leveraged loans.

(17:57):
Global financial crisis
or GFC refers to thebanking downturn in 2008
and 2009.
Risk retention is when the CLOmanager acquires securities
in its CLO to meetregulatory requirements.
Junior capital is financing
that has a lower priorityclaim in debt repayment

(18:17):
to a secured term loan spreadis the percentage difference
in current yields of various classes
of fixed income securitiesversus treasury bonds.
Or another benchmark bondmeasure yield is income returned
on investments such
as the interest receivedfrom holding a security.
The yield is usually expressed

(18:38):
as an annual percentage ratebased on the investments cost.
Current market value
or face value amortization is the process
by which the CLO repays its financing
after the reinvestment period ends.
CLO equity.
Missing payments happens whenthere are too many triple C
rated loans or defaulted loans.

(18:59):
In the CLO disclosures
for the Flat Rock Global CLOequity index can be found on
the Flat Rock Global website.
Liability management exercises
or LME are an out of court restructuring
of a company's debt in whichthe lenders take a haircut on
the principle balance of their loans.
General disclaimer section, references

(19:21):
to interest rate moves arebased on Bloomberg data.
The credit quality offixed income securities
and a portfolio is assigned
by a nationally recognizedstatistical rating organization,
such as Standard and pos, Moody's
or Fitch as an indication
of an issuer's credit worthinessratings range from triple A

(19:43):
highest to D lowest bonds rated Triple B
or above are consideredinvestment grade credit ratings.
Double B and below are lowerrated securities, also known
as junk bonds.
Any mentions of specific companies are
for reference purposes only
and are not meant to describethe investment merits of

(20:03):
or potential or actualportfolio changes related
to securities of those companiesunless otherwise noted.
All discussions are based onUS markets and US monetary
and fiscal policies.
Market forecasts
and projections are basedon current market conditions
and are subject to change without notice,

(20:25):
projections should not beconsidered a guarantee.
The views and opinions expressed
by the Flat Rock Global speakerare those of the speaker as
of the date of the broadcast
and do not necessarily represent the views
of the firm as a whole.
Any such views are subject
to change at any time basedupon market or other conditions,

(20:47):
and Flat Rock GlobalDisclaims any responsibility
to update such views.
This material is notintended to be relied upon
as a forecast, research,or investment advice.
It is not a recommendationoffer or solicitation to buy
or sell any securities or toadopt any investment strategy.

(21:08):
Neither Flat Rock Global
nor the Flat Rock GlobalSpeaker can be responsible
for any direct
or incidental lossincurred by applying any
of the information offered.
None of the information
provided should be regardedas a suggestion to engage in
or refrain from any investmentrelated course of action

(21:29):
as neither Flat Rock Global
nor its affiliates are undertaking.
To provide impartialinvestment advice, act
as an impartial advisor
or give advice in a fiduciary capacity.
This broadcast is copyright 2024
of Flat Rock Global LLC.
All rights reserved.
This recording may not bereproduced in whole or in part

(21:52):
or in any form without thepermission of Flat Rock Global.
Additional informationabout this podcast along
with an edited transcript may be obtained
by visiting flat rock global.com.