June 25, 2024 • 35 mins
In this episode of the CLO Investor podcast, host Shiloh Bates interviews Patrick Wolfe, Senior Portfolio Manager in the Global Credit Platform and Head of U.S. Middle Market CLOs at BlackRock. They discuss the current state of the middle market loans and the risks for CLO investors in today's economy. Patrick explains the differences between middle market loans and broadly syndicated loans, highlighting the need for origination and underwriting in the middle market. He also describes the competition for middle market loans and the importance of reputation and industry specialization in transactions. Other topics include the impact of higher interest rates on borrowers; the potential for increased M&A activity in the middle market; and the importance of valuations and need for standardization in the industry.
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Episode Transcript
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(00:05):
Hi, I'm Shiloh Bates and welcometo the CLO Investor podcast.
CLO stands for collateralizedloan obligations,
which are securities backed by poolsof leverage loans. In this podcast,
we discuss current news in the CLOindustry and I interview key market
players. Today I'mspeaking with Patrick Wolf,
(00:27):
the middle market CLOmanager at BlackRock.
I've been investing in Patrick'sCLOs for over a decade now,
and BlackRock is the largest CLOequity manager across Flat Rock funds.
In last week's podcast,
Paul Nikodem and I discussed some ofthe metrics that are used to pick CLO
managers and Patrick'sCLOs and his platform check
(00:51):
all my boxes.
Other investors seem to agree as BlackRockis able to get some of the best CLO
financing rates in the market.
Our primary discussion was an update onmiddle market loans and how Patrick sees
his platform as differentiated.
We also discussed the risks hesees for CLO investors in today's
(01:12):
economy. Many of the questions I poseto Patrick are the same ones investors
are asking me,
including how borrowers are managinghigher interest expense and if there are
enough good middle market loansfor everyone to get enough.
So we're going to hear the answers inthis case directly from the horse's mouth.
(01:33):
And now my conversation withPatrick Wolf. Well Patrick,
thanks for coming on the podcast.
Yeah, thanks for theinvitation. Happy to be here.
So I understand you were recentlyat a CLO conference in Barcelona.
What was that like?
The vibe of the conferencewas very positive.
You're seeing a lot of demandfrom a lot of new regions.
Slowly different regions have comeback online. So it was interesting,
(01:56):
we had meetings from peoplefrom all over Europe,
from Middle East and even asfar away as Japan and Korea.
So it was very well attended and a lotof people are exploring adding CLOs to
their portfolios or turning it back on.
We even met with a bank from Greece whowas exploring adding middle market CLOs.
So it was really an eclecticgroup of people there.
And the weather and the food ofcourse is always nice in Spain.
(02:19):
I would think that would be a verycompelling part of the conference.
So why don't we start off and if youcould just walk us through your background
and let our listeners know howyou ended up managing CLOs.
Happy to.
So I worked for Deutsche Bank around2006 in structured products and
luckily was a junior person at the timewhen we went into the global financial
(02:40):
crisis and worked all the waythrough the global financial crisis.
Saw a lot, got a lot of scars,had a lot more hair at the time,
and worked on some really interestingbankruptcies in CLOs and gained a
real good foundation of how to manageA CLO and at the time how to manage
CLOs in difficult situations.
(03:01):
And then post the global financialcrisis around 2012, 2013,
I got approached by 10 capital partnerswho was more of a multi-Strat credit
firm.
They asked me to join them as they lookedto start issuing middle market CLOs
and I joined the firm in 2013.
We were acquired by BlackRock in 2018,
(03:22):
so I've really been in this samerole for almost 11 years now.
We've become a largeissuer, middle market CLOs.
I think we're on number 14 today andwe're approaching around a little over 6
billion of middle market CLOs. Butthe broader direct lending platform,
which the middle market CLOs sit apart of is about 25 billion today.
Or I also play a senior role as portfoliomanager on the broader direct lending
(03:44):
funds. But my history and my backgroundwas born in structured products.
So then why don't you give our listenersjust a 1 0 1 on middle market loans and
how they're different frombroadly syndicated loans,
which are the biggerpart of the CLO market.
So there's quite the differencebetween middle market loans and broadly
syndicated loans, or at least therehas been for the last few decades.
(04:06):
Middle market loans,
I like the phrase is very much farmto table credit as we have to go
out and originate and find theopportunities and we have to structure
and underwrite and actually go visit thesite and spend time with management and
really manufacture an investmentopportunity from scratch where a broadly
syndicated loan, all your large investmentbanks, Morgan Stanley, Goldman Sachs,
(04:31):
JP Morgan,
all these large investment banks are outthere syndicating away small pieces of
loans and you typicallyget asked a question,
do you want to buy thisloan and at what price?
So it's much more of likegoing to a grocery store.
You can go on Bloomberg and sort byindustry sort by rating and within a day
you can acquire a hundredbroadly syndicated loans with a few phone calls to a
(04:53):
few of the big banks.We're in middle market, like I said,
we're out originating the asset.
We have much bigger teams required andwe're typically providing financing to
help the middle market economy.
Think of companies around 50 millionof ebitda and in some cases they are
selling their business to a privateequity firm or they're acquiring a
competitor,
but they just need some middle marketfinancing to grow their business or
(05:16):
transact.
And that's really the big differenceis that middle market is very much a
much bigger time commitment and amountof resources because like I said,
we don't just get to go on Bloombergand pick from a pool of loans with a few
phone calls.
So the typical loan thatyou're underwriting today,
what do you think the average loan tovalue is and what's the spread over SOFR?
(05:39):
So the average loan to value is going tobe in the high thirties to low forties
for first lien senior secured loan.
And that's really the only place we'vebeen focused in the capital structure
over the last couple of years is thefirst lien and that today is probably
around SOR five 50 to SOR 600today at that loan to value about
nine months ago, I would sayit was 600 to six 50 over SOFR.
(06:02):
So we really have seen somespread compression over the last six to nine months,
but relatively speaking,
we're probably a little bitwider than our historical levels.
So it still has been a very compellingtime to be at middle market lending.
We still get covenants in our loans.
That's a big benefit of the middlemarket as we are negotiating and
manufacturing and structuring these.
So it's hard to say it's apples toapples to the broadly syndicated loans
(06:25):
because those loans typicallydo not have covenants.
So we have in a way a better structureddownside protected credit agreement at a
wider spread. So that's wherewe're seeing levels today.
So one of the things I'vebeen seeing is private credit,
middle market lending has just becomemore and more popular each year.
Are there enough middle market loans foreverybody to get their share given how
(06:47):
many competitors there are in the marketand how much money's been raised in the
asset class?
That's a very common statement thatpeople do not expect there to be enough
loans for everything to go around.
I think people underestimate the sizeof the middle market economy and also
where that economy is. Thosecompanies are in their life cycle.
A lot of these businesses are still ownedby founders who could be from the baby
(07:11):
boomer generation who are getting olderand we're starting to see a lot of
companies transact.
And there's a quote that there'sover 50,000 companies in this
25 to 75 million ebitda and a very highpercent of those need to go through a
generational shift in the next 10 years.
So there is by far more loansthan there are capital for today.
(07:32):
I do think direct lending on realmarket lending is very underfunded.
When you look at the amount of privateequity dry powder that's been raised over
the last few years,
there's estimates anywhere from aroundone to one and a half trillion dollars of
private equity dry powder, and as Ijust mentioned on the loan to value,
it's close to one-to-one and directlending is somewhere in the hundreds of
(07:52):
billions from dry powder. You reallyneed it to be closer to parity with that.
If anything,
direct lending is underfunded relativeto private equity and there is a
huge portion of our economyin this core segment.
I do think there is room for morecompetitors and there's plenty of deals.
We are very selective.
We only execute about 5% ofthe deals we review every year.
(08:16):
So that's maybe anywhere from 60 to ahundred deals a year on average. So yeah,
I do think there'splenty. And if anything,
direct lending is underfunded relativeto the broader private equity markets.
And with a lot of your loans beingcreated in leveraged buyouts,
do you think that is some activity that'sgoing to pick up later this year or
is it that the higher base rate of SOFRhas just really slowed down that market
(08:39):
substantially and maybe there won't bean increase until interest rates come
down.
The last two months. We've seen it upmonth over month, April, may. We're very,
very busy. We're continuingto see it pick up.
I think rates will only pour gasolineon it. When rates do come down,
I think m and a activity will pickup a fair bit and it's going to be
(09:00):
really on the buyers andsellers agreeing to a price.
We have seen a lot of businesses put upfor sale and there's just a really big
bid ask and over the lastfew months that's gotten closer and you're starting to
see businesses transact. ButI think once rates go down,
there's a lot of private equityportfolio companies that need to be sold.
Some of these private equity funds aregetting really, really long in the tooth.
(09:22):
They've been in existence for over adecade and the investors are the limited
partners.
They want their money back. So I thinkas soon as people have a good feeling
that rates are coming down and you'regoing to get a slightly better valuation,
you're going to see a huge pickup in it.
But right now we are seeing prettysubstantial pickup in m and a,
but I would say that these are actuallymore new businesses that have grown
(09:45):
really well and fared very wellin the high rate environment.
You really haven't seen a businessthat's just bumped along as a lender.
A business bumpingalong is very much okay,
you just don't want to see it go downhill.
Sometimes when a company does too well,
you get refinanced really quickly andall your hard work was only worth about a
year of interest coupon. So a companythat just slowly grows, bumps along,
(10:05):
it's great. And we haven't reallyseen those companies transact.
It's the private equity sponsorseither hope and rates come down,
it helps them grow top lineor create better margins.
But the election's still out there andrate cuts. Now with the news today,
people are pricing in a cut post November.
It's not the multiple cutspeople originally expected,
I think early part of the year. So Ithink there's still some uncertainty,
(10:27):
but it's coming. There is a wave ofm and a that we'll see in the next,
I'd say six to 12 months.
So you mentioned that you're highlyselective in the loans that you make.
Are there some industries or particularred flags that screen out a lot of
borrowers in terms of your credit box?
Yeah, commodities, cyclical businesses.
You really want to be careful when youneed a crystal ball to predict their
(10:51):
ability to be refinanced in the future.
If they have a hard time meeting theirbreakevens at where a barrel of oil is
priced at,
you really don't want to make a bet wherethe barrel of oil will be in four to
five years when you're loanneeds to be refinanced.
So we tend to avoid businesseslinked to commodity inputs.
We also tend to not verycyclical businesses as well.
(11:12):
As a lender, you really wantstable growing businesses.
So where we have probably donebetter than most is on technology
software specifically.
That's an industry that we've liked forquite some time now and software just
continues to be a bigger and biggerpart of everyone's day-to-day life.
It helps people grow theirbusiness, run their business.
And during covid we saw a lot of thesesoftware businesses do fairly well where
(11:36):
a lot of people question their abilityto maintain a tough macro environment
and these businessescan be very asset light.
It doesn't take many people to keepthe lights on at some of these software
companies so you can quickly cut expenses.
So we continue to like that very muchtechnology growing growth businesses,
we are very much less intothe manufacturing, high cost,
fixed cost type business structures.We do like insurance services.
(12:00):
I like to say I like car washroll-ups more than healthcare.
So those are always fun to discuss.
So in terms of the competitionfor middle market loans,
there's lots of other firms out therewho want to originate these loans.
Do you see yourself as competing basedon price or the economics of the loan
or are there some reasons that peoplewould select your firm that aren't just
(12:22):
tied to the economics of the deal?
Economics today seem to beless and less as much of a
deciding factor. It definitelymatters where it is,
but everyone's coming out aroundthe same area. So for the ballpark,
for example,
if we say we think a loan should be priceat SOFR plus five 50 and someone else
thinks it's SOR plus 5 75,
(12:44):
it's really not that big of concessionwhere you're seeing the ability to win
transactions is really offreputation size of firm.
Are you going to be ableto grow with the business?
Is your firm something that could be muchmore of a long-term financing solution
partner?
That was something at our legacy firmthat we felt we missed out on is that we
(13:04):
were really only able to finance yourbusiness when you were 50 million of
ebitda, 75 million of ebitda.
But if you very much grew and maybewanted to go to an IPO or maybe you were
going to move to the high yield market,
our firm was stopped being able to providefinancing. And we have seen a number
of transactions where I think we won thetransaction maybe be even a hair higher
(13:27):
on pricing,
but they viewed BlackRock as much moreas a long-term financing partner is that
we could grow with the business if theyhad ambitions for an IPO BlackRock,
it would be one of the bigger IPO buyersjust by what we participate from our
ETF business.
And that's something that I think hasproven to be really helpful in competitive
situations.
(13:47):
The other place that we've historicallyexcelled at is that our team on the
underwriting side and the managementside is constructed by industry
specialization. For example, our headof healthcare comes from private equity.
He's very much still has aprivate equity mindset so he
can have much more of a peer-to-peerconversation with the sponsor of the
(14:07):
private equity firm or even the CEO andC ffo. He really speaks their language
that definitely has helped us wintransactions and competitive environment.
We're not very much a generalist or ageneric banker or just a cheap cost to
capital provider. We couldbe much more of a partner,
a financing partner that'sgoing to understand the issues that they go through,
(14:28):
aren't going to be scared of a typicaldelay that we are used to seeing in that
industry or that subsegment wheresomeone that's very general isn't used to
manufacturing delays in pharmaceuticaldrugs and that's something that happens
from time to time.
So that is another place where we'vehistorically been our biggest competitive
advantage is that our team has industryleads and they manage the investment
(14:51):
from entry to exit.
So they continue to work with themanagement team and the sponsor.
So that's some of the ways we've beenable to compete that is beyond just
pricing and economics,
but there are some sponsors that that'sall they care about and we tend not to
excel with those sponsors becausewe don't want to race to the bottom.
So we tend to look for muchmore long-term partners.
So for somebody sitting in myseat, whenever we model CLO equity,
(15:12):
we put in a 2% default rateinto all of our projections,
we put a 70% recovery rate in.
How do you think those projections willfare for the next coming years here?
So in middle market I think that'sstill a very valid assumption,
2% constant default rate at that recovery.
I think broadly syndicatedequity is having a tougher time.
(15:34):
I've seen recoveries for a few ofthe rating agency research reports on
in court restructurings being sub20 and you're seeing out of court
restructurings being inI think the mid fifties.
So everything that people have beennervous about in the broadly syndicated
loans with the weaker credit documentsand not having covenants is leading to
(15:54):
lower recoveries in bankruptcies.
The benefit of middle market is we stillhave that feel of what the leverage
loan market was 15 years ago with a highpercentage of our loans or mostly all
of them with covenants of the ability toget to the negotiating table before too
much principle loss creeps into the story.
So I do think core middle marketis just even direct lending.
(16:14):
That is still a verymuch a fair assumption.
I do think on average weprobably outperform the default rate and I think the
recovery is plus or minusfive to 10 points from there and probably averages out
to 70.
Ours is in the nineties when it comesto our CLOs that have had defaults over
the last 12 years.
But I do think in this credit environmentthere's going to be a tougher time and
(16:36):
I think two and 70 in our market is avery much a fair assumption when modeling
out that investments.
So in the broadly syndicated market,
there has been some weakercredit documentation that has resulted in some low
recoveries.
Do you feel like in the middle marketyou're still getting the documentation
that you want and that there isn't arisk of a looser documentation in your
(16:58):
particular market?
There's definitely a risk in our marketand we are seeing the segmentation of
middle market loans or directlending playing a big part in that.
So we view the market in three segments.
Let's say lower middle market is zeroto 25 million of EBITDA is the lower
segment core being 25 million to ahundred million of ebitda and then upper
(17:19):
it being a hundred million plus thatupper middle market has gotten very
competitive and we're seeing reportsof less than 10% of those loans having
covenants where on average the core middlemarket is closer to 70% of the loans
having covenants.
So you have seen some of the broadlysyndicated credit documents start to
(17:39):
creep into our market. We're doingeverything we can to hold the line on it.
One thing you can get comfortable withis maybe not the financial maintenance
covenant,
but where you've got to be careful issome of the negative covenants like your
ability to up tier or executeliability management transactions or
lts. You have seen thatcreep in not anywhere to the same degree in the probably
(18:00):
syndicated market. Andone thing people forget,
there's very smart lawyers outthere and even though J Crew Serta
chewy are some of the morefamous bankruptcies and we all focus on making sure
the weaknesses that were exploitedin those bankruptcies are tied up.
There's no saying that someone's notgoing to create the new weakness.
(18:22):
It's a bit of a whack-a-mole I've heard.
Yes, it is exactly a whack-a-mole.
There's lawyers out there trying tofigure out every which way to weaken the
document and find a loophole toexploit some of these things.
If you go back five years or evenseven years in our credit documents,
the Serta protections might not be therebecause no one believed they needed
them.
So the document is always evolving andone thing I like to highlight is there's
(18:47):
almost like a red yellow green froma strength protection, some of it.
So right now what we thought was a strongcredit protection to protect you from
Serta, today's age might beonly lightly or moderate.
So when you do have an amendment,
do you want to rewrite that protectionthe document to be even stronger because
even though you might'vethought you had the protection,
(19:08):
the lawyers find it the loophole to getit. So the document is always evolving,
it's always going to be whack-a-moleand private equity sponsors will try to
find loopholes to protecttheir investment, their fiduciary to their investors.
So if they could exploit some part ofthe credit document to increase the
recovery or create a recovery,
they're likely going to do so that's onething that we've always been focused on
(19:29):
is the sponsors aregreat until they're not.
So then one of the things I've also likedabout middle market is just that when
a company does get into stressthat you only have one or a
handful of lenders that are makingthe call and broadly syndicated,
you might have a term loanthat's a billion in size and you might have 40 or 50
different people with opinionsin the restructuring process.
(19:52):
You might have a high yield bond,
a second lien lawyers taking allkinds of fees for their time.
All that's going to eat intothe first lien recovery.
That is a big benefit that we have.
We're typically the only debtand we're mostly the first lien.
It's typically only firstlien senior to secure loans.
So it does make for a lotcleaner restructuring.
A lot of times it's done out of court.
(20:14):
We don't have to go through a formalbankruptcy system that can be very
costly and just decreases yourrecovery as a lot of people get paid in
restructurings and it could be 15 20million in fees going out the door.
So the direct lending,
you have a much more of a sitting downacross a table workout of a restructuring
in some cases only onelender or a couple lenders.
(20:37):
And for the most part everyone's inagreement and there isn't typically one
lender trying to createa priming facility.
It's very much everyone's arm in armtrying to get to the best outcome for the
restructuring.
So one of the questions I think I'm askedthe most is just that as the Fed has
hiked rates, loan yields are in,
call it the 10 to 12% the area,
(20:57):
are the borrowers able to make thoseinterest payments over an extended period
of time or do they really need thefed to start cutting in the future?
No,
a very high percentage at least of ourportfolio are still well above one and a
half times from an interestcoverage standpoint,
meaning they're able tostill service the debt.
I think for the private equity returnsto pencil out to what they were initially
(21:18):
underwritten at, they're going to needto see the Fed to start to cut rates.
We're not seeing interest rates alonepush a company into distress or de-stress.
It's typically interest rates plus a lossof the customer interest rates plus a
supply chain issue. So for the most part,
the companies have been able tomanage the higher rate environment.
They just had a lot less room for error.
(21:40):
It kind of magnifies a mistake right now.
I think if the interestrates start getting cut,
it gives them a little bit more room tolose a customer to have a supply chain
delay and still haveliquidity to manage through.
It just really has made it much moredifficult for them to make a mistake.
It's hard to recover with theirinterest rates where they are.
So do you see the higher rates isbasically just transfer in economics from
(22:03):
private equity firms tomiddle market lenders?
That's exactly correct.
We're going from mid single digitsto teen type returns on the assets
and that is coming out of theequity ownership of the business.
So they've benefited from low rates andvery high returns for quite some time.
And the term that gets thrown around alot is the golden age private credit and
(22:24):
it's really the first lie loan is makingalmost equity like returns from a yield
standpoint.
So that's why I think it'sso many headlines and so much interest in the asset
class.
It's just that double digit returns froma security where you're in the top of
the capital structure.
So one of the key trends in CLOsthis year has been declining CLO
(22:44):
financing costs tripleeight down to double B.
How does that affect yourbusiness in terms of issuance?
Does that make it more likely that you'llcome to the market deals in the future
or will you look to refi reset thedeals that are already outstanding?
From a new issue standpoint,
it doesn't really change whatwe had planned for the year.
(23:05):
From a new issue standpoint, itdefinitely makes things more appealing.
Where it does change our plan ison the reset refinance side of the
equation. So at the AAAlevels we are today,
a lot of the deals that we've priced overthe last couple of years are all of a
sudden it looks compelling from anequity return standpoint to go out and
(23:26):
reset the deal for another four yearsand possibly lower the borrowing costs
slightly.
So that's where I think you are seeinga lot more activity as people are
starting to refinance and reset new deals.
Middle market is less tiedto a few basis points.
Even when spreads were 75 basispoints wider than they are today.
(23:47):
People were still out there constantlyissuing middle market CLOs because we
just have a lot more spread inour assets and if a quarter basis,
25 basis points doesn't necessarily makeor break our returns like it does in
broadly syndicated equity where they'retrying to get to a couple basis points
of a model from an arbitrage standpointbecause they're going to magnify it 10
(24:07):
to 12 times and probably syndicated. Soevery basis point really matters at that
magnification middle market.
CLOs can be anywhere fromthree to six times levered,
so it's less of a magnifier whenwe're talking a few basis points.
But I think reset activity does definitelypick up the back half of this year.
So BlackRock has both broadlysyndicated and middle market CLOs.
(24:28):
Are the investors in thosetwo different securities,
are they different folks or do peopleplay in both your middle market and your
broadly syndicated issuances?
So we definitely do have a middle marketUS probably syndicated and European CLO
business as well, whichis syndicated loans there.
We do have crossover onthe debt side for sure.
People are familiar with the platform,
(24:50):
how robust our risk management functionsare our Aladdin systems and they
definitely get the benefits ofunderwritten one of the teams.
There's going to be a big portionof their underwriting completed,
so they do get a synergy of that.
So we definitely do see overlapon the debt investor side.
On the equity side,
I do not believe the middle marketoverlaps with the probably syndicated,
(25:12):
but I can't say it for ahundred percent certainty.
Is there anything interesting happeningin the market that we should touch on?
I think one thing that doesn't get theattention in middle market loans are
valuations.
This has become really importantrecently for the AAA investors
as because if a loan isn'tbeing marked a fair value,
(25:34):
there's no benefit or protectionto the or other debt holders.
From a triple C haircut standpoint,
we've seen the S and p triple Cs creepup from a historical average where
by nearly the s and p averages,
most people are going to be having almostsome form of a triple C haircut. Well,
that haircut only protects you if theloans are being marked a fair value.
(25:56):
If they have all the loansmarked at par or near par,
it doesn't give you the protection.
Then there's no haircut on that.
There's no haircut at that.
So I was on a panel recently whereanother manager was saying they self mark
their loans and they didn't seethe need to value their loans.
And there's just so many reasons whyvaluations should be done If you have a B,
(26:16):
D, C, it has to be done,
but the frequency and the wayyou do it is not standardized.
And then when people are looking maybeto make direct lending fund investments,
like if you're just goingto invest in someone's fund,
one manager might be marketing theirbook to represent fair value and their
returns might look lower than amanager who doesn't mark their book.
So I think valuations is something thathelps level set the different managers
(26:40):
and also gives you a goodthird party view of the credit
quality of the portfolio.
One thing that I think you're good atand the they're good investors at is they
look at the market values of our loansthat are done by third party valuation
agents and it could quickly tell youwhat loan is maybe underperforming or
having issues. It quicklyhighlights where outperformers and
(27:03):
underperformers are,
and you don't necessarilyneed to be familiar with all the underlying borrowers,
but this third party has gonein and reviewed the financials,
has spent time with the budget as a reallygood understanding on how the company
is performing.
So if there was more of a standardizationof valuations where everyone was doing
it every quarter and theywere doing it to market,
(27:25):
there'd be a much more clearplaying field where it's really
hard to light up managers side byside from a return standpoint because
one manager might have unrealized lossesbecause they're marking their book to
reflect the credit quality where onemanager hasn't marked his book and has
everything at par, even though theymight have problems underlying.
(27:45):
Now you see the BDC analysts talk aboutit where one manager has a loan marked
at 75 and two managershave it marked at par.
So it's one place I'd hope there wouldbe more standardization and more people
getting to quarterlyvaluations of the portfolio.
I definitely see that whenwe pull up CLOs and Intex,
sometimes all the loans are marked andthat other times just some percent,
(28:07):
it could be the CCCs aremarked defaulted loans.
There's always going to be a mark forthose, I think. But for my seat, yeah,
if you can get a hundredpercent loans marked,
that would enable investors like meto compare returns apple to apples.
And then it would also increase justthe liquidity of a CLO manager's shelf
because at the secondary market,
people would freely trade bonds if allthe loans are priced and it becomes more
(28:31):
challenging if there's just someblank fields by the loan prices.
So one thing I do see in our middlemarket CLOs is that sometimes there's some
broadly syndicated loans thatmake it into the portfolio.
A lot of times these are,
I call them maybe lightly syndicated loanswhere maybe they're underwritten by a
Jefferies or a UBS or something like that.
(28:54):
Do you guys ever see value therefor your middle market CLOs?
We have in the past.
I'd say that market has gottensmaller over the last couple of years.
We're seeing less and lessthrough that lightly syndicated.
There's still to us importantto be middle market borrowers,
so there's still sub ahundred million of ebitda.
Those do have some benefit is that youcan in some situations actually drive
(29:17):
change to the documentation.
It's not as much of a yes orno at what price transaction.
It's very much more ofhere's the business.
You could spend time withmanagement if you like.
You could do the same level of diligencethat you typically like and in some
markets they're open todoc changes, improvements.
We're willing to come into this deal,
but we need these two sections ofthe credit agreement tightened.
(29:41):
Maybe we need a little bit more pricing.
And in some markets we found some reallycompelling opportunities that almost
felt private in the end where we wentout and met management team and there are
some that come in three days and it'show much do you want to buy and at what
price? And those are lesslikely for us to participate.
But they have been a way to add additionalassets in some industries and even
(30:02):
some businesses we knowthat was probably five,
seven years ago was a common exit forus is we did a private deal and then the
next step was to the lightlysyndicated bank deal.
We see that less and less now wherea company just stays primarily in the
private credit space where it goes fromour market to another one of our peers
that does bigger deals.
(30:23):
With some cases we participate in enrolland sometimes the pricing is going to
be so low or the documentation is notwhat we expect, so we just go home.
But that is now,
I would say the more traditionalgraduation from our segment to the larger
segment of the market.
Well, I think that's all thequestions I had. So Patrick,
thanks so much for coming on thepodcast. Really enjoyed our conversation.
(30:44):
Thanks. She always great to chat.
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
(31:06):
any Flat Rock Global fund definition.
Section A UM refers toassets under management,
EBITDA or earnings before interest. Taxes,
and depreciation is a proxy for abusiness annual cashflow roll-up
strategies are when a private equitysponsor is actively looking to grow a
business through acquisitions.
(31:26):
Loan to value is the value of thefirst lie in debt divided by the
enterprise value of the company.
LMT or liability managementtransactions are an out of court
modification of a company's debt Uptiering refers to placing additional debt
with a priority abovethe first lien term loan.
The secured overnight financing ratesuffer is a broad measure of the
(31:50):
cost of borrowing cash overnight,
collateralized by treasury securities.The global financial crisis,
GFC was a period of extreme stressin global financial markets and
banking systems betweenmid 2007 and early 2009.
Credit ratings are opinions aboutcredit risk for long-term issues or
(32:11):
instruments.
The ratings lie on a spectrum rangingfrom the highest credit quality on one end
to default or junk on the other.
A AAA is the highestcredit quality A C or D,
depending on the agency issuing therating is the lowest or junk quality.
Leveraged loans are corporate loans tocompanies that are not rated investment
(32:32):
grade broadly. Syndicated loansare underwritten by banks,
rated by nationally recognized statisticalratings organizations and often
traded by market participants.
Middle market loans are usuallyunderwritten by several lenders with the
intention of holding theinvestment through its maturity.
Junior capital is financing that has alower priority claim in debt repayment
(32:56):
to a secured term loan spread is thepercentage difference in current yields of
various classes of fixed incomesecurities versus treasury bonds or
another benchmark bond measure,
ETFR exchange traded funds.High yield bonds are corporate debt rated
below investment grade andsometimes referred to as junk bonds.
(33:16):
Our set is a refinancingand extension of ACL O.
Investment interest coverageratio compares a company's annual
cashflow to its interest expense.
Intex is software thatCLO practitioners use.
General disclaimer section.
References to interest rate movesare based on Bloomberg data.
(33:36):
Any mentions of specific companies arefor reference purposes only and are not
meant to describe the investmentmerits of or potential or actual
portfolio changes related tosecurities of those companies unless
otherwise noted.
All discussions are based onUS markets and US monetary and
fiscal policies.
(33:57):
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 date of thebroadcast and do not necessarily represent
(34:18):
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This material is not intendedto be relied upon as a forecast,
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It is not a recommendation offeror solicitation to buy or sell any
(34:42):
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(35:06):
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(35:27):
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obtained by visiting flatrockglobal.com.
Hi, I'm Shiloh Bates and welcometo the CLO Investor podcast.
CLO stands for collateralizedloan obligations,
which are securities backed by poolsof leverage loans. In this podcast,
we discuss current news in the CLOindustry and I interview key market
players. Today I'mspeaking with Patrick Wolf,
(00:27):
the middle market CLOmanager at BlackRock.
I've been investing in Patrick'sCLOs for over a decade now,
and BlackRock is the largest CLOequity manager across Flat Rock funds.
In last week's podcast,
Paul Nikodem and I discussed some ofthe metrics that are used to pick CLO
managers and Patrick'sCLOs and his platform check
(00:51):
all my boxes.
Other investors seem to agree as BlackRockis able to get some of the best CLO
financing rates in the market.
Our primary discussion was an update onmiddle market loans and how Patrick sees
his platform as differentiated.
We also discussed the risks hesees for CLO investors in today's
(01:12):
economy. Many of the questions I poseto Patrick are the same ones investors
are asking me,
including how borrowers are managinghigher interest expense and if there are
enough good middle market loansfor everyone to get enough.
So we're going to hear the answers inthis case directly from the horse's mouth.
(01:33):
And now my conversation withPatrick Wolf. Well Patrick,
thanks for coming on the podcast.
Yeah, thanks for theinvitation. Happy to be here.
So I understand you were recentlyat a CLO conference in Barcelona.
What was that like?
The vibe of the conferencewas very positive.
You're seeing a lot of demandfrom a lot of new regions.
Slowly different regions have comeback online. So it was interesting,
(01:56):
we had meetings from peoplefrom all over Europe,
from Middle East and even asfar away as Japan and Korea.
So it was very well attended and a lotof people are exploring adding CLOs to
their portfolios or turning it back on.
We even met with a bank from Greece whowas exploring adding middle market CLOs.
So it was really an eclecticgroup of people there.
And the weather and the food ofcourse is always nice in Spain.
(02:19):
I would think that would be a verycompelling part of the conference.
So why don't we start off and if youcould just walk us through your background
and let our listeners know howyou ended up managing CLOs.
Happy to.
So I worked for Deutsche Bank around2006 in structured products and
luckily was a junior person at the timewhen we went into the global financial
(02:40):
crisis and worked all the waythrough the global financial crisis.
Saw a lot, got a lot of scars,had a lot more hair at the time,
and worked on some really interestingbankruptcies in CLOs and gained a
real good foundation of how to manageA CLO and at the time how to manage
CLOs in difficult situations.
(03:01):
And then post the global financialcrisis around 2012, 2013,
I got approached by 10 capital partnerswho was more of a multi-Strat credit
firm.
They asked me to join them as they lookedto start issuing middle market CLOs
and I joined the firm in 2013.
We were acquired by BlackRock in 2018,
(03:22):
so I've really been in this samerole for almost 11 years now.
We've become a largeissuer, middle market CLOs.
I think we're on number 14 today andwe're approaching around a little over 6
billion of middle market CLOs. Butthe broader direct lending platform,
which the middle market CLOs sit apart of is about 25 billion today.
Or I also play a senior role as portfoliomanager on the broader direct lending
(03:44):
funds. But my history and my backgroundwas born in structured products.
So then why don't you give our listenersjust a 1 0 1 on middle market loans and
how they're different frombroadly syndicated loans,
which are the biggerpart of the CLO market.
So there's quite the differencebetween middle market loans and broadly
syndicated loans, or at least therehas been for the last few decades.
(04:06):
Middle market loans,
I like the phrase is very much farmto table credit as we have to go
out and originate and find theopportunities and we have to structure
and underwrite and actually go visit thesite and spend time with management and
really manufacture an investmentopportunity from scratch where a broadly
syndicated loan, all your large investmentbanks, Morgan Stanley, Goldman Sachs,
(04:31):
JP Morgan,
all these large investment banks are outthere syndicating away small pieces of
loans and you typicallyget asked a question,
do you want to buy thisloan and at what price?
So it's much more of likegoing to a grocery store.
You can go on Bloomberg and sort byindustry sort by rating and within a day
you can acquire a hundredbroadly syndicated loans with a few phone calls to a
(04:53):
few of the big banks.We're in middle market, like I said,
we're out originating the asset.
We have much bigger teams required andwe're typically providing financing to
help the middle market economy.
Think of companies around 50 millionof ebitda and in some cases they are
selling their business to a privateequity firm or they're acquiring a
competitor,
but they just need some middle marketfinancing to grow their business or
(05:16):
transact.
And that's really the big differenceis that middle market is very much a
much bigger time commitment and amountof resources because like I said,
we don't just get to go on Bloombergand pick from a pool of loans with a few
phone calls.
So the typical loan thatyou're underwriting today,
what do you think the average loan tovalue is and what's the spread over SOFR?
(05:39):
So the average loan to value is going tobe in the high thirties to low forties
for first lien senior secured loan.
And that's really the only place we'vebeen focused in the capital structure
over the last couple of years is thefirst lien and that today is probably
around SOR five 50 to SOR 600today at that loan to value about
nine months ago, I would sayit was 600 to six 50 over SOFR.
(06:02):
So we really have seen somespread compression over the last six to nine months,
but relatively speaking,
we're probably a little bitwider than our historical levels.
So it still has been a very compellingtime to be at middle market lending.
We still get covenants in our loans.
That's a big benefit of the middlemarket as we are negotiating and
manufacturing and structuring these.
So it's hard to say it's apples toapples to the broadly syndicated loans
(06:25):
because those loans typicallydo not have covenants.
So we have in a way a better structureddownside protected credit agreement at a
wider spread. So that's wherewe're seeing levels today.
So one of the things I'vebeen seeing is private credit,
middle market lending has just becomemore and more popular each year.
Are there enough middle market loans foreverybody to get their share given how
(06:47):
many competitors there are in the marketand how much money's been raised in the
asset class?
That's a very common statement thatpeople do not expect there to be enough
loans for everything to go around.
I think people underestimate the sizeof the middle market economy and also
where that economy is. Thosecompanies are in their life cycle.
A lot of these businesses are still ownedby founders who could be from the baby
(07:11):
boomer generation who are getting olderand we're starting to see a lot of
companies transact.
And there's a quote that there'sover 50,000 companies in this
25 to 75 million ebitda and a very highpercent of those need to go through a
generational shift in the next 10 years.
So there is by far more loansthan there are capital for today.
(07:32):
I do think direct lending on realmarket lending is very underfunded.
When you look at the amount of privateequity dry powder that's been raised over
the last few years,
there's estimates anywhere from aroundone to one and a half trillion dollars of
private equity dry powder, and as Ijust mentioned on the loan to value,
it's close to one-to-one and directlending is somewhere in the hundreds of
(07:52):
billions from dry powder. You reallyneed it to be closer to parity with that.
If anything,
direct lending is underfunded relativeto private equity and there is a
huge portion of our economyin this core segment.
I do think there is room for morecompetitors and there's plenty of deals.
We are very selective.
We only execute about 5% ofthe deals we review every year.
(08:16):
So that's maybe anywhere from 60 to ahundred deals a year on average. So yeah,
I do think there'splenty. And if anything,
direct lending is underfunded relativeto the broader private equity markets.
And with a lot of your loans beingcreated in leveraged buyouts,
do you think that is some activity that'sgoing to pick up later this year or
is it that the higher base rate of SOFRhas just really slowed down that market
(08:39):
substantially and maybe there won't bean increase until interest rates come
down.
The last two months. We've seen it upmonth over month, April, may. We're very,
very busy. We're continuingto see it pick up.
I think rates will only pour gasolineon it. When rates do come down,
I think m and a activity will pickup a fair bit and it's going to be
(09:00):
really on the buyers andsellers agreeing to a price.
We have seen a lot of businesses put upfor sale and there's just a really big
bid ask and over the lastfew months that's gotten closer and you're starting to
see businesses transact. ButI think once rates go down,
there's a lot of private equityportfolio companies that need to be sold.
Some of these private equity funds aregetting really, really long in the tooth.
(09:22):
They've been in existence for over adecade and the investors are the limited
partners.
They want their money back. So I thinkas soon as people have a good feeling
that rates are coming down and you'regoing to get a slightly better valuation,
you're going to see a huge pickup in it.
But right now we are seeing prettysubstantial pickup in m and a,
but I would say that these are actuallymore new businesses that have grown
(09:45):
really well and fared very wellin the high rate environment.
You really haven't seen a businessthat's just bumped along as a lender.
A business bumpingalong is very much okay,
you just don't want to see it go downhill.
Sometimes when a company does too well,
you get refinanced really quickly andall your hard work was only worth about a
year of interest coupon. So a companythat just slowly grows, bumps along,
(10:05):
it's great. And we haven't reallyseen those companies transact.
It's the private equity sponsorseither hope and rates come down,
it helps them grow top lineor create better margins.
But the election's still out there andrate cuts. Now with the news today,
people are pricing in a cut post November.
It's not the multiple cutspeople originally expected,
I think early part of the year. So Ithink there's still some uncertainty,
(10:27):
but it's coming. There is a wave ofm and a that we'll see in the next,
I'd say six to 12 months.
So you mentioned that you're highlyselective in the loans that you make.
Are there some industries or particularred flags that screen out a lot of
borrowers in terms of your credit box?
Yeah, commodities, cyclical businesses.
You really want to be careful when youneed a crystal ball to predict their
(10:51):
ability to be refinanced in the future.
If they have a hard time meeting theirbreakevens at where a barrel of oil is
priced at,
you really don't want to make a bet wherethe barrel of oil will be in four to
five years when you're loanneeds to be refinanced.
So we tend to avoid businesseslinked to commodity inputs.
We also tend to not verycyclical businesses as well.
(11:12):
As a lender, you really wantstable growing businesses.
So where we have probably donebetter than most is on technology
software specifically.
That's an industry that we've liked forquite some time now and software just
continues to be a bigger and biggerpart of everyone's day-to-day life.
It helps people grow theirbusiness, run their business.
And during covid we saw a lot of thesesoftware businesses do fairly well where
(11:36):
a lot of people question their abilityto maintain a tough macro environment
and these businessescan be very asset light.
It doesn't take many people to keepthe lights on at some of these software
companies so you can quickly cut expenses.
So we continue to like that very muchtechnology growing growth businesses,
we are very much less intothe manufacturing, high cost,
fixed cost type business structures.We do like insurance services.
(12:00):
I like to say I like car washroll-ups more than healthcare.
So those are always fun to discuss.
So in terms of the competitionfor middle market loans,
there's lots of other firms out therewho want to originate these loans.
Do you see yourself as competing basedon price or the economics of the loan
or are there some reasons that peoplewould select your firm that aren't just
(12:22):
tied to the economics of the deal?
Economics today seem to beless and less as much of a
deciding factor. It definitelymatters where it is,
but everyone's coming out aroundthe same area. So for the ballpark,
for example,
if we say we think a loan should be priceat SOFR plus five 50 and someone else
thinks it's SOR plus 5 75,
(12:44):
it's really not that big of concessionwhere you're seeing the ability to win
transactions is really offreputation size of firm.
Are you going to be ableto grow with the business?
Is your firm something that could be muchmore of a long-term financing solution
partner?
That was something at our legacy firmthat we felt we missed out on is that we
(13:04):
were really only able to finance yourbusiness when you were 50 million of
ebitda, 75 million of ebitda.
But if you very much grew and maybewanted to go to an IPO or maybe you were
going to move to the high yield market,
our firm was stopped being able to providefinancing. And we have seen a number
of transactions where I think we won thetransaction maybe be even a hair higher
(13:27):
on pricing,
but they viewed BlackRock as much moreas a long-term financing partner is that
we could grow with the business if theyhad ambitions for an IPO BlackRock,
it would be one of the bigger IPO buyersjust by what we participate from our
ETF business.
And that's something that I think hasproven to be really helpful in competitive
situations.
(13:47):
The other place that we've historicallyexcelled at is that our team on the
underwriting side and the managementside is constructed by industry
specialization. For example, our headof healthcare comes from private equity.
He's very much still has aprivate equity mindset so he
can have much more of a peer-to-peerconversation with the sponsor of the
(14:07):
private equity firm or even the CEO andC ffo. He really speaks their language
that definitely has helped us wintransactions and competitive environment.
We're not very much a generalist or ageneric banker or just a cheap cost to
capital provider. We couldbe much more of a partner,
a financing partner that'sgoing to understand the issues that they go through,
(14:28):
aren't going to be scared of a typicaldelay that we are used to seeing in that
industry or that subsegment wheresomeone that's very general isn't used to
manufacturing delays in pharmaceuticaldrugs and that's something that happens
from time to time.
So that is another place where we'vehistorically been our biggest competitive
advantage is that our team has industryleads and they manage the investment
(14:51):
from entry to exit.
So they continue to work with themanagement team and the sponsor.
So that's some of the ways we've beenable to compete that is beyond just
pricing and economics,
but there are some sponsors that that'sall they care about and we tend not to
excel with those sponsors becausewe don't want to race to the bottom.
So we tend to look for muchmore long-term partners.
So for somebody sitting in myseat, whenever we model CLO equity,
(15:12):
we put in a 2% default rateinto all of our projections,
we put a 70% recovery rate in.
How do you think those projections willfare for the next coming years here?
So in middle market I think that'sstill a very valid assumption,
2% constant default rate at that recovery.
I think broadly syndicatedequity is having a tougher time.
(15:34):
I've seen recoveries for a few ofthe rating agency research reports on
in court restructurings being sub20 and you're seeing out of court
restructurings being inI think the mid fifties.
So everything that people have beennervous about in the broadly syndicated
loans with the weaker credit documentsand not having covenants is leading to
(15:54):
lower recoveries in bankruptcies.
The benefit of middle market is we stillhave that feel of what the leverage
loan market was 15 years ago with a highpercentage of our loans or mostly all
of them with covenants of the ability toget to the negotiating table before too
much principle loss creeps into the story.
So I do think core middle marketis just even direct lending.
(16:14):
That is still a verymuch a fair assumption.
I do think on average weprobably outperform the default rate and I think the
recovery is plus or minusfive to 10 points from there and probably averages out
to 70.
Ours is in the nineties when it comesto our CLOs that have had defaults over
the last 12 years.
But I do think in this credit environmentthere's going to be a tougher time and
(16:36):
I think two and 70 in our market is avery much a fair assumption when modeling
out that investments.
So in the broadly syndicated market,
there has been some weakercredit documentation that has resulted in some low
recoveries.
Do you feel like in the middle marketyou're still getting the documentation
that you want and that there isn't arisk of a looser documentation in your
(16:58):
particular market?
There's definitely a risk in our marketand we are seeing the segmentation of
middle market loans or directlending playing a big part in that.
So we view the market in three segments.
Let's say lower middle market is zeroto 25 million of EBITDA is the lower
segment core being 25 million to ahundred million of ebitda and then upper
(17:19):
it being a hundred million plus thatupper middle market has gotten very
competitive and we're seeing reportsof less than 10% of those loans having
covenants where on average the core middlemarket is closer to 70% of the loans
having covenants.
So you have seen some of the broadlysyndicated credit documents start to
(17:39):
creep into our market. We're doingeverything we can to hold the line on it.
One thing you can get comfortable withis maybe not the financial maintenance
covenant,
but where you've got to be careful issome of the negative covenants like your
ability to up tier or executeliability management transactions or
lts. You have seen thatcreep in not anywhere to the same degree in the probably
(18:00):
syndicated market. Andone thing people forget,
there's very smart lawyers outthere and even though J Crew Serta
chewy are some of the morefamous bankruptcies and we all focus on making sure
the weaknesses that were exploitedin those bankruptcies are tied up.
There's no saying that someone's notgoing to create the new weakness.
(18:22):
It's a bit of a whack-a-mole I've heard.
Yes, it is exactly a whack-a-mole.
There's lawyers out there trying tofigure out every which way to weaken the
document and find a loophole toexploit some of these things.
If you go back five years or evenseven years in our credit documents,
the Serta protections might not be therebecause no one believed they needed
them.
So the document is always evolving andone thing I like to highlight is there's
(18:47):
almost like a red yellow green froma strength protection, some of it.
So right now what we thought was a strongcredit protection to protect you from
Serta, today's age might beonly lightly or moderate.
So when you do have an amendment,
do you want to rewrite that protectionthe document to be even stronger because
even though you might'vethought you had the protection,
(19:08):
the lawyers find it the loophole to getit. So the document is always evolving,
it's always going to be whack-a-moleand private equity sponsors will try to
find loopholes to protecttheir investment, their fiduciary to their investors.
So if they could exploit some part ofthe credit document to increase the
recovery or create a recovery,
they're likely going to do so that's onething that we've always been focused on
(19:29):
is the sponsors aregreat until they're not.
So then one of the things I've also likedabout middle market is just that when
a company does get into stressthat you only have one or a
handful of lenders that are makingthe call and broadly syndicated,
you might have a term loanthat's a billion in size and you might have 40 or 50
different people with opinionsin the restructuring process.
(19:52):
You might have a high yield bond,
a second lien lawyers taking allkinds of fees for their time.
All that's going to eat intothe first lien recovery.
That is a big benefit that we have.
We're typically the only debtand we're mostly the first lien.
It's typically only firstlien senior to secure loans.
So it does make for a lotcleaner restructuring.
A lot of times it's done out of court.
(20:14):
We don't have to go through a formalbankruptcy system that can be very
costly and just decreases yourrecovery as a lot of people get paid in
restructurings and it could be 15 20million in fees going out the door.
So the direct lending,
you have a much more of a sitting downacross a table workout of a restructuring
in some cases only onelender or a couple lenders.
(20:37):
And for the most part everyone's inagreement and there isn't typically one
lender trying to createa priming facility.
It's very much everyone's arm in armtrying to get to the best outcome for the
restructuring.
So one of the questions I think I'm askedthe most is just that as the Fed has
hiked rates, loan yields are in,
call it the 10 to 12% the area,
(20:57):
are the borrowers able to make thoseinterest payments over an extended period
of time or do they really need thefed to start cutting in the future?
No,
a very high percentage at least of ourportfolio are still well above one and a
half times from an interestcoverage standpoint,
meaning they're able tostill service the debt.
I think for the private equity returnsto pencil out to what they were initially
(21:18):
underwritten at, they're going to needto see the Fed to start to cut rates.
We're not seeing interest rates alonepush a company into distress or de-stress.
It's typically interest rates plus a lossof the customer interest rates plus a
supply chain issue. So for the most part,
the companies have been able tomanage the higher rate environment.
They just had a lot less room for error.
(21:40):
It kind of magnifies a mistake right now.
I think if the interestrates start getting cut,
it gives them a little bit more room tolose a customer to have a supply chain
delay and still haveliquidity to manage through.
It just really has made it much moredifficult for them to make a mistake.
It's hard to recover with theirinterest rates where they are.
So do you see the higher rates isbasically just transfer in economics from
(22:03):
private equity firms tomiddle market lenders?
That's exactly correct.
We're going from mid single digitsto teen type returns on the assets
and that is coming out of theequity ownership of the business.
So they've benefited from low rates andvery high returns for quite some time.
And the term that gets thrown around alot is the golden age private credit and
(22:24):
it's really the first lie loan is makingalmost equity like returns from a yield
standpoint.
So that's why I think it'sso many headlines and so much interest in the asset
class.
It's just that double digit returns froma security where you're in the top of
the capital structure.
So one of the key trends in CLOsthis year has been declining CLO
(22:44):
financing costs tripleeight down to double B.
How does that affect yourbusiness in terms of issuance?
Does that make it more likely that you'llcome to the market deals in the future
or will you look to refi reset thedeals that are already outstanding?
From a new issue standpoint,
it doesn't really change whatwe had planned for the year.
(23:05):
From a new issue standpoint, itdefinitely makes things more appealing.
Where it does change our plan ison the reset refinance side of the
equation. So at the AAAlevels we are today,
a lot of the deals that we've priced overthe last couple of years are all of a
sudden it looks compelling from anequity return standpoint to go out and
(23:26):
reset the deal for another four yearsand possibly lower the borrowing costs
slightly.
So that's where I think you are seeinga lot more activity as people are
starting to refinance and reset new deals.
Middle market is less tiedto a few basis points.
Even when spreads were 75 basispoints wider than they are today.
(23:47):
People were still out there constantlyissuing middle market CLOs because we
just have a lot more spread inour assets and if a quarter basis,
25 basis points doesn't necessarily makeor break our returns like it does in
broadly syndicated equity where they'retrying to get to a couple basis points
of a model from an arbitrage standpointbecause they're going to magnify it 10
(24:07):
to 12 times and probably syndicated. Soevery basis point really matters at that
magnification middle market.
CLOs can be anywhere fromthree to six times levered,
so it's less of a magnifier whenwe're talking a few basis points.
But I think reset activity does definitelypick up the back half of this year.
So BlackRock has both broadlysyndicated and middle market CLOs.
(24:28):
Are the investors in thosetwo different securities,
are they different folks or do peopleplay in both your middle market and your
broadly syndicated issuances?
So we definitely do have a middle marketUS probably syndicated and European CLO
business as well, whichis syndicated loans there.
We do have crossover onthe debt side for sure.
People are familiar with the platform,
(24:50):
how robust our risk management functionsare our Aladdin systems and they
definitely get the benefits ofunderwritten one of the teams.
There's going to be a big portionof their underwriting completed,
so they do get a synergy of that.
So we definitely do see overlapon the debt investor side.
On the equity side,
I do not believe the middle marketoverlaps with the probably syndicated,
(25:12):
but I can't say it for ahundred percent certainty.
Is there anything interesting happeningin the market that we should touch on?
I think one thing that doesn't get theattention in middle market loans are
valuations.
This has become really importantrecently for the AAA investors
as because if a loan isn'tbeing marked a fair value,
(25:34):
there's no benefit or protectionto the or other debt holders.
From a triple C haircut standpoint,
we've seen the S and p triple Cs creepup from a historical average where
by nearly the s and p averages,
most people are going to be having almostsome form of a triple C haircut. Well,
that haircut only protects you if theloans are being marked a fair value.
(25:56):
If they have all the loansmarked at par or near par,
it doesn't give you the protection.
Then there's no haircut on that.
There's no haircut at that.
So I was on a panel recently whereanother manager was saying they self mark
their loans and they didn't seethe need to value their loans.
And there's just so many reasons whyvaluations should be done If you have a B,
(26:16):
D, C, it has to be done,
but the frequency and the wayyou do it is not standardized.
And then when people are looking maybeto make direct lending fund investments,
like if you're just goingto invest in someone's fund,
one manager might be marketing theirbook to represent fair value and their
returns might look lower than amanager who doesn't mark their book.
So I think valuations is something thathelps level set the different managers
(26:40):
and also gives you a goodthird party view of the credit
quality of the portfolio.
One thing that I think you're good atand the they're good investors at is they
look at the market values of our loansthat are done by third party valuation
agents and it could quickly tell youwhat loan is maybe underperforming or
having issues. It quicklyhighlights where outperformers and
(27:03):
underperformers are,
and you don't necessarilyneed to be familiar with all the underlying borrowers,
but this third party has gonein and reviewed the financials,
has spent time with the budget as a reallygood understanding on how the company
is performing.
So if there was more of a standardizationof valuations where everyone was doing
it every quarter and theywere doing it to market,
(27:25):
there'd be a much more clearplaying field where it's really
hard to light up managers side byside from a return standpoint because
one manager might have unrealized lossesbecause they're marking their book to
reflect the credit quality where onemanager hasn't marked his book and has
everything at par, even though theymight have problems underlying.
(27:45):
Now you see the BDC analysts talk aboutit where one manager has a loan marked
at 75 and two managershave it marked at par.
So it's one place I'd hope there wouldbe more standardization and more people
getting to quarterlyvaluations of the portfolio.
I definitely see that whenwe pull up CLOs and Intex,
sometimes all the loans are marked andthat other times just some percent,
(28:07):
it could be the CCCs aremarked defaulted loans.
There's always going to be a mark forthose, I think. But for my seat, yeah,
if you can get a hundredpercent loans marked,
that would enable investors like meto compare returns apple to apples.
And then it would also increase justthe liquidity of a CLO manager's shelf
because at the secondary market,
people would freely trade bonds if allthe loans are priced and it becomes more
(28:31):
challenging if there's just someblank fields by the loan prices.
So one thing I do see in our middlemarket CLOs is that sometimes there's some
broadly syndicated loans thatmake it into the portfolio.
A lot of times these are,
I call them maybe lightly syndicated loanswhere maybe they're underwritten by a
Jefferies or a UBS or something like that.
(28:54):
Do you guys ever see value therefor your middle market CLOs?
We have in the past.
I'd say that market has gottensmaller over the last couple of years.
We're seeing less and lessthrough that lightly syndicated.
There's still to us importantto be middle market borrowers,
so there's still sub ahundred million of ebitda.
Those do have some benefit is that youcan in some situations actually drive
(29:17):
change to the documentation.
It's not as much of a yes orno at what price transaction.
It's very much more ofhere's the business.
You could spend time withmanagement if you like.
You could do the same level of diligencethat you typically like and in some
markets they're open todoc changes, improvements.
We're willing to come into this deal,
but we need these two sections ofthe credit agreement tightened.
(29:41):
Maybe we need a little bit more pricing.
And in some markets we found some reallycompelling opportunities that almost
felt private in the end where we wentout and met management team and there are
some that come in three days and it'show much do you want to buy and at what
price? And those are lesslikely for us to participate.
But they have been a way to add additionalassets in some industries and even
(30:02):
some businesses we knowthat was probably five,
seven years ago was a common exit forus is we did a private deal and then the
next step was to the lightlysyndicated bank deal.
We see that less and less now wherea company just stays primarily in the
private credit space where it goes fromour market to another one of our peers
that does bigger deals.
(30:23):
With some cases we participate in enrolland sometimes the pricing is going to
be so low or the documentation is notwhat we expect, so we just go home.
But that is now,
I would say the more traditionalgraduation from our segment to the larger
segment of the market.
Well, I think that's all thequestions I had. So Patrick,
thanks so much for coming on thepodcast. Really enjoyed our conversation.
(30:44):
Thanks. She always great to chat.
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
(31:06):
any Flat Rock Global fund definition.
Section A UM refers toassets under management,
EBITDA or earnings before interest. Taxes,
and depreciation is a proxy for abusiness annual cashflow roll-up
strategies are when a private equitysponsor is actively looking to grow a
business through acquisitions.
(31:26):
Loan to value is the value of thefirst lie in debt divided by the
enterprise value of the company.
LMT or liability managementtransactions are an out of court
modification of a company's debt Uptiering refers to placing additional debt
with a priority abovethe first lien term loan.
The secured overnight financing ratesuffer is a broad measure of the
(31:50):
cost of borrowing cash overnight,
collateralized by treasury securities.The global financial crisis,
GFC was a period of extreme stressin global financial markets and
banking systems betweenmid 2007 and early 2009.
Credit ratings are opinions aboutcredit risk for long-term issues or
(32:11):
instruments.
The ratings lie on a spectrum rangingfrom the highest credit quality on one end
to default or junk on the other.
A AAA is the highestcredit quality A C or D,
depending on the agency issuing therating is the lowest or junk quality.
Leveraged loans are corporate loans tocompanies that are not rated investment
(32:32):
grade broadly. Syndicated loansare underwritten by banks,
rated by nationally recognized statisticalratings organizations and often
traded by market participants.
Middle market loans are usuallyunderwritten by several lenders with the
intention of holding theinvestment through its maturity.
Junior capital is financing that has alower priority claim in debt repayment
(32:56):
to a secured term loan spread is thepercentage difference in current yields of
various classes of fixed incomesecurities versus treasury bonds or
another benchmark bond measure,
ETFR exchange traded funds.High yield bonds are corporate debt rated
below investment grade andsometimes referred to as junk bonds.
(33:16):
Our set is a refinancingand extension of ACL O.
Investment interest coverageratio compares a company's annual
cashflow to its interest expense.
Intex is software thatCLO practitioners use.
General disclaimer section.
References to interest rate movesare based on Bloomberg data.
(33:36):
Any mentions of specific companies arefor reference purposes only and are not
meant to describe the investmentmerits of or potential or actual
portfolio changes related tosecurities of those companies unless
otherwise noted.
All discussions are based onUS markets and US monetary and
fiscal policies.
(33:57):
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 date of thebroadcast and do not necessarily represent
(34:18):
the views of the firm as a whole. Anysuch views are subject to change at any
time based upon market or otherconditions and Flat Rock Global disclaims
any responsibility to update such views.
This material is not intendedto be relied upon as a forecast,
research, or investment advice.
It is not a recommendation offeror solicitation to buy or sell any
(34:42):
securities or to adoptany investment strategy.
Neither Flat Rock Global nor the FlatRock Global Speaker can be responsible
for any direct or incidental loss incurredby applying any of the information
offered.
None of the information provided shouldbe regarded as a suggestion to engage in
or refrain from any investment relatedcourse of action as neither Flat Rock
(35:06):
Global nor its affiliates are undertaking.
To provide impartial investment advice,
act as an impartial advisor or giveadvice in a fiduciary capacity.
This broadcast is copyright2024 of Flat Rock Global
LLC. All rights reserved.
This recording may not be reproducedin whole or in part or in any form
(35:27):
without the permissionof Flat Rock Global.
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