June 26, 2024 • 43 mins
Unlock the secrets of Collateralized Loan Obligations (CLOs) with industry expert Shiloh Bates from Flat Rock Global. Shiloh, boasting over 20 years of experience, simplifies the complexities of CLOs, comparing them to mini-banks with diversified portfolios of first lien senior secured loans. Learn about the intricate structure of CLOs, from AAA tranches to the high-yield equity tranches, and discover why CLO equity attracts investors with its high profitability and cash flow potential. Shiloh also provides a thorough analysis of the risks and historical performance of CLOs, offering a compelling perspective on the future of this asset class.
In our conversation, we dive deep into what sets CLO equity investments apart from traditional bonds. Shiloh highlights the advantages of CLOs, such as their low loan-to-value ratios and the importance of diversification across sectors like healthcare, technology, and business services. Hear insights from past economic downturns, and understand why CLOs often outperform high-yield bonds with their secured nature and higher yields. Shiloh explains the lower default rates and greater recovery prospects that make CLOs an enticing alternative, especially in the current economic landscape.
Prepare for an eye-opening exploration of CLO portfolio management and market resilience. Shiloh discusses the critical roles of portfolio managers and their relationships with investment banks, ensuring lucrative opportunities. Learn how CLOs have stood strong during financial crises, including the 2007-2008 meltdown, and understand their structural advantages. Finally, get a sneak peek into Shiloh's comprehensive book on CLO investing, a must-read for anyone keen to deepen their understanding of this potent financial instrument. Don't miss out on this wealth of knowledge from one of the leading experts in the field.
The content in this program is for informational purposes only. You should not construe any information or other material as investment, financial, tax, or other advice. The views expressed by the participants are solely their own. A participant may have taken or recommended any investment position discussed, but may close such position or alter its recommendation at any time without notice. Nothing contained in this program constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in any jurisdiction. Please consult your own investment or financial advisor for advice related to all investment decisions.
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Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Speaker 1 (00:08):
My name is Michael Guyatt, publisher of the Lead
Lag Report.
Joining me at the rough hour isShiloh Bates of Flat Rock
Global.
Shiloh, introduce yourself tothe audience and to me a little
bit more formally.
Who are you, what's yourbackground, what have you done
throughout your career and whatare you doing currently?
Speaker 2 (00:25):
done throughout your career and what are you doing
currently?
Sure, well, great to be withyou today here.
So I've spent about 20 plusyears in the CLO industry so CLO
stands for Collateralized LoanObligations and I started my
career as an investment banker.
I did that for two years andthen I transitioned to the buy
side where for 10 years I wasinvesting.
(00:47):
I was working for CLO managersand I was buying, investing in
the loans that go into CLOs, andthen for the last decade plus,
I've been investing in CLOsecurities, so particularly the
CLO equity tranche and the CLOBB.
So I've spent almost my entirecareer in the CLO space.
(01:11):
Last year I published a book onCLO investing.
It's called what's called thatCLO investing, with the emphasis
on CLO equity and BB notes.
That's what we focus on at FlatRock, where I am the chief
investment officer.
We manage about a billiondollars in CLO securities and we
(01:34):
think the outlook for our assetclass is pretty compelling at
the moment.
The book I wrote, by the way,is for investors who just want
to know more about the CLO assetclass, so there's no particular
loan or bond or structuredfinance experience to get
(01:54):
through the book.
It's just 220 pages, writtenfor anybody who has some kind of
expertise or some financialwherewithal should be able to
get through it pretty easily, Ithink.
Speaker 1 (02:09):
All right.
So there's a number of keywordsI want to have you define.
First of all, because I hearcollateralized loan obligations
and then I hear equity, andthose words collateralized and
loan and obligation all might beconfusing to most people that
just know about stocks.
So let's start basic what is aCLO?
And then explain what a CLOequity is.
Speaker 2 (02:31):
Sure, so the way to think about a CLO is that it's
really a simplified bank.
So the bank has 500 million ofassets in it and the assets are
going to be a diversifiedportfolio assets in it and the
assets are going to be adiversified portfolio of first
lien senior secured loans.
There might be 200 plus ofthese loans in the CLO and these
(02:52):
loans are created in leveragedbuyouts.
So imagine Aries, apollo, kkr.
They're buying a company, saythe enterprise value is a
billion.
They might finance half thepurchase price with equity from
the private equity firm and theremainder may come in a first
lien term loan.
And so the attraction of doingthe term loan from the
(03:16):
perspective of private equity isthat it's just a way for them
to leverage their investment.
So the private equity firmbelieves that the business that
it's buying will be able to growrevenue and profits over time,
so they want to lever thatinvestment.
And then, from the perspectiveof the first lien term loan,
(03:36):
this is a loan that today mightpay.
They're going to be floatingrate, so it's three months, so
for plus maybe 350, uh basispoints, uh or thereabouts.
So we're talking about 9% iskind of the the yield uh on on a
lot of these loans.
And then the loan is secured byall the assets of the company.
(03:58):
Uh and so, like in my uhexample, as long as the
enterprise value of the businessdoesn't decline by half during
that business's life, then thefirst lien lender is going to
get repaid at the end of the day.
So how we you know, if you lookback over call it 30 years, the
(04:20):
track record for these leverageloans is pretty favorable.
The track record for theseleverage loans is pretty
favorable.
So, like, by our math, there'sabout a 2% default rate in CLOs.
The recovery rate on loanshistorically has been about 70
cents on the dollar and whatwe've seen over the last two and
(04:43):
change years is that becausethe floating rate, because the
Fed is hiked so much, thefloating rate three months so
far is high.
It's at 5.4%, and that meansthat we're receiving a lot of
income on these loans that maybewe would not have expected to
receive.
So we've benefited from thehigher Fed funds rate which
(05:05):
translates into higher threemonths so far.
So those are the assets of theCLO.
So, again, there's 200 of theloans that I just described.
And then the CLO financesitself by issuing different
securities.
We call them tranches to soundsophisticated and basically
there's a AAA that finances thisloan pool and there's a AA and
(05:29):
kind of down the stack until youget to securities that we focus
on.
So we're focused on the doubleB note, which is usually the
junior, most debt securityissued by the CLO, and then the
CLO equity sits at the bottom.
And so if you're an investor inCLO equity, how you think about
(05:50):
that is that the interest ratethat you earn on the CLO's
assets is much higher than theCLO's financing cost, and so
that creates profitabilitythat's distributed to the CLO
equity investors quarterly andso the profitability of the CLO
(06:10):
creates high cash flows to theequity.
And then the risk that you'retaking is that loans default and
there's loan losses in the CLO.
If and when that happens, thoseare losses that are borne by
the equity, but fortunately it'snot a kind of unquantifiable
(06:31):
risk.
Basically we can look back overthe last 30 years.
We see it as roughly a 60 basispoint loss rate on the loans.
And so when you buy a CLOequity piece you never assume
that you're going to go the CLOmanager is going to go 100 or
200 for 200 on the loans.
These loans are single B ratedon average.
(06:55):
They're not investment grade,and so there are going to be
some defaults, and you budgetfor that using this 60 basis
point loss rate and, net of theloss rate, you're still
targeting returns of the mid tohigh teens, and so that's how I
would describe CLO equity in anutshell.
And then the double B security,which is something that we also
(07:20):
focus on.
It's a little bit simpler.
It's just, you know, it's justa debt instrument.
The rate today is around threemonths, so for plus 600 basis
points or a little bit inside ofthat, and that gets paid its
interest.
After the, the other debtthat's more senior to the double
B gets paid its interest, itsinterest, and so the CLO that I
(07:49):
described might have a life of,could go as long as maybe nine
years.
But again, the analogy, thebest analogy to think about this
, is just a simplified bank.
So if you buy stock today inlike a JP Morgan or a Bank of
America, they're in 30 differentbusiness lines.
They're still paying legalsettlements from their misdeeds
of the past.
In a CLO, it's just a portfolioof loans financed at a low cost
(08:12):
with the profitability flowingthrough to the equity.
Speaker 1 (08:20):
It sounds to me like the last three years were almost
the perfect backdrop.
These didn't really have creditspreads widened at all.
It's purely about interestrates.
Anything that was variable didwell without the commensurate
default risk that normally youmight otherwise see in something
that was as fast as it was.
(08:41):
Talk through different interestrate cycles and credit cycles,
how, in general, the asset classtends to behave.
Speaker 2 (08:50):
Yeah, sure.
So the interest rate increaseswere beneficial to us really
since 2022.
Now, although the base ratewent up for CLO equity, it
actually did trade down duringthe year, and the reason for
that was at the end of 2021, wewere targeting around a 15%
(09:13):
return on our investments, andthen in 2022, risk premiums for
all asset classes went up and sodid the risk of a sharp
recession.
That never showed up, butduring 2022 and the beginning of
2023, people were looking atequity and saying, okay, I'm not
(09:37):
targeting 15% anymore, I'mtargeting very high teens, and
because of that, owners of CLOequity needed to write down the
fair market value of theirinvestments.
But the sharp downturn in theeconomy did not materialize and
we've benefited from the higherbase rate, and so those CLO
(09:59):
equity securities really havebeen coming back.
They haven't fully retraced thedrawdown of 2022, but we're
certainly heading in the rightdirection.
The loans in CLOs they do starttheir lives with a 50% or less
loan to value, and so, as aresult, we're not so sensitive
(10:19):
to the overall kind of growthrate of the economy.
So, whether the economy grows2% or 3% or if it shrinks one,
these are very relevant numbersif you're investing in, like
common stocks or the S&P 500,for example.
But as a lender and that's whatthe CLO is basically a lender,
(10:41):
even if a business is acquiredand revenue and cashflow never
grow during, you know, call itthe six year life of the term
loan, um, you know, even in thatcase, as a lender you're
probably fine with it.
I mean, you're you're going todeleverage.
You know, deleverage slowlyover time.
Um, in fact, when the businessdoes very, very well, uh, what
(11:03):
happens from the perspective ofa lender is just that you get
paid, repaid very quickly andyou did a bunch of work and due
diligence on a company and nowit's, you know, refinanced
itself at a lower rate.
You know, potentially with,with a different group of
lenders and so like.
For us, really kind of therisks on the underlying loans
(11:23):
are that some kind of you knowthat there's regulatory changes
or technological changes orlosses at big customers.
These are things that you know.
Maybe specific, to be specificto just one company in a CLO or
to one particular industry.
We're really just focused oncases where the performance of
(11:47):
the borrower, the wheels, comeoff the cart, if you will, but
the overall growth rate of theeconomy within some bounds isn't
really a big driver of theresults we're going to get from
our CLO equity pieces.
Speaker 1 (12:06):
Are there?
You mentioned, leveragedbuyouts?
Are there certain sectors thattend to dominate the asset class
?
Speaker 2 (12:14):
Sure.
So the biggest industries in ina CLO are going to be uh,
there's three of them.
So healthcare, uh, is one, uh,business services is another and
technology is a third.
So when I go through all theseum, so in healthcare, uh,
usually you know this might be11% or so of the portfolio.
(12:37):
What you're going to find inthere are very diversified
business models.
So it's not healthcare wherethere's one risk to all 10% or
11% of the portfolio.
What you'll actually see isit's 10% and it's hospitals and
(12:58):
it's drugs and it's devices,maybe billing.
There's not one thing thatwould happen in the economy or
to these businesses where all10% or 11% would be at risk.
And then technology, which iskind of a similar amount of the
CLOs AUM that's going to be.
(13:20):
It was not not a couple of guysin a garage launching a product
.
This is, you know, enterprisesoftware, where you have
businesses with 500 million plusrevenue, where they're really
kind of entrenched with theircustomers would be very hard to
replace the software.
(13:41):
And then business services isalso like a 10, 10 to 11% of of
a typical CLO and basicallybusiness services is just a
catch-all for basically the CLOmanager saying we couldn't find
of the 32 other you knowpotential industries that could
be assigned to.
You know we couldn't find one,so we we called it business
(14:02):
services and that's kind of thecatch-all.
So I think there's not.
So the point of this is thatbasically, you know the CLO is
going to have 200 differentborrowers in there.
It's going to be diversified byindustry.
If I went back in time in 2015,I think CLO managers did learn a
(14:24):
lesson, a hard one, and thatwas just that back then the
typical CLO portfolio might'vehad.
Four or 5% of the loans were tooil and gas companies, where
you know the results there weretotally tied to a commodity
price at the end of the day.
So in that case there was onerisk and you know we were in a
(14:48):
downside case in 2015 and 2016,.
A lot of those loans tradeddown pretty substantially during
the time and as a result, Ithink our CLO managers today are
very they don't do a lot ofenergy loans one, but they're
hyper-focused on not having anyrisk that could kind of be
(15:08):
present in more than one or twoor maybe three different loans,
or maybe three different loans.
Speaker 1 (15:18):
The question that comes to mind for me is why
bother with bonds at all ifthat's the case I mean, aside
from the fixed versus variableaspect of it CLOs have generally
higher yields, right andthey're secure, and largely most
people don't know about them,which to me is attractive,
because it probably meansthere's more undervaluation.
Speaker 2 (15:43):
So why even consider traditional bonds at all?
Yeah, so our funds basically,people are allocating to,
especially to our BB Focus Fund,really as an alternative to
high yield, and we think it's amuch more interesting way to
play the credit markets thanhigh yield.
So if you're investing in aportfolio of high yield bonds,
one, you're placing a bet oninterest rates, whether you want
(16:08):
to or not, and from here theexpectation is the Fed is going
to cut, but we don't know.
That's been the expectation fora long time.
And then if you look at defaultrates for high yield bonds, for
example, over the last 30 years, high yield defaults at about a
(16:29):
3% rate and when there is adefault, the high yield bond is
generally unsecured.
Um, so an unsecured bond isjust basically an IOU from the
company.
It's a, it's a promise to pay,but there's no specific
collateral backing, uh, backingthe claim.
And so if there's a first lienterm loan, for example, at the
(16:52):
company that's going to be ahead, that's going to get the first
recovery, uh, bond would comesecond.
So the recoveries there arekind of in the high 30s looking
back over the last 30 years.
And so in a double B corporateyou can always have defaults.
(17:15):
So the defaults again aredriven by anything kind of
negative and idiosyncratichappening at the company.
But for CLO securities and I'lltalk about the double B, since
that's the junior most debttranche If you look back over
the last 30 years, the defaultrate is about 25 basis points,
(17:36):
and so it's a small fraction ofthe default rate or a loss rate
in high yield.
And the reason for that is thatif you invest in the CLO double
B, you're benefiting from thefirst loss equity that's
contributed to the CLO on dayone.
(17:57):
And so when loans, from theperspective of a double B
investor, when loans in the CLOare defaulting, that's really a
risk for the equity investor,not for you.
And so over time over this 30years, the default rate on these
double Bs has been de minimis.
And then today, because of thehigher base rate they pay,
(18:23):
depending on the structure ofthe BB, it's 6% over three
months so far.
So that's about 11.5% yield,about 11.5% yield, and our view
is, if you can make 11.5% andthe historical default rate is
de minimis for these securitiesand there's been a lot of them
(18:44):
issued we think that that'sreally compelling and that's why
CLOs do make it into the news.
There's a lot more stories nowon Bloomberg or the journal
where people are interested inthe asset class and basically
that's the reason attractiverisk-adjusted returns.
Speaker 1 (19:09):
Such on liquidity right.
I know there are a number ofETFs out there that also try to
do CLO investing, but when youhave a real dislocation or
volatility scale, do you get thesame kind of mispricing in CLOs
like you would in the highyield illiquid junk bond space?
Speaker 2 (19:36):
Yeah.
So I think there's lots ofopportunities in a down market
and you know, kind of one of thebarriers to the asset class for
investing in CLOs is that youknow, basically there's four
concepts in CLOs and happy to gothrough them.
But that makes CLOs a littlebit more complicated than owning
like a high yield bond, forexample.
So, like CLOs are, they're onlysold to, usually just sold to,
(20:00):
you know, qualifiedinstitutional buyers.
Clos are modeled in softwarecalled Intex that's widely used
by market participants andinvesting in CLOs without that
software, you know, could bechallenging.
Investing in CLOs without thatsoftware could be challenging, I
(20:20):
think, for a lot of people.
And so we're earning what Ithink is a complexity premium
for understanding an at scalewhich I think we are at, flat
Rock, the individual, the fulltranches of the CLO securities
(20:45):
that we're buying.
They might be, in the case of anequity tranche it might be 50
million, in the case of a doubleB it might be 30 million, and
when these securities arecreated, an investment bank is
going to the market to try tofind the best buyer and so
because of the size, the totalsizes of these investments, the
(21:09):
investment banks can't go to theentire world.
You can't show 100 people a 70million opportunity because if
everybody said yes, they like it, well, there's not going to be
enough paper to go around.
And so, kind of like,structurally, how my market
(21:29):
works in terms of the process ofbuying securities is that the
investment banks just go to theguys who they think will be the
best buyers, guys that theyalready have relations,
relationships with, and so itmakes it harder as a um, as a
newer participant or lessexperienced one uh, to come into
(21:51):
the market and uh and beeffective.
Into the market and beeffective.
Speaker 1 (22:00):
The high yield part of the marketplace I often put a
spotlight on in my own research, largely because I can't quite
wrap my head around small capstocks not doing anywhere near
as well as large caps have,which suggests to me that
there's refinancing riskconcerns which are holding back
(22:20):
that part of the equity spaceversus credit spreads which are
saying there's no default riskat all.
This has been a big theme ofmine for the last year.
I can't quite understand thedisconnect there.
Do you get a sense that thehigh yield space is properly
valued in general?
Forget about CLOs for a momentSort of just the idea of the
(22:42):
marketplace thinking defaultrisk is a lot less than maybe it
is.
Speaker 2 (22:47):
Yeah.
So I'm definitely not an experton high yield bonds, but our
view is that what we've kind ofseen anecdotally in the numbers
and there's an index out therewhere you can kind of look at
the performance of theunderlying loans and CLOs and
basically what it would show youis that you know the revenue
(23:09):
and profitability performance ofthe loans has been very strong
for the last two years andprofitability performance of the
loans has been very strong forthe last two years.
And basically we've seen thiscycle where the borrowers that
we have are doing very well and,as a result, the Fed needs to
(23:29):
keep interest rates higher.
That's been kind of thefeedback loop.
I do think here at this pointthe higher rates may be starting
to have more of an effect andwe're very cautious.
At Flat Rock we make investmentsas though a recession is around
the corner.
That's how we think about ourbusiness.
I do think things are slowing alittle bit.
(23:51):
I think the Fed is starting tohave the higher rate is starting
to have an effect on somebusinesses.
But again, for us, as long asthe performance of the company
doesn't totally fall out of bed,then as a first lien lender
we're in pretty good shape.
And then, if you're talkingabout high yield specifically, a
(24:12):
lot of borrowers actually haveboth a first lien term loan that
might be in a number of CLOsand they also issue high yield
bonds.
And so it's the same companywith two different securities.
And when we look at kind of therelative value between owning a
first lien loan and a bond, thebig message is that because the
(24:36):
Fed has hiked so much, you knowyou can get basically equity
like returns from the first lienloan, and so we really just
don't see any reason to stretch,um, you know, to high yield to
potentially earn a little bitmore in terms of income.
And it's also the same thingfor second lien loans.
Um, so, like our strategies atFlyrock are basically first lien
(25:00):
exposure strategies, uh andthat's it, and um, but again,
but again, I'm actually not anexpert on the high yield market.
Speaker 1 (25:07):
It's a question that somebody asked.
I want to show it on the screenfrom a viewer CLOs are they,
like, the next source of acrisis?
And I know I'm sure you'veheard similar things people that
are not involved and I think alot of that comes from,
obviously, the 07, 08 type oftype of period, but let's tease
(25:27):
that out a little bit, sort ofthe idea of that as a source of
a crisis or not forward to thecurrent period.
Speaker 2 (25:47):
So during the financial crisis, clos would
have traded down on amark-to-market basis
substantially.
But if we're talking about theCLO equity tranche and that's
the tranche that takes the mostrisk in a CLO, one thing that's
very surprising to people isthat if you would have bought a
CLO equity tranche in 2007, soright before the GFC, and you
(26:08):
would have held it through itscall it a 10-year life, the
average IRRs would have beenclose to 30%.
So that's, you know you made30% every year over 10 years.
So that's you know.
If you compare that to theperformance of CDOs, where the
(26:28):
underlying collateral was, youknow subprime mortgages of
dubious credit quality, you knowyou saw AAAs, their default,
and then, in my little niche,you know, clos, even the equity
tranche, did well, and so then,and defaults were really de
minimis, you know, kind of likethrough the capital stack.
(26:50):
I mean, I quoted the double Bdefault rate as like 25 bps
annually.
So CLO securities did reallywell, and so I guess you know.
The question is why?
Well, one is just the qualityof the assets in a CLO.
So again, first, lien loans tocompanies that are backed by
(27:11):
sophisticated private equityfirms with initial loans to
value of like 40 to 50%.
So that's what we're doingSignificantly better collateral
than you would have found in theABS CDOs that defaulted.
So another kind of thing toknow about CLOs that's really
(27:33):
important is just that when youget into recessionary periods,
default rates on loans shouldpick up.
That's negative for all theinvestors in the CLO.
But at the same time, clos arereinvesting vehicles.
So when the CLO starts its life, it might have a portfolio of
(27:54):
400 or 500 million of loans.
Those loans prepay every threeto four years, prepay every
three to four years, and duringthe CLO's reinvestment period
the CLO manager goes into themarket and buys new loans with
the proceeds.
And so during the GFC, defaultrates on loans picked up
(28:18):
substantially.
The default rate peaked atabout 8%.
So that's very negative for allthe CLOs investors.
But at the same time, the loanindex traded down as well, and
so every time a loan prepaid apar, the CLO manager went to the
market and they bought a newloan at a discount, and it turns
out that a lot more loansprepay a par than ever default.
(28:40):
Prepay a par, they neverdefault, and so each time you
buy a discounted loan, that's anexpected gain in the future,
and so the 30% IRRs for theequity.
A big driver of that was justthat the CLO manager could buy
discounted loans with proceedsof the loans that prepaid,
discounted the loans withproceeds of the loans that
(29:02):
prepaid, and they were able toget actually, instead of having
net losses on the loans, theyhad net gains because of the
cheap loans that they bought.
So then, since the GFC well,right after the GFC, people were
not issuing CLOs.
The CLO market really didn'tturn back on until 2011.
(29:26):
And now I mentioned before it'slike a trillion dollar AUM asset
class, and so because ouracronym is CLO, it starts with a
C, and everybody, a lot ofpeople read and enjoy the Big
Short.
I certainly did, but what we'redoing is our performance has
(29:47):
been strong, and so that's whykind of the interest in CLOs
today, I think, are a functionof good historical performance,
and then also the higher baserate kind of helps us out, and
then also the higher base ratekind of helps us out.
So then is it, are CLOs asource of risk in the economy?
(30:08):
So I think not.
So the CLO is set up initiallywith around a 12-year maturity,
and so the idea with thatmaturity is that every loan in
the CLO should be repaid by thetime the CLO ends its life, and
(30:29):
there's no mark to marketmargining or anything like that
in a CLO.
So there's no for selling ofloans.
In fact, if you're a CLO equityinvestor, the worst thing that
could happen to you is that CLOdistributions are missed.
So if the CLO underperforms andby that I mean there's too many
defaulted loans or loans thattraded down or loans that were
(30:55):
revalued at or re-rated attriple C or downgraded If you
have too many of those then theCLO equity does not get paid and
instead the CLO's profitabilityis used to acquire more, more
leverage loans.
So there's not any to have kindof like contagion you know or
(31:17):
you know you would.
There's.
There's nothing that wouldcause you know for selling of
loans in CLOs.
So another is just that thebanking system today is more
resilient because of CLOs, andby that what I mean is that the
(31:42):
kind of loans that I've beentalking about today,
historically these were owned inmany cases by banks directly,
and now what we see is thatthese loans really are owned in
CLOs and maybe some other, likeloan mutual funds or ETFs, but
banks have largely exited owningthese loans.
So they might a Bank of Americaor JP Morgan might underwrite
the loan or arrange it.
(32:03):
But they syndicate it to 50 or100 different accounts and they
earn a fee for doing that.
But after the syndicationprocess they really don't have
much exposure to the loan at all, and from the bank's
perspective, the security that'smore interesting to them than
(32:26):
owning the loan directly is theCLO AAA.
So they buy the senior, mosttranche of the CLO.
They skip investing in the loandirectly.
If you invest in CLO AAAs you'regoing to earn a rate that's
lower than the rate you wouldhave earned by owning the loan
(32:47):
directly.
But the banks are focused ontheir return on equity and if
you have a AAA-rated securitythere's very little capital you
need to set aside for that, andso banks see the more efficient,
the more profitable way toinvest their dollars is to buy
CLO AAAs, and that leaves theexposure of loans to people like
(33:13):
me at Flat Rock who want therisk.
So our view is that these arehigh quality loans, that they'll
default rarely and that we canmake, depending on the security,
kind of mid to high teens inthe equity tranche and lower
returns in the BB.
But we're not our investors aresigning up to take this risk,
(33:40):
and we think it's a good one totake this risk and we think it's
a good one.
Speaker 1 (33:44):
Once the portfolio is constructed, what does the
maintenance look like, in otherwords, as a portfolio manager.
Speaker 2 (33:57):
What is it that's actually being done day to day?
Sure, so in our equity fund,for example, we're going to have
like 40 different CLO equitytranches that we bought since
the fund's inception about sixyears ago.
And basically to be aneffective CLO equity investor,
(34:22):
you need to look at deals thatare called primary deals, where
a CLO is being created.
You also look at CLOs thattrade in the secondary market
and you're trying to alwaysdetermine what's the best
risk-adjusted returns among thetwo.
And then, in terms ofmaintenance just kind of keeping
yourself up to date on theperformance of the CLOs they
(34:44):
report to you monthly with atrustee report that's 100 pages
of information on what'shappening with the CLO, what
loans have been bought, whattests, how the CLO is performing
versus its many tests, and then, four times a year, is
performing versus its many tests.
And then four times a year weget a quarterly payment report
(35:13):
which again takes all theinterest payments from the CLO,
allocates it to the owners ofdifferent CLO securities and
then the remainder, like I'vesaid, is swept to the equity
tranche.
So that's done every quarter.
And then also for me, part ofthe job is just if you have a
lot of data through thesetrustee reports, but we are in
(35:35):
constant contact with the CLOmanager about the performance of
loans as well.
So I should point out, atFlyrock we're not a CLO manager,
so each CLO does have a manager.
That's the person who picks theinitial loan portfolio and
keeps the CLO fully investedduring the reinvestment period.
(35:56):
For us, some of our CLOmanagers are basically the
biggest publicly traded assetmanagement firms.
Our CLO managers and ourbiggest CLO manager across our
funds is BlackRock.
Speaker 1 (36:16):
Let's touch on the book for a bit as we get close
to the top of the hour.
It is not easy to write a book,I don't care how long it is.
Talk about that, drew.
Was that your first book?
How challenging was the actualprocess.
Speaker 2 (36:30):
So the genesis of the book is that in 2020, I had
some time on my hands and Idecided to write just like a
60-page manual on how I approach, uh, clo investing.
And uh, there were some otherkind of white papers uh out
there, um, for CLOs, but theywere written from the
(36:53):
perspective of, like you know, alawyer or maybe you know, a
different market participant.
And so I I had, kind ofuniquely, this white space where
it's like I don't thinkanybody's written about our
business from the perspective ofa CLO equity investor.
So I wrote that, we put it onour website and, you know, I was
(37:14):
really surprised by how manypeople read it, and I think it's
partially a function of thefact that it's just there's no
other resources.
There's other resources outthere, like if you want to
inform yourself on CLOs, you cando a Google search and lots of
articles will come up.
But you know, this had a lot ofinformation you would want put
together in a way where I evenhad kind of examples.
(37:35):
It's like, okay, here's twoCLOs and this is where one
trades and this is where theother trades.
This is where one trades andthis is where the other trades,
and this is like how, how wewould think about the
explanation for the differencein price.
And so then I found, you know,clo managers were reading the
manual, and so so were mycompetitors, kind of kind of
(37:56):
funnily or kind of funny.
And then so then I that gave methe impetus to write the full
book, which is 220 pages.
And you know, it's not like,you know, if you're writing a
novel or something, you know,you sit down and with a blank
sheet of paper, and I think thatwould be very tough to do.
(38:17):
But for CLOs, you know, a lotof my time is spent educating
people on the asset class.
We have a pitch deck that hasdiagrams of CLOs and how the
cash flow is allocated amongstthe different investors in CLOs,
and so basically a third of thebook is just a copy and paste
(38:42):
of stuff that I'd already puttogether at one point.
And then I'm constantly doingQ&A with our investors.
So a lot of the people who haveinvested in our funds, they've
learned about CLOs through usreally.
(39:02):
So we've done that, we've donethat education, and so a lot of
the book just kind of naturallycomes together with, you know,
things that were already done.
And then I just kind of thoughtabout hey, you know, like,
what's the story of of CLOs andhow I would kind of how, how I
would tell it in a way thatmakes sense and, um, and so,
(39:24):
yeah, so we published it, uh,last year and you know, a lot of
people in the industry havetold me they read it.
I, uh, I don't know, that'sthat's what they tell me.
I don't question it, uh, and sowe've, we've, um, yeah, we've,
we've, I've had a lot of successwith it.
And um, um, you know, we've,we've, I've had a lot of success
(39:44):
with it and um, it's kind ofthe only, it's the only book in
in CLOs, uh, at the moment.
Speaker 1 (39:49):
Uh, charlotte, for those who want to track more of
your thoughts and get access tothe book.
Uh, where would you point themto?
Speaker 2 (39:55):
Yeah, sure, so the book is just on, uh, on Amazon,
uh, or we're Barnes and Nobleand then, um, you know, at Flat
Rock, we try to be, you know, athought leader in CLOs, and so
we have like an insights pagewhere we try to write about, or
comment about, the materialthings happening in the market
(40:17):
and so, like, just on ourwebsite, you can see, you know,
what we've found interesting,what we've written about, and
it's just, it's public, soanybody can go in there.
Uh, we also have a CLO equityindex, uh, which is, um, she's
also on our website and you cansee how CLO equity has performed
(40:37):
, uh, on a quarterly basis since2014.
Speaker 1 (40:43):
And we have the only, yeah that's the only CLO equity
index as well.
Everybody, I encourage you tolearn more about CLOs and check
out Shiloh's book.
Hopefully, maybe consider thiseducational.
Certainly part of themarketplace that most people are
not that aware of, but has somereally strong risk adjuster
(41:04):
returns.
So thank you, Shiloh.
I appreciate your knowledgehere and how you explained
everything.
Yeah, great to be with youReally enjoyed it.
Thank you, buddy Cheers.
My name is Michael Guyatt, publisher of the Lead
Lag Report.
Joining me at the rough hour isShiloh Bates of Flat Rock
Global.
Shiloh, introduce yourself tothe audience and to me a little
bit more formally.
Who are you, what's yourbackground, what have you done
throughout your career and whatare you doing currently?
Speaker 2 (00:25):
done throughout your career and what are you doing
currently?
Sure, well, great to be withyou today here.
So I've spent about 20 plusyears in the CLO industry so CLO
stands for Collateralized LoanObligations and I started my
career as an investment banker.
I did that for two years andthen I transitioned to the buy
side where for 10 years I wasinvesting.
(00:47):
I was working for CLO managersand I was buying, investing in
the loans that go into CLOs, andthen for the last decade plus,
I've been investing in CLOsecurities, so particularly the
CLO equity tranche and the CLOBB.
So I've spent almost my entirecareer in the CLO space.
(01:11):
Last year I published a book onCLO investing.
It's called what's called thatCLO investing, with the emphasis
on CLO equity and BB notes.
That's what we focus on at FlatRock, where I am the chief
investment officer.
We manage about a billiondollars in CLO securities and we
(01:34):
think the outlook for our assetclass is pretty compelling at
the moment.
The book I wrote, by the way,is for investors who just want
to know more about the CLO assetclass, so there's no particular
loan or bond or structuredfinance experience to get
(01:54):
through the book.
It's just 220 pages, writtenfor anybody who has some kind of
expertise or some financialwherewithal should be able to
get through it pretty easily, Ithink.
Speaker 1 (02:09):
All right.
So there's a number of keywordsI want to have you define.
First of all, because I hearcollateralized loan obligations
and then I hear equity, andthose words collateralized and
loan and obligation all might beconfusing to most people that
just know about stocks.
So let's start basic what is aCLO?
And then explain what a CLOequity is.
Speaker 2 (02:31):
Sure, so the way to think about a CLO is that it's
really a simplified bank.
So the bank has 500 million ofassets in it and the assets are
going to be a diversifiedportfolio assets in it and the
assets are going to be adiversified portfolio of first
lien senior secured loans.
There might be 200 plus ofthese loans in the CLO and these
(02:52):
loans are created in leveragedbuyouts.
So imagine Aries, apollo, kkr.
They're buying a company, saythe enterprise value is a
billion.
They might finance half thepurchase price with equity from
the private equity firm and theremainder may come in a first
lien term loan.
And so the attraction of doingthe term loan from the
(03:16):
perspective of private equity isthat it's just a way for them
to leverage their investment.
So the private equity firmbelieves that the business that
it's buying will be able to growrevenue and profits over time,
so they want to lever thatinvestment.
And then, from the perspectiveof the first lien term loan,
(03:36):
this is a loan that today mightpay.
They're going to be floatingrate, so it's three months, so
for plus maybe 350, uh basispoints, uh or thereabouts.
So we're talking about 9% iskind of the the yield uh on on a
lot of these loans.
And then the loan is secured byall the assets of the company.
(03:58):
Uh and so, like in my uhexample, as long as the
enterprise value of the businessdoesn't decline by half during
that business's life, then thefirst lien lender is going to
get repaid at the end of the day.
So how we you know, if you lookback over call it 30 years, the
(04:20):
track record for these leverageloans is pretty favorable.
The track record for theseleverage loans is pretty
favorable.
So, like, by our math, there'sabout a 2% default rate in CLOs.
The recovery rate on loanshistorically has been about 70
cents on the dollar and whatwe've seen over the last two and
(04:43):
change years is that becausethe floating rate, because the
Fed is hiked so much, thefloating rate three months so
far is high.
It's at 5.4%, and that meansthat we're receiving a lot of
income on these loans that maybewe would not have expected to
receive.
So we've benefited from thehigher Fed funds rate which
(05:05):
translates into higher threemonths so far.
So those are the assets of theCLO.
So, again, there's 200 of theloans that I just described.
And then the CLO financesitself by issuing different
securities.
We call them tranches to soundsophisticated and basically
there's a AAA that finances thisloan pool and there's a AA and
(05:29):
kind of down the stack until youget to securities that we focus
on.
So we're focused on the doubleB note, which is usually the
junior, most debt securityissued by the CLO, and then the
CLO equity sits at the bottom.
And so if you're an investor inCLO equity, how you think about
(05:50):
that is that the interest ratethat you earn on the CLO's
assets is much higher than theCLO's financing cost, and so
that creates profitabilitythat's distributed to the CLO
equity investors quarterly andso the profitability of the CLO
(06:10):
creates high cash flows to theequity.
And then the risk that you'retaking is that loans default and
there's loan losses in the CLO.
If and when that happens, thoseare losses that are borne by
the equity, but fortunately it'snot a kind of unquantifiable
(06:31):
risk.
Basically we can look back overthe last 30 years.
We see it as roughly a 60 basispoint loss rate on the loans.
And so when you buy a CLOequity piece you never assume
that you're going to go the CLOmanager is going to go 100 or
200 for 200 on the loans.
These loans are single B ratedon average.
(06:55):
They're not investment grade,and so there are going to be
some defaults, and you budgetfor that using this 60 basis
point loss rate and, net of theloss rate, you're still
targeting returns of the mid tohigh teens, and so that's how I
would describe CLO equity in anutshell.
And then the double B security,which is something that we also
(07:20):
focus on.
It's a little bit simpler.
It's just, you know, it's justa debt instrument.
The rate today is around threemonths, so for plus 600 basis
points or a little bit inside ofthat, and that gets paid its
interest.
After the, the other debtthat's more senior to the double
B gets paid its interest, itsinterest, and so the CLO that I
(07:49):
described might have a life of,could go as long as maybe nine
years.
But again, the analogy, thebest analogy to think about this
, is just a simplified bank.
So if you buy stock today inlike a JP Morgan or a Bank of
America, they're in 30 differentbusiness lines.
They're still paying legalsettlements from their misdeeds
of the past.
In a CLO, it's just a portfolioof loans financed at a low cost
(08:12):
with the profitability flowingthrough to the equity.
Speaker 1 (08:20):
It sounds to me like the last three years were almost
the perfect backdrop.
These didn't really have creditspreads widened at all.
It's purely about interestrates.
Anything that was variable didwell without the commensurate
default risk that normally youmight otherwise see in something
that was as fast as it was.
(08:41):
Talk through different interestrate cycles and credit cycles,
how, in general, the asset classtends to behave.
Speaker 2 (08:50):
Yeah, sure.
So the interest rate increaseswere beneficial to us really
since 2022.
Now, although the base ratewent up for CLO equity, it
actually did trade down duringthe year, and the reason for
that was at the end of 2021, wewere targeting around a 15%
(09:13):
return on our investments, andthen in 2022, risk premiums for
all asset classes went up and sodid the risk of a sharp
recession.
That never showed up, butduring 2022 and the beginning of
2023, people were looking atequity and saying, okay, I'm not
(09:37):
targeting 15% anymore, I'mtargeting very high teens, and
because of that, owners of CLOequity needed to write down the
fair market value of theirinvestments.
But the sharp downturn in theeconomy did not materialize and
we've benefited from the higherbase rate, and so those CLO
(09:59):
equity securities really havebeen coming back.
They haven't fully retraced thedrawdown of 2022, but we're
certainly heading in the rightdirection.
The loans in CLOs they do starttheir lives with a 50% or less
loan to value, and so, as aresult, we're not so sensitive
(10:19):
to the overall kind of growthrate of the economy.
So, whether the economy grows2% or 3% or if it shrinks one,
these are very relevant numbersif you're investing in, like
common stocks or the S&P 500,for example.
But as a lender and that's whatthe CLO is basically a lender,
(10:41):
even if a business is acquiredand revenue and cashflow never
grow during, you know, call itthe six year life of the term
loan, um, you know, even in thatcase, as a lender you're
probably fine with it.
I mean, you're you're going todeleverage.
You know, deleverage slowlyover time.
Um, in fact, when the businessdoes very, very well, uh, what
(11:03):
happens from the perspective ofa lender is just that you get
paid, repaid very quickly andyou did a bunch of work and due
diligence on a company and nowit's, you know, refinanced
itself at a lower rate.
You know, potentially with,with a different group of
lenders and so like.
For us, really kind of therisks on the underlying loans
(11:23):
are that some kind of you knowthat there's regulatory changes
or technological changes orlosses at big customers.
These are things that you know.
Maybe specific, to be specificto just one company in a CLO or
to one particular industry.
We're really just focused oncases where the performance of
(11:47):
the borrower, the wheels, comeoff the cart, if you will, but
the overall growth rate of theeconomy within some bounds isn't
really a big driver of theresults we're going to get from
our CLO equity pieces.
Speaker 1 (12:06):
Are there?
You mentioned, leveragedbuyouts?
Are there certain sectors thattend to dominate the asset class
?
Speaker 2 (12:14):
Sure.
So the biggest industries in ina CLO are going to be uh,
there's three of them.
So healthcare, uh, is one, uh,business services is another and
technology is a third.
So when I go through all theseum, so in healthcare, uh,
usually you know this might be11% or so of the portfolio.
(12:37):
What you're going to find inthere are very diversified
business models.
So it's not healthcare wherethere's one risk to all 10% or
11% of the portfolio.
What you'll actually see isit's 10% and it's hospitals and
(12:58):
it's drugs and it's devices,maybe billing.
There's not one thing thatwould happen in the economy or
to these businesses where all10% or 11% would be at risk.
And then technology, which iskind of a similar amount of the
CLOs AUM that's going to be.
(13:20):
It was not not a couple of guysin a garage launching a product
.
This is, you know, enterprisesoftware, where you have
businesses with 500 million plusrevenue, where they're really
kind of entrenched with theircustomers would be very hard to
replace the software.
(13:41):
And then business services isalso like a 10, 10 to 11% of of
a typical CLO and basicallybusiness services is just a
catch-all for basically the CLOmanager saying we couldn't find
of the 32 other you knowpotential industries that could
be assigned to.
You know we couldn't find one,so we we called it business
(14:02):
services and that's kind of thecatch-all.
So I think there's not.
So the point of this is thatbasically, you know the CLO is
going to have 200 differentborrowers in there.
It's going to be diversified byindustry.
If I went back in time in 2015,I think CLO managers did learn a
(14:24):
lesson, a hard one, and thatwas just that back then the
typical CLO portfolio might'vehad.
Four or 5% of the loans were tooil and gas companies, where
you know the results there weretotally tied to a commodity
price at the end of the day.
So in that case there was onerisk and you know we were in a
(14:48):
downside case in 2015 and 2016,.
A lot of those loans tradeddown pretty substantially during
the time and as a result, Ithink our CLO managers today are
very they don't do a lot ofenergy loans one, but they're
hyper-focused on not having anyrisk that could kind of be
(15:08):
present in more than one or twoor maybe three different loans,
or maybe three different loans.
Speaker 1 (15:18):
The question that comes to mind for me is why
bother with bonds at all ifthat's the case I mean, aside
from the fixed versus variableaspect of it CLOs have generally
higher yields, right andthey're secure, and largely most
people don't know about them,which to me is attractive,
because it probably meansthere's more undervaluation.
Speaker 2 (15:43):
So why even consider traditional bonds at all?
Yeah, so our funds basically,people are allocating to,
especially to our BB Focus Fund,really as an alternative to
high yield, and we think it's amuch more interesting way to
play the credit markets thanhigh yield.
So if you're investing in aportfolio of high yield bonds,
one, you're placing a bet oninterest rates, whether you want
(16:08):
to or not, and from here theexpectation is the Fed is going
to cut, but we don't know.
That's been the expectation fora long time.
And then if you look at defaultrates for high yield bonds, for
example, over the last 30 years, high yield defaults at about a
(16:29):
3% rate and when there is adefault, the high yield bond is
generally unsecured.
Um, so an unsecured bond isjust basically an IOU from the
company.
It's a, it's a promise to pay,but there's no specific
collateral backing, uh, backingthe claim.
And so if there's a first lienterm loan, for example, at the
(16:52):
company that's going to be ahead, that's going to get the first
recovery, uh, bond would comesecond.
So the recoveries there arekind of in the high 30s looking
back over the last 30 years.
And so in a double B corporateyou can always have defaults.
(17:15):
So the defaults again aredriven by anything kind of
negative and idiosyncratichappening at the company.
But for CLO securities and I'lltalk about the double B, since
that's the junior most debttranche If you look back over
the last 30 years, the defaultrate is about 25 basis points,
(17:36):
and so it's a small fraction ofthe default rate or a loss rate
in high yield.
And the reason for that is thatif you invest in the CLO double
B, you're benefiting from thefirst loss equity that's
contributed to the CLO on dayone.
(17:57):
And so when loans, from theperspective of a double B
investor, when loans in the CLOare defaulting, that's really a
risk for the equity investor,not for you.
And so over time over this 30years, the default rate on these
double Bs has been de minimis.
And then today, because of thehigher base rate they pay,
(18:23):
depending on the structure ofthe BB, it's 6% over three
months so far.
So that's about 11.5% yield,about 11.5% yield, and our view
is, if you can make 11.5% andthe historical default rate is
de minimis for these securitiesand there's been a lot of them
(18:44):
issued we think that that'sreally compelling and that's why
CLOs do make it into the news.
There's a lot more stories nowon Bloomberg or the journal
where people are interested inthe asset class and basically
that's the reason attractiverisk-adjusted returns.
Speaker 1 (19:09):
Such on liquidity right.
I know there are a number ofETFs out there that also try to
do CLO investing, but when youhave a real dislocation or
volatility scale, do you get thesame kind of mispricing in CLOs
like you would in the highyield illiquid junk bond space?
Speaker 2 (19:36):
Yeah.
So I think there's lots ofopportunities in a down market
and you know, kind of one of thebarriers to the asset class for
investing in CLOs is that youknow, basically there's four
concepts in CLOs and happy to gothrough them.
But that makes CLOs a littlebit more complicated than owning
like a high yield bond, forexample.
So, like CLOs are, they're onlysold to, usually just sold to,
(20:00):
you know, qualifiedinstitutional buyers.
Clos are modeled in softwarecalled Intex that's widely used
by market participants andinvesting in CLOs without that
software, you know, could bechallenging.
Investing in CLOs without thatsoftware could be challenging, I
(20:20):
think, for a lot of people.
And so we're earning what Ithink is a complexity premium
for understanding an at scalewhich I think we are at, flat
Rock, the individual, the fulltranches of the CLO securities
(20:45):
that we're buying.
They might be, in the case of anequity tranche it might be 50
million, in the case of a doubleB it might be 30 million, and
when these securities arecreated, an investment bank is
going to the market to try tofind the best buyer and so
because of the size, the totalsizes of these investments, the
(21:09):
investment banks can't go to theentire world.
You can't show 100 people a 70million opportunity because if
everybody said yes, they like it, well, there's not going to be
enough paper to go around.
And so, kind of like,structurally, how my market
(21:29):
works in terms of the process ofbuying securities is that the
investment banks just go to theguys who they think will be the
best buyers, guys that theyalready have relations,
relationships with, and so itmakes it harder as a um, as a
newer participant or lessexperienced one uh, to come into
(21:51):
the market and uh and beeffective.
Into the market and beeffective.
Speaker 1 (22:00):
The high yield part of the marketplace I often put a
spotlight on in my own research, largely because I can't quite
wrap my head around small capstocks not doing anywhere near
as well as large caps have,which suggests to me that
there's refinancing riskconcerns which are holding back
(22:20):
that part of the equity spaceversus credit spreads which are
saying there's no default riskat all.
This has been a big theme ofmine for the last year.
I can't quite understand thedisconnect there.
Do you get a sense that thehigh yield space is properly
valued in general?
Forget about CLOs for a momentSort of just the idea of the
(22:42):
marketplace thinking defaultrisk is a lot less than maybe it
is.
Speaker 2 (22:47):
Yeah.
So I'm definitely not an experton high yield bonds, but our
view is that what we've kind ofseen anecdotally in the numbers
and there's an index out therewhere you can kind of look at
the performance of theunderlying loans and CLOs and
basically what it would show youis that you know the revenue
(23:09):
and profitability performance ofthe loans has been very strong
for the last two years andprofitability performance of the
loans has been very strong forthe last two years.
And basically we've seen thiscycle where the borrowers that
we have are doing very well and,as a result, the Fed needs to
(23:29):
keep interest rates higher.
That's been kind of thefeedback loop.
I do think here at this pointthe higher rates may be starting
to have more of an effect andwe're very cautious.
At Flat Rock we make investmentsas though a recession is around
the corner.
That's how we think about ourbusiness.
I do think things are slowing alittle bit.
(23:51):
I think the Fed is starting tohave the higher rate is starting
to have an effect on somebusinesses.
But again, for us, as long asthe performance of the company
doesn't totally fall out of bed,then as a first lien lender
we're in pretty good shape.
And then, if you're talkingabout high yield specifically, a
(24:12):
lot of borrowers actually haveboth a first lien term loan that
might be in a number of CLOsand they also issue high yield
bonds.
And so it's the same companywith two different securities.
And when we look at kind of therelative value between owning a
first lien loan and a bond, thebig message is that because the
(24:36):
Fed has hiked so much, you knowyou can get basically equity
like returns from the first lienloan, and so we really just
don't see any reason to stretch,um, you know, to high yield to
potentially earn a little bitmore in terms of income.
And it's also the same thingfor second lien loans.
Um, so, like our strategies atFlyrock are basically first lien
(25:00):
exposure strategies, uh andthat's it, and um, but again,
but again, I'm actually not anexpert on the high yield market.
Speaker 1 (25:07):
It's a question that somebody asked.
I want to show it on the screenfrom a viewer CLOs are they,
like, the next source of acrisis?
And I know I'm sure you'veheard similar things people that
are not involved and I think alot of that comes from,
obviously, the 07, 08 type oftype of period, but let's tease
(25:27):
that out a little bit, sort ofthe idea of that as a source of
a crisis or not forward to thecurrent period.
Speaker 2 (25:47):
So during the financial crisis, clos would
have traded down on amark-to-market basis
substantially.
But if we're talking about theCLO equity tranche and that's
the tranche that takes the mostrisk in a CLO, one thing that's
very surprising to people isthat if you would have bought a
CLO equity tranche in 2007, soright before the GFC, and you
(26:08):
would have held it through itscall it a 10-year life, the
average IRRs would have beenclose to 30%.
So that's, you know you made30% every year over 10 years.
So that's you know.
If you compare that to theperformance of CDOs, where the
(26:28):
underlying collateral was, youknow subprime mortgages of
dubious credit quality, you knowyou saw AAAs, their default,
and then, in my little niche,you know, clos, even the equity
tranche, did well, and so then,and defaults were really de
minimis, you know, kind of likethrough the capital stack.
(26:50):
I mean, I quoted the double Bdefault rate as like 25 bps
annually.
So CLO securities did reallywell, and so I guess you know.
The question is why?
Well, one is just the qualityof the assets in a CLO.
So again, first, lien loans tocompanies that are backed by
(27:11):
sophisticated private equityfirms with initial loans to
value of like 40 to 50%.
So that's what we're doingSignificantly better collateral
than you would have found in theABS CDOs that defaulted.
So another kind of thing toknow about CLOs that's really
(27:33):
important is just that when youget into recessionary periods,
default rates on loans shouldpick up.
That's negative for all theinvestors in the CLO.
But at the same time, clos arereinvesting vehicles.
So when the CLO starts its life, it might have a portfolio of
(27:54):
400 or 500 million of loans.
Those loans prepay every threeto four years, prepay every
three to four years, and duringthe CLO's reinvestment period
the CLO manager goes into themarket and buys new loans with
the proceeds.
And so during the GFC, defaultrates on loans picked up
(28:18):
substantially.
The default rate peaked atabout 8%.
So that's very negative for allthe CLOs investors.
But at the same time, the loanindex traded down as well, and
so every time a loan prepaid apar, the CLO manager went to the
market and they bought a newloan at a discount, and it turns
out that a lot more loansprepay a par than ever default.
(28:40):
Prepay a par, they neverdefault, and so each time you
buy a discounted loan, that's anexpected gain in the future,
and so the 30% IRRs for theequity.
A big driver of that was justthat the CLO manager could buy
discounted loans with proceedsof the loans that prepaid,
discounted the loans withproceeds of the loans that
(29:02):
prepaid, and they were able toget actually, instead of having
net losses on the loans, theyhad net gains because of the
cheap loans that they bought.
So then, since the GFC well,right after the GFC, people were
not issuing CLOs.
The CLO market really didn'tturn back on until 2011.
(29:26):
And now I mentioned before it'slike a trillion dollar AUM asset
class, and so because ouracronym is CLO, it starts with a
C, and everybody, a lot ofpeople read and enjoy the Big
Short.
I certainly did, but what we'redoing is our performance has
(29:47):
been strong, and so that's whykind of the interest in CLOs
today, I think, are a functionof good historical performance,
and then also the higher baserate kind of helps us out, and
then also the higher base ratekind of helps us out.
So then is it, are CLOs asource of risk in the economy?
(30:08):
So I think not.
So the CLO is set up initiallywith around a 12-year maturity,
and so the idea with thatmaturity is that every loan in
the CLO should be repaid by thetime the CLO ends its life, and
(30:29):
there's no mark to marketmargining or anything like that
in a CLO.
So there's no for selling ofloans.
In fact, if you're a CLO equityinvestor, the worst thing that
could happen to you is that CLOdistributions are missed.
So if the CLO underperforms andby that I mean there's too many
defaulted loans or loans thattraded down or loans that were
(30:55):
revalued at or re-rated attriple C or downgraded If you
have too many of those then theCLO equity does not get paid and
instead the CLO's profitabilityis used to acquire more, more
leverage loans.
So there's not any to have kindof like contagion you know or
(31:17):
you know you would.
There's.
There's nothing that wouldcause you know for selling of
loans in CLOs.
So another is just that thebanking system today is more
resilient because of CLOs, andby that what I mean is that the
(31:42):
kind of loans that I've beentalking about today,
historically these were owned inmany cases by banks directly,
and now what we see is thatthese loans really are owned in
CLOs and maybe some other, likeloan mutual funds or ETFs, but
banks have largely exited owningthese loans.
So they might a Bank of Americaor JP Morgan might underwrite
the loan or arrange it.
(32:03):
But they syndicate it to 50 or100 different accounts and they
earn a fee for doing that.
But after the syndicationprocess they really don't have
much exposure to the loan at all, and from the bank's
perspective, the security that'smore interesting to them than
(32:26):
owning the loan directly is theCLO AAA.
So they buy the senior, mosttranche of the CLO.
They skip investing in the loandirectly.
If you invest in CLO AAAs you'regoing to earn a rate that's
lower than the rate you wouldhave earned by owning the loan
(32:47):
directly.
But the banks are focused ontheir return on equity and if
you have a AAA-rated securitythere's very little capital you
need to set aside for that, andso banks see the more efficient,
the more profitable way toinvest their dollars is to buy
CLO AAAs, and that leaves theexposure of loans to people like
(33:13):
me at Flat Rock who want therisk.
So our view is that these arehigh quality loans, that they'll
default rarely and that we canmake, depending on the security,
kind of mid to high teens inthe equity tranche and lower
returns in the BB.
But we're not our investors aresigning up to take this risk,
(33:40):
and we think it's a good one totake this risk and we think it's
a good one.
Speaker 1 (33:44):
Once the portfolio is constructed, what does the
maintenance look like, in otherwords, as a portfolio manager.
Speaker 2 (33:57):
What is it that's actually being done day to day?
Sure, so in our equity fund,for example, we're going to have
like 40 different CLO equitytranches that we bought since
the fund's inception about sixyears ago.
And basically to be aneffective CLO equity investor,
(34:22):
you need to look at deals thatare called primary deals, where
a CLO is being created.
You also look at CLOs thattrade in the secondary market
and you're trying to alwaysdetermine what's the best
risk-adjusted returns among thetwo.
And then, in terms ofmaintenance just kind of keeping
yourself up to date on theperformance of the CLOs they
(34:44):
report to you monthly with atrustee report that's 100 pages
of information on what'shappening with the CLO, what
loans have been bought, whattests, how the CLO is performing
versus its many tests, and then, four times a year, is
performing versus its many tests.
And then four times a year weget a quarterly payment report
(35:13):
which again takes all theinterest payments from the CLO,
allocates it to the owners ofdifferent CLO securities and
then the remainder, like I'vesaid, is swept to the equity
tranche.
So that's done every quarter.
And then also for me, part ofthe job is just if you have a
lot of data through thesetrustee reports, but we are in
(35:35):
constant contact with the CLOmanager about the performance of
loans as well.
So I should point out, atFlyrock we're not a CLO manager,
so each CLO does have a manager.
That's the person who picks theinitial loan portfolio and
keeps the CLO fully investedduring the reinvestment period.
(35:56):
For us, some of our CLOmanagers are basically the
biggest publicly traded assetmanagement firms.
Our CLO managers and ourbiggest CLO manager across our
funds is BlackRock.
Speaker 1 (36:16):
Let's touch on the book for a bit as we get close
to the top of the hour.
It is not easy to write a book,I don't care how long it is.
Talk about that, drew.
Was that your first book?
How challenging was the actualprocess.
Speaker 2 (36:30):
So the genesis of the book is that in 2020, I had
some time on my hands and Idecided to write just like a
60-page manual on how I approach, uh, clo investing.
And uh, there were some otherkind of white papers uh out
there, um, for CLOs, but theywere written from the
(36:53):
perspective of, like you know, alawyer or maybe you know, a
different market participant.
And so I I had, kind ofuniquely, this white space where
it's like I don't thinkanybody's written about our
business from the perspective ofa CLO equity investor.
So I wrote that, we put it onour website and, you know, I was
(37:14):
really surprised by how manypeople read it, and I think it's
partially a function of thefact that it's just there's no
other resources.
There's other resources outthere, like if you want to
inform yourself on CLOs, you cando a Google search and lots of
articles will come up.
But you know, this had a lot ofinformation you would want put
together in a way where I evenhad kind of examples.
(37:35):
It's like, okay, here's twoCLOs and this is where one
trades and this is where theother trades.
This is where one trades andthis is where the other trades,
and this is like how, how wewould think about the
explanation for the differencein price.
And so then I found, you know,clo managers were reading the
manual, and so so were mycompetitors, kind of kind of
(37:56):
funnily or kind of funny.
And then so then I that gave methe impetus to write the full
book, which is 220 pages.
And you know, it's not like,you know, if you're writing a
novel or something, you know,you sit down and with a blank
sheet of paper, and I think thatwould be very tough to do.
(38:17):
But for CLOs, you know, a lotof my time is spent educating
people on the asset class.
We have a pitch deck that hasdiagrams of CLOs and how the
cash flow is allocated amongstthe different investors in CLOs,
and so basically a third of thebook is just a copy and paste
(38:42):
of stuff that I'd already puttogether at one point.
And then I'm constantly doingQ&A with our investors.
So a lot of the people who haveinvested in our funds, they've
learned about CLOs through usreally.
(39:02):
So we've done that, we've donethat education, and so a lot of
the book just kind of naturallycomes together with, you know,
things that were already done.
And then I just kind of thoughtabout hey, you know, like,
what's the story of of CLOs andhow I would kind of how, how I
would tell it in a way thatmakes sense and, um, and so,
(39:24):
yeah, so we published it, uh,last year and you know, a lot of
people in the industry havetold me they read it.
I, uh, I don't know, that'sthat's what they tell me.
I don't question it, uh, and sowe've, we've, um, yeah, we've,
we've, I've had a lot of successwith it.
And um, um, you know, we've,we've, I've had a lot of success
(39:44):
with it and um, it's kind ofthe only, it's the only book in
in CLOs, uh, at the moment.
Speaker 1 (39:49):
Uh, charlotte, for those who want to track more of
your thoughts and get access tothe book.
Uh, where would you point themto?
Speaker 2 (39:55):
Yeah, sure, so the book is just on, uh, on Amazon,
uh, or we're Barnes and Nobleand then, um, you know, at Flat
Rock, we try to be, you know, athought leader in CLOs, and so
we have like an insights pagewhere we try to write about, or
comment about, the materialthings happening in the market
(40:17):
and so, like, just on ourwebsite, you can see, you know,
what we've found interesting,what we've written about, and
it's just, it's public, soanybody can go in there.
Uh, we also have a CLO equityindex, uh, which is, um, she's
also on our website and you cansee how CLO equity has performed
(40:37):
, uh, on a quarterly basis since2014.
Speaker 1 (40:43):
And we have the only, yeah that's the only CLO equity
index as well.
Everybody, I encourage you tolearn more about CLOs and check
out Shiloh's book.
Hopefully, maybe consider thiseducational.
Certainly part of themarketplace that most people are
not that aware of, but has somereally strong risk adjuster
(41:04):
returns.
So thank you, Shiloh.
I appreciate your knowledgehere and how you explained
everything.
Yeah, great to be with youReally enjoyed it.
Thank you, buddy Cheers.
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