The case for investing in CLO equity

Wed Apr 23, 2014

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CLO new issuance in the U.S. will likely remain strong in 2014.


 

By Chris Acito

Once a moribund market following the financial crisis, collateralized loan obligations (CLOs) have garnered a fair amount of attention from credit investors in the last year and a half. The CLO universe now has over 100 active managers, and 85 deals priced in 2013, the third highest yearly volume of CLO issuance1.

We believe that CLO equity is one of the most compelling investment opportunities for 2014 because it has the potential to provide multi-year returns of 10%+ net per annum and strong ongoing cash flows (15%+ net per annum). In addition, CLO equity should actually benefit from a systematic widening of corporate loan spreads, an attractive feature in today’s rate environment.

For those unfamiliar with CLOs, they are term-financed securitizations of diversified pools of corporate bank loans, the senior-most corporate obligation secured by liens on all assets. As investment structures, CLOs have two critically important features. One is active management, meaning that throughout its investment period, a CLO manager can buy and sell individual loans with the hope of producing trading gains, and avoiding deteriorating credit. The other is non-mark-to-market covenants, meaning the mandatory deleveraging of a CLO structure is not governed by loan price movements unrelated to credit events.

As a result, CLOs have proven to be resilient investment vehicles. In spite of leveraged loans having a one-year peak default rate of 9.6% in 20092, there has never been a default in any CLO tranche rated AA or higher in the history of CLO issuance. For CLOs issued from 1994 to 2013, only 0.41% (25 tranches out of 6,141) have defaulted, with the highest rated tranche rated single-A3.

Residing at the bottom of the capital structure, CLO equity receives residual cash flows from the excess spread of the tranches above it, but is also the first absorb losses.

So what is driving our interest?

First, we believe that CLO new issuance in the U.S. will likely remain strong in 2014,4 in the range of $65 to $75 billion, the fourth highest year since 1999. This will be especially true if there is a rise in mergers and acquisitions requiring financing. Also, as banks wrestle with – and regulators clarify - Volcker Rule-induced uncertainty as to whether they can hold certain CLO tranches, we expect CLO financing should get even stronger than current levels. Lastly, part of the interest in CLO equity reflects a benign outlook for default risk. (JP Morgan projects a default rate of about 2% in the overall loan universe.)5.

Second, CLO equity offers attractive risk-adjusted returns compared to other credit investments. Gapstow believes the current projected net IRR for new issue CLO equity can be 10% to 12% under fairly conservative assumptions on default rates, recovery rates, and other factors.

Third, CLO equity has a front-ended cash flow profile. Investors receive quarterly cash distributions, typically 3% to 5% of their initial invested capital, provided that the credit performance is within expectations. Investors have historically received the full amount of their investments (i.e., 1.0x cash-on-cash) around year six, with significant future distributions remaining. Equity distributions are now averaging 20% to 25% annually6.

Fourth, newly issued CLO equity should benefit from systematic widening of credit spreads, as a result of a CLO’s ability to reinvest the payoffs of its underlying loans. In this case, the CLO would reinvest in wider spread assets than assumed in the modeled base case. Therefore, CLO equity is that rare investment that has both a positive carry and a long volatility profile. This long volatility profile is evident in the track records of CLOs issued prior to the financial crisis. CLOs from the 2006 and 2007 vintages achieved median IRRs ranging from 14% to 16%7, which compare favorably to other structured credit and private equity pools organized during the same period. According to the Cambridge Associates U.S. Private Equity Index, the median IRR for 2006 vintage private equity funds was 7.7% and 11.6% for 2007 vintage private equity funds8.

Fifth, CLOs provide credit exposure with less interest rate sensitivity than high-yield bonds, the fixed rates of which create substantial interest rate duration. CLOs are comprised of floating rate securities financed by floating paper; together they provide a hedge against interest rate movements9.

There are further benefits to CLO equity investors who can make "control" equity investments, i.e., ownership of more than 50% of the equity tranche. A control holding enables an investor to structure deal terms, including asset concentration limits and rights to remove the collateral manager. A control investor also has refinancing rights, which can reduce the cost of debt in the event CLO liability spreads tighten in the future. Lastly, the control investor can also call or wind down the CLO by directing the manager to liquidate the underlying collateral to capitalize on loan price appreciation or if the return outlook on new loan investments diminishes.

Investors seeking to fulfill credit-related mandates should consider the benefits of CLOs, and more specifically CLO equity. Their attractive return potential, cash flowing features, long volatility profile, and low sensitivity to interest rate changes have a place in many institutional portfolios.

Chris Acito is the founder and CEO of Gapstow Capital Partners, a $1billion alternative investment firm that allocates to opportunities in the public and private global credit markets.


[1] JP Morgan US Fixed Income Markets 2014 Outlook, November 27, 2013.

[2] Credit Suisse Leveraged Loan Index, via CIFC

[3] And most of these defaulted tranches were in CLOs with market-value triggers, not in traditional CLO structures. (Wells Fargo, CLO Desktop Primer March 2014.)

[4] Morgan Stanley 2014 Global Securitized Products Outlook

[5] JP Morgan, referring to 2014

[6] Morgan Stanley 2014 Global Securitized Products Outlook

[7] Morgan Stanley 2014 Global Securitized Products Outlook

[8] This generalization is not strictly true. First, loans are often issued with a LIBOR floor. Therefore, in a rising rate environment, CLO financing rates will rise while the interest received will not change until the floor is breached, thus detracting from returns. Secondly, CLOs are sometimes issued with a small fixed rate tranche. In addition, the CLOs are sometimes allowed to hold a small percentage of fixed rate assets.

ISSN: 2151-1845 / CDC10004H