Collateralized Loan Obligations (CLOs) endured the Great Financial Crisis in 2008 to evolve and emerge into its current form today. The durability of CLOs was due in part to built-in structural risk protections. Analyzing and underwriting the credit quality of underlying loans also played an important role.
Credit underwriting remains a key tenet of CLO investing: will borrowers be able to pay interest and principal on a timely basis for the life of their loans?
CLO managers seek to answer this question for every loan in a CLO portfolio to optimize cash flows and mitigate potential losses.
The ability of a CLO manager to underwrite the credit quality for each underlying loan is fundamental to CLO performance. This ability also helps differentiate top performers among the myriad of CLO managers.
CLO performance relies on the financial health of the underlying borrowers and loans in the portfolio. Loans may be used for new projects, acquisitions, leveraged buyouts, and even dividends or stock repurchases. Underlying loans are primarily senior and secured, which helps protect the CLO in case of default. However, most borrowers are typically rated single-B by Moody’s and S&P, below investment grade.
With lower-rated borrowers, their company profits and cash flows are more likely to fluctuate with the broader economy. The company may be more vulnerable in an economic downturn, a downturn in its sector, or changing competitive dynamics. Higher debt levels can further increase the vulnerability of a borrower. It is the job of a CLO portfolio manager to evaluate each borrower’s financial position, future prospects, and the likelihood of meeting interest and principal payment obligations in the future.
Avoiding defaults is a critical facet of credit investing. Some CLO managers aggressively pursue higher yields and spreads by investing in lower-quality loans. These managers may pay a price in an economic downturn. Lower quality, highly leveraged, or weaker borrowers may default on interest and principal payments in troubled times that could impair cashflows to CLO equity and mezzanine tranche investors.
Under their indentures, CLOs are regularly tested and monitored for their ability to meet cashflow obligations to CLO debt noteholders. If a CLO loan portfolio fails any of these tests, payments to the equity tranche (and sometimes even mezzanine tranches) are suspended. Cash flow must then be used to pay down and redeem senior tranches, starting with the AAA tranche. Diverting this cash flow is designed to bring the CLO back into compliance with the cash flow and collateral tests. Then, payments to equity and mezzanine tranches can resume. This diversion of cash flow will negatively impact the total return for CLO equity, the most junior tranche of the CLO capital structure.
As indicated above, a CLO portfolio manager can make the difference between consistent and interrupted cash flows for CLO equity investors. In fact, a recent study by the Federal Reserve Bank of Philadelphia calculated an 18% per annum difference in IRRs for CLO equity between top-decile and bottom-decile CLO managers. Moreover, the top one-third of managers in the study sample were more likely to repeat their above-average performance.
The credit underwriting abilities and track record of a CLO manager are important. An effective CLO manager helps to maintain a robust underlying loan portfolio that can pay quarterly interest to the senior CLO tranches while also sustaining cash flow for CLO equity holders. Credit underwriting is a necessity, as it enhances the built-in risk protection inherent in a CLO structure.
Because of the importance of credit underwriting in CLO portfolios, manager selection is critical to CLO investing, particularly for the equity tranche.
At Clarion Capital Partners, we strive to partner with top-tier CLO managers. We evaluate managers on their experience, track record, depth of resources, and leadership and investment teams. In addition, we pursue in-depth quantitative analysis across multiple dimensions.
Top CLO managers do more than avoid excess defaults in their underlying loan portfolios. Top managers also can earn yields on their loan portfolios through loan portfolio construction and by actively trading the portfolio to earn trading gains. Higher-quality managers can extract higher returns through higher loan portfolio spreads than lower-quality managers from similarly rated portfolios of loans.
To help identify top-tier CLO managers, we have constructed proprietary stratification dashboards that enable us to compare individual managers broadly and at the individual deal level in real-time. With our dashboards, we can evaluate the underlying loan portfolios by credit rating, loan seniority, loan size, and other factors.
CLO investing entails a variety of risks and uncertainties. Selecting the right CLO manager can help improve outcomes, starting with diligent analysis of credit quality.
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