What is the key to successful investing in CLO equity?
We believe CLO manager selection is fundamental for CLO equity investors. Effective Collateralized Loan Obligation (CLO) manager selection can make a significant difference in optimizing risk and return when investing in CLOs, particularly for a portfolio of higher yielding CLO equity investments.
Combined, the members of the Structured Credit group at Clarion Capital Partners have decades of experience in evaluating CLO managers and their track records. We apply this experience as we construct portfolios focused on CLO equity, CLO mezzanine, and CLO Warehouse (new issue) investments.
These investments offer the potential for the highest yields in the CLO universe, but also require adept risk management due to their potential credit risk exposure in the CLO capital structure.
Handpicking the right roster of CLO managers is vital to investing in this asset class.
At Clarion Capital Partners, we curate a preferred list of CLO managers out of a universe of over 125 CLO managers in the U.S. These managers must demonstrate value-added ability across the following disciplines:
Collaboration is key in the creation and management of a CLO:
CLOs are built upon a pool of underlying senior-secured leveraged loans. An intricate bulwark of rules and constraints, designed to protect investor cash flows and principal payments, govern the management of a CLO. Thus, a CLO manager must be adept not only at credit selection and portfolio construction, but also managing to the constraints set in the documentation of the CLO structure.1
The dispersion of performance across CLO equity investments shines a spotlight on the wide variation of CLO manager skills. While CLO debt holders receive floating rate interest payments, CLO equity investors receive the residual cash flow from the loan collateral pool after these payments. Thus, the credit portfolio management success of the CLO manager is paramount to CLO equity investors.
This dispersion of returns is most visible when analyzing CLOs that have gone full cycle to maturity (typically 8 to 10 years). The illustration below focuses on CLO equity returns for CLOs originated between 2002 and 2007, up until the Great Financial Crisis.
Source: Wells Fargo Research and Clarion Capital. Data as of August 31, 2020. Gross IRRs are calculated assuming an equity purchase price of par (100.00). Net IRRs reflect hypothetical expenses and fees for a fund investing in CLO equity, including: a) one-time organizational expenses of $0.990 million amortized over a five-year period, b) annual expenses of $0.750 million per year, c) a management fee of 1.50% per annum, and d) a 15% incentive fee subject to an 8% hurdle with a 100% catch up.
As illustrated above, selecting the right CLO managers is fundamental to CLO equity performance.
On a net basis, top quintile CLO managers earned IRRs 6.5% to 16.9% higher per year, posting profits each vintage year. Meanwhile, bottom quintile managers were not able to boast the same level of success, having posted negative gross returns in one calendar year and negative net returns in two calendar years.
“On a net basis, top quintile CLO managers earned IRRs 6.5% to 16.9% higher per year…”
At Clarion Capital Partners, we perform ongoing qualitative and quantitative analysis of CLO managers. Here are some of the key metrics we highlight:
We seek managers who are able to build and maintain above average excess spread. Cash flows for CLO equity are based on the interest remaining from the loan portfolio assets after paying the liabilities on the debt tranches. More income from the excess spread of the loan portfolios delivers even more income to CLO equity on a levered basis.
We seek managers who “build par” through trading gains. These trading profits contribute to higher total returns for CLO equity. “Par build” also provides a cushion as the loan portfolio matures and some borrowers face credit challenges or events over time. We prefer managers with strong “par build” early in the lifecycles of their CLOs.
Some CLO managers add low-rated or triple-C loans to boost yield and income. We believe this can be counterproductive. We seek managers with lower exposures to CCC, low-priced loans (perceived as distressed), or downgraded loans. Such loans reflect potential credit problems among borrowers that can impact “par build”.
These problematic loans may also receive haircuts to their value in the ongoing collateral and interest coverage tests designed to protect CLO debt investors. Failure to satisfy these quarterly tests can mean the cash flow to CLO equity is suspended. This suspended income is diverted to pay down AAA tranches or buy more collateral until the CLO “self-heals” and satisfies the test requirements again.
At Clarion Capital Partners we believe it is prudent to align with CLO managers with a history of taking a conservative stance toward exposure to risky issues. While the extra income might be attractive in the nearer-term, we believe that credit investing is about what you don’t own, particularly during periods of market difficulties. What a manager doesn’t own may translate to incremental total return.
The pandemic downturn of 2020 illustrated the importance of a high-quality loan portfolio for CLOs. Managers with excess CCC holdings had to stop payments to their CLO equity tranches as additional downgrades during the pandemic triggered CLO equity cash flow suspensions.
Top-performing CLO managers with high-quality loan portfolios and minimal levels of low-rated and low-quality loans were able to navigate the pandemic downturn without such cash flow suspensions.
Depending on market conditions, participating as an investor in the creation process of a new CLO can be profitable, although such opportunities are fewer in number. The process of accumulating loans is referred to as a CLO warehouse.
We select CLO warehouse opportunities from among our group of curated CLO managers. We seek CLO warehouse opportunities with managers who are collaborative and communicative. We also prefer managers who can effectively steward the costs of managing a CLO warehouse vehicle. Leading CLO managers can negotiate lower interest rates for the warehouse financing facility based on their reliability, broad following among institutional managers, and capital markets power.
Some boutique CLO managers can also be fine partners in a CLO warehouse investment. Some boutique CLO managers can excel as specialized, collaborative partners who can manage capital costs to provide a competitive edge to their CLO warehouse investors.
To learn more about how Clarion Capital Partners selects CLO managers, feel free to contact us for an in-person discussion with our portfolio team.
1. Keith Ashton, “Investing in CLOs,” Ares, Spring/Summer 2020, p. 11. https://www.aresmgmt.com/sites/default/files/2020-06/Ares_Investing%20in%20CLOs%20White%20Paper_2020_0.pdf