1. Carlyle is now the world’s biggest CLO manager, having acquired CBAM earlier this year. Do you think there is more consolidation on the way for the CLO industry?

While I believe the CLO industry will probably see more M&A activity over the coming years, we will also likely see new entrants to the market given the attractiveness of the CLO asset class. One thing that we’ve seen this year is that larger managers with established track records are able to issue CLOs and take advantage of volatility and lower loan prices, while smaller managers struggle to find investors. The top thirty managers accounted for 57% of issuance last year, while they account for 70% so far this year. I believe that if newer managers can’t find investors, they may eventually look to sell or acquire.

2. The CLO market has been backed up with aging warehouses, and some managers have resorted to splitting warehouses in two to improve the arbitrage. Is that still a viable strategy?

Over the last few months, we have seen some creative strategies to deal with underwater warehouses. We have seen some splitting of warehouses to make room for lower dollar price purchases into ramping CLOs in addition to some small liquidations when loans rally. We have also seen some higher dollar price warehouses term out with expensive AAAs, with the thesis of repricing the capital structure once the market normalizes. All of these have allowed continued CLO creation, albeit at a slower pace than last year.

3. Similarly, the leveraged loan market has been backed up with hung LBOs. A senior Apollo exec recently said that clearing the Citrix would not be enough to reopen markets — what’s your take on the forward issuance pipeline?

Hung loans on bank balance sheets have effectively closed the capital markets for the better part of 2022. The banks will need to see a stabilization in loan prices in order to underwrite large leveraged buyouts and M&A deals at caps that make sense — meaning caps that are not in the 80’s. Once this large slate of deals on the banks’ balance sheets has cleared, I expect to see opportunistic deals come back to the market with best effort underwriting, but that probably doesn’t happen until next year. Those deals will likely be for pushing out maturities and tuck-in M&A, which will be the beginning of our market opening back up. If banks have success with this re-opening, and loan prices inch back up, we can expect to see underwrites come back to levels that companies can stomach.

4. How does the most recent inflation print, and the associated expectation of continued Fed rate hikes impact your outlook for leveraged loans?

The market hasn’t seen leveraged loans yield over 8% in a very long time, so we believe there is value in floating rate performing credit today, with some convexity opportunity. To buy a portfolio of floating rate, senior secured, performing credit and get current income over 7% seems like a good place to park cash in times of uncertainty. As of 10/14/22, the total return of the LSTA index is only down 2.8% this year, which shows the stability of the asset class on a relative basis. Inflation is just one of the many risks that credit managers are dealing with today – the outlook is certainly hazy given the array of uncertainties in the economy. Though most have not managed portfolios in an environment with high single digit inflation, none had ever managed through a global pandemic or a great financial crisis, and CLOs performed well through both of these cycles.

5. What’s your view on second lien risk in the current risk environment?

In times of uncertainty, you are supposed to move up in quality. So, it’s hard to make the case to have meaningful second lien exposure. That said, second liens are yielding more than high yield and don’t have the duration risk. Therefore, if you find credits that will grow through what may be a recessionary environment, I believe you can find good pockets of alpha.

6. When pitching to CLO equity and debt investors, how do you balance the return tailwind of higher base rates with the potential credit headwinds of a slowing economy and rising defaults?

This is an environment where credit underwriting and active trading is paramount and not a beta play whatsoever. If you are able to find performing credits where EBITDA will be stable to growing, they can deal with higher interest expense as the loan market is starting from a position of very high interest coverage. Those are the credits that you should be buying in CLOs — where you have upside to the lower dollar entry prices and your capital structure is long term, non-mark-to-market, and can withstand volatility. What you want to avoid is credits with Covid bumps, inability to pass inflationary costs through, or the bottom of the market which has been struggling for some time but had been able to be bailed out by market liquidity. Dispersion is only increasing as there are more managers and more underlying credits. So, in an environment with heightened credit risk, you want to choose managers that are good at fundamental credit analysis and actively manage the underlying risk in the portfolio. If you can do that, the absolute return on both debt and equity should be attractive in a historical context, especially with rates moving up, since these are floating rate investments and don’t have the duration risk.

7. Any big-picture takeaways from how your portfolio is performing?

We are currently seeing more dispersion in performance given the variety of challenges in today’s market (e.g., weakened consumer demand, inflation, higher interest rates, exposure to Europe, etc.). That said, overall, we are still seeing revenue growth on average, which makes sense given nominal GDP is growing in the high single digits. Loans have generally performed better than most other asset classes this year, due to their floating rate nature and defensive position in the capital structure. But, if a company disappoints, you could see a 5 plus point movement down in trading price, showing that the market is not forgiving anything in this environment.

8. There’s been a lot of backlash against the ESG movement recently. As a credit investor, what do you find is the biggest challenge when applying ESG criteria to your portfolio?

ESG risks are credit risks. I think many credit analysts have analyzed ESG risks during underwriting for their entire careers without labeling them as such. At Carlyle, we believe the assessment of ESG risks is critical to investing, as having a more fulsome analysis of Environmental, Social and Governance factors only enhances underwriting and risk analysis. However, there are limitations to the amount of information that we can gather on certain ESG risks, so it’s not as clear cut as some other areas. As the industry continues to evolve, and data reporting becomes more standardized, we believe ESG will become an increasingly important criteria in investment portfolios.

9. You’re a born-and-bred New Yorker. What is your favorite place in the whole city?

I really enjoy Riverside Park. I have 4 kids and a dog, so getting outside is important for all of our sanity. Taking walks or runs alongside the river, seeing my kids learn to ride bikes in the same places I did, walking the dog, going to all of the playgrounds, watching the boats. It’s very much a Zen place for me.