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The growth of liability management transactions has been a source of anxiety for CLO managers, pushing some to sell credits prematurely and burn par. However, this will inevitably create opportunity to grow and differentiate in a competitive field.

Damien Mount, the head of structured credit and CLO portfolio manager at Silver Point Capital, spoke with 9fin on how CLO managers are adapting to the threat of LMEs.

Silver Point is known for its presence in the distressed space, having held a $4.6bn final close this week of an opportunistic fund that invests in structured credit, among other products. The firm's special situations team works closely with its CLO team.

Mount also discussed defensive portfolio positioning, and appealing to third-party equity investors.

1. Are the rise of LMEs a cause of concern for CLO managers? How are you navigating them and what does the future of recoveries look like?

For managers and investors LMEs are, in the very least, a major conversation point. LMEs have caused dramatically different recoveries among different CLO managers and they'll continue to do so in the future. Traditional CLO managers that may have very high trading volume or very large AUM do not necessarily have distressed expertise, which means that in any LME they will be “playing in an away game.”

We see it as an opportunity because Silver Point is uniquely positioned. Our BSL CLO team sits in the middle of our public desk, and we are surrounded by a 30-person special situation team, which is world-class.

I really only see three key ways to maintain a profitable business in this market. The first is to invest in companies with sustainable businesses and appropriate capital structures. The ability to perform LMEs doesn't necessarily matter if performance remains good. The second thing you can do to protect yourself is to focus on which loans have weaker documents, and make sure those loans are more liquid, and trade out of those loans at the first sign of weakness in the business. To quote my mentor Steve Vaccaro, “credit is not hard, discipline is hard.” And that's where discipline comes in. The third way to protect yourself is to be in the middle of a world-class special situations team.

2. How are CLO managers thinking about strategies to prevent LMEs on the front end, such as blockers?

Blockers are great, and every single lender, when they're able to, is demanding different protections in credit agreements. However, it's market-driven, and, in a hot market, it is difficult to maintain those standards for many large managers.

Today, we're in an environment where many CLO managers are impacted by a combination of triple-C downgrades and LMEs, as well as sales of loans at a loss due to fear of LMEs. Most large BSL managers, at the first or maybe second sign of trouble, will sell a loan ahead of any potential LME. This creates continued discounted prices in triple-Cs and in lower priced loans, which can be an opportunity in some cases.

We've also noticed that when a manager looks to reset an older CLO, they will often take advantage of that time to clean up the portfolio and reduce the triple-Cs and lower priced loans, which just results in continued sales of those names. We believe we should always maintain adequate cushions in our triple-C basket, so that we're never constrained in trading and we can take advantage of opportunities as they arise. It's no market for a novice. Unless you are a large special situations player and work closely with top advisors and lawyers, you are at a disadvantage.

3. When positioning your portfolios in this market, what sectors are you overweight, or underweight?

We focus on diverse defensive portfolios in any market and therefore we remain overweight sectors like business services, software and healthcare. We're underweight sectors that are showing structural decline or are typically more cyclical, such as telecom and media, consumer goods and transportation. And we also avoid sectors that are a little more volatile because of commodity risk or some other sort of concentration like energy or power, especially single power plant facilities. We benefit from the research of our special situations team as well.

As an example, we've remained well below 1% in telecom which I think is extremely low among CLO managers. We were not in Altice France. As you recall, that had a significant negative impact on CLO managers, where we had no exposure at all. We didn't like the unsustainable capital structure in an industry that was showing significant technology disruption. And so we've been underweight telecom from the beginning in 2022, when we started investing in BSL for the CLO business. Silver Point has been investing in loans for over 20 years.

4. We’ve seen the return of third-party CLO equity this year. What strategies are managers using to stand out when securing third-party equity in a competitive environment?

Liability compression has really driven a lot of interest across the board from third party equity. Managers often adopt different styles and many of them can be successful, but investors would all agree that managers should stick to their style. When looking at the arbitrage, day-one arbitrage is important and seems to be somewhat healthy at the moment, but it's never amazing. And ultimately it's hard to tell a great vintage while you're in it.

We believe that more savvy equity investors tend to care more about a manager's ability to manage through a cycle, how adequately they're staffed, and how well they're set up to succeed in many different market environments. So Silver Point’s style: we focus on diverse defensive portfolios and active trading to deliver organic par build while minimizing tail risk in our portfolios, such as low priced loans and triple-Cs.

5. Do you think all managers are feeling the benefit of third-party equity coming back?

Definitely not the same opportunity for all. It really seems as though managers with good historic performance and good teams have been able to print deals and maintain management fees, whereas managers who have struggled with performance have been printing much less or at extremely discounted fees. And so you're right that third party equity has been more selective. It really can vary deal to deal and it comes in many different formats, but suffice to say, a lot of weaker managers would choose not to print a deal rather than to accept the offer on the table from third party equity.

6. Captive equity funds have been a key tool enabling managers to price new issues. What has the fundraising environment been like this year?

Now that the BSL CLO market is circa $1tn dollars, LPs recognize the importance of having a dedicated allocation to CLOs. And so people are willing to talk about CLOs even if they haven't been involved in the past.

An LP basically has three options to be involved in CLO equity. They can either invest in individual CLOs, or they can invest in a third party fund, or they can invest in a captive equity fund. And all of those options can be good. It just depends on the LP's resources and ability to do their own due diligence. We think the captive equity fund is great for aligning the investor with a manager through the market cycle. These can allow managers to buy loans when they're cheap, and not when they have to, and take a much longer term investment horizon, which should lead to greater performance. And captive equity funds are also very efficient from a fee perspective. However, captive equity funds require LPs to conduct extensive manager research because you want to pick a manager who is well positioned to succeed in any market cycle.

7. Silver Point entered CLO management in 2022 and has since printed five BSL CLOs. What’s next for you?

Over the past two years, we've built an 11-person team, including seven analysts from really strong BSL CLO shops like Blackstone, CIFC, and Octagon. We've printed at a pace of about one per quarter, and I would expect that to continue into the future. We have raised third-party equity in some of our existing deals, and will continue to do so.

8. We’ve seen several US-based CLO managers exploring a European debut recently. What are your thoughts on smaller managers launching a CLO platform in Europe?

We are a global credit manager and we do see the importance of the European market, but Europe is different. Sectors are different, credits are different, and certainly bankruptcy laws are different. So you really need to build a team with boots on the ground that understands the market. As such, if you see us expanding to Europe for a CLO business, we'll do so properly with a solid team. We have no current plans, and it really would be a function of recruiting the best talent. That’s not something that can happen quickly.

I'm going to go with The Credit Investor's Handbook by Michael Gatto. Michael is a partner at Silver Point and runs our private side, but it's the first of its kind. It's a step-by-step guide to analyzing credit and really should be required reading for any new analyst. It's quite exceptional.

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9Questions — Damien Mount, Silver Point — How LMEs are changing the game for CLOs

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