Pearl Diver Capital is one of the most experienced CLO investment firms in the business having launched in September 2008 — a pivotal moment from the industry as those brave enough to put capital into CLO tranches were handsomely rewarded as the market rallied in subsequent years.

The CLO market has bounced back from other episodes — the eurozone crisis, the 2016 energy crisis and then Covid. And Pearl Diver has been a mainstay, centring its business on the asset class, although it has evolved from its early days as a majority CLO equity investor to buying across the capital stack, across US and Europe, and between primary and secondary markets.

Last month 9fin revealed the firm would be branching out beyond the CLO market for the first time by investing in SRTs.

Matthew Layton, partner at Pearl Diver, explains why the firm sees value and growth in SRTs, how big the CLO investment universe has become, and why the expression ‘Day one arb is not great, but you’re buying the optionality’, doesn’t quite stand up to scrutiny.

1. What was the rationale behind your expansion into SRTs?

We see our move into SRTs as a natural progression from CLOs, and whilst one of the things we pride ourselves on is that over the last 17 years [since Pearl Diver was established] we have focused entirely on the CLO market, we view investing in SRTs as a natural extension.

Since day one of Pearl Diver, the infrastructure and composition of our team has been geared towards underwriting portfolios of corporate credit, and analysing the interaction of the portfolio with the structure. So SRTs are not too dissimilar to how we look at the CLO space.

In many cases there is even crossover in terms of the underlying credits we already see in the CLO space. In some cases there isn’t, but that’s fine as we have the skillset to underwrite new credits.

Initially we will certainly look at areas of the SRT market where there is overlap with the broadly syndicated loan and high yield bond space. But the SRT market is growing to include a wider variety of assets and we will evolve as well. For the foreseeable future though, with the healthy pipeline that we have built, we are going to stick with SRTs backed by assets that we are familiar with.

There’s no escaping that SRTs are a growing market and one of the benefits of our expansion into this area is that we’re already in the same community: the paper is usually issued off the same desk as structured credit and CLOs, so we‘re already in the information flow.

2. Do you view CLOs and SRTs as counter-cyclical products?

Not particularly counter-cyclical given that CLOs and SRTs actually share many similar characteristics. Losses in SRTs and the debt tranches of CLOs have been extremely low historically, and on top of that investors receive very stable consistent cashflows — that stability is clearly very attractive.

But CLOs also offer something slightly different because of the way that the structure is tranched. We run liquid, private equity-style draw-down funds, and a listed vehicle, and that’s a reflection of the fact that CLOs offer something to every investor depending on their risk/return and liquidity profile.

3. You’ve opted to invest in SRTs via an interval fund — is there sufficient liquidity in the asset class?

There is sufficient liquidity yes, because the liquidity comes from the predictability of cashflows.  There will be an initial lock-up period for the seed investors, and that is to be expected. But investors really like the idea of some form of liquidity over time. Interval funds, across many different credit asset classes, are popular and SRTs offer the ability to create that structure and satisfy liquidity demands.

4. You’re managing CLO investments through multiple structures, but what’s your view on CLO ETFs?

ETFs feel like a democratisation of CLOs — they give smaller investors and retail investors exposure to CLOs, which they might otherwise be unable to access. If you look at the track record of senior CLO tranches, even down to the double-B bonds, it is far superior to the underlying leveraged loans, both from a returns and default perspective. There are very large established loan ETFs so from that standpoint, it absolutely makes sense for CLO ETFs to exist.

At Pearl Diver we currently manage various structures. For example we have draw-down structures similar to private equity, which allows us to actively manage and trade relative value across the portfolio, whilst taking a much more longer-term view because we do not face potential redemptions. This works well for CLO equity and junior CLO mezz.

We also run liquid strategies — typically for CLO debt tranches  — and that works well for certain investors that are looking for better credit protections and liquidity. But it’s important to match the liquidity of the tranches, whether it be triple-A or single-B, to the potential liquidity needs of the investors. This is where the daily liquidity needs of ETFs present a fresh dynamic for the market.

It will be interesting to see how this evolves just given the size of CLO ETF market. For example when First Brands hit the headlines, we saw significant volatility in investment grade CLO ETFs. This from an event which had, it’s fair to say, a relatively minor impact on the underlying structures. But nevertheless ETFs experienced quite a significant reaction.

So if there is a more widespread credit event, it will be interesting to see what will happen with ETF pricing. Is the liquidity strong enough to support the potential need to realise cash? It could definitely present a buying opportunity for other funds and fund structures investing in the same assets. That opportunity would only be magnified when you go from investment grade to mezzanine ETFs.

5. With so much capital raised for captive CLO equity, how has that impacted the available universe of deals you can invest in? Has it affected your appetite for CLO equity?

Across our platform we only manage one dedicated equity strategy which is our listed 40 Act vehicle Pearl Diver Capital Company. In our PE-style funds we generally blend equity and debt to give a consistent outcome where we still target an IRR in the teens. So primary equity only plays a part role in our portfolio construction. But to your point the overall market has restructured to some extent since affiliate equity funds came along. Really though we are agnostic between primary and secondary, we invest where see best relative value, across both debt and equity.

The secondary market is deep, there is plenty of paper to choose from and still be highly selective. This year there has been around $250bn of CLO tranches traded in the secondary market, which is pretty similar to the last three or four years. Now add new primary issuance of roughly $300bn.

Primary equity therefore only really accounts for less than 10% of total transactable paper. Factor in that affiliate funds generally only want to take a majority equity position, and that’s only roughly 5% of the overall market which has to retained by affiliate funds.

The rise of captive equity funds over the last 10 years has been a true success. But this capital is difficult to raise and is highly valuable. So if a third-party investor wants to come into a new issue equity, the opportunity is still there. Managers often backstop 100% of the equity but are very happy to be sold down to preserve capital, so third party and affiliate funds work together all the time.

6. How does liquidity factor into your relative value assessments?

Liquidity is probably one of the first things that we discuss when we debate in investment committee. Mistakes in underwriting do happen, and it is important that if a double-B, single-B or equity tranche begins to underperform that we can trade out. That’s a key theme of our active management style. Hence we run highly diversified portfolios of mezz and equity.

Our objective is to build diversified liquid portfolios, and naturally a $2m double-B is easier to trade than a $25m majority equity position. There’s really only a handful of investors, ourselves included, that can trade those large majority equity pieces.

Another important aspect for us, on top of liquidity, is diversification, across vintages and also across managers and styles. Manager style is critical in terms of driving performance in different market conditions.

The historical data, and we have benchmarked every post-GFC CLO, shows that there will be periods throughout the economic cycle during which the more aggressive managers outperform and periods where the conservative managers come out on top. 

We use statistical methods to assess the type of loans in which every manager of every individual CLO has invested and there are distinct patterns of performance during different economic conditions. We select our managers to create a diversified balanced portfolio of styles to enable outperformance in different economic conditions.

7. What is your biggest pet peeve when it comes to CLO pitches that you’ve heard?

‘Day one arb is not great, but you’re buying the optionality’.

We have invested in over 200 CLO equities, we know the market and the truth is that portfolios do not get better over time. Capital structures are locked in for two years and it takes a long time to build loan spread — underlying corporates do not refinance wider, they sit and wait.

Meanwhile in a new issue CLO, you’re naturally going to pick up some tail over those two years, no matter how good your underwriting is. If the capital structure is wide, you do have the refi and reset optionality, but that is some time away and you can end up playing catch up.

Optionality works well if you're able to lock in very tight liabilities and the loan market happens to widen as you're ramping. But that scenario requires some element of luck.

Day one arb will not give you the final IRR, but it's a good indicator. Then deduct the expected losses and that will get you somewhere close.

8. We’ve had so much growth in the CLO market in recent years, and with growth sometimes complacency follows. What worries you most about the market today?

It’s not necessarily a worry, but I think it’s clear that right now is not a time to overreach.

It feels like 2017-2018 when we came off the back of a market downturn. We've seen a bit of a blip around Liberation Day, but actually the markets have just continued to recover and rally from there on, even factoring for the October First Brands-driven sell off.

I think it's hard to build a case at the moment for further spread compression. And given everybody's heightened alertness and awareness to any negative headline after First Brands, I think that's going to continue to be the case through 2026. There's also some macro considerations as well, such as the state of the US economy, the jobs market, interest rates and then the November mid terms.

But it feels like, whether the US economy needs it or not, that we are going to have lower interest rates. There’s likely to be side effects to this and we will see how that plays out.

I think 2026 could be a year where the market widens, tightens, widens and tightens again, a bit like a sawtooth. Those are also the periods where CLO managers hopefully can build some par and also the periods, where we're able to step into both the primary and the secondary markets to drive returns.

9. What has been your most exciting adventure outside of the CLO market?

I once drove around the entire island of Australia — we encountered bush fires, snakes and countless kangaroos over six weeks.