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Michelle D'Souza

The US CLO market is off to a record start to the year with $46.1bn issuance year-to-date, according to 9fin data. In fact, February new issue supply at $20.2bn marked the second busiest month in the history of the CLO market (Nov 2021 at $25.6bn), according to JP Morgan CLO research. Both Bank of America and JPM have revised their 2024 forecasts upwards.

And with arbitrage slowly improving, CLO equity investors are trickling back into the primary market. Sound Point Capital however was one of the few investors that invested throughout last year.

9fin spoke to Ujjaval Desai, head of structured products investing at the firm, on the rationale for this, how institutional investors can access CLO equity and the rise of ETFs and listed funds, opening up the asset class for retail investors.

1. With so much attention on many forms of credit investing today, why should investors revisit CLO equity and mezzanine for their portfolios?

We believe CLO equity is one of the very few asset classes where you can get mid-teen returns on a risk-adjusted basis. CLO equity has produced these returns across various interest rate and spread regimes, and we expect these returns to continue.

We’ve also found CLO equity compares very favourably to other alternative products such as private equity given its equity-like returns, but with credit downside. Unlike private equity or private credit, CLO equity offers liquidity to investors as well. And so that's why there's been a lot of interest in this asset class of late.

CLO mezzanine can be a great investment for insurance companies and pension funds, providing significant pickup in yield for the given rating.

We've seen CLO mezzanine perform exceptionally well over the long run with close to zero defaults since the GFC. In this current environment, CLO mezzanine generates around 8 to 10% returns, despite the tightening we've seen over the last six months.

The fact that these are floating rate investments benefits from high interest rates, while providing significant downside protection because of the robust CLO structure.

2. Describe the dynamics of the market right now. We’ve seen a surge in new US CLO issuance — what’s driving this and do you see it continuing? What is the impact on spreads/returns?

It’s been a banner year so far following the robust 2023. New issuance as well as resets have been revived, which has been driven by interest from investors throughout the capital structure.

CLO equity arbitrage, the asset spread minus liability costs, also looks very attractive, and much more so than last year. This has resulted in strong interest for equity, especially minority equity, over the last few weeks.

Banks and institutional fund managers continue to be very interested in triple-As. In 2022, and 2023, some of the large US banks were largely absent but we have just started to see some of those banks coming back. With Basel III capital charge clarifications later this year, we hope to see more sustained activity. Meanwhile, international players like Japanese banks and other European investors have continued to participate for the last few years, and we think that interest level is going to stay pretty strong.

For mezzanine tranches, insurance companies have shown strong interest in the asset class, finding these attractive on a relative value basis compared to ABS and other corporate bonds.

On the CLO asset side of the equation, most of the portfolios were ramped in the secondary market but there has been a pick-up of new loans.

We think CLO spreads have reached an equilibrium, allowing plenty of new issuance and refinancings to clear the market near current levels. It’s likely issuance will be fairly elevated both in primary and resets and refis for the foreseeable future, subject to no macro disruptions.

3. The market for CLO investing is improving as rates normalise, drawing equity investors slowly back to the market with attractive returns. Sound Point, however, was one of the few investors to have invested in CLO equity throughout. What was your hurdle for equity investments?

We were one of the most active primary equity investors in the market in 2023.

Many equity investors stayed out of the primary market claiming that the cost of debt was too high, with not enough cash on cash return for the equity tranche.

To the contrary, we thought these vintages were actually very attractive. While the cost of debt was high, managers were able to buy loans at very cheap levels. This allowed them to trade high cash-on-cash returns for much higher capital gains. As the loan market recovered, we believed we would get much better returns from these investments.

That's exactly what's happened as the market has recovered. Loans have now traded closer to par and these equity investments have gained 10 times the accretion the loans have had, given the leverage in the structure.

The challenge in investing in equity during volatile markets is identifying strong managers, buying the right quality portfolios and timing the market correctly, to capture the right arbitrage.

We don’t view CLO equity as a trade that you're supposed to get in and out of. We view it as a much longer-term strategic opportunity.

We believe our long-standing relationships with managers and banks have allowed us to source attractive deals early on in the process, control the deal timing and get the best economic terms in order to maximise the return.

There are also a few bells and whistles that you can have to help with CLO arbitrage.

Warehouse carry, for example, can be quite accretive. But warehouses are a double-edged sword and you have to be very careful in utilising it correctly. If you end up with the wrong warehouse structure and, at the wrong time, without a takeout identified that can be quite damaging to your return. So, appropriate warehouse investments require significant expertise.

Fee rebates are also another option on the table.

As an equity investor, you have a lot of these kinds of levers to pull. But at the end of the day, you can't lose sight of the fact that you are entering into a partnership with the manager and working with banks on a longer term basis to achieve a favourable return outcome for all parties.

4. Tell me more about your current approach to the secondary CLO market. What equity profiles do you like? What do you think about the relative value between primary and secondary?

Broadly, we have found primary to be better value than secondary. But there have also been times when secondary looks very interesting so we analyse on a daily basis.

Sometimes things are mispriced in the secondary because of softness in loans. But sometimes the primary market just doesn't exist and when it does, it takes a long time to get done. We view the secondary market as a tool to enhance risk-adjusted returns by doing relative value swaps and risk managing portfolios.

We look for strong managers that are on our approved list and believe it’s not worth sacrificing quality just to get some stated returns. Our preference is cleaner portfolios, lower tail risk, and longer-dated deals with longer investment periods.

5. One of the most important factors driving outperformance is buying CLO debt and equity managed by the right CLO managers. What’s your approach to selecting and tiering CLO managers?

Manager selection is one of the most important aspects of investing in CLO equity.

We have ranked managers using subjective and objective metrics including (but not limited to): franchise; portfolio quality; track record in ramping deals; building par; equity distributions; and portfolio construction (sector risk or single name risk).

When we combine all these factors, we're able to identify the kind of managers that have performed well, historically.

But we’re always trying to fine tune these factors based on market conditions. So, if we are concerned about a specific event in the market, or a certain type of volatility, we will then zero in on those factors and pick managers that we believe will perform better in those conditions. And so, it's an evolving iterative process.

The tiering and manager selection process is our internal process. But many times, the market consensus view is very different from how we're thinking about it, and that is how we're able to identify mispriced investments, both in terms of purchases, but also very importantly, in terms of sales.

We are not shy to get involved with a manager quickly if we think that they're the right manager to work with in a particular market setting. But we are equally as quick to exit an investment in a particular manager if they are not performing according to plan or their investment process or style is shifting. It's a fairly active process that is monitored and updated weekly.

6. How do you assess the downside risks in CLO equity? How does CLO equity compare to double-Bs and to other alternative investment opportunities?

We believe tail risk has been built into CLO portfolios over the past few years, driven by high inflation and high interest rates which has put significant pressure on companies resulting in increased defaults with lower recovery rates.

We think primary and recent vintage secondary CLO equity is the best option for finding diversified loan portfolios that are high quality and allowing the CLO structure work for the investor.

We think this profile of equity can generate double-digit type returns even in these stress cases of higher risk, higher defaults and higher downgrades. Compared to double-Bs in today's market, which can probably generate eight to 10% returns, we still think equity can generate a much better risk adjusted profile.

One question people ask is why should we buy CLO equity if there is volatility on the horizon?

And the answer to that is in the historical data. Historically, CLO equity has performed extremely well in times of stress. During volatile markets, CLO equity actually tends to outperform and produce better returns than expected going into the volatility.

And that comes down to the fact that these portfolios are diversified, actively managed, and the structure of the CLO itself has been very well tested.

Looking ahead, although there have been a lot of positive developments in the market lately, there is still potential for volatility. In this environment, we think it's good to be in CLO equity because that volatility can be beneficial to you in your portfolios.

7. What are the ways in which institutional investors can access CLO equity? What are the pros and cons of each?

Institutional investors have three main channels to invest in CLO equity. One way is by investing directly. The second way is investing in captive funds. And the third way is investing in a diversified portfolio of third-party equity.

Direct investments make sense for large institutional investors, but it requires significant in house expertise and resources, which most investors don't have.

The channel that has really opened up for investors over the last few years has been captive funds. These are private equity style funds that are launched by a CLO manager allowing investors to access their own deal flow. In other words, manager’s own CLOs issued for a defined period of time.

These funds allow investors access to the manager’s pipeline very efficiently. And in some cases, they are marked-to-model which some investors like.

However, there are certain challenges investors should be aware of in these types of funds.

One is the potential for lack of control that investors have over the timing of CLOs that are being invested, resulting in a potential conflict of interest with the manager. The second is lack of liquidity. And the third is that these funds are static. The fund buys five to eight CLO equity pieces, and you cannot trade out of these.

In these funds, manager selection becomes very, very important. You want managers that exhibit discipline around their desire to earn fees and get scale, as they are the ones who control when CLOs are issued, not you as an investor. Investment team stability and continued performance for the life of these vehicles is key. These funds have a seven to 10-year life and with no ability to mitigate your risk, investors are counting on these teams to stay in place and continue to perform.

The last channel to access CLO equity is through a diversified third-party equity fund. You’re working with an independent fund manager who builds a portfolio across various managers and vintages. With these funds, we believe some of the challenges associated with captive equity funds can be mitigated.

But these funds do have an additional layer of fees. And typically, these funds are marked-to-market so there is an additional potential challenge for some investors.

8. For third-party equity funds, with many competitive offerings in the market, what factors should investors consider when selecting a fund to invest in?

With third-party funds, we believe the key considerations are the fund manager and the structure of the fund. We look for the following expertise when selecting the manager:

Differentiated investment sourcing, structuring and negotiating

Capability and flexibility to access primary or secondary markets and nimbleness to move between debt and equity, depending on market conditions

Risk management expertise through credit analysis and data systems

Active portfolio trading to capture best relative value

A proven track record of delivering alpha in both up markets and importantly, in down markets

The structure of the fund is also a critical factor to consider. Some funds are PE-style vehicles that have a defined entry point and a five-to-seven year life while others are evergreen funds that one can access at any time and provide liquidity with some lock-up provisions.

Additionally, some funds pay annual distributions while others automatically reinvest any portfolio income received.

9. We see increasing activity in retail funds, whether listed funds or ETFs. How big is this opportunity? And how different is it managing these vehicles?

I think this is a very exciting space and we see this as a tremendous opportunity.

There was a fairly limited set of opportunities available for retail investors to access CLOs in the past. With the advent of listed funds for equity and mezz investments, and ETFs for senior investment grade tranche investments, we think retail investors finally have options to choose from.

The CLO asset class has now grown to a trillion-and-a-half-dollar market cap. With increased liquidity up and down the capital stack, these funds can be a great way for retail investors, high net worth individuals and the RIA channels to add CLOs to their credit and alternative allocations.

In terms of structures, the benefit of these funds is that many of them pay out high distributions. So, all the income that's earned on the underlying investments will be paid out and this can provide retail investors significant liquidity on its own.

Additionally, if it’s a listed fund that's traded on exchange, an investor has the ability to sell their shares. Many times these funds tend to trade at a premium to NAV so investors can exit the market if that premium exists. And those are similar to the BDC space, which is a much more established marketplace.

We look forward to seeing how the retail funds space develops further.

9Questions — Ujjaval Desai, Sound Point — 2023 primary CLO equity was attractive

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