Back in 2019 Canyon had been talking to #1 arranger Citi on the project, but the Citi senior CLO team of Laura Coady, Hugh Upcott-Gill and Luis Leoncarsi are now the senior team at Jefferies, and when the project was dusted off, they got the call and brought the deal earlier this month.

The pandemic, however, proved much more disruptive than the change of arranger logo, and the project didn’t relaunch during the balmy days of 2021. Then 2022 happened, the market sold off, and the warehouse didn’t actually open until July 2022. Even then, the Canyon team sat on their hands; loans got squeezed tighter in late July and August so there wasn’t much value to be had.

Waiting proved to be a smart play, as it allowed Canyon to load up once the UK’s mini-budget had started to wreak havoc. As Miller said: “On the back of the UK LDI crisis, we acted very aggressively. We understood exactly what was going on. We’d seen it before, we had a good understanding of who was selling, who was buying and what their balance sheets looked like, and we bought just shy of 20% of the ultimate portfolio at these super cheap prices”.

Roll forward to 2023, and the market was firm enough to term out the warehouse at a reasonably cost-effective level. The timing was on a knife edge, but came out on the right side of the chaos, with the liabilities locked largely before SVB failed, a 180 bps triple-A, and Canyon ramping in a disrupted and fearful market.

“Typically pricing is at a premium for a new manager, but it’s a little hard to calibrate, because there weren’t a ton of deals done and the market was moving very fast,” said Miller. “So maybe if you picked an existing manager three days prior we look wide, but if you looked two or three days after there was simply no possibility of pricing, it was too volatile.” 

Canyon had a nicely syndicated triple A with six accounts, and an array of new and existing investors through the stack.

Miller also made quite an interesting point about the disrupted liquidity environment at the time, particularly after LDI.

“We were bidding parties back up to three points on loans that were quoted on screens in the mid or low 90s, and getting hit, so that was a very fortuitous start to the warehouse,” he said.

I’m sure this isn’t some secret trading sauce that Canyon has; it’s just being a smart player that’s buying when others are forced sellers.

But it does throw some light on the interplay between the leveraged loan index and CLO pricing.

Through all of the volatile episodes last year and this year, it has felt like CLOs are on the wrong side of market movements, with liabilities widening faster than assets and loans tightening too quickly on thin demand. There are structural reasons for that, some of which we’ve discussed, but it’s also possible that screen loan prices / the loan indices are just a bit wrong when the market gets rough.

Eyeballing the ELLI vs CLO triple A has made the arb look mostly terrible for months, but perhaps it looks less terrible if the index isn’t properly representing periods of disruption.

Anyway, there’s an interesting quant project for someone to do here; if you’ve got ELLI prices and constituent prices, plus CLO manager purchase/trade levels, you should be able to backtest and see who’s getting the best execution, and how far away this is from the theoretical market level. Maybe some managers are consistently gouging their counterparties; maybe others are the gougees.

If you know of any study like this, ping it through, I’d be super-interested.

As a manager, Canyon plans to play the larger capital structures in the middle of the fairway, being neither high WAS nor low WARF by inclination, and focus on not losing money, and letting the structures do the work. There’s a strong track record of US performance to point to, with no interest deferrals and no downgrades through Covid, even in the older vintage transactions.

Miller also argues that Canyon should do well in getting allocated (typically more of a challenge in the sponsor-controlled European market) thanks to its role as a major provider of independent subordinated capital to sponsors. 

“We have great relationships with the sponsors because we're often the financing party for the subordinated portion of their deals,” said Miller. “So when you have a multiple 100s of millions order on a second lien or a bond they have syndicated ahead of their term loan, they tend to treat you better on the term loan. We utilise that and bring that to bear as a platform when we go to bat for our loan allocations.”

This is arguably even more important given the thin supply in European loans at the moment.

Miller: “On a couple of deals we've seen recently as we've ramped this euro transaction, sponsors have done really small fungible add-ons for repayment of an RCF, small M&A or repayment of a stub that was left outstanding. We've got the calls on these and taken sometimes 20% of the add-on. That will be a much smaller portion of the total facility size, but they’re calling us because we’ve given them a financing solution in the past.”

Other sizeable managers with big credit opportunities businesses can probably make similar claims, but that doesn’t make it less true. Canyon is sizeable with a long track record, and even in the European market it’s already running $3bn AUM, so that can be plenty relevant. This isn’t necessarily an avenue open to many of the largest managers, since they’re subdivisions of competing sponsors.

Another research idea — if you take a manager like, say, AlbaCore, which has a strong track record supporting TDR Capital LBOs with flexible and subordinated capital (BCA Marketplace/Constellation, Modulaire/Alegco Scotsman, Arrow Global, Stonegate), are the CLOs detectably overallocated to TDR Capital TLBs?

CMBS 3.0

After every crisis, there’s usually an attempt to fix the problems that cropped up. 

CMBS in Europe before the global financial crisis caused more than its fair share of heavily litigated problems, with ugly fights over class X notes (CSAM vs Titan Europe 2006-1, Hayfin Opal Luxco v Windermere VII),  swaps restructurings, payment allocations and much more. Even where things didn’t end up in litigation, there were protracted fights over servicing standards, servicer replacements, related party sales, and so much more. Just breathing the words “Heart of la Défense” or “Opera (Uni-Invest)” will bring back PTSD for certain bondholders.

So as the market reopened, the Commercial Real Estate Financial Council Europe (CREFC) released “CMBS 2.0” guidelines to address some of these issues. Regulators also added a few twists (on risk retention and disclosure). Guidelines and regulations aside, the market also naturally moved away from some of the most obviously egregious structures — long-dated and mismatched swaps, for example, which blew up several transactions, were out as much for commercial reasons as because of the guidelines, while LTVs also came in lower.

I wouldn’t describe the current backdrop in CMBS as a “crisis”, but there could still be a push to rework structures in the wake of recent experience. 

As Bank of America puts it:

We see refinancing risk increasing but we think the dire headlines are somewhat overblown. The main result of balloon defaults is likely to be extensions rather than losses, in our view. Where declining property values no longer support existing leverage, we expect consensual extensions may be the best option with increased note margins for noteholders.

CRE assets generally had a bad pandemic, as people simply stopped coming into offices, staying in hotels and visiting shopping malls, and the response from servicers was mostly some variety of can-kicking — waiving tests, granting extensions, suspending valuations and pushing out the problems.

Much of the can-kicking is now coming due, and causing tensions, such as the Frosn 2018-1 default. 

We were briefly excited about the Deco 2019-RAM tender (€50m from the sponsor to attack the upcoming maturity) but this turned out to be a damp squib. Just over €3m of senior bonds were tendered, and accepted, but this is not going to get the capital structure into a refinanceable condition. It does signal that the sponsor has as spare €47m it can point in another direction, so doubtless things will get addressed. Perhaps that was the real issue — once you signal to bondholders that you’ve got the money, they’re gonna want par.

So what’s on the wishlist for the next round of CMBS? Bondholders weren’t too upset about the Covid waivers at the time, because what other option was there? Even in the pre-crisis whole business structures (like the pubcos) where bondholders had a clear seat at the table, they mostly waved through waivers if the ask was reasonable.

Still, you might expect some tightening of servicing standards for the next round of CMBS deals, with less discretion around extensions and waivers, and perhaps more regular or robust valuation mechanics. Rates have risen sharply over the last year, and so should assumed cap rates for CRE assets. Negotiating an A&E on a CRE loan now with a valuation from early last year is highly suspect.

CMBS is mostly the clean part of the CRE universe these days, but that might actually crank up the stress level given the rising rates backdrop. BofA again:

“Ironically, it may be the highest quality properties that were financed at the lowest cap rates. Where debt service payment shortfalls are occurring, extensions become a less viable option and properties may need to be sold under inopportune conditions, which may lead to losses on sub-IG notes in some cases, we think.”

Where there does need to be a clean-up is in the property-owning corporations, especially those with German exposure (Germany was also the problem child for pre-GFC CMBS). 

Adler Real Estate is in restructuring, things are getting complicated at Aggregate Holdings, Vivion Investments is under question, Signa Development and Demire are trying to distance themselves, and lately investment grade peer Aroundtown (out of 9fin’s coverage universe) has taken a beating.

These companies have plenty of capital markets debt in HY bonds and occasionally IG, and these sometimes even have covenants, but they’re a world away from CMBS in transparency and flexibility. 

Securitisation finances actual assets, in a direct and open way. There’s no “servicing standard” at play when a company just owns buildings, and disentangling valuations is more art than science. CMBS debt might be “non-recourse”, but it’s much more user-friendly for a bondholder than exposure to an essentially opaque book of CRE assets through corporate debt.

Bring on the retail

There’s a justifiable view that the European CLO market (hey maybe the whole European capital markets?) are kind of small and backward compared to the might and depth of the US. Common criticisms in CLO land include the absolute level of issuance across both leveraged finance and CLOs, the resulting high degree of overlap in European CLO portfolios, illiquidity in loan trading, and the difficulty that managers have in differentiating themselves. 

There are also just some sloppy practices in European loans; issuers that barely stir themselves to disclose numbers never mind offer a fulsome lender call, for example. The cliché in Europe is that the sponsors are in charge, though it’s probably a question of degree. US lenders, predictably, also complain about over-mighty sponsors.

Anyway, nobody would dispute that the European CLO market hasn’t got quite the depth and power of the US, and we wonder what could change that. 

One rapidly expanding answer in the US is the CLO ETF sector — there are now products on offer from Janus Henderson, BlackRock, Invesco, and PineBridge. Deutsche Bank has done a bit of work on the sector, and estimates that ETFs only capture around 0.2% of the US market……but there’s a perfectly plausible path for this to grow, and grow a lot.

None of these funds currently invest in European CLOs, but if any market could use a more stable source of funding it’s European CLO senior tranches — the presence or absence of a few sizeable bank treasuries can turn the market from feast to famine and back again.

That doesn’t mean there’s no ETF money in European CLOs. Pimco’s Euro Short Maturity UCITS ETF, for example, has a whole bunch of securitised products exposure, including CLOs from Accunia, HPS, Ares, Spire, KKR, Black Diamond, Assured IM, BNPP Asset Management, Cair, Carlyle, Investcorp, Alcentra, CSAM, Man GLG, Oak Hill, OCP, Palmer Square, Blackstone, Natixis IM and WhiteStar.

So, quite a few, though smallish clips, and apparently concentrated (like the US CLO ETFs) at the senior end. It looks something like an outgrowth of the broader Pimco Income Fund complex, just another pocket to allocate the big Pimco anchor order into, but it does show that there’s a little bit of ETF money getting in there already.

ETFs themselves can have quite different roles in the capital markets. They can be an easy way for retail to take exposure to a basket of otherwise inaccessible products (100k denomination Eurobonds, or indeed securitisations), but they can also be used as hedging or market beta instruments by institutions. 

Bond ETFs were much discussed in the wake of Covid, with some observers blaming ETFs for exacerbating the pandemic sell-off. Others (here’s a take from, uh, the world’s largest ETF provider) saw fixed income ETFs as a useful price discovery mechanism that kept functioning while bond prices were gapping.

There’s no particular reason why CLO tranches, especially in the IG part of the cap structure, should be less liquid than bonds, especially HY, so I imagine it’s possible to get comfortable with the gap/tracking risk. 

The bigger issue for spinning up a European CLO ETF is probably the lack of diversity in the underlying assets. Your ETF can go buy triple-As from a ton of different managers, but the vehicle as a whole is still going to be very over-exposed to the same few names. Problems with Altice, Liberty Global, Ineos or EG Group will be hitting every manager you own; there’s optical diversity but not much of a real spread.

Dan Zwirn doesn’t like CLOs

Dan Zwirn is an interesting guy who’s seen a lot. Here’s an excellent Bloomberg story from 2012 which gives some of the background and talks through his tussle with the SEC, but the relevant part is that he was doing asset-backed private credit illiquid opportunities long before it was cool, and his current fund, Arena Investors, is still working in this area. I interviewed him in the wake of the Covid crash for GlobalCapital, and my colleague David Bell caught up with him last week.

A consistent theme in talking to Dan is his view on the misalignment of interest in CLOs, particularly those which rely on third party equity. 

As he said to David, “You then have this ecosystem of interconnected areas across middle market, private equity, leveraged finance, direct lending, and CLOs. All of that is about has been driven by the availability of terribly underpriced CLO equity that’s been willing to be owned by people not managing the CLOs — completely disconnected from an alignment perspective.”

He also notes: “Maybe the leverage on direct lending is lower, which is probably the biggest reason why it's arguably safer. The people who are the direct lenders tend to own the equity in the structures of the financing, whereas the managers of CLOs literally have no skin in the game. They have negative skin in the game”.

Is he right? He’s much smarter than me, but we can chew it over at least. 

The basic idea of CLOs is to make the boring business of investing in par loans exciting — if you get a bunch of assets that can be called and repriced any time they trade over 101, only a goodly dose of leverage can get you towards interesting return targets. 

Clearly there are some basic alignments — the bulk of manager fees are subordinated in the waterfall, there’s the 20% above 12% IRR kicker, so managers do want to manage successful CLOs, in the sense of “successful at generating equity returns”. 

But there’s potentially a bit of a nuance here. Most CLO managers have “don’t lose money” as a mantra (it’s the general par loan credo) and the leverage does the work to make it exciting, but the payment structure probably does encourage swinging for higher yields. High margins flowing through the structure mean high excess spreads to help hit that 12% IRR.

The structure is designed to prevent over-enthusiastic reaching for yield, with constraints on triple-C buckets, and weighted average rating factor. CLOs also have limited buckets for some standard yield-enhancing shortcuts — illiquid assets, subordinated or second lien exposure, high concentrations, financings to stressed companies.

This seems mostly successful to me — in Europe at least the CLO buyer base is fenced in on the middle ground. Loan syndicate desks are well aware that B2 loans with a decent spread are CLO catnip, and demand falls off in the B3/CCC bucket, or if a loan can’t hit CLO cost of capital + 150-200 bps. It doesn’t feel like managers are swinging for the fences.

But at a market-wide level, it does seem like there might be too much CLO equity available for the overall health of the LevFin ecosystem. 

The story of the last decade is mostly one of furious demand for leveraged loan product, stimulated by a buoyant CLO market, leading to degradation in documentation. The story of the last year in particular is a market where CLO arbitrage was known to be terrible for most of the year, but in which volumes tracked nicely onto their long term trendline after the fallow year of 2020 and the boom in 2021.

That might just be because CLO equity has been a pretty good trade, Dan’s opinion notwithstanding. You can say that’s because interest rates were low for a decade, and default rates remained very low, so it was easy to put on the “don’t lose money” trade — basically just avoid retail. But good it has been, even through Covid, and even through the ugliness of last year excess spread has poured through the structures. What’s not to like? 

The excess of equity might also have to do with the complex of alternative asset management and hidden leverage that’s grown up, plugging in insurance capital, and fund level leverage into the mix. The money allocated to CLO equity probably isn’t pure equity, in other words — look for the leverage behind the leverage. 

We’re still scratching our heads over this structure, on a related note — it appears to be a pair of CLNs passing funds through to “investments in a basket of private equity and CLO funds”, with a reinsurance wrapper. It’s a fair bet that it’s a source of leverage somehow, and if there’s a rated example, there are probably more in private.

Risk retention has also had a perverse effect. The logic of the rules never really made sense for the CLO market, where managers trade actively and do not originate their assets; there is no incentive for negative selection. 

But applying the rules encouraged large manager to raise dedicated risk retention capital, which in turn traps capital in CLO equity and encourages the big funds to keep printing no matter what the market does.