High interest rates and a lack of liquidity in domestic markets are two of the reasons why CLOs are an attractive product in the region, sources say.

In addition, new fund rules have also expanded the investor base in the region, while CLOs look marginally more attractive than private credit given where they sit in an LP’s portfolio.

High interest rates and lack of liquidity sets the scene

HMC Capital is a capital advisory platform in Latin America with a footprint in Brazil, Chile, Peru, Colombia and Mexico. The firm partners with GPs around the world that are strategically looking at this region and also have an asset management arm.

“As a non-developed market, non-investment grade and high yield credit markets in Brazil have weak secondary markets with a lack of liquidity,” said HMC’s Bernado Queima.

“Just to give you a sense, if you want to take your money out of a high yield fund in Brazil, investors need to give a fund six to 12 months’ notice in advance. And if that's happening in Brazil, you can imagine what's happening in the other markets in the region which are smaller in size.”

CLOs are a way to access a developed market with more liquidity and add diversity to portfolios. 10 years ago, HMC began working with CLO investor Pearl Diver Capital.

“At that time, nobody knew what a CLO was. It was even worse because a lot of people confused CLOs with CDOs when the memory was still fresh from the global financial crisis, so mentioning three letters was a no go,” added HMC’s Daniel Dancourt.

“People previously viewed CLOs as a niche investment but now it’s a $1.2trn market so that argument is out of the way and makes it easier for investors to mention CLOs to investor committees.”

Kerrill Gaffney, partner at Pearl Diver told 9fin there has been a huge educational process, but the interest in CLOs in the region has certainly increased and people are understanding that this is not a niche product.

“HMC has been an excellent and longstanding partner and we have been working very closely with them for the last 10 years to distribute our funds,” said Gaffney.

“Interest rates in Brazil have been high for a long time so investors really want the yield. They are also now understanding not only the attractiveness of floating rate products in an environment of rising and elevated rates, but also the structural protections of CLO double-B and triple-B CLO tranches.”

In addition, Gaffney said investors have seen how CLOs performed so well going through the 2008-9 global financial crisis, Covid-19 and other periods of stress, and how they've outperformed corporate credit on a risk return basis.

Focus on mezz

Pearl Diver has been marketing in the region for the last 10 years, initially with PE-style closed-ended drawdown vehicles. In 2018, a reverse inquiry from a large family office prompted Pearl Diver to launch an evergreen Global Income Fund. That fund focuses purely on junior mezzanine tranches.

The Gama fund launched last year is a direct feeder into the Pearl Diver Global Income Fund. That vehicle, which has monthly liquidity, is denominated in reals (also meaning there is a pickup in returns when hedged back to the local currency).

Pearl Diver Global Income Fund invests in triple-Bs and double-Bs of US and European CLOs, across primary and secondary markets.

US CLO ETFs are largely focused on triple-A and double-A tranches, but the focus for Latin America is more on junior mezzanine CLO tranches.

In Chile last year, for example, bank interest rates on deposits were around 12-13% as they are tied to inflation. CLO triple-As wouldn’t work in this case because a fund manager needs to outperform what the region can get from their bank interest rates.

Andean pensions explore CLOs

Outside of Brazil, Dancourt says he is starting to see more interest in the Andean region, particularly in Chile and Peru, from pension funds. Gaffney also says the firm is exploring other markets such as Uruguay and Argentina.

Pearl Diver has feeders denominated in Chilean pesos and a USD feeder, originally for the closed-ended vehicles but also now for the open ended vehicles. Alongside this, there is also a Cayman Islands-based feeder for other parts of Latin America, for example Argentina and Uruguay investors.

“The educational process is much further ahead in Brazil and Chile, but the other countries are getting up the learning curve, they're understanding the attractiveness of CLO structures and they like the liquidity,” Gaffney said.

“I suppose central America and Mexico would be next on the cards, but from what we understand Central American pension funds have only started allocating to private equity. Emerging markets are all starting to hear more about CLOs, whether they're ready to invest or not remains to be seen, but I think eventually it will happen.”

New fund rules attract more investors

Another reason for the growth over the past few months is due to new fund regulation in Brazil released in October.

“In the past, only professional investors could invest in CLOs in Brazil for feeder funds,” said HMC’s Agnaldo Andrade.

“The new rule allows firms to market this type of product or to have a feeder with CLOs for affluent high net worth individuals market. We launched the feeder in July last year only for a professional investors to build a track record, ready to market the product to high net worth investors after the rule.”

Most of global fixed income funds that have been successful in South America pretty much all have allocations to CLOs, says Dancourt.

“I think clients are also getting more used to it with indirect exposure through multi-credit strategies that has a small component of CLOs as part of their portfolios,” he said.

“Oaktree Capital and Neuberger Berman, for example, are one of the most successful multi-credit managers in the country with a big portion of the fund invested in CLOs.”

Given the lower default rates in triple-B and double-Bs versus traditional corporate credit rating, plus a much higher yield pickup, investors now want to want to add an allocation to CLOs.

CLOs versus private credit

CLO tranche returns are somewhat comparable to private debt, another asset class which is proving popular with investors. But CLO investing has a few benefits over private credit, which HMC believes makes the asset class more attractive.

“In the institutional markets, as clients have gone more into alternatives, they have added private debt exposure,” said HMC’s Dancourt.

“But what usually happens is that private debt sits in the same bucket as US private equity under alternatives. So an investor can have a 5% or 10% private credit limit, but there will still only be maximum 15% alternatives allocation.”

Private credit is not in an ideal position when pension funds are looking for higher returns, because even though the risk adjusted return is very good, the absolute return can be higher in private equity funds, he added.

Pensions are therefore seeing CLOs as strategies that can come up with a good private credit-type return, but as a fixed income category.

The illiquidity factor of private debt also CLOs look very attractive, says HMC, which also has strategies investing in private debt through listed vehicles such as BDCs.

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