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Analysis CLOs
Do defaults predict equity returns?
by Poh-Heng Tan
At first glance, recently redeemed European CLOs show some sort of correlation between final IRR and the number of defaults in their portfolio. But what other factors affect performance?
Now that at least 24 EU CLOs have been redeemed since October 2023, we can look at the correlation between the estimated IRRs of these redeemed deals (based on the original balance) and their underlying collateral annual default rates. In summary, we see that the final equity IRR of a CLO is not solely determined by defaults, as chart 1 shows.
To analyse these results it is first important to separate out two types of deal. Seven CLOs that priced in 2022 and early 2023 have already been called. As shown in chart 1, equity tranches in all these deals (except the worst performer), achieved IRRs ranging from 30% to 70%, based on an issue equity price of 95. And all except that worst performer registered a 0% default rate.
Essentially, these deals functioned as principal-driven CLOs. They generated returns primarily through asset price appreciation rather than ongoing income. This strategy capitalised on market volatility, leading the deals to perform exceptionally well as the loan market rallied.
1: Final IRR vs collateral annual default rate for European CLOs
Source: Intex, CLO Research
Henley CLO wins by a length
Among this pack of high performers, Napier Park’s Henley CLO IX stands out. If we conservatively assume an initial equity price of EUR 100, this deal’s equity tranche still achieved an impressive 62.0% IRR and a multiple on invested capital of 1.61x (see table 1).
This deal was arranged by JP Morgan. It priced on 9 November 2022, and was redeemed on 4 December 2023. Structured as a static transaction, it achieved an efficiently leveraged capital structure due to its short life and the significantly discounted purchase price of the assets (likely in the low-90s range). Consequently, the equity tranche represented only 4.7% of the total EUR 282m capital structure. Despite the small size of the equity tranche, the deal maintained a solid initial class F par value ratio of 111.32%, based on the initial portfolio par value of EUR 300m. Total management fees were 20bps.
Leaving aside these idiosyncratic principal-driven CLOs, we come to a batch of standard deals, hailing from 2013 to 2021 vintages. Among them, several equity tranches achieved IRRs of around 10% or higher, despite their underlying collateral annual default rates varying significantly, from almost 0.0% to 1.2%. This variation clearly demonstrates that many factors, beyond just default rates, can influence a deal’s final IRR.
In fact, two seasoned deals that produced estimated mid-single digit final equity NAVs experienced annual default rates of over 1.7% — yet the difference in their estimated final equity IRRs was around 8 percentage points.
Taking ALM at a 16.8% final IRR
Among the regular CLOs, ALM Loan Funding III stands out. It achieved an estimated final IRR of 16.8% over a period of nine years. Even assuming an issue price of EUR 100, its equity tranche still recorded an impressive IRR of 15.4%. This 2014 vintage deal was reset twice, first in 2017 and again in early 2020. Both resets were accretive, leading to a tighter cost of funding (as shown in chart 2) and an extension of the reinvestment period.
ALM Loan Funding III’s impressive final equity NAV, strong annual equity distributions (at a rate of 14.4%), and the front-loaded nature of these distributions all contributed to a robust final equity IRR.
Given its strong equity distributions over a long period of time, this deal would still see a respectable final IRR even if its final equity NAV were much lower. This highlights that deals delivering a consistent stream of equity distributions are less reliant on the final equity NAV, which is subject to the timing of calls and idiosyncratic risks. This is advantageous for equity investors.
Deals benefiting from a consistent stream of equity distributions are less reliant on final equity NAV
ALM Loan Funding III experienced only one default, amounting to a minuscule 3bps per annum. The solid final realised equity NAV, which is around the mid-70s, suggests that the manager, Apollo Global Management, preserved the principal value of the underlying collateral pool. Of course, the opportune timing of the redemption plays a role, too. Had this deal been called during a weaker loan market, the final equity NAV would likely have been much lower than the actual realised value.
Another deal managed by the same manager also had a low default rate (5bps per annum), yet its IRR registered below 10.0%. This underscores the fact that a long list of factors, aside from default rates, can influence final IRR.
2: ALM Loan Funding III arbitrage (%)
Source: Intex, CLO Research
Other factors affecting CLO equity IRR
Underlying collateral
The performance of a deal’s underlying collateral is influenced by defaults, recovery rates, market conditions, trading and reinvestment, cash drag, par build, interest generation, movement in reference rates, loan repricing, amend-to-extend activities, rating changes, market value gains and losses, and realised gains and losses.
After a breach of the overcollateralisation (OC) tests, interest will be channelled into the principal account and reinvested. Conversely, in some scenarios, principal proceeds can be directed into the interest account. In either case, the timing of equity payments is affected.
Cost of funding
A CLO’s cost of funding is driven by market conditions, the market’s perception of what tier the manager belongs to, portfolio quality (and spreads), capital structure, documentation, technical factors, refinancing, prepayment rates and the duration of the deal.
Typically, resetting a deal (refinancing it and extending its investment period) is easier when the deal is performing well and market conditions are favourable. If a deal has lost a significant amount of collateral market value, it becomes challenging to reset, as pricing the long-dated liabilities becomes prohibitively expensive.
As a deal pays down, its capital structure becomes less levered and its cost of funding increases, providing more incentive to call or reset the deal—especially as equity payments diminish.
Management and incentive fees
Some seasoned managers have more bargaining power due to their top-tier performance. Hence they may charge higher fees and the hurdle for paying incentive fees may be set lower.
Static deals incur lower total management fees.
Issuance, refi/reset and running costs
It typically takes several years to offset these costs.
Leverage
Some deals are structured conservatively, without any single B or even double B tranches. Static deals are more levered due to their shorter duration.
In general, the less conservative the capital structure, the wider the expected IRR range.
Timing of the call
Investors are likely to redeem a deal when it makes economic sense to do so.
