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Analysis CLOs
European managers struggle to add alpha
by Poh-Heng Tan
Before the COVID pandemic, European CLOs comfortably outperformed the Morningstar European Euro-Denominated Loan Index. Since then, alpha has declined for many managers
The past four years have been volatile, and the European loan market has been challenging. So how well have European CLO managers done at credit picking? To find out, we looked at the average alpha generated (see methodology) for a sample of 218 deals from 2015 to 2019, and compared them with the Morningstar European Euro-Denominated Loan Index. The results were mixed at best.
Before the pandemic, European CLO managers demonstrated robust performance, with an average total alpha close to 20bps, as shown in chart 1, below. However, come April 2020, the total alpha for the sample sharply declined to a low of approximately –50bps. It is fair to say that the pandemic caught everyone off guard, making it unfortunate if managers experienced significant underperformance as a result. Nonetheless, credit must be given to managers who maintained their composure and navigated the challenging trading environment.
Some agile managers recovered more swiftly than others by capitalising on market dislocation, while others continued to lag behind their peers. Through much of 2020, EU CLO managers, on average, trailed behind the index, as shown above.
1: Average European CLO performance vs loan index
*For 2019 deals, performance data starts from August 2021. Source: Intex, Pitchbook Data, CLO Research, LPC
Alpha increases as market strengthens
After COVID-19, as the loan market began to improve, European CLO managers regained their footing. In 2021 when the loan market showed notable strength, their average total again approached 20bps. In fact, some seasoned EU CLO deals were called in 2021, which seemed well-timed given the buoyancy of the loan market, coupled with the managers’ outperformance on average against the loan index.
Nevertheless, EU CLO managers fell behind the loan index once again from July 2022 to December 2023 when the loan market experienced significant volatility due to inflationary pressures, an elevated interest rate environment, recessionary fears, and other macroeconomic factors.
18.3
bps
European CLO manager peak alpha generation before pandemic
EU CLO managers should have expected to navigate the elevated interest rate environment, but some were caught off guard. Managers, on average, underperformed the loan index by 5bps to 15bps, but saw nowhere near the magnitude of failure experienced in April 2020. One driver was that the median manager typically had exposure to fixed-rate assets of around 8% to 9%.
The interest alpha trend has been on a downward trajectory, coinciding with the rising interest rate environment. Furthermore, some CLOs from the 2015-2019 vintages face more reinvestment restraints as they season, impacting their ability to maintain a good level of portfolio interest income. As of the reporting date reading in May 2024, the sample’s interest alpha was merely 1bps, indicating that EU CLO managers are now mirroring the interest return of the index.
2: European CLO alpha generation by horizontal vs vertical risk retention (bps)
*For 2019 deals, performance data starts from August 2021. Source: Morningstar, CLO Research
Vertical versus horizontal risk retention
Chart 2 (above) depicts the average alpha metric trends for deals with horizontal risk retention (manager’s majority equity retention) and deals with vertical risk retention (third-party majority equity).
Deals with vertical risk retention outperformed their counterparts from late 2020 to early 2023. However, their average performance metrics underperformed compared to deals with horizontal risk retention after late 2023.
On average, deals with third-party majority equity investors tend to show greater fluctuations in alpha. This perhaps underscores the notion that deals with third-party majority equity investors face greater performance expectations to attract continued third-party equity capital and therefore adopt a more interest income-oriented strategy.
Sometimes, the outperformance in interest alpha is not sufficient to offset the underperformance in market value alpha, leading to overall total alpha underperformance.
Positive alpha in early 2024
As the market continued to rally towards the end of 2023, there was once again an improvement in alpha performance. In January 2024, the average alpha of seasoned EU CLO managers finally returned to positive territory, indicating that, on average, these managers were performing slightly ahead of the index. However, that has slipped back into negative territory, albeit marginally, since April 2024. This seems to have coincided with issues caused by Altice. The average exposure to Altice for the sample was 1.48% versus 0.44% for the index.
As of May 2024, the average total market value, interest return and overall alpha metrics of EU CLO managers were -3bps, -4bps, and 1bps, respectively.
While average metrics can obscure many details, chart 1 offers valuable insights into the overall performance of EU CLO managers in recent years. It’s crucial to acknowledge that some managers consistently outperformed the loan index throughout the study period, while others frequently underperformed. As a result, investors should not assume that the involvement of a CLO manager reduces risk. EU CLO managers achieved positive alpha in only 20 out of the 53 months covered by the study. This highlights the fact that outperforming the loan index over a sustained period is not easy.
Another observation is that EU CLO managers tend to track the market value return performance of the index closely in strong loan markets, such as in 2021. However, they have underperformed in weaker conditions. More recently, managers’ performance has aligned closely with the index from a market value return perspective, as illustrated by the market value line in chart 1.
Methodology
To calculate a deal’s total market value (MV) or interest return (IR) alpha, we determine the investment return for each period from its closing to its most recent reporting date. This involves compounding the portfolio’s monthly (or other periodic) total market value or interest returns since the closing date. Next, we annualise the portfolio’s total market value or interest return and compare it to the annualised return of the index. The difference between these returns is the deal’s alpha.
