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Opinion CLOs
The ability to deliver superior credit performance gained in importance
by Thomas Majewski
Thomas Majewski
Founder & managing partner
Eagle Point Credit Management
A trusted brand is no longer enough — CLO manager tiering is now based on a range of data
For over a decade leading up to 2020, credit markets experienced a period of relative calm and stability after the disruptions in 2008-09. This benign environment coincided with the tremendous growth of the CLO 2.0 market. During this time, tiering of CLO collateral managers began to take shape far more than in the 1.0 era. Since credit performance didn’t differ widely, the primary criteria that emerged for investors in determining collateral manager tiering during this period often related principally to assets under management and brand recognition. Perceived bond liquidity was also an important consideration for many CLO investors.
This approach meant that newer CLO collateral managers faced a lengthy battle to climb the ranks, often requiring many years of operation before even approaching middle-tier levels. However, the onset of the pandemic in early 2020 marked a turning point in the CLO landscape. COVID-19, coupled with subsequent geopolitical conflicts and interest rate hikes, reintroduced volatility and uncertainty to credit.
CLO collateral manager performance began to vary significantly. Simultaneously, technological advancements revolutionised how investors could analyse and compare CLOs: the proliferation of data analytics tools and platforms, such as Valitana, allowed for granular real-time assessments.
Size and brand recognition still held some advantages, but the ability to deliver superior credit performance in challenging market conditions gained in importance. This shift in focus from size to performance led to more dynamic tiering. Investors now pay close attention to the characteristics of each CLO, rather than relying solely on the collateral manager’s overall reputation or size. Some are also willing to accept lower spreads for CLOs with cleaner, better collateral, even for emerging managers.
Manager hierarchy becomes more fluid
Over time, what had been a somewhat stable classification system has taken on new nuances, sometimes even within the same tier. Many of the recognisable tier one CLO collateral managers are still tier one — but others have moved above them into a tier one-plus class, and others have fallen. Some tier three CLO collateral managers trade like they are tier two, while those which had fought their way into tier two subsequently fell back to tier three as their collateral pools underperformed.
The evolution of CLO manager tiering has been particularly pronounced for equity investors, the class where returns are most sensitive to CLO manager performance. In the current market environment, trading acumen, creating gains and avoiding losses have become critical factors, often carrying as much weight as the initial spread arbitrage and triple A relationships. This shift reflects the growing recognition that success in CLO equity investing is driven less by the initial arbitrage than by the ongoing management of the loan portfolio and the CLO’s structure.
Divergent outcomes and greater scrutiny
The intersection of increased data availability and widely divergent outcomes has made the task of selling CLO equity more challenging for CLO collateral managers with weak equity performance track records. Investors are now able to take a holistic view of a CLO collateral manager’s capabilities, considering their full range of activities in the market, not just their triple A print. Key questions that come into play today include: Can the CLO collateral manager effectively handle liability management exercises (LMEs)? Do they have the trading skills necessary to navigate spread compression? The answers to these questions can significantly impact the performance of CLO equity tranches and, by extension, the CLO collateral manager’s standing in the tiering hierarchy.
In the past, brand recognition and size might have been sufficient to attract equity investors. Now, as the market has evolved and due diligence has become more rigorous, many investors use large sets of data to evaluate a CLO collateral manager’s ability to generate superior returns in various market conditions. CLO collateral managers must actually perform, focusing on delivering consistent, superior performance to their CLOs’ owners, the equity investors. There is no more hiding behind a default track record. Historic equity IRRs are now readily available to well-equipped investors. This evolution creates a more efficient and resilient CLO market, better equipped to weather future economic trends and continue its vital role as one of the largest providers of capital to US companies.