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January 2024 | Issue 260
Analysis
CLOs
What CLO investors really need to know
Mike Peterson
Poh-Heng Tan
Many potential CLO equity buyers are put off by the apparent complexity of these investments, but newcomers can quickly gain a good understanding by focusing on seven key elements
From the drivers of CLO performance to cashflow modelling, these are the seven things every CLO equity investor needs to know.
1. What drives CLO equity performance
A CLO can be seen as a mechanism for investing in a diverse pool of corporate debt. From the perspective of its first-loss tranche, the rated tranches exist to provide long-term, non-recourse funding for a diverse portfolio of senior secured, non-investment-grade corporate loans, managed by a CLO manager.
A CLO’s equity return (IRR) is the long-term total investment return of the portfolio, net of funding costs. The following factors can affect CLO equity IRR:
- Underlying collateral performance, which is influenced by a wide array of factors, including market conditions, trading and reinvestment, defaults, recovery rates, and realized gains and losses.
- Cost of funding, which is driven by factors including market conditions, the market’s perception of what “tier” the manager belongs to and the duration of the deal.
- Management and incentive fee structure, which can be higher for more seasoned managers.
- Upfront issuance costs, which it will typically take several years to offset.
- Leverage of the CLO structure, with a less conservative capital structure resulting in a wider range of possible IRR outcomes.
- Timing of the call: that is, when it makes economic sense for investors to redeem the deal.
A good starting point is to look at the equity IRRs of all post-2012 CLOs
2. How to choose a CLO manager
The CLO manager is crucial, as this firm has a direct impact on the investment performance of the underlying CLO portfolio. Many factors need to be considered, such as:
- Company and organizational structure, including the team’s stability and experience in managing CLOs.
- Investment philosophy and investment committee approval process: for example, whether decisions are through consensus or based on a portfolio manager’s call.
- Controls, operations and technology: including portfolio management systems and controls to monitor compliance with investment policies.
Generally speaking, investors should look for a low turnover at the senior management level, a large and experienced credit research team, and long-standing collaboration between experienced senior portfolio managers and senior credit analysts. It is also important to understand how the interests of limited partners, risk retention funds, equity investors and debt holders are balanced.
Discussing specific credits with the CLO manager is useful. It can provide insights into the manager’s approach to selecting assets and managing credit risk that are not obvious from written materials.
Understanding the CLO manager’s investment performance is, of course, vital. A good starting point is to look at the equity IRRs of all post-2012 CLOs that have been redeemed. But it is essential to understand the limitations of the different metrics used for evaluating manager performance.
3. How CLO cashflows work
Before equity investors can make sense of CLO metrics, they need to understand how CLO cashflows work, and be aware of the important differences in the rules governing cashflows from deal to deal.
A key principle is that the flows of money going into and out of a CLO are divided into two streams: principal and interest. Principal payments from the underlying assets (generally) flow into the CLO’s principal account; interest payments flow to CLO interest, according to the detailed rules of the interest waterfall.
There are two main ways that principal amounts can be paid out as interest. One feature, seen mainly in European CLOs, allows increases to the CLO’s par value made from trading gains to be paid out on the following quarterly payment date. This differs from par flush, a one-off payment permitted when the CLO ends its ramp-up period with a portfolio par balance that is higher than its target.
Any ability for the CLO to switch money from the CLO’s principal stream to the interest stream can allow larger and earlier payments to equity investors, potentially boosting returns to equity.
Almost all CLOs pay the manager an incentive fee which is linked to equity distributions. The basic structure is almost always the same: once the equity has received an IRR of 12% then all subsequent equity distributions are split 80:20 between equity investors and the manager. However, the way the IRR hurdle is defined can make a big difference to the timing of the incentive fee.
4. How CLO balances work
CLO cashflows are governed by a set of tests, most of which are based on ratios, so it is vital for equity investors to understand how the balances used in these ratios are constructed. Perhaps the most important test is the OC test, which, while it is failing, cuts off distributions to equity. The test compares the value of the assets in the portfolio against the amount of outstanding CLO notes.
From the equity investor’s point of view, one of the benefits of a CLO is that it provides term funding without mark-to-market triggers. The balance used in the OC test numerator is therefore the par value and not the market value of the CLO’s assets. However, there are some important adjustments which do introduce an element of market value into the mechanism, including:
- The treatment of defaulted assets, which is typically based on the lower of their market value and a flat recovery rate assumption.
- A reduction for assets rated triple C and below (but which are not actually in default), which applies once triple C
- holdings exceed a threshold of (almost always) 7.5%.
- An adjustment for assets bought below a predefined price, known as discount obligations, and which are valued not at par but at their purchase price.
5. How CLOs handle distressed assets
CLOs are generally designed to consist of performing loans and managers are usually prohibited from buying any that are in default. However, CLOs generally give the manager some leeway to respond to distress situations arising in the portfolio, and this can have a significant impact on equity performance. Some of the mechanisms used to deal with distressed situations include:
- Supplemental reserves: funds that would have been paid to equity but which are put aside by the manager to purchase assets arising from a future restructuring.
- Contributions, which are injections of new funds by equity investors to be used in a similar way to supplemental reserves.
- Work-out obligations: a new ability for CLO managers to participate in restructurings and have the resulting assets to count towards the OC numerator balance.
- Priming: an even more recent development, which gives CLO managers flexibility to participate in aggressive balance sheet restructurings outside of a conventional debt restructuring.
- Defaulted swaps, which allow the manager to buy a defaulted asset with the proceeds of another defaulted asset.
CLO rules governing post-reinvestment trading have a big impact on the CLO’s speed of amortization
6. How to assess the CLO portfolio
A bottom-up analysis of a CLO’s assets can help investors avoid managers with poorly constructed portfolios. It also gives investors the chance to ask important questions about individual credits and may allow them to work out the average credit score of the CLO portfolio. However, bottom-up analysis of the initial portfolio ignores the track record and investment return performance of the manager. So it needs to be combined with an assessment of the manager’s investment track record and a clear understanding of the constraints of the deal rules.
Among the key rules of every CLO are the concentration limits, also known as portfolio profile tests, which determine how much of specific asset types the manager is able to own. Table 1 (left) shows market standards in European and US CLOs for some key concentration limits. (Concentration limits vary greatly from deal to deal and, in reality, few individual CLOs would have exactly this set of limits.)
7. How to model CLO cashflows
As shown in table 2 (below), top-tier US CLO managers have the potential to reduce the annual loss rate by 30 to 60bps compared to lower-tier US managers. For top-tier EU CLO managers, the annual loss rate is similar to that of a loan index. However, lower-tier EU CLO managers can have elevated annual loss rates of between 0.8% and 0.9%.
The speed at which CLO rated debt is paid down after the reinvestment end date depends on several factors, including the behaviour of the CLO manager, market conditions, the documentation of the CLO, and the composition of the collateral pool. Equity-friendly deals can typically expect a slower pay-down rate in the first and second years of the post-reinvestment period.
In addition to manager track record and investment style, CLO rules governing post-reinvestment trading have a big impact on the CLO’s speed of amortization (few broadly syndicated CLOs ban all purchases after the end of the reinvestment period). For example, most deals need to comply with a weighted average life (WAL) test, which acts as an important practical constraint on post-reinvestment purchases. However, the exact form of compliance with this test differs in important respects from deal to deal.
About the authors
This article is an extract from Dealscribe and CLO Research’s guide What CLO Equity Investors Need To Know. A copy of the full report is available by request at https://forms.gle/PQGvbVd3ePgYoHbz6
Poh-Heng Tan is the founder of CLO Research, which provides balanced, unbiased and impactful research on CLO investment returns and manager performance.
Mike Peterson is the founder of Dealscribe, which provides independent analysis on CLO governing documents, allowing rapid comparison of deal terms across more than 2,300 deals.
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Global credit funds & CLO's
January 2024 | Issue 260
Published in London & New York.
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