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News Investor’s Corner
‘With CLO equity, I like the ability to buy discounted loans in periods of stress’
by Shant Fabricatorian
Creditflux: We’re speaking at the end of March, at a time of tremendous geopolitical uncertainty. Do you see geopolitical risk as the biggest issue currently facing credit investors?
Shiloh Bates:
In terms of risks, I would put AI displacement of software businesses as the number one risk. For a first lien, senior secured lender, geopolitical risk isn’t going to be a key driver of results for CLO equity, in my opinion. How to rate software, displacement of software businesses by AI — that’s at the top, that’s what is moving the Morningstar Loan Index.
If you’re first lien and senior secured, you’re in a pretty good place
Shiloh Bates
Chief investment officer
Flat Rock Global
CF: How do you mitigate against the risks from that perspective? What’s your strategy been to try and address those risks?
SB: If you look through into the underlying loan portfolios, you get about 11% exposure to software, and then another, say, 4% that is AI or kind-of software — things like healthcare and IT.
In CLO equity, we’re long these loans. So there’s not really any hedging — I think that’s common in my space. You buy CLO equity because you think senior secured loans are attractive and you want to own them with the built-in leverage of the CLO, and you want to target mid-teen returns. And if you don’t like the strategy, you probably just invest in something else rather than hedging.
I guess part of your question is whether this is a risk that should have been hedged. There’s probably 40 or so CLO managers we work with. And a lot of them are pretty optimistic about what they view as very low default rates for software loans — that, at least, is their projection.
This is probably the first opportunity to really buy discounted loans for CLO managers on a prolonged basis since 2022. You had a short period of time around Liberation Day. And now you have what could be an extended period of time where you’re buying loans or they’re potentially buying loans that they feel good about that are coming at discounts, where there is not, at least yet, any deterioration in revenue and cashflow.
One of the things I like best about CLO equity is the ability to buy discounted loans in periods of stress. The only problem with it is that the periods of stress don’t feel great. But once you get through it, you look back and hopefully, if you’re working with the right CLO managers, you’ve capitalised and you’re better off.
CF: Do you prefer CLO managers to stay away from software?
SB: Ultimately, it’s going to be up to them. We’re relying on their 10-year-plus track record of doing a good job with these assets. When I talk to CLO managers, they take you through their criteria for the software loans with which they’ve become comfortable.
Some of the biggest factors would be: what’s your retention rate, or how disruptive would it be for a business to pull out of the existing software that they have and replace it, and retrain and potentially offer support for the new software?
Asset management is a regulated business, and I’d be surprised to see mission critical software vibe-coded in the near-term. Healthcare is another example along these lines. Again, hopefully, that’s not going to be stuff that’s vibe-coded on the weekends.
Declining software business enterprise values are going to be an issue for private equity firms that own these companies. A lot of times, they bought these businesses at 15x EBITDA, and the first lien loan is, say, 5-6 times that. So the initial loan was at 40% LTV; there’s a lot of equity cushion there, and the businesses are free cashflow positive.
I think there will be winners and losers, but I think if you’re first lien and senior secured, you’re in a pretty good place.
