Determining Top-Tier CLO Managers
Managing collateralised loan obligations (CLOs) is not an easy task. We all know that credit has many downsides and limited upsides. Credit professionals tend to – understandably – focus more on managing downside risks. It is not a surprise that stress testing is a commonly heard term in our market! Be that as it may, managing a CLO is about finding the middle ground. A CLO equity needs to be rewarded for taking the first loss risk and running a very low-spread portfolio is not generally how an arbitrage CLO works.
Why would people want to invest without proven returns? If no one wants to invest in the first loss tranche due to poor return, it would be difficult to put together a CLO! Debt holders are equally important because, without rated tranche investors, it does not work either. Taking a calculated risk by delivering a decent carry and protecting against the downside requires excellent credit skills and experience that will truly test CLO managers.
This is why investors pay managers around 40bp for managing the loan collateral pool within the confines of the CLO structure and documentation. Ideally, the manager should outperform the leveraged loan index by close to that amount – fingers crossed!
Some managers do well for investors by making marginally more high-conviction trades with good spreads, providing the deal with the required ‘carry’. In contrast, others deliver higher ‘carry’ through the first-period par distribution instead of running a higher-than-average spread portfolio.
What does it mean when managers claim that they have made three great trades? It is like making three amazing tennis shots, but it might not necessarily mean one has won the game due to other unforced errors and misses.
One often hears, ‘I think manager A is top tier.’ This might be due to perception or the metrics one chooses to measure a manager’s skillsets.
The credit environment has stayed benign for some time now, however, is it so good that we can expect a grand slam title for CLO equity? Well, it depends.
Let’s use the analogy of an electric vehicle. The range of an electric vehicle is probably the most important consideration for buyers. An electric vehicle might give you a claimed range of 325 miles., However, one caveat regarding the estimated operating range to keep in mind is that it is an average based on an instrumented laboratory analysis conducted under strictly controlled conditions. A given driver’s real-world range can be widely different depending on various factors – cold weather, traffic, elevation change, under-inflated tires, heating, carrying loads and driving style. Speeding or dangerous driving certainly does not help, too!
Similarly, how CLO managers manage their collateral pools in different climates is essential. Collateral investment performance varies due to trading gains and losses, unrealised gains and losses, par build, interest earned, cash drag, and par distribution.
In our first article, we talked about watching collateral performance relative to the leveraged loan index.
Based on 2017 vintage EU CLO deals (as an example), we have observed the following:
The blue line – total investment alpha (total annualised collateral return net of the S&P leveraged loan index return on an unlevered basis); The orange line – average alpha.
| Performance against the S&P leveraged loan index* | Outperformance by over 30bp | Within +-30bp | Underperformance by -30bp |
| Group one | Group two | Group three | |
| % of EU CLO deals (2017 vintage) | 32% | 41% | 27% |
| Annualised collateral return minus WACC (including management fees) | 1.2% | 0.7% | -0.1% |
| Average exposure* (%) to retail, consumer goods, durable | 7.6% | 6.5% | 8.7% |
| Average exposure* (%) to Chemicals, Plastics & Rubber; Containers, Packaging | 13.4% | 11.8% | 9.8% |
| Aaa print (average) | 89bp | 86bp | 84bp |
| Average WARF* | 2820 | 2810 | 2840 |
| Change in WARF p.a. | +100 | +108 | +97 |
| Latest WARF cushion | +130 | +98 | +107 |
*from deal’s closing date to late 2019
- Over 40% (group two) of the 2017 vintage deals tracked the S&P leveraged loan index. This group saw a 0.7% net return on an unlevered basis. While arbitrage looked less ideal, CLO equity investors have the advantage of the time value of ‘options’ which could eventually show a better arbitrage result over the deal’s life.
- That said, the better performing deals (group one) saw a 1.2% net return on an unlevered basis. Does this mean that some CLOs continue to deliver decent arbitrage even in a less ideal climate?
- Some deals with an average WARF delivered good collateral returns while some others underperformed despite running a lower WARF. It is interesting to note that 5 deals in group three had less than 2800 WARF. Does this mean that running a lower WARF does not necessarily translate to good performance?
- Retail exposures looked similar across the three groups. Does this mean that idiosyncratic risk seems to be the current main theme instead of sector issues?
- Group one seemed to have the widest average Aaa print. Does that mean that timing tends to dictate Aaa prints rather than the managers’ performance?
- The annual change in WARF was in line with Moody’s idealised default probability table.
To conclude, CLO managers play an essential role in delivering the ‘claimed range’ even in a less ideal climate through careful and thoughtful driving.
Disclaimer
The information, research, data, research related opinions, observations and estimates contained in this document have been compiled or arrived at by CLO Research Group, based upon sources believed to be reliable and accurate, and in good faith, but in each case without further investigation. None of CLO Research Group or its service providers, their directors or authorised personnel makes any expressed or implied presentation or warranty, nor do any of such persons accept any responsibility or liability as to the accuracy, timeliness, completeness or correctness of such sources and of the information, research, data, research related opinions, observations and estimates contained in this document. All information, research, data, research-related opinions, observations, and estimates in this document are in draft form as of the date of this document and remain subject to change and amendment without notice. Neither CLO Research Group nor any third-party providers shall be subject to any damages or liability for any errors, omissions, incompleteness or incorrectness of this document. This article is not and should not be construed as an offer, or a solicitation of an offer, to buy or sell securities and shall not be relied upon as a promise or representation regarding the historical or current position or performance of any of the deals or issues mentioned in it.
