CLO manager scrutiny is growing just as market conditions make their job harder. Nevertheless, differentiation is set to accelerate as investors have to adapt the way they assess management performance.
Jason Merrill, investment specialist at Penn Mutual Asset Management, says: “This pandemic is obviously very unusual and has thrown the market into a downturn. Winners will be those with a strong hand willing to step in and buy cheap assets.”
However he adds: “There is a difference between those who talk about being a strong hand and those who actually do buy cheap assets. It is really important for investors to look at the numbers to see which managers actually did buy cheap assets when they said they were going to. Investor sentiment regarding manager tiering is likely to shift based on how managers perform during this downturn.”
That performance divergence is already happening. Poh-Heng Tan, founder of the CLO Research Group says: “Before, there was already disparity in performance, but it was not as big. For example, in February, when I looked at some performance data across the different managed deals by various managers, I saw a range of around 2-2.5% in terms of performance alpha in the same cohort, but now it is over 4.0% points.”
Historically, there have been a range of factors investors have used to assess managers. These factors often included qualitative assessments such as manager perception within the market, the risk of the platform, consistency in terms of investment strategy and the way that this strategy is communicated to investors. The crisis has already altered what is generally perceived as the most useful or appropriate metrics.
Merrill says: “Market participants are focusing more on the junior OC cushion. A material portion of the market has equity payments that are going to be shut off. For higher-rated tranches, having that equity shut off could be perceived as a positive, due to accelerated paydowns.
“However, deals with PIK’ing equity are likely to experience reduced liquidity across the capital stack. Another credit metric that investors are focusing on is aggregate exposure to industries considered most affected by the coronavirus. Triple-C spikes continue to affect a lot of managers.”
The most commonly used metrics may only show a part of the story in terms of performance. Therefore, some turn to alternative methods for insight.
Tan says: “I look at the gross underlying collateral return on a full month to month basis since inception, stripping away all the structural nuances. One could then assess the entirety of all trades (not only three good trades), unrealised gains and losses, income generated (adjusting for fixed rates), among others.”
He continues: “Some managers consistently outperform the S&P leverage loan index. I look at the collateral performance and compare it to the index.”
The wholesale actions by the rating agencies are also shifting perceptions. Merrill notes: “It is kind of a different feel compared to last year. With all the loan downgrades that are coming through, all the managers out there have some exposure to losers.”
He adds: “It is hitting everybody, so loan downgrade exposure is less of a differentiating factor. Rating agencies are now looking at downgrading CLO tranches, and the largest exposure to CLO downgrade watch activity was with bottom tier managers. If a market participant has an aversion to CLO downgrades it probably behoves them to stick with top tier managers.”
This article was originally published in Structured Credit Investor on 30 April 2020 and has been reproduced with permission.