CLO ROUNDTABLE, AN INSIDE VIEW FROM CLO INDUSTRY EXPERTS US CLO Equity Is Attracting High Global Demand – How Can Investors Maximise the Opportunity? December 2021
Introduction It is with great pleasure and privilege that we present the Maples Group’s third ‘Bringing you CLOser…’ inside view from recognised CLO industry experts. In this roundtable discussion, James Reeve from the Maples Group’s CLO team speaks with Mohamed Seif and Dan Norman of Lakemore Partners, a leading private credit investment firm primarily investing in control CLO equity on behalf of global investors, about the global demand in CLO equity, investment strategies, analysis, qualitative and quantitative benefits in supermajority equity positions and strategic investor-manager partnership, together with market review and forecasts for 2022. This roundtable was moderated by: James Reeve Finance Partner, Cayman Islands Maples Group Participants: Mohamed Seif Co-Founder & Managing Director Lakemore Partners Dan Norman Managing Director & Head of U.S. Business Operations Lakemore Partners
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Bios MOHAMED SEIF
CO-FOUNDER & MANAGING DIRECTOR
Seif is Managing Director of Lakemore Partners and a member of the firm’s Board of Directors. He is the Chief Investment Officer at Lakemore Partners and chairs the Investment Committee. In his role as CIO, he is responsible for building and setting the firm’s CLO equity investment strategy, as well as overseeing all investment processes. He has 42 years of investment management experience during which he has managed more than US$30 billion across conventional and alternative asset classes. Prior to Lakemore Partners, Seif was Chief Investment Officer at Safanad, a global principal investment firm focused on Private Equity, Real Estate, and Liquid Strategies. Previously, he spent 17 years with NCB, where he was Head of Asset Management overseeing more than US$26 billion in conventional and alternative asset classes that included Specialist Credit, Hedge Funds, Real Estate and Private Equity. He was instrumental in building the proprietary trading and alternative asset management business of NCB. Previously, he was Head of Risk for the Middle East region at CSFB – London & Cairo where he was a member of the emerging markets team. He also worked for the investor services group at Citibank – London. Seif holds a Bachelor of Arts in Economics with a minor in Psychology from the University of Cairo.
DAN NORMAN
MANAGING DIRECTOR & HEAD OF U.S. BUSINESS OPERATIONS
Dan is Managing Director & Head of U.S. Business Operations, and a thought leader focused on growing Lakemore Partners’s credit investing platform globally. He is a successful, respected, and cycle-proven executive with over 35 years of global businessbuilding and investment management experience. Dan joins Lakemore Partners following his retirement in 2020 from Voya Investment Management (“Voya”) where he most recently served as Group Head and Senior Managing Director. While at Voya, he founded Voya’s Senior Loan Group in 1995 and co-managed the Group’s global loan platform including its global CLO business, which by the end of 2020 had managed 46 CLOs with a combined size of over US$22 billion. During his 29-year tenure at Voya and its predecessor firms, Dan structured and managed over 80 loan funds and accounts with a combined maximum fund size of over US$50 billion. He created extensive distribution networks and more than 300 investor relationships across North and South America, Europe, Asia, Australia, and the Middle East. Dan currently serves as a Board Member of the Business Loans Coalition, the Loan Syndication and Trading Association’s (LSTA) grassroots advocacy affiliate, and as an advisory Board Member of The Maricopa Partnerships which manage diverse business and investment interests. He previously served as a Board Member of the Loan Syndication and Trading Association as well as the International Association of Credit Portfolio Managers. Prior to Voya, he co-founded The Prime Financial Companies, serving as COO and CFO. Dan started his career at Arthur Andersen & Co. He holds a BS and MBA from the University of Nebraska. CLO Roundtable – December 2021 | 2
JAMES REEVE PARTNER
James is a partner of Maples and Calder’s Finance team in the Maples Group’s Cayman Islands office. He advises on structured finance transactions (in particular CLO transactions, related risk retention structures and catastrophe bonds), fund financing matters (acting for both lenders and borrowers) and general banking and financing work. James also has experience advising on asset finance transactions (particularly off-balance sheet commercial aircraft financing and leasing) and general corporate and commercial transactions, along with restructurings and securities listings on the Cayman Islands Stock Exchange. James joined the Maples Group in 2011 and was elected as a partner in 2018. He previously worked as a banking and finance lawyer at a magic circle firm in London where his practice focused principally on project finance. James has been ranked in the Legal 500.
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Roundtable James Reeve Moderator
Why is US CLO equity attractive in the current market?
Dan Norman Lakemore Partners
CLO equity, which accounts for roughly US$80 billion of the broader $806 billion US CLO market, has attracted significant global investor attention in recent months. As the Covid-19 pandemic upended our lives (and financial markets), CLOs provided investors with transparent and resilient returns, with many market participants impressed at the asset class’s ability to prosper through a challenging period of heightened volatility. Given 2020 was the third recessionary cycle since the inception of CLO equity as an asset class roughly 25 years ago, the asset class has an established history of providing investors with a reliable return profile and the ability to benefit through recessionary environments. Indeed, the consistent, predictable, and stable cash flows distributed to CLO equity investors through this period of high market volatility have shone a bright light on the asset class. As a result – particularly in a yield-starved environment such as we’ve seen through the latter half of 2020 and year-to-date 2021 – increasing numbers of investors are intrigued by the attractive risk-adjusted returns provided by US CLO equity.
James Reeve Moderator
Thanks Dan. Yes, “Proven Resilience” was the headline we adopted for our US CLO market overview back in May in light of analyses that the Maples Group had performed; certainly that is a very positive conclusion one can draw from the both the performance and the behaviour of the US CLO market through the Covid-19 pandemic. But that resilience, combined with the yield-starved environment you just mentioned, has translated not just into increasing numbers of investors looking at CLOs but new managers coming to market too of course, with six debut deals in 2021. We have also witnessed the CLO technology being applied (or reapplied) to offer investors enhanced structural features and protections in other securitization contexts of course, for example Aircraft ABS and CFOs.
Dan Norman Lakemore Partners
This increased market focus has been propelled forward by the fact that CLO equity is benefiting from what are arguably some of the most attractive cash flow arbitrage conditions in its 20-year+ history. By our calculations, the difference between CLO income and expense (known as CLO equity arbitrage) is running at around 20% yearto-date, which leads us to believe that the pandemic and post-pandemic recovery CLO equity vintages could be some of the highest returning on record. The 20% CLO equity arbitrage that we see in the current market is driven predominantly by two factors: historically low pricing on the liability side, and above-average loan spreads on the asset side. Moreover, leveraged loan market supply has been abundant in the wake of the COVID-19 crisis and year-to-date has already broken the previous full-year issuance record (see Total Leveraged Loan
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New Issuance Volume chart below), which provides loan-picking optionality for CLO collateral managers. Meanwhile, leveraged loan default rates and the LSTA distressed ratio (loans trading below 80) have plummeted to multi-year lows. All of these factors provide a fundamentally strong outlook for leveraged loans, which benefits the CLO market, as the largest buyer of the US senior loan asset class (approximately 74%, as of Q3 2021). Understandably, with conditions like these, many new investors are looking to get in on the action, and this historically high arbitrage has been a key driver of the record-setting CLO volumes that have come to market year-to-date (see US CLO New Issues, Refinancings and Resets chart on page 9).
Source: S&P LCD. Please note, leveraged loan issuance volumes are as of October 31, 2021; CLO ownership as of end of Q3 2021 (data published quarterly).
However, in our view, not all CLO equity tranches are equally attractive; investors in the asset class can opt for several different strategies that will ultimately produce a wide range of returns. Many larger CLO equity investors seek to own a majority, or more than 50%, of the equity tranche; other investors seek to invest in a minority position. In this roundtable, we will discuss some of the different types of majority equity styles as they relate to the broader US CLO market. James Reeve Moderator Mohamed Seif Lakemore Partners
What are the differences in CLO equity styles? In the market today, you’ll find three primary styles of CLO equity investment strategies. Many investors in CLO equity take minority positions, which means the equity is broadly syndicated and there is no majority holder. Much like being the minority shareholder in a company, individual minority CLO equity investors have limited
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influence on the broader CLO structure, including structural decisions, such as refinancing debt tranches or resetting the fundamental terms of the CLO structure. These are key decisions that can materially affect the CLO equity return profile over time. The alternative to a minority CLO equity holding is to be a control equity investor. As the name suggests, CLO control equity investors take the majority stake in the equity tranche, with a simple majority of more than 50% ownership sufficient to secure “control”. The remaining minority position, which is often split into many pieces, is offered in the broadly syndicated market. The syndication process is managed by the arranging and distributing investment bank, and typically the control CLO equity investor will not be aware of these minority equity holders, which can lead to challenges later down the line. Finally, there are supermajority CLO equity investors, which means the equity investor holds c. 90% of the tranche. Of course, a natural question at this point could be: who holds the remaining balance of the equity tranche? Often, the CLO’s collateral manager is eager to hold this portion, as it’s both a strategic and an economic alignment of interests between the supermajority investor and the collateral manager; in effect, it’s a win-win for the collateral manager and the supermajority equity holder. James Reeve Moderator
Thank you for that very helpful summary.
Dan Norman Lakemore Partners
Simply put, to return to the earlier shareholder analogy, the more of a stake you hold in the company as shareholder, the more influence you have over the decisions of management. The same holds true for CLO equity investing: the larger the investment, the greater the decision-making optionality. Certain decisions that may be taken by the CLO equity investor through the life of a CLO are vitally important in determining the ultimate IRR experienced by equity investors. Of course, the timing of said decisions is equally important.
From the investor’s point of view, why is a control equity position important?
Decisions often need to be taken quickly in periods of shifting loan, CLO and macroeconomic market conditions. For example, in a falling liability cost environment, it is important to time new CLO issuance, or existing CLO reset and refinancing decisions correctly – too early, and the CLO liability pricing will be wide of its low point, but too late, and the CLO equity investor may miss the tights of pricing for a particular vintage. Employing a supermajority CLO equity strategy enables these decisions to happen opportunistically and efficiently, which ultimately gives the CLO equity investor the maximum opportunity to get the timing right. Our experience suggests that maximizing control in a supermajority equity style provides significant benefits that can enhance CLO equity returns, including the ability to:
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• •
We see the value of controlling the entire equity tranche to be around 7% to 10% (in absolute terms) in incremental equity return compared to a minority position.
James Reeve Moderator
• • •
Achieve best-in-class commercial terms with collateral managers and arrangers Construct a defensive initial portfolio, which leads to par building opportunities post close during volatile market periods Optimize the timing of liability pricing to achieve the lowest possible vintage cost Decide on CLO reset, refinancing and liquation timing to enhance equity returns Allocate to top-tier, cycle-aligned collateral managers through a multi-manager portfolio style
One of the questions we are often asked is: what is the quantifiable value of this supermajority control optionality? In our experience, we see the value of controlling the entire equity tranche to be around 7% to 10% (in absolute terms) in incremental equity return compared to a minority position. We find that a higher level of control leads to a materially higher level of incremental IRR. It is certainly very interesting that the qualitative benefits of supermajority control have such a marked quantitative benefit too; the magnitude of which I am sure many of our readers will be unfamiliar.
Can you describe some of the decisions a supermajority CLO equity investor may take through the lifecycle of a CLO? Dan Norman Lakemore Partners
Managing a CLO through its life, from genesis to wind down, features multiple moving parts over the course of its term. Some important highlights include:
CLO Structuring During the structuring phase, a supermajority CLO equity investor is able to work with both the collateral manager and arranger to include equity-friendly language in deal documentation that may support more attractive CLO returns over time. By way of comparison, a CLO transaction with minority investors will need to collaborate with all equity investors to gather input on key document features and may fail to include some accretive document terms, due to the differences in investment objectives of a supermajority long-term investment strategy vs. a minority shortterm investment strategy. The second key benefit during deal formation for the supermajority style is the ability to manage deal timing and execution, given the absence of a minority equity syndication process. This is particularly effective in a stressed or distressed market environment, such as during the Covid-19 crisis last year, when the market for minority equity investors completely dried up. As the flight to safety ensued and loan prices dropped, an attractive investment opportunity surfaced for new CLO issuance that supermajority control equity investors were able to take advantage of.
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A third important benefit of the supermajority style is the ability to decide and align the initial portfolio to a defensive construction without being forced to “stretch for spread”, i.e., a non-commensurate increase in risk in order to obtain a higher spread. Minority investors typically buy CLO equity positions based on upfront modelled IRRs and short-term cashflows, which directly correlate to initial loan portfolio spreads. Having minority investors involved in a CLO equity tranche, even in simple majority control deals, often encourages the collateral manager to add spread at the expense of additional credit risks, to ensure that the last dollar of minority equity being syndicated is sold and the CLO transaction is able to close. In essence, a supermajority CLO equity style offers greater negotiating power, better portfolio stability and improved optionality during the structuring and CLO formation phase. It also reduces distribution fees, which can be a significant upfront deal cost.
Portfolio Positioning As supermajority investors, an important strategic decision that can be made with the collateral manager is the choice between managing the CLO to strive to maintain cashflows or to protect and gain par. This decision needs to be in complete alignment with the collateral manager, who then operates to manage the CLO with that objective. In most distressed market conditions, the best decision from a risk and return perspective is to protect and strive to gain par, which at certain times could come at the expense of potentially breaching certain debt covenants. In a deal involving minority investors, this alignment becomes far more challenging as the CLO manager’s decision to protect par could result in CLO cash flow diversions for equity investors, which may aggravate the minority investor group. Aggravating the minority investor pool can have a significant impact on the CLO manager’s ability to broadly syndicate minority equity for future transactions.
Resets and Refinancings Post-closing and after the non-call period ends, decisions regarding resetting and refinancing are in the CLO equityholder’s hands. This is true regardless of the equity style deployed: broadly syndicated into minority pieces; held by a majority control investor and one or more minority investors; or held by one supermajority investor. Optimally timed resets and refinancings, during which deal terms can be amended or liabilities repriced, can have a significant impact on the final IRR, which means that controlling this optionality, particularly during volatile periods, can have an important impact on maximizing returns. As 2021 comes to a close, the CLO market broke the record for the highest full-year volume for CLO new issues before Q4 had even begun (see US CLO New Issues, Refinancings and Resets chart, next page), with an abundance of refinancings and resets also taking place, as CLO equity investors sought to take advantage of the historically high cash flow arbitrage.
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Source: S&P LCD, as of September 30, 2021.
Depending on the document, a simple majority of equity might be all that is required to make refinancing and reset decisions. For broadly syndicated equity holdings, while it is theoretically possible for minority investors to club together in order to reach a sufficient quorum to approve these events, in practice, this can prove challenging. It is often said that trying to track down equity holdings that have been broken up into small minority equity positions can be akin to herding cats. In the case of a highly fragmented CLO equity tranche, it can be difficult to track down the owners of CLO equity minority positions, particularly if some of the positions have been actively traded. Meanwhile, for control and supermajority equity investors, the decision to reset and refinance the CLO comes more readily. Having already reached the required quorum decisions can be made swiftly, allowing the collateral manager to work efficiently with the control equity investor.
Liquidating a CLO As a CLO exits its reinvestment period, the control equity investor will make the final decision regarding when to wind down the CLO structure or to call the CLO. The timing of these events has a significant impact on the final return realized by the equity investor. As the liquidation process begins, a supermajority CLO equity holder is able to work directly with the collateral manager on the assets to be sold first, while a simple majority control equity holder may be required to consider the views of the minority equity investor. The larger the majority, the more aligned discussions with the collateral manager are likely to be on timing for loan liquidation.
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James Reeve Moderator
Why would top CLO collateral managers want to work with control equity investors? Why do CLO collateral managers do repeat control equity deals?
Mohamed Seif Lakemore Partners
We find that many top-tier managers prefer to engage in repeat control equity deals, with a trusted and knowledgeable equity partner. This consistent equity investment in a collateral manager’s pipeline enables the collateral manager to build an aligned partnership with a control CLO equity investor, which can provide several benefits, including maximizing refinancing, reset, amendment and liquidation optionality, as mentioned above. From a strategic point of view, given the significant influence that the control CLO equity investor has over a transaction, it is important for the collateral manager and equity investor to maintain a strong relationship. These trusted relationships are even more important in the supermajority equity style. With a repeat majority CLO equity investor, both the collateral manager and the arranger will typically have less structuring and distribution work, which can lead to lower arranging and distribution costs overall.
James Reeve Moderator
It is clear that there can be some very significant tangible benefits derived from a strategic partnership between CLO managers and a supermajority investor.
Looking at it specifically from a portfolio management perspective, what do you think are some of the important points to note? Mohamed Seif Lakemore Partners
From a portfolio management perspective, a CLO arranged with a control equity investor can benefit from additional scrutiny, as the control equity investor is able to monitor the underlying loans in the portfolio. Indeed, we observe that default rates within CLOs that have a supermajority equity investor have experienced lower default rates than both the market and the collateral manager’s other CLOs by vintage. Typically, the initial CLO portfolio construction must align with the last minority equity positions sold, which may create a situation where the portfolio will exhibit higher credit risk seeking incremental spread. In our experience, a more defensive initial portfolio construction leads to lower loss rates over time.
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James Reeve Moderator
It looks like Lakemore Partner’s investment style is very specific. Can you explain your style, and describe what has the highest impact on performance?
Mohamed Seif Lakemore Partners
Lakemore Partners does indeed have a unique investment style, in that we are one of the few supermajority equity investors in the US CLO market. Our conviction is focused on our belief that CLO equity is an asset class that deserves a core allocation in an institutional investor’s alternative assets portfolio. Our investment style can be summarized as: • • • •
Focused on achieving reliable long-term performance with stability; By partnering with the best performing and most experienced collateral managers, and together owning 100% of each CLO equity tranche to maximize decision making optionality; With the core driving philosophy of not seeking incremental returns by taking additional credit risks at the onset; While being optimally positioned to add incremental returns through par and spread builds during inevitable bouts of volatility over the life of each CLO investment.
Over more than twenty years of CLO investing experience, our team has built deep and trusted relationships with collateral managers and arrangers, which affords us preferred access to top-tier managers. For some collateral managers, Lakemore Partner’s equity represents between 30% to 60% of their annual new issue pipeline. We believe that these trusted, long-term relationships enable us to secure dedicated access, portfolio strategy alignment and attractive economic terms. We invest in US CLO equity positions via the primary market, partnering with a select group of top-tier collateral managers that are aligned with our defensive strategy. From inception, we agree to a defensive portfolio construction, in addition to engaging in thorough loan-by-loan assessment through the life of the CLO to rationalize and reduce residual risk; our team features experienced distressed credit analysts that conduct independent analysis on portfolio holdings in order to identify said risks. Our multi-manager style also provides valuable insights from the collateral manager research teams on loan names and their investment thesis. This gives us the ability to better manage our individual CLO investments. Throughout our portfolios, we maintain regular, transparent communication and reporting with our collateral managers to ensure complete alignment in order to maintain our targeted risk profile. Moreover, Lakemore Partners invests across several vintages, which offers vintage diversification benefits by lowering volatility of returns. Our recent analysis into the benefits of vintage diversification in CLO equity investing found that investing on a five-year rolling basis reduced the range of expected IRR outcomes by roughly half.
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James Reeve Moderator
Thank you very much for sharing those insights.
Given current market conditions, in your view, what does the opportunity set look like for CLO equity over the coming 12 - 18 months? Dan Norman Lakemore Partners
We expect the CLO equity market to continue to attract a lot of attention in the coming months, and for good reason. As discussed, CLO equity currently offers historically attractive cash flow arbitrage and CLO equity has proven its cash flow stability through the COVID-19 pandemic, delivering consistent and predictable cash-on-cash returns. We believe that 2020-2022 vintages are likely to be among the best performing on record for the asset class. The market turbulence in 2020 helped to clean up the loan market, with plentiful broader economic stimulus and an active primary market resulting in a fundamentally robust loan market. Default rates are now at ultra-low levels – plummeting to just 0.20% in October – and upgrades have outnumbered downgrades for more than a year. Additionally, with more than US$1 trillion in private equity dry powder held by North American private equity firms, we expect to see a continued supply of new loan issuance and refinancing transactions in the market. All of these factors should keep forward default rates low and ensure CLO arbitrage levels remain resilient. Meanwhile, the significant opportunity set continues to grow, as we’ve seen recordbreaking CLO new issue volumes, and we anticipate that the new issue CLO market will continue to be buoyant in the coming 12 months, owing to the historically high CLO equity arbitrage available in the market.
James Reeve Moderator
A truly unprecedented year for the CLO market as a whole that’s for sure, with the possibility of sustained high levels of activity for some time to come it would seem! The Maples Group global CLO team is excited to see what 2022 holds in store for us as we continue to grow, build upon our depth and breadth of experience and harness our market share to produce valuable analysis and collaborative market commentary. We thank the Lakemore Partners team for its immensely informative contribution and unique perspectives on the market and US CLO equity investing.
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