The Exchanges

Q What was your path from that early experience alongside those cycles in CLOs?

A So initially my job was again, just picking the loans that go into the CLOs. So I did that for about 10 years and then I had an opportunity to start investing instead of the loans, investing in CLO securities directly. So I started buying CLO double B notes, which are backed by pools of leverage loans, and then eventually made my way to investing in CLO equity, which is the riskiest part of the CLO trade, if you will. And then the firms that I worked for fortunately just saw a lot of growth and that enabled me to expand my skillset and to be one of the larger players in the space. Over time. So that's been a lot of fun, and I've been fortunate in that.

AI assessment note: “initially my job was again, just picking the loans that go into the CLOs.”

Q I'd love to dive in a little bit, maybe through your book, about what these investment opportunities are today. So we talked about what the assets are in these pools, Why don't you talk some about what is involved on the right-hand side of these balance sheets?

A So the easiest way to think about a CLO is that it's a simplified bank. So if you buy a share of, for example, Bank of America or JP Morgan stock today, basically you're going to get exposure to maybe 20 or 30 different lines of business. But in a CLO, it's really just a pure play lending vehicle. So the CLO might have five hundred million of assets in it, Again, the loans are almost exclusively first lien floating rate loans, and then to finance that pool of loans, there's long-term financing, and it's sold in tranches, which are rated triple A at the top, and that's most senior and secured, and then down to double B, which is the junior most CLO debt tranche, and then there's the CLO equity. Similar to my bank analogy, the loans that the CLO owns, its assets, They pay a much higher rate than the CLO's financing cost, so that means each quarter there should be a nice amount of profitability that flows to the CLO equity after all the CLO's debt has been paid, and there's a CLO manager as well that earns a fee to look after all the loans in the CLO. So if you're an investor in CLO equity, today you're targeting returns in the mid to high teens, and basically you're exposed to any loss On the CLO's loans. So the risk that you're taking is loans in the CLO default, but fortunately it's not a unquantifiable risk. It's, you can look back 30 years, and by our estimate, the default ra…

AI assessment note: “it's sold in tranches, which are rated triple A at the top... and then there's the CLO equity”

Q You mentioned at the onset that there are now a hundred different managers of CLOs. I'd love to map out what this investment universe looks like. So of these hundred that create these and manage the CLOs, who are these organizations?

A So the biggest alternative asset managers are all going to have large CLO groups. So Blackstone, BlackRock, KKR, Aries, they all have CLO management teams. They earn, call it, 30 to 50 basis points to put together the initial loan portfolio to keep the CLO fully invested. During its reinvestment period and really to make sure the CLO is passing all of its tests. So the CLO managers are competing amongst themselves for capital from people like me. So they do that by having the best performance of the underlying loans in their CLOs. And they also do it by getting the best debt execution on their CLO. So for me, that's the two things. Those are two really of the key ingredients that make for good CLO equity returns. And also for a nice stable performance of double B rated notes.

AI assessment note: “So Blackstone, BlackRock, KKR, Aries, they all have CLO management teams.”

Q As you're diving into any one of those opportunities, you've got a different capital stack on the right-hand side of the balance sheet of the CLO, and then you've got, say, 200 loans on the left-hand side. How do you go about doing your research to determine whether you think it's an attractive opportunity?

A So one of the things that we don't do is Deep dive due diligence on the underlying loans. And the reason for that is a few. So one, there's going to be 200 or 300 different loans in the portfolio. Usually the max loan size is going to be one percent of AUM or thereabouts. And then if we're talking about broadly syndicated CLOs, the loans are traded. So you could do due diligence on underlying loan. It's 50 basis points of the loan portfolio. And then you found out three months later the CLO manager traded it and replaced it with another loan. So you're not really going one by one through loans and asking the CLO manager to explain themselves. So there's some big picture details that are reported by the CLO that would be of interest. So one is the amount of defaulted assets in there, which usually there are going to be some, the amount of triple C rated assets. So those are loans that you have much higher risk to default. And then another metric would be the amount of loans trading below a 90 dollar price. So we usually Think of loans that are worth 91 cents or higher as being worth par and loans that likely default at that two percent rate. But if the loans at 80 might not have defaulted yet, it might not even be triple C, but you would never buy a CLO with a loan trading at 80 and not make some kind of adjustment in terms of the price you'd be willing to pay. Another thing tha…

AI assessment note: “So there's some big picture details that are reported by the CLO that would be of interest.”

Q So when you're looking at this CLO equity, and you want to know that they have that attractive debt financing, it sounds like there's a chicken and egg if you're supplying the equity before you know what the terms of the debt will be. How do you resolve that in your research?

A The equity needs to be first, but the AAA is probably on deck and there's probably already been a number of conversations there. So that's part of it. But another thing is that in my market, it's very transparent as to which managers are getting the best debt execution. A seal of manager might come to me and just say, Hey, I print the tightest AAA in the market. I did it last month and three months before that. And I was talking to a Japanese bank and they seem pretty interested. And so that gets the conversation going. But the other part of this, once you have the equity, you're in a CLO warehouse and you're buying loans prior to the formation of the CLO, you have three to six months to figure out the full commitment on the AAA. So if it comes back maybe wider than you might like as an equity investor, you can always just stay in the warehouse and just wait for a better time or better execution.

AI assessment note: “you have three to six months to figure out the full commitment on the AAA”

Q When you build a portfolio, what does it look like in terms of the number of positions or line items that you'll have?

A To be diversified in the CLO market, I would say it's something like having max positions of around five percent of the portfolio. Each CLO, again, is going to have 200 or 300 different loans in it. You would not need a hundred CLO equity tranches to be diversified. And then two, a lot of the CLOs are going to own similar loans. So for example, Asurion is the largest loan in CLOs today. They do contracts for iPhone and Samsung phones, the insurance contracts. If you go and buy a CLO, you'll probably find them in there. I think having, call it, 20 different CLO equity tranches would result in a pretty diversified portfolio. The one thing you want to be diversified though is just the life of the CLO. So in a diversified CLO fund, you wouldn't want to own 20 CLO equity tranches all bought in twenty-twenty-one. You would want the CLOs bought at different times, and that's important because the CLO starts its life with a two-year non-call period. During which the rate on the triple A down to double B, it's all fixed and you can't really monkey around with it. But after the two year non-call period comes off, if it's to the advantage of the equity, you can go into the market and refinance the CLO's debt at lower rates. You can extend the life of the CLO or you can decide to call the CLO and that's just liquidating all the loans and getting your money back.

AI assessment note: “having, call it, 20 different CLO equity tranches would result in a pretty diversified portfolio”

Q What is your research team look like to implement the strategy?

A We have an investment committee, which is three folks, myself, our CEO, and our CFO. And then people who are working on a CLO team, there's three of us. And CLO investing is not similar to the team structure you might see at a private equity firm or even private credit firm, for example. CLOs are modeled in software that everybody uses. So to get a good sense of what's happening, you pull it up and literally in 10 minutes, you have a pretty good idea of what you're looking at and if it's interesting. So in CLO investing, as you become more senior in your career, You don't start flying over from 10,000 feet and making broad pronouncements about the market or managers. All the details are super relevant. I've been doing this 20 plus years, and I'm still reading indentures and modeling CLOs and involved in all the negotiations that go with putting a CLO together. To contrast it with loans, for example, if you buy a first lien loan with a 40% loan to value, And for some reason there's an error in the model. At the end of the day, you still line at 40% loan value and you're probably getting your money back. CLOs and CLO equity in particular, that's not the case. So CLOs are going to produce a stream of cash flows over time. And then there's one payment at the end when the CLO is liquidated and people get whatever cash remains. There's no par payout at the end. A lot of times you're …

AI assessment note: “We have an investment committee, which is three folks, myself, our CEO, and our CFO.”

Q So what was your early experience like in that niche market at the time?

A So basically I was a credit analyst picking loans for the CLOs. So there might be 10 or so different loan opportunities that would come across your desk in a month, and your job is to sort through the best opportunities. So the typical loan that goes into a CLO is going to be a first lien senior secured loan. Today, the loans pay around SOFR plus three and a half to four percent. And basically the idea is that if you're investing in first lien loans, you're starting off with a loan to value of around 40%. So you're not so sensitive to whether or not the economy grows at two percent or three percent or even shrinks a little. You're exposed to is really the situation where the wheels fall off the cart. In terms of the company's business model. So loans with a 40% initial loan to value, they do default rarely. Fortunately, usually it's due to some regulatory or technological change or loss of big customers. But as the credit analyst job to sort through the downside risks of the loans that go into the CLO and figure out the ones that survive really in if there's a pretty substantial downturn in the economy.

AI assessment note: “basically I was a credit analyst picking loans for the CLOs”

Q pencil out on the one hand, most of that 30 year history was in a declining rate environment. It's a pretty stable economic environment with lower defaults. So that could be a negative if defaults go up. On the other hand, with rates going up and you own floating rate paper, you're going to have a higher yield. How do you think about going forward the balance of those two?

A For an owner of the underlying loans, higher rates is great to the extent that the borrower can make the payments. How we think about that is, well, the initial loan of value, it's around 40%, maybe 50% at the max. So there's a lot of junior capital and equity that supports the business. So these loans are created in leveraged buyouts where a large private equity firm, they're buying a company and they might put up, call it half of the equity or purchase price. From the perspective of the borrower, they can either make their interest in principal payments or they can toss the lenders the keys. Those are really the only options. So because the loan to value starts off, we think pretty attractive place, even as rates have gone up, borrowers still have the capacity to make the payments. And even if they didn't, from the perspective of the private equity firm that owns the company, they're looking at a future interest rate environment that should be decreasing. At least that's what the SOFR forward curve would say. So they would be highly incented to support a business that has decent prospects, that has a good business model, Help them make the higher interest payments rather than just turning over the keys to the lender. So that's for the underlying loans that are in the CLO. Depending on the pool of loans in the CLO, you're still going to see interest coverage ratios. So that co…

AI assessment note: “higher rates is great to the extent that the borrower can make the payments.”

Q Along that type of example, how do you think about the active management component by the CLO manager?

A So I think active management is very important. You're paying them 40 basis points on average, and for that, you're not just getting somebody who's picked an initial portfolio of loans and then just let it sit there. The CLO managers, the good ones, they're actively trading their portfolio. In the loan market, how that works is, for example, if JP Morgan or B of A is underwriting a new leverage loan, they price that in a way to really incentivize buyers Of the loan to come in, in the primary transaction. So a new loan might come at a price of 99 cents on the dollar, but it was underwritten in a way that, after it was allocated, that it's worth 99 and a quarter, or 99 and a half. Some little bump in economics is what you get by playing in the primary market for loans. So a lot of the time, some successful strategies in leveraged loan management would be to be very active in primary, where you're getting loans that trade up incrementally, and over time, Rotating out of loans that might be more risky or just be more seasoned. So those are some of the strategies they do, but the amount of churn, CLO equity investors are definitely looking for managers with more churn of the loan. So that implies active management. Now it needs to add alpha. It's not just rotating in and out, but I think that's a metric that people in my seat are going to focus on. I think there's also a qualitative…

AI assessment note: “I think active management is very important. You're paying them 40 basis points on average”

Q When the manager goes to the market to create one of these, how do they address the buying market beyond what, say, that most senior tranches coming from Asia?

A So to form a CLO, really the first thing you need is a CLO equity investor like myself. So without the equity, there's really not much that can be done. Maybe the manager can put up the equity themselves. Sometimes it's going to be part of the CLO's permanent financing. Other times it's maybe a bridge until they locate a third party CLO equity investor like myself. But once you have the equity, then you can set up what's called a CLO warehouse, and that's used to acquire loans prior to the formation of the CLO. And then you start marketing the CLO's debt. So the AAA then is the most important. And then the other CLO securities, the ones rated AA down to BB, those are important, but less so. The AAA is 65% of your funding costs. So you need to get good debt execution there. And then later in the process, the other tranches get filled out. So each CLO has a CLO arranger. They have a team That puts together an indenture, which has the rules that the CLO is going to follow, and that negotiates economics with people up and down the CLO capital stack.

AI assessment note: “later in the process, the other tranches get filled out. So each CLO has a CLO arranger”

Q What is the universe of the initial equity providers?

A So I think there's about 15 of us. One of the common jokes in the CLO industry is that you go to CLO conferences, of which there's many, and it's a common theme that, ah, you know, there's new investors coming into the market, and you kind of always hear this, but really, I see the same 15 guys. We are often sharing in the same deals. We're speaking at conferences together. It is a niche asset class, although it's grown to be a trillion, and it's just a little bit more complicated than owning a high yield bond directly or a S&P, 500 stock or a mutual fund. So it does take a little bit of learning to get up the curve, but I think for people who spend the time, I think the risk adjusted returns are very favorable.

AI assessment note: “So I think there's about 15 of us.”

Q What are the advantages of that structure compared to say a BDC or even just a portfolio of the loans?

A If you contrast it to a BDC, I think one of the challenges for BDC investors is on the one hand, the BDC is like a close in fund. The shares trade around all day, so you can get liquidity really at any time, but the BDC can trade at a premium or discounted book. Unfortunately for BDC investors, usually it's a discount. So an investor in those shares, they have both the volatility of changes in the underlying prices of securities. But on top of that, the volatility of just the difference between where the funds trade in the market versus the underlying NAV. So the end result of that is BDCs are wildly volatile. And in a period like COVID, for example, that downturn, a lot of BDCs cut in half. And well, if that can happen from a portfolio of predominantly secured loans that pay a dividend yield of nine or I think that's one of the reasons that people would prefer the interval fund over the BDC.

AI assessment note: “one of the reasons that people would prefer the interval fund over the BDC.”

Q What's one fact you find interesting that most people don't know about you?

A So once I started working, I did two years on the sell side and then transition. I think I worked for six years on the buy side in Los Angeles. And then after that, That would have been a time where a lot of people in my position would have maybe gone back to school and got an MBA, but I had already done the CFA and I had a master's in public policy where there would have been some overlap with an MBA. So what I decided to do is I took a sabbatical and traveled the world for two years. So I visited over 20 countries, learned Spanish. I learned Portuguese. I still speak Spanish. The Portuguese is gone, unfortunately. I also did a lot of surfing, so I'm from a lower middle class family, and we didn't have the opportunity to take a lot of vacations when I was younger, and I took that two years to see the world and really enjoy life.

AI assessment note: “I took a sabbatical and traveled the world for two years.”

Q You have what sounds like just a mass of data. So all of these CLO managers over 10 years, each one, each CLO having 200 names in it, the performance of all those. How do you process all of that information that's coming in?

A A lot of the big investment banks, they have CLO research teams. They're analyzing the data as well as we are. So they'll put out a stat that says something like, hey, in the last year, these are the top 15 managers who have Growing the par balance of their loans. Or another bank might say, hey, these are the managers who reduce their triple C loan exposure. And when you look at that, one of the challenges in evaluating a CLO manager is that there's so many different metrics that you could choose. I could list a dozen of them. At the end of the day, what it really adds up to is what I care about and what our investors care about is the IRR of their deals. But pretty much every market participant, I think, uses software called Intex, which models CLOs very quickly. You can pull up your portfolio and see how it compares to the other CLOs out there. There's this qualitative element. Once you're having a good experience with a CLO manager, it probably would be hard for a newer CLO team to wiggle themselves into the list of people that you're looking to work with.

AI assessment note: “uses software called Intex, which models CLOs very quickly”

Q If you look at the drivers of your return over time, how much of it is the year over year yield that accrues down to the double equity and how much of it comes from the unwinding of the portfolio?

A So one of the things that's interesting about CLOs is that I mentioned they have this two year non-call period on them in which you can't really tinker with your triple A and double B or what they are. But after that, what we hope to do with a lot of our CLOs is really have them as permanent capital vehicles. So I mentioned that the reinvestment period might be five years, but if you go out five years and the CLO has performed well, you're incented to just try to go back into the market and extend the CLO's life and add another five-year reinvestment period to it. So by doing that, you skip two to three years of potential deleveraging and receiving lower cash flows. Instead of having that period, you just stay fully invested. And keep going. So a transaction like that would be very accretive for the equity.

AI assessment note: “you skip two to three years of potential deleveraging... you just stay fully invested”