The Exchanges

Q What was this problem with the market value CLOs that you were asked to step into?

A The marks on the loans were going down. Simple as that. And at some point in those days, the bank kept the top 75% of the CLO on their balance sheet and sold away the bottom 20 to 25% to third parties. Now, those CLOs had traditional or what you would call a margin-style trigger that if the price of loans fell below a certain amount, the senior investor, the bank in this case, had a lot of additional rights, including liquidating the portfolio. Now, at the time, the bank had over ten billion dollars of exposure to these investments. The bank's market cap was only around thirty billion dollars at the lows in 2002. So it was a non-trivial amount. And my task was to get the bank out of its senior exposure while not getting complaints to the chairman. Many of the bottom clients in the residual tranches were some of the biggest insurance companies in the world and very important clients of the bank. And we were successful. We didn't take a loss and we didn't get a complaint. So that was very good. But a lot of our proposal To the residual investors was, well, let's just get rid of these market value triggers. There's also something called cash flow CLOs, where if we take your portfolio, we'll roll your equity in the portfolio into this new vehicle. We'll pay off the old debt, us, we were kind of happy with that, and we can sell new debt into the market with cash flow triggers. And t…

AI assessment note: “The marks on the loans were going down. Simple as that.”

Q When you're assessing those collateral managers to get at the 20% that you feel like get it right, is that a data-driven assessment, or is it knowing the people?

A Ted, it's all of the above. It starts by knowing the people. And once in a while, probably once a year, we have a team come in, we don't know any of the people. And between both my senior partners and I, if we don't know any of the people, We're probably not going to invest, but we'll take a look. It's free to look. And you know, you never know, maybe there's a diamond in the rough, but having the advantage of having worked with the folks for so long, you see firsthand that person on the plane could have been easily on their third movie and, you know, getting some sleep. You get the DNA of the people and understanding that who's checked out, who's bought a new boat, who's got the new place in the vineyard they're going to. It's finding that group that has the DNA, and that's only from personal interactions, and then overlay a quantitative analysis. They can be hard worker, but results pay the bills, not effort. We have tremendous amount of data. We own a software company called Valatana, which started out as our internal analytics, and it has the data now on every CLO in the market. So even if I'm not an investor in CLO X, On my iPhone even, I can see the portfolio and all the trades last month in that CLO, even if I'm not a party to the CLO. So the richness of the data, there's no more transparent pooled investment vehicle than a CLO. Imagine you could call Fidelity and say, l…

AI assessment note: “Ted, it's all of the above. It starts by knowing the people.”

Q How does the sourcing of transactions work in the secondary market?

A So here it's equally murky, but different. CLOs trade secondary two different ways. So one is called a BWIC, or bid, wanted, and comp process, and if I look at my phone, There'll be 15 BWICs today, due at various times, usually at some CLO debt and some CLO equity. There may even be one or two majority pieces out for bid today. If you're a deep insider, you probably know who the seller is, but it's not published to the seller is, or you might know that person bought that bond originally. So it's probably them selling it or whatever it may be. Not that it particularly matters, but some sellers are simply doing a pricing exercise, particularly around month end. So everyone on the street does a ton of work, puts in all these bids, does not trade. So the amount of hours, you know, our analysts will spend a few hours, but the analysts at the firm up the street and the next firm up the street have also spent hours and hours and hours. So it can be a woefully inefficient process. So one of the things we try and understand is, is this a real seller first off? And do they have realistic expectations? Everyone's a seller at a certain price. Is this a realistic seller? If we're going to spend our time and effort on it, let's figure this out. Then you put in a bid, like a BWIC might be due at 10 o'clock. Bids have to be good for three hours. Hmm. What do you think happens in those three ho…

AI assessment note: “CLOs trade secondary two different ways. So one is called a BWIC”

Q You mentioned at the onset the power of having rights as the equity holder in the early years collapsing that first CLO. What are the different ways that you exercise those rights?

A Sure. Every position in our portfolio, once we get past a short non-call period at the beginning of a CLO, we can do nothing. We can sell the security in the market. Those are always available to us at any time. We could force a liquidation of the CLO, tell the collateral manager game over, sell the loans, pay off the debt, we'll keep the residual. We could refinance a CLO, and this is where we keep everything the same except go out and lower the debt spreads. The AAAs were at 200, now they're at one 50. Just call up the old guy. Sorry, we'll give you one 50 on the wire. If not, we're going to market. Most of the time they just say go to market. Call PIMCO if they're answering the phone or wherever else you might go. Or we can reset a CLO. And this involves reopening the entire portfolio, all the documents, and recasting the tenor of the CLO, adding a new five-year reinvestment period, new rules, and whatever their most latest provisions are in the market. Those are the basic things we can do. So we have those five options available to us. The first two at any time, and then the last three after that non-call period in addition. We've, in our history, taken well over a hundred corporate actions here across our portfolio. Owning a CLO, buying it is just the beginning. Managing it and making sure the collateral manager is focused on it. The more you talk to portfolio managers abo…

AI assessment note: “we can do nothing. We can sell the security... force a liquidation... refinance”

Q Structurally, what type of vehicle did you decide to pursue it in?

A So we offered a number of different ways. We have a public vehicle, which is a closed end fund. So you can just buy and sell the shares freely on the New York Stock Exchange under ticker EIC. It's a closed end vehicle. It's not an ETF where we then have to go quickly sell the security same day. I'd be a little more cautious with that. It just takes a little extra effort and the risk of harm to investors, in my opinion, could be greater. Not impossible to manage, but a higher bar at a minimum. So that's the principle way to do it where the Portfolio managers can focus on fundamental long-term value creation, and investors can choose their entry and exit point without harming other investors. So that's the ideal. We also manage it in separate account format for institutional investors.

AI assessment note: “We have a public vehicle, which is a closed end fund.”

Q So having seen this whole market from its really inception in a lot of ways, how did you decide what strategy you wanted to pursue?

A That was the easiest decision of all, actually. A majority CLO equity strategy is our principal business. We do some other things in CLO debt, but the CLO equity market to me is a grossly misunderstood market. People associate it with CDOs, People think it's the next harbinger of doom in many cases. The reality is 96% of all the cash flow CLOs created prior to the financial crisis had a positive return to the equity class, and the median IRR was 15%. So using the dartboard school of security selection, you really had a struggle to lose money if you could hold the securities through the cycle. If you sold at the bottom, you sold stocks at the bottom, you've lost all your money. If you sold anything at the bottom, you're gonna lose your money. The CLO asset class worked with very limited exception. If you stay with it the whole time, it was very unusual to lose money now, but the dispersion of outcomes was great from the 25th percentile to the 75th percentile, about seven percent or 700 basis points difference in performance, just in that middle 50%. When you look up and down the tails, even 10% wide of that on either side. So it was an asset class that worked It was misunderstood. There's a ton of inefficiencies in the creation process and in the secondary trading process, which our systems and processes are designed to capture. CLOs are not reported on trace, for example. So it…

AI assessment note: “A majority CLO equity strategy is our principal business.”

Q So in that primary issue market, once you've done all of this work, you've built these relationships, how much turnover do you have over time in, let's call it your roster of collateral managers?

A One to two a year. There's basically been the, once we Once we ramped up, so we started in 2012, by 2015, we had a bit of a mature portfolio. It's one or two a year, and sometimes it's just a pause. One firm was our largest exposure at a point. They bought another small firm. It was probably, it was less than 10% of their AUM, but just the pain and suffering of any merger, doesn't matter how big it is, is a challenge. Maybe they got a little distracted and was maybe during a difficult time in the credit market. We kind of backed off for a while. Then they got sold to an even bigger company. It wasn't a, no integration, just that business changed business cards a little easier, but we let some time pass. They righted the ship and we're back in business with them. So there are situations like that, that have happened. There are some that if the senior person retires, you have to make a decision on the next person. How are they going to Take over and do things well. Other examples, the number two PM at one of our largest CLO collateral managers got hired to be the number one at a different big firm. And we hadn't done business with that firm in a while, but we knew that she was going to light it up. Did very well for us in the past. The old firm had a deep enough bench. We weren't worried. The new firm, big, big private equity firm on her first day on the job, we said, well, why d…

AI assessment note: “One to two a year. There's basically been the, once we Once we ramped up”

Q Which two people have had the biggest impact on your professional life?

A I'll say one directly, and maybe one a little more indirectly, a fellow named Mike, who was my boss at JP Morgan way back when, I was 25, and he was probably 50. And this is when I was hired to undo those broken CLOs. He was the senior executive put in charge, and they needed someone to do all the nuts and bolts work, and that was me. But when you think about a typical hierarchy at a bank, the boss is two or three years older than you. He or she probably got their guard up, making sure you're not going for their job and all these other bad things that might've happened over the years. This was someone that was able to take me under his wing as a mentor. No way in the world, you know, he had six times more experience than me. There wasn't a question that I could be a threat to him. And as a result, he gave me All the time and knowledge and mentoring I could possibly have hoped for. And then I'll actually point to Chuck Davis over at Stone Point. Incredibly nice and kind individual, obviously extraordinarily successful, but I will often say of Stone Point, they're an HR firm with a little investment business on the side. Obviously more than a little investment business on the side, but what I've learned from them is you get the people part of things right, And you have a halfway decent business idea. No success is guaranteed, but you really have to stuff it up from there. And I w…

AI assessment note: “a fellow named Mike, who was my boss at JP Morgan... Chuck Davis over at Stone Point”

Q The other way you hear banks getting into trouble, and it is probably part of that other 70%, is just leverage, the sense of leverage. You mentioned getting that long-dated financing on the right side of the balance sheet of a CLO. How does leverage work both in getting that broad financing and then the tranching of the liabilities for the CLO manager?

A There's a couple of pros and cons with leverage. If things go well, it enhances your returns. If you buy a stock on margin and it doubles, you know, you've Made four times your money if you did it that way. Obviously, if it goes down, your broker is going to call you up and either have you send in money or liquidate your position if you're not happy. Leverage the risk is it can make you do something you don't want to do on the day you don't want to or the day you don't have the ability to if you're out of money. Our leverage doesn't have that feature. It certainly amplifies the returns up and down, but it doesn't ever force us to put in money or sell assets on a bad day. So you have to understand the terms of leverage to evaluate the risk of leverage. In the case of using short term repo financing or overnight repurchase agreements or margin financing, you're subject to the whims of the lender on almost on a daily basis. And when things go down, Lenders make phone calls. They're not the most happy calls to receive or make, but that's what happens. We don't have that in the CLO market. So when you look at the leverage, you have to understand the terms. So that's very good. And then what's the A versus the B? What's the C? How does that come to be? That's an art with the rating agencies, and each of the big rating agencies use different methodologies. They come out with similar r…

AI assessment note: “Our leverage doesn't have that feature... what's the A versus the B?”

Q Well, why don't we start with your background in this world of structured credit?

A Well, it was not a straight line for sure. Things started accidentally. I studied accounting in State College in upstate New York at Binghamton and turned up at one of the then big six accounting firms, no longer with us, unfortunately. And after some training, they went around the room the first day and And so you're going to Solomon, you're going to XYZ, you're going to this client, this client, and they skipped over me. And I was a little nervous. And they said, oh, come with us. Uh oh, everything was fine. May I ask where we're going? Oh, you're very interested in securitization. We'd like to have you join our securitization group. Okay. No, I didn't fully remember what securitization was, but they had sent a form, a copy that you filled out and mailed back in, and one of the boxes I apparently ticked was securitization, and I guess I was the only one who checked it in the starting class that year. So they moved me to this group. Thankfully, I could model a loan or amortize a mortgage in Lotus one, two, three, and that gave me an immediate edge over many other people in this group who were still grappling with Principle and interest and all the silly calculations you have to do, but from just stumbling in to this literally by ticking a box I didn't fully appreciate, I got into something I knew how to do, and that was really enjoyable. As an accountant, Usually your client i…

AI assessment note: “one of the boxes I apparently ticked was securitization”

Q What is the competitive landscape for the CLO equity activity look like?

A There are a handful of bonafide competitors and a whole laundry list of transient competitors. We hold the top competitors in high regard, and I believe they would say the same of us. There are full-time folks who are dedicated to have multiple professionals dedicated to this market. We all have different flavors. Many of them are based here in Greenwich as luck would have it, but we have a respect for each other. We know what they're going to do. They probably know the things we're going to do. And the nice thing is there's always another. So if we were running a real estate fund, let's say, and the Chrysler building came up for sale, that's a once in a career trade. You're going to bid, you're going to come up with every last dollar you can to be the highest bidder because you want to own the darn Chrysler building. On a CLO, there's always the next one, and we have to keep that in mind. Let's not, if we can sense this, someone else bidding keenly. Okay, that's fine. We'll let this one go. That's the nice thing in our world. There's always another. They're good and bad. There's not a shortage of supply. Real estate, they're not making any more. CLOs, they're making more. But it helps us. It makes it easier to be much more disciplined, frankly. And when we see our competitors acting, we have public vehicles. Some of them have public vehicles. You can kind of see what's going o…

AI assessment note: “There are a handful of bonafide competitors and a whole laundry list of transient competitors.”

Q And what happens with the interest that those loans pay?

A Sure. So interest in principle comes off, and just like in any securitization, the trustee puts them in tooth as an interest account and a principal account. We're really getting into the nuts and bolts here, but I'm sure you have a few securitization listeners who will love this. The principal, with very limited exception for the first five years, just gets reinvested by the collateral manager back into replacement loans. Could be new loans or secondary loans. There is one exception for There's something called an over collateralization test, and this can impact the principal account or interest account. If on the day of measurement, which is there are four days a year, these are measured quarterly. The other 361 days of the year, the OC tests do not matter. But on these four days, if you're failing your test, which is a ratio of par of assets versus liabilities with some adjustments, if you're failing that test, any principal in the principal account would need to reuse to pay down the AAA class if you're failing the test. Now, a good collateral manager will have zero dollars in the principal account on the day of determination, and you know that day is coming, and it's very easy to manage your portfolio. If you've left money in there, you're probably asleep at the switch, and probably not someone we're investing with from Eagle Point. Now, interest goes into another account,…

AI assessment note: “Now, interest goes into another account, and again, that's paid out quarterly”

Q So stereotypically, when those opportunities are the best, and you can imagine, right, we're in the depths in early oh nine, and through, you know, things are starting to recover. That's typically when it's next to impossible to raise capital. So great idea to invest in this asset class. How did you go about forming a business at that time?

A Well, it took a year or two extra. There's no real disadvantage to be a majority investor in a CLO, except that you need a lot of capital So you can have a diverse portfolio of majority positions. And as I mentioned earlier, we have, I literally saw the report yesterday. We now have 101 majority positions across CLOs, but let's say you could convince someone you've got this great idea and you're the best guy to do it. The average new fund seeder, probably fifty million dollars, twenty five million dollars. We'll leave the money with you for a little while and see how it goes. That was not sufficient to Demonstrate the point that I believed we could make, and we have subsequently made, of that an investor enabled with scale of capital and a deep understanding of the inefficiencies of the CLO market could persistently outperform the market. Part of the way to do that is being very visible to the market that you've got that scale of capital right out of the gates. And we've been blessed. Our scale of capital across all our vehicles has grown, but I was kind of beyond the scope of what a typical fund seeder would be. So I really needed to find my way into private equity to find that kind of money. We were looking for a quarter billion dollars. Now, if you talk to most private equity firms, very rarely do they like to get involved with new companies, and very rarely do they like to …

AI assessment note: “So I really needed to find my way into private equity to find that kind of money.”

Q I'd love to walk through some aspects of that investment process as you're seeking to get at the high end of that 700 basis points of dispersion. So why don't we just start with the sourcing?

A So I'm going to use some words that sound a lot like a private equity process versus a bond process here. Now then we buy fixed income securities. They're traded on the fixed income desk. They're on the mortgage key on Bloomberg. We have a proactive outbound origination process. This is when we're creating new CLOs. I'll talk about when we're buying secondary CLOs shortly. Proactive outbound origination process. There are about a 120 active collateral managers in the market. We have firsthand personal relationships with all of them. And just like at a bank, there's executives that make all the decisions and go home every night. Their CLOs have collateral managers that make the decisions on a day-to-day basis, and they go home every night. And one of the things was actually on that road show in Singapore, when I was signing a agreement to set up Eagle Point, I was with a collateral manager. And obviously that's the longest flight in the world getting to Singapore. I might have lovely food on Singapore Airlines. I was going to have a glass of wine and go to sleep because we have meetings, of course, when we land. My travel companion, who was a CLO manager, I was a banker at the time. He's my client. He's reading credit memos the whole darn way. Okay, have a good night. Just so you know, the first meeting's at nine o'clock. Be ready. We land at six. We'll shower and get right to t…

AI assessment note: “We have a proactive outbound origination process. This is when we're creating new CLOs.”