CLO: a consistent approach to the asset class with some differences

A CLO (Collateralized Loan Obligation) is a type of securitization: creating a CLO involves pooling leveraged loans (and more recently also bonds) into a CLO fund. This fund is set up as a special purpose vehicle (SPV) and then securitizes the assets' cash flows into debt and equity-like tranches, which are sold to various investors. The CLO debt tranches provide structural leverage to the equity tranche, allowing for leveraged exposure to a pool of diversified leveraged loans and high-yield bonds. There are different ways to structure a vehicle, each affecting equity cash flows and influencing how a portfolio manager shapes the portfolio's composition.

Managed arbitrage CLOs aim to capture the excess spread between assets and liabilities through targeted investments and asset selection.

While I appreciate the analysis recently published by the CLO Research Group, I would like to add further comments that complement, rather than exhaust, what has already been discussed.

Each CLO vintage has its own story; no two vehicles are built the same across different years. For this reason, I prefer to compare CLO vehicles ramped up and issued during the same period. While every deal has its structural nuances, certain common features appear in almost every vintage, largely because market participants often exhibit a certain uniformity in their strategies at specific moments, as well as due to factors beyond the manager's control. Understanding structural differences is important. For instance, the presence of a single-B rated tranche (sometimes retained by managers) to provide additional structural leverage is critical, as it significantly impacts equity cash flows. The absence or presence of the Class F tranche can also influence a manager’s collateral selection and the metrics used to evaluate the asset pool.

Various coverage and collateral quality tests are regularly measured to assess the health of a CLO's underlying portfolio. However, to understand any asset pool, investors must consider that some vintages may print under favorable market conditions, while others do not.

Conditions such as collateral availability, arbitrage between asset and liability spreads, and asset selection possibilities during both portfolio ramp-up and post-issuance are vital considerations. Key questions that guide CLO investment decisions include: do managers apply the same asset selection and allocation strategies across different vintages under management? If not, why? Where do managers position themselves within rating agencies' matrices during reinvestment periods and post RP, and what factors affect their navigation through these matrices? What changes the dynamicity of trading? How do they stay true to their strategies?

CLOs are actively managed, which means most of the collateral’s principal proceeds - from trading activity, loan or bond maturities, paydowns, asset prepayments, or recoveries from defaulted assets - can be reinvested in new collateral during the CLO's reinvestment period (typically 4-5 years), subject to certain conditions. Each deal’s documentation balances the flexibility and re-strictions of collateral reinvestment, and the manager's discretion plays a crucial role. The management style can significantly affect the ability to spot leverage market opportunities and avoid pitfalls.

In terms of collateral diversity, the smaller and more concentrated European loan market leads to more flexible limits on obligor and industry concentrations in CLO portfolios. Additionally, the presence of privately rated transactions in some pools makes quality comparisons more challenging. Overlap in manager-selected assets is also an issue, especially now that the average overlap in European CLOs is higher than in previous iterations. Today, the overlap between vehicles and managers often exceeds 45% (with tail risks), compared to CLOs 1.0 (25%) and the earlier days of the 2.0 eras (35%).

Points to examine when investing in CLOs include: do seasoned managers with multiple vehicles show wide variations in returns across different vintages? Do smaller managers provide more consistent equity distributions? How does the language around par flush and trading gain payouts affect trading strategies? And how do managers cope with bearish markets, especially under the pressure of non-performing assets and par-burn?

Manager performance varies between the US and European markets. The US market tends to show more dispersion in manager performance, with some managers in the 75th percentile one year and in the 25th percentile the next, whereas European managers generally maintain a more consistent investment style. This difference may result from available collateral or from who owns equity control in the vehicles, as well as the target returns. Debt investors must investigate the equity buyers and understand their priorities and investment horizons.

CLO equity cash flows are often referred to as "front-loaded," meaning that the interest cash flow profile is typically higher early in the CLO’s life. Most equity investors still evaluate performance based on cash-on-cash IRR. However, recent suggestions that the final liquidation value of the vehicle plays a significant role in secondary market equity levels are misleading. This value becomes relevant toward the end of the reinvestment period or during late or non-reset liability exercises, but not before.

CLO equity is a nuanced asset class, and each deal’s equity tranche is unique, requiring detailed analysis. The premium above the liquidation value of the subordinated tranche is particularly difficult to identify, and this has been a contentious point among CLO managers, especially during consolidation talks and agreements. European cases demonstrate this challenge clearly.

Some European CLO platforms have successfully discovered how to satisfy investors, while others have struggled due to poor performance or misunderstandings about CLO structures. Over the past 20 years, some platforms have disappeared, others have shifted their management styles, and some have adapted their investment approaches to the economic cycle and market conditions. Limiting analysis to standard metrics like WAS, WARF, and MVOC provides an incomplete picture. It is crucial to ask: what makes a manager opportunistic or conservative beyond traditional metrics? Does a manager’s classification – active or passive - change from quarter to quarter or year to year?

The best CLO manager is often the one who consistently produces the highest cash coupons for the equity tranche, assuming a certain level of risk and asset quality. To evaluate an entire CLO platform, investors must look at multiple vintages and examine total manager exposure across various loans and bonds in different portfolios. Key questions include: how effective is the manager at buying low-priced assets, selling at high valuations, collecting coupons, and avoiding CCC-rated situations or defaults? This analysis requires deep expertise and market presence, developed over many years.

However, a more specific investment in a particular CLO debt or equity, either newly issued or vintage, requires a narrower focus. Here, the vehicle’s characteristics relative to other recent deals play a crucial role in assessing the risk/return profile. Evaluating various metrics in isolation may yield counterintuitive results, and risks can be misunderstood. Therefore, combining metrics in different set of pairs with credit knowledge, structuring, and legal expertise allows for a better understanding of both the portfolio and the manager’s approach. This is perhaps the most important takeaway from my experience as both an investor and a manager.

Finally, while CLOs are complex, managed structures, engaging in dialogue with the portfolio manager remains the best way to understand the leveraged loan market and its derivative - the managed ABS product known as a CLO.

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