Investors have learned that a collateralized loan obligation (CLO) manager’s experience matters. Prior to the financial crisis, many firms were able to issue CLOs despite having very little knowledge of the leveraged loans used as collateral, let alone the structure itself.
They did not survive.
As a result, today’s investors may be willing to pay a premium for a CLO manager’s experience.
However skill isn’t the only thing that sets managers apart, according to Scott D’Orsi, a partner with Feingold O’Keeffe Capital, a private firm specializing in the investment and management of credit, stressed and distressed strategies. D’Orsi, who heads the firm’s CLO business, contends that managing these structures is as much a matter of style as it is skill.
Within the first few years of the life of a CLO, the manager can actively buy and sell assets used as collateral, and in some deals the manager can continue to reinvest interest payments even after the formal reinvestment period has come to an end. D’Orsi says some managers will use this leeway to the benefit of one class of investors over another, and he says this is the way it should be. It provides diversification.
Attractive yields and strong fundamentals have been driving up demand CLOs, and the new issue market is rolling out the deals at a pace not seen since before the financial crisis; issuance topped $7 billion a month in the last thre months of 2012. Feingold O’Keeffe Capital is among the managers returning to market for the first time since the crisis. The firm currently runs two absolute return strategies and CLOs with total assets of $1.4 billion.
ASR’s sister publication, Leveraged Finance News, recently spoke with D’Orise about the year ahead, triple-A pricing, warehousing, and loan covenants, among other things.
LFN: The CLO new issues market has greatly exceeded initial expectations this year. Do you feel like demand for the product is strong enough to sustain the momentum in 2013?
Scott D’Orsi: I think it’s going to stay very robust. There are a lot of green arrows at the moment for CLO issuance—you’ve got a fairly benign default outlook in terms of the collateral, at about two percent; you’ve got well-priced assets in terms of spread, as well as news issuance that continues to be priced at a discount to par. On the liability funding side, there’s been a consistent expansion of the investor base throughout the year. I wouldn’t be surprised if the pace we’ve seen in the last three months continues right through at least the first half of 2013.
An expanding CLO investor base, perceivably across the capital structure, is part of the reason so many deals are getting done. Are there still situations where certain tranches are difficult to place?
D’Orsi: I wouldn’t say it’s ever easy. There continues to be some bottleneck at the triple-A level, but I think that tends to be more a matter of negotiating terms as opposed to a market clearing price. And at the moment, there seems to be a bit of widening in some of the mezzanine tranches, simply because a lot of broker-dealers are trying to get deals done before year end, so we’re seeing a flurry of deals trying to get priced. But I think that is more a phenomenon of the final weeks of the year.
Then do you see pricing coming in?
D’Orsi: I do see the general trend continuing as far as liability funding costs getting lower. I think as you look at triple-As currently pricing in the 140 area, it could probably tighten another 15 or 20 basis points in the relatively short term. CLO triple-A yields, even at those levels, continue to look attractive compared to other similarly rated securitized assets.
With regards to equity tranches, I’ve heard it said that investors in other structured products, notably residential mortgage-backed securities, are showing interest. Is that something you’re seeing?
D’Orsi: It has been taking place in the market over the last couple of months. More traditional residential mortgage-backed investors who are familiar with the CLO product have begun to become more active in the space. The CLO market provides a more attractive yield opportunity than the residential mortgage-backed market.
How do you feel about warehousing? Do you think it’s necessary for a CLO to be mostly ramped when it’s priced?
D’Orsi: In an ideal world there is warehouse capability to allow for three or four months of purchasing and warehousing. But the fact of the matter is that market isn’t there right now, primarily because the broker-dealer community doesn’t want to keep that risk on their balance sheet. But we don’t think it’s an impediment in any way to being able to acquire collateral and execute a deal.
I do think it raises that issue—the fact that if there are a number of deals that are looking to price within the same two-week period, there’s definitely the likelihood of having significant overlap of the collateral. Which is why a lot of investors, particularly your mezzanine and equity investors, are likely to stager the deals they play, to avoid that. It’s one thing to hold a lot of 2012 paper; it’s another thing to hold a lot of Q4 2012 paper.
If you had a wish list regarding today’s loan market offerings what would it include?
D’Orsi: It would be good to see some new loans that come as a result of M&A activity, just so you’re able to add diversification to your portfolio.
Some market participants are bothered by covenant-lite loans, but many managers don’t seem to care. Where do you come down on this?
D’Orsi: I’m an old-line commercial lender so financial maintenance covenants always matter and are always preferred to the absence of them. However, I don’t think it’s an absolute requirement for a loan to be suitable for a CLO. It is incumbent upon collateral managers to make those distinctions. There tends to be reaction, particularly by triple-A inventors, to summarily judge cov-lite as presenting such risk to a portfolio that there has to be a limitation on it. I can appreciate that stance, but I think it becomes problematic, not necessarily from a ramp up standpoint, but if you happen to be in a period where new issuance is primarily cov-lite and the collateral manager is restricted from reinvesting proceeds. It then becomes an unintended consequence of a cov-lite stipulation for a manager to reinvest at all.
Do you feel the consolidation of CLO managers has been positive, negative or inconsequential to the market? Is there enough balance between small and large firms, new and seasoned?
D’Orsi: I think it’s positive. ... Where you start to get into some issues is the fact that it’s probably been over-distributed. You saw some firms able to issue CLOs that had very little experience in the leverage loan market, let alone understanding of the CLO product itself. A financial crisis will take care of that lack of experience to put it diplomatically. I think the CLO is really a capital formation that supports the leveraged loan market. It provides market efficiency for several different types of investors to come into a portfolio of loans. And I think there are some managers able to manage within that framework successfully and others that cannot.
If you look at the performance of CLOs grouped by managers you’ll certainly see CLO investment style. And you’ll see some managers where you’re better off investing in the triple-As and others where it’s worthwhile to invest in the equity. That’s as it should be. Because even though we’re all sourcing from this one-trillion dollar asset class, we’re going to have different credit selection criteria, different views on how portfolios are managed, how they’re traded throughout the lifespan of a CLO. I think it’s healthy for outside investors to have that diversification. It’s another way of saying a CLO shouldn’t be viewed as just a conduit into the leveraged loan market. The manager will put its fingerprints on the performance of that CLO.
How do you differentiate yourself as a manager?
D’Orsi: Our CLOs are very actively managed, and by that I meant that we’re constantly looking to maintain the right risk profile throughout the life of the CLO. If you look at our history of CLO management, and particularly our trading history, that active style bears itself out. ... Another differentiation is, unlike a lot of collateral managers that have accessed the market in the 2.0 world, we are what I would call conflict free. And by that I mean we never own any of the equity, or are never in a position that is in conflict with our position in the CLOs. Our job as collateral manager is to defend that collateral without having the conflict of also being positioned in the equity, whether it’s a minority or majority stake, or potentially being short other parts of the capital structure.
What are the biggest challenges CLO managers face today in launching a deal?
D’Orsi: I think the primary challenge right now is probably getting consensus between your triple-A investor and your equity investor, not necessarily in terms of price, but as far as terms and flexibility afforded to the collateral manager.