Launched in 2018 and backed by Elliot Investment Management, Paul Singer's storied hedge fund, Elmwood Asset Management follows its parent's research-intensive investment style to identify undervalued assets. A longtime investor in CLO equity, Elliot seeded Elmwood with a significant capital commitment. The alternative asset manager quickly ramped up its assets under management (AUM), and along with additional capital from a diverse group of equity investors, Elmhurst's AUM now tops $26 billion.
"It's all about credit selection," said Brian McNamara, co-founder, president, CEO, and CIO of Elmwood, and an alum of GoldenTree Asset Management and Credit Suisse's leveraged-loan trading desk. "The foundation is hiring smart, experienced analysts who think like portfolio managers, giving them resources to do best in class research, and setting up investment processes appropriate in the current market."
McNamara recently spoke to Asset Securitization Report (ASR) about current CLO challenges such as historically tight arbitrage, and the risks in today's volatile market.
ASR: How is Elmwood addressing tight arbitrage?
McNamara: I don't want to downplay the arbitrage issue, and it is unequivocally impacting CLO creation. But what we like about CLO equity is the optionality it creates. The funding environment is very favorable, and you're locking it in for typically five-plus years. If we have a sustained spread-widening environment, corresponding to periods of heightened volatility, you can drive a lot of value into the CLO structure.
I don't want to downplay the arbitrage issue, and it is unequivocally impacting CLO creation.
ASR: So volatility may fuel wider spreads on the asset side, and it takes longer for liability spreads to catch up?
McNamara: That's true, but I would go further. If I issue a CLO today, with funding at, say, 152 bps over SOFR, and in three months the market widens out 100 bps on the loan side, now I'm buying new issue at wider spreads and it's driving more return into my portfolio. I'm also able to buy assets in the secondary market at discounted prices and build par into the structure. And I'm still sitting on my 152 bps cost-of-funding for the next four and a half years.
ASR: Are you anticipating more volatility, in that case?
McNamara: The short answer is we're building high quality, liquid portfolios to be positioned to trade actively in periods of volatility and be on offense in a weaker market. We think the CLO structure has proven its ability and that there's real logic and value in dollar-cost-averaging into this marketplace.
ASR: What do you see as the biggest issue CLOs face?
McNamara: LMEs are a major one. Pre-COVID, you had a watering down of documentation and higher leverage levels, but no LME activity yet. After COVID, we have LME activity, it's not going away, and it has changed this market radically. The conventional, value-focused framework is no longer sufficient. Now you have to view the dynamics in the lender group, the sponsor's behavior, and the document flexibility. You have to predict how the restructuring or LME may occur. Ultimately, it's shifted the value to managers who are better at credit selection.
ASR: How has Elmwood addressed that shift?
McNamara: We spend a lot of time hiring analysts; those boots on the ground are critically important. Many hail from backgrounds investing across the capital structure, not just CLOs. We really run a high-yield, fundamental, relative value-oriented investment strategy in a market that trades with a high degree of sensitivity to ratings. That's what it takes to outperform in this current world.
ASR: What do you look for in your hires?
McNamara: First, not everybody likes to be a risk taker, so we like to hire people who've already been on the buyside and have demonstrated a comfort level with this business. Second, we set a high bar for experience, which can be really intangible and we think is undervalued by the market. Finally, we seek people who can underwrite and price risk in a non-ratings-based framework. That's critically important, because that's ultimately what drives recoveries.
ASR: Have you modified your investment processes post-COVID?
McNamara: Our process has been effective since day one, but we've added resources. For example, a year-and-a-half ago we onboarded Gartner, a tech-focused consultancy, long before the AI software selloff. It has dedicated analysts who are available to our team on [an] ongoing basis. A company may have the best mousetrap today, but someone else can have a better idea tomorrow and eat its lunch. Only extensive, primary research can provide the insight to separate the winners from losers.
ASR: Some market participants say LMEs have become less aggressive. Do you agree?
McNamara: I'm more cynical, and I think it's very situational. In a recent deal, there was a cooperation agreement in place that was set up to be pro rata, but it expired inside the maturity of the loan. The LME steering committee allowed that agreement to expire, then created a new cooperation agreement that was non-pro rata and jammed all the minority guys. When people are losing money, the knives come out and it's every CLO for itself.
ASR: A bankruptcy court's
McNamara: I'd love to think Serta will change the market, but I think it's just going to change the pathway used to do these deals.
ASR: What are some other issues occupying market participants' thoughts?
McNamara: What's really going to matter is the 2028 maturity wall. The tenor on those loans is almost always seven years, so the maturity wall harkens back to the 2021 vintage. A lot of LBO activity got done in 2021 at inflated earnings when rates were near zero, debt-to-EBITDA acquisition multiples were very, very high, and a lot of leverage was put on these businesses. Now some have come off those sugar-high earnings and rates have risen, so it has sapped their cashflow and multiples have compressed. There are a lot of zombies out there, and we're going to see a heightened level of restructuring and LME activity.
What's really going to matter is the 2028 maturity wall.
ASR: Will the restructuring begin next year?
McNamara: It's already started, but it will grow next year.
ASR: Do you have examples?
McNamara: It's all very situational. Some transactions are going swimmingly, and lenders can bump up their coupon and tighten up documents, and the sponsor can get a maturity extension. We've tried to get access to that paper, and the existing lenders have sopped it all up. By contrast, some companies' existing lenders are crossing their fingers and hoping to get refinanced out. But there are also high-quality companies the sponsor doesn't want to let go of, and it's putting in equity. We have two such transactions now. I won't declare victory until it's done, but the sponsors are showing a willingness to contribute equity capital to facilitate the refinancing. That's going to be necessary in a good number of deals.
ASR: How is Elmwood addressing this risk?
McNamara: We're probably quicker to sell than five years ago, because the downside risk can be so severe in LME transactions. We also added our first head of restructuring a little more than a year ago. That was adapting to the new world where we needed to be on the offense and a voice in the room in these restructurings and LMEs.
ASR: Do you typically find yourself in the favored group?
McNamara: More and more we do. This is a result of both our growing AUM and thus position size, together with increased institutional focus spearheaded by our head of restructuring.
