Retail investors have become important players in the leveraged loan market, and this creates both challenges and opportunities for CLOs, still the biggest buyers of loans.
Over the past several years, collateralized loan obligations have had to compete with bank loan funds to acquire collateral for deals. More recently, retail investors have been yanking money from loan funds, sometimes $1 billion or more a week. This has worked to the advantage of CLOs, which were happy to buy the loans that fund managers unloaded to meet share redemptions.
For example, Octagon Credit Investors took advantage of a dip in loan prices over the summer to quickly print a CLO at the request of one of its own investors, using the proceeds to snap up collateral, largely in the secondary market.
Lauren Basmadjian, a portfolio manager at Octagon, said this is why the firm was so active in the primary market in 2014; Octagon originally planned to do just four deals, instead of five. She says it’s important to pay attention to market technicals, in addition to doing credit analysis of loans. Retail investors could easily wreak havoc if the re-enter the market in droves, driving prices back up and prompting a wave of loan refinancing.Leveraged Finance News spoke with Basmadjian recently about navigating a market with mounting challenges, from weak protection for investors to impending risk retention regulations.
LFN: Octagon has been quite busy on the CLO market this year. Do you plan to keep up the pace in 2015?
Basmadjian: We have a deal planned for the first quarter, and we’ll start thinking about the second quarter soon. The pace depends on the level of demand for both equity and debt, and where the asset prices are. I imagine that 2015 will be busy, but we won’t necessarily do five deals like this year—that’s not normal for us. We tried to take advantage and do a quick print-and-sprint transaction during the initial sell-off. Liabilities were still fairly tight, and we had a reverse inquiry from an investor that we wanted to work with, but that transaction was not planned for this year.
How are you feeling about the recent crop of leveraged loan deals?
Over the last couple of months, we’ve seen a lot of attractive deals in the market. And because of the technical imbalance, we’ve been getting paid well for the risk. There is some bifurcation of quality, I’d say. On one hand, we’ve seen a lot of what I would call “organic product,” which is driven by M&A, like large corporates buying corporates or spinoffs, for example. Many of these are public companies that generally don’t take every turn of leverage they can get, and they’re not modeling to very tight cash flows either. But we’ve also seen some aggressive LBOs. It feels like two very different crops.
Would you say that you’re seeing looser lending standards?
The documents have been loose for some time, so I wouldn’t say that they’re getting looser. This is the new normal. There’s very weak language around restricted payments, incremental debt, restricting and unrestricting assets, even things like most favored nation clauses. Underwriters try to be cute and only offer 18 months of MFN protection; eventually, if you push back enough you’ll get it for the life of the deal. Overall documents are loose, but I don’t think that’s any different from last year, and frankly I don’t think that’ll be different next year.
Is that something you’d like to see change?
Of course. We’re credit people, and we spend a lot of time with our documents. Often we’re told we’re one of the only lenders giving comments on a lot of these items, but I don’t believe that. I speak to a lot of our peers who say they’re giving comments. So I’m sure a lot of guys are doing their work on this, but are not always successful in getting their changes through, except for on call protection at times, and on most favored nation clauses. We’ll get changes on deals that are struggling, but it’s deal-by-deal, and sometimes underwriters don’t have document flex, they just have price to give.
Beyond regulation, what are the biggest challenges for CLO managers today?
Understanding technicals has become more important. Retail has become such a big part of our market, and we see how the flows can move dramatically. Last year they doubled, with more than $70 billion coming in. Then, recently, we had a week with more than $1.5 billion flowing out. And while the market didn’t fall dramatically like it did in 2011, there was material weakness. As a result of the large outflows last month, loans were down almost 2 points at one point. We’ve regained a lot of that, but we have to pay a lot of attention to the technicals. Retail can be dangerous in a couple of ways: first of all, it’s not long-term financing; retail funds can move money out of the market and drive prices down pretty quickly. At the same time, if rates rise and we see a lot of money coming back into the market, asset spreads could severely compress. We could be living through another re-pricing wave like we did last year, which is dangerous for equity arbitrage when credits are performing well.
How does Octagon plan to deal with U.S. risk retention rules? We assume that being majority owned by (private equity firm) CCMP helps.
Since the draft came out a year ago, we’ve spent a significant amount of time with our counsel and the LSTA talking about options. We’re highly cash flow-generative, so we could start to seed portions of our CLOs. We continue to explore several options that we think are viable, including the majority-owned affiliate option, or perhaps issuing preferred shares, and there are others as well. I think we’ll start to see some new structures tested in 2015, and we’re eager to see what the industry consensus is. I don’t think that everyone becoming completely self-funded is necessarily the best solution.
What do you think the market’s going to look like post 2016? I would expect some decreased issuance as the market gets comfortable with the regulation and leading up to its implementation. When Volcker—which is fairly simple—came into effect, the entire market paused, even though there was a clear answer: you can’t have bonds in your funds anymore. I think investors are going to be very focused on learning each manager’s plan for risk retention compliance and trying to pick the survivors.
How do you think pricing will be affected, if at all?
You would think that pricing would tighten on liabilities. I’m a little fearful of the CLO engine slowing down dramatically at the end of 2016 and into 2017. That could be concurrent with a downturn in the cycle where we would also have a higher default rate and no growth. I think retail investors could get spooked if they see defaults go up, which could trigger outflows, and if you’re not creating long-term financing, you could have a real liquidity problem for companies when they need liquidity the most.
