The CLO industry has spent the last few years lobbying to reduce the impact of financial regulation enacted since the financial crisis. So President-Elect Donald Trump’s vow to reevaluate the regulatory landscape is certainly welcome.
Managers of collateralized loan obligations have long argued the requirement to keep 5% of the economic risk in their deals is particularly onerous. Most acquire their collateral in the secondary loan market, and have little balance sheet of their own.
John Thacker, a senior managing director and chief credit officer for Crestline Denali Capital, sees some merit in the so-called risk retention rule, however.
While requiring managers to hold 5% may be “overkill,” Thacker is supportive of the concept of shared investor risk. The co-founder of the former Denali Capital prior to its merger with Crestline Investors has been an advocate of risk-retention since before the financial crisis. Denali has always kept sizeable share of the equity, or the riskiest tranche, in its own deals.
It was the need for additional capital to comply with risk retention drove Crestline-Denali marriage in 2014. Since then, the combined firm has issued three deals totaling $1.1 billion. Two were in 2016: the $350 million Crestline Denali XIV offering in October, as a follow-up to the similarly sized Crestline Denali XII deal in March.
“We do want to show our investors that we are side by side with them, and they can rely on us to act in a reasonable manner based on that,” the manager says.
But any changes, such as a less onerous risk retention requirement, or a lifting of the ban on high yield are likely far off.
“One of the first subjects the new proposed Treasury Secretary [Steven Mnuchin] is talking about is reform of Dodd Frank – but he’s using the word “reform” or an equivalent word – he’s not talking about repeal,” said Thacker. “Outright repeal or significant revision of those regs would have to go through the regulatory review process, which would not be instantaneous.”
Thacker spoke with Asset Securitization Report recently about the potential for regulatory relief, his 2017 outlook for the CLO market, and managers’ desire for more flexibility from investors to manager their portfolios.
Early expectations are the CLO market will take a breather after the rush of refis and reset deals before the Dec. 24 risk retention deadline. How do you think the market will finish the year, and how does 2017 shape up?
Clearly there has been a burst of CLO refinance and reset activity motivated at least in part by the forthcoming effectiveness of the U.S. risk retention regs. We see that carrying straight through to the Dec.24 deadline with a final tally of $67-$70 billion of total U.S. CLO issuance for 2016. January is traditionally a slow month in CLO executions, but beyond then we would expect new CLO formation to be suppressed by the effectiveness of the risk retention rules so long as they remain in force.
What are Crestline’s plans for 2017? Do you anticipate more or fewer deals than you’ve done in recent years?
Our last two CLOs have been structured to be compliant with the U.S. and with the intent to comply with EU risk retention regs and we expect our near term issuance to be the same. As such we expect our 2017 new CLO issuance activity to be at the same pace as our recent deals, roughly two CLOs per year.
How did Crestline adapt to the risk retention rules, and how has the firm constructed deals to comply?
We formed our new partnership with Crestline Investors in October 2014 in large part motivated by the forthcoming risk retention regs. The new partnership is structured to allow us to invest and retain within the partnership a majority of the equity in our CLOs to meet the 5% retention rule, a major element of both the U.S. and EU regimes. With this solid foundational approach in place, we are now also in a position to consider alternative structures – vertical strips, CMV, MOA – as investor inquiries warrant.
As a concept we’ve always been a proponent. Every CLO that we did, even in the “1.0” era, we as the manager invested in the equity. It was usually in the range of 5-10% of the equity tranche, not the total asset value of the deal. We do want to show our investors that we are side by side with them, and they can rely on us to act on us to act in a reasonable manner based on that.
How do you think the market will react to the incoming Trump administration?
It depends. The leveraged loan market has always been correlated to general economic conditions as relates to new issuance, default rates and the like. Spread and yield is more technically driven and depends on investor demand.
If general expectations come to fruition (i.e., generally expansionary fiscal policies and gradually tightening monetary policies), we would expect to see ongoing growth in overall leveraged loans outstanding, with rising yields, but perhaps default rates reverting to the historical mean as rising debt service costs put pressure on cash flows.
Would you expect changes in regulatory issues to significantly impact the leveraged loan or the CLO industry?
At the level of interpretation and enforcement, that’s where a new administration could immediately perhaps issue some enforcement or interpretive statements that, for example, would give relief under the Volcker rule or the risk retention rule, perhaps around this concept of a qualified CLO. But I don’t think any of that is likely to happen in the very near term.
On risk retention, even a repeal of the U.S. reg would still leave the EU rule in place for a CLO sponsor that wants to avail itself to European investors.
How is risk shaping your decisions on portfolio construction? Are there industries to emphasize or de-emphasize?
For us, it’s been pretty much steady as she goes. We don’t have and never have had any meaningful amount of oil and gas or coal mining, metal/mining or other commodities credits in our funds. It just doesn’t match up with our style which looks for stable cash flows to take on the leverage that’s implied in a leveraged loan and commodities-based businesses never match up well with that because they’re cash flows by definition are erratic.
Ours has always been an issuer-oriented, fundamental approach to investing and portfolio construction, with a high degree of both issuer and sector diversity.
There’s been a spike in investments in CLOs from outside the U.S. What’s the appeal for foreign investors?
Fundamentally, CLOs have always been an efficient vehicle for global investors to gain access and exposure to the U.S. corporate senior debt asset class and its attractive elements of seniority, security and floating rates. A relative strengthening in the U.S. dollar versus other currencies should accentuate the attractiveness of the CLO and leveraged loan asset classes.
Where do you think corporate defaults are headed?
The loan market has had almost a default holiday for the last four or five years. There have been a few notable events that were really echoes of the pre-crisis era deals – TXU, Caesars – but it’s really been a really low default rate environment and that’s buoyed by the near-zero interest rates that have prevailed over the last four or five years.
Now that we’re likely heading into an increasing interest rate environment, borrowers are actually going to clear that prevailing 1% Libor floor and will actually start to experience actually increased borrowing costs.
And how would that impact underlying credit quality?
As long as that’s gradual and at a moderate pace, both borrowers and the U.S. economy more generally will be able to absorb it. If for whatever reasons the Fed feels it has to move more dramatically and more upwardly, you’re going to see more constraints put on borrowers’ debt service ratios and down the road, ultimately would lead to higher default rates. But in the near to medium term, our view is it’s not likely to do anything more than rise to sort of historical mean.
Zero percent default rates for persistent periods is unnatural in the leveraged loan markets, and if anything, we hope much of the market conditions revert to norm rather than these more artificial conditions that have prevailed.
How do you anticipate CLOs will react to the changing rate environment?
CLOs have always been attractive due to their natural match funded nature (i.e. floating rate long term assets funded by floating rate term long term liabilities). So long as LIBOR rises gradually and moderately (no short term gyrations as was seen in the crisis years, and not to such a high level as to put excessive pressure on borrowers’ debt service coverage capabilities), rising rates should be neutral to positive to the CLO market.
Moody’s Investors Service expects CLO managers to seek more flexibility in running their portfolios next year. In what areas would that likely occur?
For a long while in the CLO 2.0 era, deals have had strict four-year reinvestment periods. Now we’re starting to see that stretch to 4.25, 4.5, and now even five-year reinvestment periods. It gives the manager a longer period of time not just to manage the portfolio, but absorb some of the upfront costs of putting a CLO in place. That makes the product more attractive to equity investors.
With CLOs, the devil is in the details when you get around to things like weighted average life tests, recovery rate tests and all of the other collateral quality matrices that are embedded within the CLO document. There is a little bit more flexibility in what are commonly referred to as “stips” [stipulations] that can come back into the market and that can benefit managers and their flexibility and ultimately the CLO equity investors’ return performance as well.