CLOs are finding new fans from among the ranks of another kind of vehicle that invests in leveraged loans — business development companies (BDCs).
BDCs are increasingly buying the junior-most securities issued by CLOs, equity that CLO managers might otherwise get stuck holding. This is contributing to the revival in CLO issuance by freeing up managers' balance sheets, enabling them to work on more deals.
While both CLOs and BDCs lend to speculative-grade companies, they are very different animals. BDCs are a kind of closed-end fund and are heavily regulated by the Securities and Exchange Commission (SEC). They can issue publicly traded stock, meaning they are not limited to accredited investors and are also attractive to certain kinds of institutional investors, such as pension funds, that are also heavily regulated.
Since BDCs never have to return money to shareholders (investors sell their stock on an exchange, rather than redeem it from the manager), they have a permanent source of capital. This makes it practical to hold illiquid securities, such as the debt of very small companies or the equity of CLOs.
Like other highly regulated investment vehicles, however, BDCs are limited in the amount of leverage they can employ to boost returns. As a result, they tend to invest in securities that are low in an issuer’s capital structure.
CLOs, by comparison, are private, lightly regulated investment vehicles that are typically domiciled outside the U.S. Like other kinds of securitizations, they issue securities backed by a pool of assets, in this case loans. The cash flow from the underlying assets is used to make payments on the securities.
So why would BDCs buy securities issued by another investment vehicle that holds commerical loans, rather than lend directly to companies? The short answer is that CLOs offer exposure to loans that are more broadly syndicated, and more senior in a borrower’s capital structure. These investments have been performing well but might otherwise be unattractive to BDCs.
“(CLO) equity returns are in the 12% to 15% range, which, on a pure yield basis, is in the strike zone for many BDCs,” said Christian Oberbeck, chairman and chief executive of Saratoga Investment Corp., a business development company with a portfolio of $93.7 million.
“The underlying asset class is first-lien loans. A BDC has a hard time making first-lein loans directly, because, without leverage, on an absolute basis, broadly syndicated senior loans yield Libor plus 500 (bps) or so, below where BDCs want to lend,” Oberbeck said. “But if the loans are aggregated into a highly diversified CLO, in different tiers, you can generate a 12% to 15% return, with a good quality underlying asset class.”
Saratoga owns the subordinated notes of a single CLO, Saratoga Investment Corp. CLO 2007 Ltd, which represented about 27% of the fair value of the BDC’s investment portfolio as of May 31.
This illustrates another, more complicated explanation of BDC appetite for CLO equity: many BDCs are managed by affiliates of the managers of the CLOs. A year ago, Saratoga Investment Corp., which was then called GSC Investment Corp., was in default on its own debt and was rescued by a $55 million recapitalization, including an equity investment by Saratoga Investment Advisors. Saratoga Investment Advisors is an affiliate of Saratoga Partners, a private equity firm spun out of Dillon Read in 1998.
The BDC was renamed, its senior management replaced by executives from Saratoga Investment Advisors, including Oberbeck, and its asset base expanded, in part through the acquisition of subordinated notes of the Saratoga CLO.
“The CLO equity we have is somewhat strategic to us, we own all of the equity and manage the CLO,” Oberbeck said. “It gives us a strong presence in the leveraged loan market, access to the broadly syndicated and middle market. A good information flow comes out of that capability and it’s a very attractive investment for us.”
For these same reasons, Oberbeck said, Saratoga has considered making other, non-strategic investments in the equity of CLOs the firm does not manage. CLOs “have done pretty well over time, even through the last downturn. However, if you had to mark them to market or sell them during the downturn, you might not have done so well.”
While most BDC holdings are illiquid, CLO equity is particularly vulnerable to downgrades because of diversification requirements, including triple-C baskets. “If you get downgrades because triple-C baskets get filled and management fees and dividends to equity can get cut off. The cash gets diverted to amortize the debt ahead of payments to the equity,” Oberbeck said.
He added that there is a very limited secondary market for these securities, which are very complex to analyze. “You have to look at the portfolio manager and the portfolio itself. In a downturn, a good CLO manger can take steps, such as trading securities in the portfolio, to avoid tripping covenants. However, in a hard, fast downturn, sometimes you can’t get out of the way.”
Another downside to investing in CLOs, according to Oberbeck and others, is that they generally count as “bad assets” that fall outside of a BDC’s investment mandate. BDCs can allocate no more than 30% of their portfolios to such investments.
Despite such drawbacks, there are a number of other BDCs that hold CLO equity or plan to. “What we’ve seen is interest in CLO equity as an alternative to setting up an asset management platform that selects loans and manages loans,” said John Timperio, a partner in the structured finance practice at Dechert. He said some BDCs are looking at building a team that manages the CLOs themselves, and then buying a substantial portion of the equity, in which case they would have to consolidate the CLOs on their balance sheet.
That’s what TICC Capital has done. On Thursday the BDC said it had issued a $225 million CLO, its first, through a special purpose vehicle in which a wholly owned subsidiary owns all of the equity. TICC already allocates a quarter of its portfolio to junior securities CLOs, but chief financial officer Patrick Conroy described these as “passive” investments that the firm acquired at a steep discount in the secondary market. By comparison, he said, issuing a CLO and holding on to the equity gives TICC the opportunity to borrow money (via the sale of senior notes) at attractive rates and make more loans. Some of TICC’s existing portfolio holdings will be used as collateral for the CLO.
Timperio said some BDCs are looking at investing in CLO equity without managing them. However, BDCs that own too much of the equity of an individual CLO may still have to consolidate the entire deal on their balance sheets, even if they are not affiliated with the manager. “It’s a big topic in the BDC world, what you can buy in terms of CLO equity and not run the risk of consolidation,” he said.
Cynthia Krus, a partner in the corporate practice group at Sutherland, said there’s no formal guidance from the SEC on the amount of equity BDCs can hold in a CLO without consolidating for regulatory purposes, and it appears unlikely the agency will come out with any. BDC investment in CLO equity is subject to fact and circumstance tests, including the level of ownership and control, management and the nature of the CLO’s holdings.
“This is an area the SEC has been spending a great deal of time on,” Krus said. (The agency did not respond to a request for comment by press time.)
While not every BDC invests in CLO equity, these investment vehicles have been raising money hand-over-fist this year through IPOs, follow-on equity offerings and by issuing their own debt.
According to research by Stifel Nicolaus Weisel, there are 32 publicly traded BDCs with a total market cap of nearly $18 billion. Many are reporting second-quarter results now, but currently the industry is trading at a median 90% of net asset value per share, so total assets are even greater.
Krus said regulatory filings indicate that there are 18 new BDCs in registration with the SEC, four of which will be structured as unlisted BDCs, with more still in the pipeline.
As one of the few buyers of CLO equity these days, BDCs are having an impact on the way these deals are structured. One of the most notable things they are demanding is shorter non-call periods. Many of the deals brought to market this year can be called after just two years, or even less. By comparison, deals issued before the credit crisis often had non-call periods of three years or more.
BDCs and other equity buyers are also demanding more control over redemptions of CLOs.
“Equity investors are very focused on control rights in the deals,” Timperio said. “If you own equity, you want to be sure it’s out there as long as you want it to be.” On the other hand, equity buyers “certainly want the ability to refinance deals if spreads get even tighter.”