"Skin in Game" Rule a Boon for New Breed of CLO Manager

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Rules requiring CLO managers to keep skin in the game of their deals has taken a toll on smaller firms. But the resulting thinning of the ranks has created room for some new players that are better capitalized, most notably insurance companies.

At its peak, the universe of managers issuing collateralized loan obligations hit 143 in 2014, according to Thomson Reuters LPC.

That number has dwindled substantially in the nearly two years since federal regulators published rules requiring sponsors of collateralized loan obligations to retain 5% of the risk in their deals. Only 86 managers printed new deals in 2015, and midway through 2016 the lineup of CLO managers issuing new deals fell to just 62, according to Thomson. (Moody’s Investors Service has rated only 48).

New managers are even rarer than new deals. Just only six debuted in 2015, a fractionof the 42 managers who entered the market in the first CLO post-crisis boom year of 2012.

Another five managers debuted this year, including two insurance companies (traditional investors in CLO notes) and former asset management unit of a property & casulaty firm which invests in senior loans for several funds its subadvises.

Middle market lender Maranon Capital led the pack in March, issuing $354.7 million deal. Since April, four new issuers have hit the streets. Guardian Life priced a first-ever $406 million CLO through its Park Avenue Institutional Advisers asset-management subsidiary in July. That followed a $455 million transaction by financial services giant TIAA-CREF in June. And in May, Newfleet Asset Management – the fixed-income unit of Virtus Investment Management, a 2009 spin-off of Phoenix Life – issued a $356.3 million CLO.

Each of the deals has a substantial residual notes balance that will be retained by the parent firm, substantially complying with the risk-retention standards that officially take effect in December (existing CLOs are exempt from the rule during their non-callable period, thought it’s unclear whether the exemption would remain in the event of a refinancing or the addition of new collateral).

For Newfleet, the introduction of its first CLO was the culmination of nearly a year’s worth of planning and loan warehousing that allowed it to issue Newfleet CLO 2016-1, a deal led by Wells Fargo.

At the heart of the strategy, said Newfleet senior managing director and senior loan sector head Frank Ossino, was the recognition that the risk-retention standards created an opening for a well-capitalized asset management firm like Virtus.

“What got us really interested was this period where, because of risk retention, there may be some players that can no longer survive in this space,” said Ossino, in an interview with Asset Securitization Report. “And despite being a new issuer, we might be able to take (market) share over time because of advantages that we may have, namely for solving for risk retention.”

It’s notable that Virtus, Guardian Life and TRIA-CREF are launching inaugural deals amid a dramatic slowdown in overall volume. Issuance was off 50% to approximately $26.2 billion through June, compared to the same period in 2015. Of the deals done, the market has been top-heavy with larger CLO issuers doing multiple deals (including Euro transactions), including Carlyle Group, GSO/Blackstone Debt Funds Management, Apollo Global Management, Golub Partners, and BlueMountain Capital Management.

At the same time, some well-established managers such as Ares Capital Management and CIFC did not issue deals in the first half of the year due to tepid market conditions.

But the three deals – as well as the CLO debut of a mid-market lender, Brightwood Capital – came as volume picked back up in the second quarter ($5.4 billion of new deal volume in May and $6.6 billion in June) and the corporate leveraged loan issuance that supplies the CLO pipeline surged by 64% in the second quarter ($214 billion) over the first quarter of the year.

Meredith Coffey, executive vice president of the Loans Syndication and Trading Association, said the industry was buoyed by the entry of new well-capitalized entrants. But she does not believe it will be enough to offset the exodus of managers from the CLO market, which is the largest buyer of senior loans sustaining capital to speculative-grade and mid-market companies. 

““We’re always glad new entrants are coming into the market – we think it validates CLO performance,” said Coffey. “Our concern continues to be will that be enough to make up for a decline in issuance due to risk retention.”

The LSTA is involved in a lawsuit with other structured-finance trade groups against the Federal Reserve looking to stop the enforcement of risk-retention standards on CLOs. The groups have argued the standards were misapplied to the asset class since CLO managers, asserting that the managers serve only as money managers and arrangers – not originators – and do not fit the “securitizer” standard set forth in Dodd-Frank.

That lawsuit, however, is pending and not expected to be resolved at the federal district court level until the summer of 2017 – well past the December 24, 2016 enforcement date of the new rules.

The LSTA is also seeking pushing Congress to pass bill that would establish a standard for a “qualified” CLO exemption. The proposal is similar to an existing qualified mortgage exemption that allows the securitization of certain home loans without the required retention by meeting certain standards for transparency and the alignment of mutual interest between investors and managers. The bill, sponsored by Rep. Andy Barr, R-Ky., remains stalled in committee.

Even if the LSTA is successful, however, the calculus for Newfleet and other well capitalized managers does not change.

Ossino said Newfleet’s attraction to the market stems from the Virtus subsidiary’s deep involvement with senior loans. Newfleet has roughly $2.5 billion in broadly syndicated loans in assets under management for several retail mutual funds it subadvises for firms including SunAmerica and Dunham & Associates.

With only 12-15% of the market for leveraged loans contained in loan mutual and exchange-traded funds – and 60 to 65% in CLOs – Ossino acknowledged that Newfleet simply didn’t have a horse in the race. But with the backing of Virtus, Newfleet could perhaps lap the field on other less-capitalized contenders unable to meet the risk-retention standards that investors are expecting.

“The guy who used to manage two or three CLOs – the proverbial two guys and a Bloomberg – may not work as we enter next year. That guy will either have to sell himself or ride off into the sunset with whatever cash flow his two or three deals are making,” said Ossino.

“The survivors are going to be the folks who have capital or access to capital. That’s our calculus,” he said.

Newfleet was among the first of the new rookie crop of broadly syndicated loan buyers to enter the market when it priced its CLO in May. Its real work began in August when Newfleet began to warehouse loans at an opportune time in a buyer’s market.  “We managed to buy a lot of names at attractive prices and buy some new issue at attractive prices as well,” said Ossino, who said the entire $317.5 million of loans in the identified collateral pool were purchased below par.

Buying discounted loans allowed Newfleet to make its “arb” when it priced the CLO this spring at a substantial premium compared to other deals being priced in the same period. Octagon Investment Partners 27 issued a week later had a triple-A coupon price of 153 basis points over Libor – compared to 1.85% over Libor for Newfleet’s similar ‘AAA’ stack. The ‘BBB’ spread difference was 200 basis points between the deals. 

“Our liabilities are wider than the normal CLO,” Ossino admits. “As a first-time issuer there’s a premium that investors want to get paid to own a new manager.” (Octagon’s CLO was that firm’s 16th CLO 2.0 transaction).

TIAA and Guardian Life had the same obstacle. Guardian’s Park Avenue Institutional Advisors CLO 2016-1 and TIAA CLO 1 each priced its ‘AAA’ paper at 170 basis points over Libor, when more established issuers such as CVC Credit Partners obtained a more favorable 150 basis point spread over Libor for its 29th overall CLO, Apidos CLO XXIV.

Ossino, a former senior loan credit manager at Hartford Investment Management before coming to Virtus in 2012, acknowledges that Newfleet and the other new players on the block have to prove their performance to investors before commanding more favorable terms with investors. He must also prove the CLO’s performance with Virtus’ executives in order to obtain backing for another deal – which will likely involve third-party investment in the equity stakes of the deal.

CLOs aren’t critical to Newfleet, which has a total of $11 billion in assets under management (including the $2.5 billion in senior loans). Stil, Ossino is optimistic that the market – and regulatory – expectations will align in Newfleet’s favor to keep deals flowing from its fledgling platform.

“All else equal, depending on variables like market demand,  cost of funding and the overall arbitrage, you can see a situation where we do one a year or one every 18 months. It’s very realistic,” he said. “The thinking is we are not one and done.”

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