Sound Point Capital Management both manages collateralized-loan-obligations (CLOs) and invests in their equity and mezzanine debt. In a recent discussion with Asset Securitization Report (ASR), Ujjaval Desai, the head of the alternative asset manager's three structured-products investment funds, including publicly traded Sound Point Meridian Capital, raised concerns about the rash of captive funds investing in CLO equity and the "lack of discipline" that can result.
Desai has plenty of perspective. He joined Sound Point in his current position in 2019, after investing in CLO equity and mezzanine at Ares Management since 2011, when it acquired Indicus Advisors, a debt advisor and manager he had co-founded six years earlier. He spent the previous decade at Goldman Sachs and Morgan Stanley structuring and originating CLOs.
At Sound Point, Desai manages approximately $1 billion in CLO equity and mezzanine debt. The firm is also a large CLO issuer, managing approximately $35 billion in CLOs and $43 billion in total assets. He spoke about current market challenges and risks for CLO equity and mezzanine from an investor's perspective, and what his firm looks for in smaller CLOs that may face liability management exercises (LMEs) which force them into inferior recovery positions.
ASR: How are today's financial and economic uncertainties impacting CLOs?
Desai: Interest rates, credit quality, default rates, and generally what's happening in the credit markets are key concerns for any investor. The Fed may lower rates, presumably because it sees inflation under control, but the impact of tariffs is still unknown. There will be a new balance, but plus or minus 100 basis points on rates won't materially impact our market. We're not losing sleep over that.
The main issues we see are company specific. We can't control macro issues, but we can control our investments in companies. Our focus is the micro level, and we like the loan market. We think that in the current environment, credit is actually the right place to be.
ASR: Why does credit look attractive for your firm?
Desai: Companies in the [syndicated] loan market have had attractive earnings, and they've been able to withstand shocks. These are large, established companies that have strong track records and equity sponsorships. They have the ability to access the credit markets and strong balance sheets. There are single names to deal with, but on a macro basis we don't see a massive recession anytime soon. There may be inflation and interest-rate volatility … but we believe these companies are strong enough to deal with that.
ASR: Where do you have concerns?
Desai: Between 6% and 8% of the loan market is now trading below 90 cents on the dollar, when most loans are trading at or above par. Those companies are struggling, whether it's issues having to do with their balance sheets, industry sector, management or something else. We have a view on each of them, and we're asking CLO managers about their views and how they're thinking about that risk. Those credits are the next LME candidates.
ASR: LMEs remain prevalent, and borrowers and lenders steering LMEs often push smaller lenders into less advantageous positions. Does that concern you?
Desai: That's a new construct that didn't happen before. We're seeing smaller managers having a lot less say in the process and lower recovery rates relative to large managers. As an investor, we're very focused on that issue.
ASR: Do you still consider smaller CLO managers?
Desai: We do, and we factor our view of likely defaults and recoveries into our underwriting. We'll demand premiums from smaller managers and look at how they've dealt with these situations historically. Good managers of smaller CLOs are cognizant of that risk and they run very diverse portfolios. If they see a company heading toward an LME, they'll trade out of the credit and replace it with something comparable.
Smaller managers have higher liability costs, because their debt doesn't price as tightly. However, their management fees are less, and they may be nimbler because it's easier to get in and out of their smaller positions. An investor in CLO equity must have a more forward-looking view that takes these types of factors into account when analyzing a CLO manager's performance—where it is headed in terms of the overall franchise—to figure out the right price to charge for the investment.
ASR: What other CLO-market risks do you see?
Desai: One concern is insufficient loan issuance. That's been going on for years, and everybody keeps saying new issuance is coming, giving us some breathing room. But currently issuance is mostly repricing companies' existing loans and add-ons. Demand is strong, and as a result loans are trading at or above par and spreads are very tight. Loans have cut 50 basis points of spread over the last year while liabilities have cut just half that. So even though we're positive on the loan market, we're not seeing CLO arbitrage as attractive on the standard deal. That means equity returns have compressed, and we have to work harder to find transactions that make sense, whether they're in the primary or secondary markets—we're agnostic to that. We're now seeing more interesting opportunities in the secondary equity market.
We invest over a medium- to long-term horizon—three to five years—and there the risk is the default and recovery rates, not necessarily short-term volatility. That's the beauty of the CLO structure: Short-term volatility may not really hurt you.
So the question as an investor is whether it's the right entry point today.
ASR: What else are you monitoring?
Desai: A lot of the capital for CLO equity is being driven by captive vehicles, in which the manager raises third-party capital for only its CLOs, rather than using a third-party equity provider, like us. We pick and choose which investments make sense from a risk and return perspective, but money raised by captives has to be spent. Most of the CLOs done in the new issue market today are using captive vehicles, and one could argue there's a bit of a lack of discipline there.
ASR: Why do you think discipline is lacking?
Desai: If the money is already raised, managers are more incentivized to do deals regardless of returns. Investors will see it in the math, so if the math doesn't work, then you know the CLO is probably not driven by third-party equity.
ASR: How are you viewing the mezzanine piece of CLOs?
Desai: Mezz is generally sold to third parties and there are plenty of buyers. Its price is based on the manager and quality of the portfolio. Spreads have tightened since May, but they still haven't reached the tights of February, whereas the loan market is looking at multi-year tights and the equity market is at all-time highs.
Mezz has done quite well this year given the tightening we've seen, and there's probably more tightening to come. But it's floating rate and callable, so it doesn't tend to appreciate a lot.
