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Tetragon, a CLO equity buyer, makes a play for debt tranches as well

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In September, longtime CLO equity investment firm Tetragon Credit Partners expanded its reach into the market with a decision to add CLO debt purchases to its shopping list.

Since 2004, Tetragon had invested more than $2.4 billion across 105 actively managed collateralized loans, providing the firm and its clients returns on the controlling shares of broadly syndicated loan portfolios involving 32 different managers.

While having controlling equity holdings in CLOs allows Tetragon to direct deal strategy for deals managed by external firms - including decisions on revinvestment strategies, refinancing and even manager replacement - equity holdings carry risks, as well.

Outside of asset sale proceeds, equity holders generally receive only the remaining interest funds after all P&I proceeds are issued to investors. Conversely, equity-stakes holders are first in line for losses should payments from corporate loan obligors fall short through due to defaults, delinquencies and bankruptcies.

But September's announcement reveals the firm will complement its equity strategy by also focusing on the debt-note structure of deals, in hopes of gaining returns on the performance lowest-rated mezzanine and subordinate tranches.

Scott Snell, portfolio manager for Tetragon Financial Group and one of three principals of Tetragon, discussed the new strategy as well as his observations of the 2019 CLO market and his outlook for 2020 issuance and market trends.

What is the driving the decision to expand beyond what has been the traditional control-equity stakes?
SCOTT SNELL: Tetragon has been getting more inbound investor requests, specifically in CLO mezzanine debt. For buy-and-hold investors, CLO debt offers a differentiated profile typically providing stable income and credit ratings, which is important to some investors. We also think there are times when the market is more volatile where active trading strategies present attractive total return opportunities. By taking our expertise in CLO equity and applying it to building portfolios in the CLO debt space, Tetragon believes it can deliver exceptional overall value to our investor base. Our success will be driven by strong manager relationships, a deep understanding of the legal documents, and our ability to select the best risk adjusted credit portfolios.

Any particular reason why minority-equity investing may be more attractive now?
When buying minority equity, an investor gives up control of some of the optionality or voting rights that one has as a majority equity investor. It is a different type of analysis and the opportunity has to be more compelling in terms of the risk/reward characteristics. We think the additional yield pickup from minority equity can make sense, but we do think control matters so the risk premium that we demand is definitely higher for minority equity.

Can you can give an overview of what you see in the market for some of those lower-rated mezzanine and subordinate CLO debt tranches?
Recently we have seen increased selling in the secondary market of triple-B and double-B-rated paper. The market is starting to differentiate based on performance, underlying credit quality and how managers are reacting to market conditions. This year a few loans have had violent price movements on the back of missed earnings or some type of restructuring event. With stress building in some portfolios, I think the market has generally reacted appropriately and we are seeing investors sell out of weaker deals. As a result, the increase in trading activity has created more technical pressure, which has driven pricing wider both in the primary and the secondary market.

So what kind of challenges or maybe even opportunities does that present to CLO managers?
Given the growth in the loan market, CLO managers have more opportunities to differentiate performance, whether that's staying in the larger, broadly syndicated loan universe or taking more liquidity risk by buying smaller loans. I think with some of the price action you've seen this year and continued retail outflows, it's really given managers the ability to trade around their portfolios and to move into either higher-rated credits or names where they have strong conviction. We think it's an environment that is ripe for CLO managers with good credit-picking skills to differentiate themselves in terms of spread, price and ratings in their portfolios.

How is the current investor base impacting the issuance volume in CLOs and perhaps even how the deals have been structured.
There is a stable investor base that is always looking to participate either in the secondary or the primary market. But really, what drives spreads tighter or wider is determined by the marginal investor. Over different periods of time, you'll see large banks come in and out of the market (particularly in triple A’s), or it could be certain insurance companies or overseas institutional investors. Right now, I'd say there are a couple of new asset managers looking to add in the CLO market. However, given what's happened with rates, there has been a preference among the asset-manager community to be less invested in CLOs and more exposed to traditional fixed-income products like investment-grade corporate bonds. You haven't seen as much of that marginal demand from newer investors, which is why CLO liability spreads are relatively wide. And I think given some of the increased focus on what's happening to the loan market and negative idiosyncratic credit stories, overall demand has been more tepid this year than in the recent past.

Is manager tiering as pronounced toward the end of the year; or are more investors maybe becoming more comfortable with these new managers coming on board?
You really have to bifurcate the new-manager universe. There are a few new managers that have come to market with very strong capital backing and experienced teams. In many cases, they have already issued two or three transactions which have been received well by the market. On the other hand, there are other newer managers that might not be as well established nor have as strong of a track record. We have seen those new managers struggle as the market has demanded higher liability spreads, which makes it very challenging for the arbitrage to work. I think to the extent the market becomes more friendly and you do see a pickup in demand particularly for triple As, that dynamic could change. But right now, it's fairly difficult.

Does that bifurcation [on pricing] for the triple-A level, does that also manifest itself in the mezzanine and subordinate tranches and even the equity stakes?
Definitely you see bifurcation down the stack. Investors will typically use a similar framework to assess risk in mezzanine tranches as they do for senior debt. Tiering and pricing levels will depend on a variety of factors, including the manager’s default track record, team experience and portfolio characteristics. In some cases, the frequency of issuance and size of platform can also create a negative supply technical, which may impact spreads. For equity tranches, investors typically try to find managers with a similar outlook on the market and risk tolerance. Every equity investor has different hot button issues that they focus on. For us, we emphasize the manager’s expertise and track record, the positioning and spread of the portfolio, and also the team’s experience with managing CLO structures. Of course, the overall economics will also determine how an equity investor views a particular transaction.

Is tiering driven more by return performance or overall management skills?
Certainly past performance and track record are important when evaluating a management platform. However, there are other factors to consider such as the tenure of the team, compensation structure, and the type of organization. Additional considerations include the risk profile of the portfolio, credit rating distribution, the diversity score and weighted average spread of the underlying assets. It also is important for investors to consider manager styles. The market has gravitated towards more conservatively positioned portfolios, given the recent volatility and some of the concerns about where we might be headed in terms of the economy. However, some investors have shorter holding periods and may focus less on the long-term credit outlook if they intend to sell in three to six months. Deal documents and legal language have also become a bigger focus. Some investors are more concerned about getting certain terms, particularly around Libor replacement language. This type of deal term can override manager tiering criteria, especially for some of the largest AAA buyers.

What concerns arise about loan assets sensitive to the trade wars?
There is increased focused on how the trade war is playing out and the potential impact to company earnings, but it is not the only factor contributing to negative sentiment. Several technology companies have not met growth expectations, the retail sector continues to be under assault from online competitors, and commodity prices remain an issue for the energy space. You also have litigation risks which are affecting pharmaceutical companies with exposure to opioids. Earnings remain a focus with several high-profile misses coming out of the second quarter. In those cases, the market has punished loan prices with significant moves down. For now, we're closely watching the next round of earnings to see how companies perform versus expectation. While we do think the general economy is in decent shape, we anticipate more credit issues to pop up before year-end.

How do you see year-end issuance and spreads developing? And what are some of your early takes on where you think the market might go in 2020?
I think we’ll see issuance continue at the current pace heading into year-end. Right now it's not particularly slow in the primary market, but it's not particularly robust either. There are a number of managers and equity investors that would like to proceed with transactions, but the market tone is relatively weak. On the positive side, you have seen loan prices come off about a point over the last month, which has helped the equity arbitrage. However, I don't think there is a large amount of pent-up demand and don't expect to see a big pickup in terms of supply going into year-end. Regarding 2020, I think we are probably flat, to down slightly, year over year, in terms of issuance. Some of the issues that have plagued the market this year around idiosyncratic credit stories and tepid demand from the CLO tranche liability side will likely persist next year.

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