CLOs are losing their luster with an important investor base: business development companies.

BDCs are closed end funds that lend to small and medium-sized companies. Several of them also put their money to work in loans to larger companies, via collateralized loan obligations; they are among the biggest buyers of the riskiest securities issued by CLOs, known as the equity.

But this month, two BDCs, TICC Capital Corp. and THL Credit, announced plans to exit their holdings of CLO equity. Both cited the diminishing valuations of their own stock, which they attributed to a growing belief among shareholders that CLO equity is not a good investment.

On Aug. 4, TICC Capital disclosed that its investment management arm – under new ownership – plans to divest $293 million of its CLO equity holdings to concentrate almost solely on lending directly to middle-market companies.

“I think that we are experiencing a very interesting feedback right now in terms of the dynamic of CLO equity housed within the BDC structure,” Jonathan Cohen, chief executive for Greenwich, Conn.-based company, said on a  conference call following the release of second quarter earnings.

“The market, I think, has essentially spoken. And the voices said that this is not a desirable asset quest for BDCs.”

Boston-based THL Credit, meanwhile, announced in its Aug. 6 second-quarter earnings report that it, too, was going to ditch its CLO equity positions (totaling $19 million) to redeploy its capital making its own loans. Returns on CLO equity holdings have diminished to the point that, like a “number” of other BDCs, THL Credit is “effectively closed out” of the capital markets “based on where we are trading relative to our NAV,” Sam Tillinghas, co-CEO and co-chief investment officer, said on the conference call.

David Preston, a CLO analyst at Wells Fargo, subsequently published a report stating that these decisions do not reflect the market view of CLO equity performance – just the view of how these investments perform under a BDC structure.

CLO equity returns can range from 14.5% and 15.7%, according to Wells; that’s well within the range targeted by most BDCs.

However, Preston had previously warned that equity returns might likely be lower for CLOs issued in the fourth quarter of 2014 and the first quarter of 2015, due to higher funding costs.

As holders of the most subordinated tranches of CLOs, equity holders are the last in line to collect interest and principal payments on the loans used as collateral for these deals. As spreads on more senior CLO securities have widened, there is less of a “cushion” between interest earned on the loans and interest paid out on senior securities.  This makes equity holders more vulnerable in the event that defaults spike or interest rates increase. (Both CLO securities and the loans used as collateral are floating rate.)

BDCs are limited in their leverage (1:1 debt-to-equity) so funds tied up in dwindling CLO equity returns can’t be put to use with higher-earning senior loans – hence the decisions by TICC and THL to exit their CLO equity positions. 

“Most of the BDCs have an origination engine they have to keep feeding” and need to create liquidity, Aaron D. Peck, a managing director for BDC Monroe Capital, said in an interview with ASR sister publication Leveraged Finance News.

TICC’s exit is being orchestrated through the sale of its investment management arm to Benefit Street Partners, a credit investment arm of Providence Capital Partners. According to a release, the new owners will focus on senior loans and some mezzanine/subordinated debt through proprietary access to Providence’s network of clients and industry contacts.

In his Aug. 11 report, Preston noted that “the management teams of TICC and TCRD have a great deal of CLO expertise, as investors and as managers, and understand the dynamics of the CLO equity market, which should limit the chance of a hasty exit that could push secondary equity prices lower.”

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