The economics of actively managing a pool of leveraged loans for the benefit of several different classes of investors is not good. So some CLO managers are putting their deals on autopilot.
Collateralized loan obligations with static portfolios have less overhead than actively managed deals, allowing managers to charge lower fees. These deals also amortize much more quickly than CLOs with actively managed portfolio, which appeals to certain investors.
There’s a downside to putting an investment portfolio on autopilot: investors risk being stuck with loans to companies that are in financial distress or default, since managers are unable to sell assets and replace them with better ones. This puts the onus on manager to make the good decisions right out of the gate.
So far this year, four managers - Palmer Square Capital Management, American Capital CLO Management, Zais Group and Telos Asset Management - have issued static CLOs totaling $1.1 billion this year, according to Wells Fargo Securities. Three of them are small shops with $5 billion or less in CLO assets under management.
While that’s a small portion of overall CLO issuance, it’s a pace without precedent since the financial crisis.
“There were ad hoc issuances of static or semi-static CLOs, but what we’ve seen this year, especially at beginning of the year, is very different from what we’ve seen last four years,” said Leon Mogunov, a Moody’s structured finance analyst. “There was a good reason for that. It’s all about arbitrage; it’s about opportunistic time during the specific market conditions.”
Conditions were optimal for a CLO slowdown earlier in the year. Leveraged loans were off to a tortoise-like $18 billion issuance level in January, squeezing the pipeline supply for CLO asset purchases. Meanwhile, investors soured on the deteriorating credit quality of energy and other commodity loans in CLO portfolios.
Spreads widened on tranches, even on the ‘AAA’ tranches where the spreads expanded to 190 basis points in February from the 150s in the latter parts of 2015. “It’s probably driven by investors,” said Al Remeza, associate managing director at Moody’s, on the influx of static CLO deals, “because market conditions have been such that spreads on CLO liabilities have been very wide. As a result it becomes uneconomical to do CLOs at very high spreads.”
“That creates a very difficult equity arbitrage situation where people aren’t able to make the required return on CLO equity,” says Chris Long, president of Palmer Square Capital Management, issuer of two static CLOs in 2016. “With the static CLO – because it’s shorter in nature and brings in a larger and broader investor base – the cost of liabilities have come at cheaper levels.”
The conditions that made standard-issue CLOs unaffordable to issue opened the door for managers who push the static CLO format, like Palmer Square. What allows static CLOs to succeed, say analysts and managers, is the reduced fee structure involved in an unmanaged portfolio, as well as the ability to offer lower yield to investors who’ll take tighter spreads in exchange for shorter-term maturities with little extension risk.
Telos CLO 2016-7, issued in March by Telos Asset Management, is an eight-year structure maturing in 2025. Comparably, Telos’ last CLO issued in December 2014 will still have two years remaining due until its final maturity (of 2027, with the inclusion of a reinvestment period in 2019) when 2016-7 is retired.
Palmer Square Capital Management of Mission Woods, Kansas, has completed two static CLOs this year, and it plans to come to market regularly. The firm has built a dedicated platform to separate them from its five previous transactions, which are actively managed. It plans to come to market regularly with static deals.
Long says this is because his shop sees more than just one-off opportunities for static CLOs to fill in for standard portfolios. He has found that he attracts a wider base of investors who have aren’t comfortable or knowledgeable enough about how CLOs are actively managed. Many also are wary of the long-term unknowns of extensions or the future mix of portfolio assets.
In a static CLO, the portfolio’s loans are fully identified at pricing, have an immediately amortizing structure with no reinvestment period – and with no active manager involvement, investors spend less time (and expense) having to conduct due diligence on manager performance.
Management fees are typically 25-50% less, Long said. And that’s not because managers step away after the ramp-up and marketing of a portfolio – they still must conduct credit analysis on asset and industry performance. But managers do not have to manage cash balances from repayments to schedule for reinvestments, for instance; they also are excused from having to rebalance the portfolio for overcollateralization and other tests due to the immediate amortizing nature of the vehicle.
The cost structure also benefits from the reduction in legal and ratings agency fees as well as document expenses, said Long. “You can see and touch the portfolio right off the bat and make an investment decision based on your comfort level,” Long said. Ultimately, he says, “we believe the return is also more predictable in that the expected returns fall into a relatively tight band given the shorter duration of the product.”
Moody’s Remeza notes that static CLOs also different factor components to standard CLOs. In particular, deal covenants in standard CLOs are examined for “worst-case limits” and other theoreticals to stress-test a portfolio’s performance under duress.
“If a deal was in fact static, we would be looking at the actual characteristics of the portfolio,” said Remeza. “There wouldn’t be a risk that the portfolio could worsen through trading and that could in turn factor into the overall rating of a CLO.”
The risks, of course, carried by the static CLO is that they must carry any developing distressed debt to duration, with the inability to offload the loans or make amendments with borrowers absent investor consent.
Long says that’s another factor in why Palmer Square is comfortable with static CLOs. He says Palmer Square remains a conservative CLO sponsor, with a low-risk, higher-rated pool of loans that keeps its weighted average rating factor (WARF) at low-risk levels.
According to Wells Fargo, Palmer Square indeed has the lowest (or least risky) median WARF score of any of the 64 U.S. CLO managers with at least four CLOs in their reinvestment periods.