A couple of questions naturally follow on from a decision to invest in corporate credit: firstly, “What segments of corporate credit should I consider?”, and secondly, “How should I structure my exposure to this asset class?”
For us, broadly syndicated senior secured loans (BSLLs) made to larger, leveraged corporates offer an appealing balance between risk and reward. According to data from Morgan Stanley, the market has grown in recent years to approximately $1.2 trillion of outstanding. It is a mature market that has gained significant traction since the financial crisis. By comparison, PDI data show that direct lending funds – typified by funds acting as lenders, usually to small to medium-sized businesses to disintermediate banks – have raised $1.14 trillion since 2008 when the global financial crisis hit.
BSLLs are typically $500 million-$1 billion in issue, with EBITDAs of around $125 million-$250 million. The syndication process brings together numerous independent credit investors to scrutinise all aspects of the proposed transaction. The lending documentation is derived from well-known Loan Market Association and Loan Syndications & Trading Association templates. Due diligence practices also follow a well-trodden path.
Furthermore, the nature of the larger firms involved means that a greater level of financial reporting transparency may be achieved. By contrast direct lending is less likely to involve a syndicate and utilises documentation that could vary significantly from deal to deal. As a result, a direct lending fund must weigh the cost of bespoke structuring versus flexibility.
The nature of BSLLs is likely to promote higher underwriting and standards to satisfy the demands of numerous parties, which may limit the spread that can be charged but provides clear advantages from a credit risk perspective. A direct lender may not have to satisfy multiple stakeholders and can enter into situations with higher spreads. However, the borrower in question may be in a better position to play different lenders against one another and the absence of a syndicate could increase the risk of adverse selection.
Liquidity may be a consideration for some credit market participants. A BSLL can be sufficiently large so that a ratings agency can provide ongoing assessments at a much lower cost than a typical direct loan. One of the benefits of this is it promotes secondary market liquidity, which provides price transparency. This helps to promote an actively traded market where risk can be bought and sold. A direct loan, particularly to a niche or small company is likely to attract a liquidity premium, but there must be a sufficient risk and reward for this.
In addition to the above comes the ability to work out in a credit event situation. The experience, resources and the combination of relatively standardised documentation of lenders in the BSLL market may lead to a rate of recovery enhancement. A credit manager’s human resources can come to the fore in this situation as operational burdens from restructuring and monitoring the portfolio lead to competing priorities.
A CLO is a securitisation of predominantly BSLLs. Alternatively, it could be thought of as term-funded credit fund, which benefits from the properties of BSLLs that we have previously mentioned; syndication, documentation, underlying portfolio liquidity etc. CLOs are a significant purchaser of BSLLs, approximately representing 50 percent of total loans outstanding.
Credit portfolios contained in CLOs are assembled by well-established credit managers that tend to be broadly diversified across sector and geography – typically with
over 100 borrowers across 15-plus industries. The credit assets under management of these managers are generally larger and so teams of seasoned professionals can spread the load of credit selection, monitoring and work-out. Moreover, asset sourcing is a comparatively low-cost activity as the origination route via investments banks is well-travelled.
CLO managers are paid fees for their management services, and this is a consideration when investing in CLOs. However, these fees are tiered according to performance and performant CLO managers often have multiple-decade-long proven track records of loss mitigation – in excess of broader loan market indices – that outweigh the cost. Furthermore, in Europe risk-retention rules require the CLO manager to hold a proportion of the CLO securities from deals they run, which promotes alignment with investors (of CLO securities).
Another important difference between BSLL funds and CLOs arises from the composition of the fund’s investor capital. Traditional funds comprise a single class of investor capital, which may be locked-in or open-ended, and potentially some fund-level leverage provided bilaterally to the fund on a shorter or longer-term basis.
Conversely, CLOs issue multiple classes of listed bonds, or tranches, in a single transaction. The proceeds of these tranches finance the purchase of the entire BSLL portfolio. These CLO securities are all backed by the same BSLL portfolio (also known as CLO collateral), but differ in terms of relative risk/reward characteristics. Senior tranches receive interest and principal cashflows generated by the collateral first, but in doing so receive a relatively lower contractual interest coupon. As one looks at tranches down the CLO capital structure, expected returns increase but the priority of claim of the collateral cashflows decrease.
BSLLs at new issue will typically yield LIBOR plus 300-500 basis points, whereas direct lending can potentially have a much wider range of returns. CLOs allow investors to choose their position in the capital structure, from (initially rated) AAA to B in terms of debt securities. There is also a subordinated equity tranche, which accrues the excess cashflows. Generally, through the cycle we see returns and yields in CLOs showing relative value through the capital structure; from AAA to B. The subordinated tranche yield to maturity can reach the teens. In a ratings agency study, which took data from 1993-2016, European CLO tranches from AAA to A faced no principal or interest impairments. The 12-month impairment rate for all CLO debt tranches on a historical average basis is 0.2 percent.
Aside from the previously mentioned appealing qualities of CLOs, such as relatively attractive credit risk profile, alignment of CLO managers with investors of CLO securities, a full capital structure backed by a BSLL portfolio, etc, there is also an active primary and secondary market. The secondary market works in a similar fashion to the corporate bond market and with over $500 billion-plus in outstanding paper the market is sizeable.
Therefore, in our opinion CLOs make for an attractive risk reward proposition. However, it should be noted that they are a sophisticated product that requires expertise in analysis and trading. Coupled with the former, we think that the latter aspect can add noticeable value. Serone recommends that investors partner with a highly experienced, specialist manager in this space in order to improve the chances of achieving their investment objectives.