Despite negative connotations, CLOs have proven a remarkably resilient instrument, argues 3i Debt Management’s Andrew Bellis
In the late 1980s a team at Drexel Burnham Lambert created the world’s first CBO (collateralized bond obligation). That financial product, which would spawn a number of siblings such as CDOs (collateralized debt obligations) and CLOs (collateralized loan obligations) significantly influenced the financial markets and became synonymous (rightly or wrongly) with the recent financial crisis.
However, what most investors forget is that this product is simply a financing tool rather than an asset class. The assets that were “collateralized” – loans; bonds or other forms of debt – fundamentally drove the performance. Put simply, you get out what you put in and hence despite all the negative press and associations CLOs have performed remarkably well.
A CLO is a way for an investor to achieve a leveraged exposure to the US or European non-investment grade corporate loan markets via a portfolio of loans that are actively managed by an experienced asset manager. For investors that own private equity it is very close to home. The loans in CLOs will often be the ones that are put in place to support a specific company buyout by a private equity firm and currently earn interest at Libor +4-5 percent.
A CLO offers investors, via an investment in CLO equity, a mid teens return on the loan asset class. It does that by financing a portfolio of actively managed loans with typically 85-90 percent debt and 10-15 percent “equity”. The equity is really an “excess cash flow” investment and this, coupled with the structure of the debt financing, is key to how and why CLOs work. The debt financing provided is long term, limited recourse and not mark-to-market based.
The equity investor, provided the portfolio doesn’t sustain a certain amount of default and loss, receives the excess interest that it generates on the portfolio after paying interest due on the debt and applicable management and administration fees. In today’s market this should amount to cash on cash returns of 20 percent per annum before the CLO amortizes after the first three or four years.
In other words, as the equity investor in a CLO you find yourself in the situation where you would expect to be paid out first before your lenders are repaid in full! Indeed the payout profile of CLO equity is close to being the opposite of private equity, thus making it an interesting investment opportunity for those investors also exposed to private equity.
The debt investors are protected via coverage tests; these are essentially an asset-to-liability ratio (asset balance reflecting credit not mark-to-market losses). If that ratio falls below a certain level then that excess cash stream to the CLO equity gets diverted to pay down some of the debt until the ratio comes back into compliance. That is exactly what happened during 2009 when average annual cash distributions to US CLO equity holders fell to under 10 percent, but by 2011 that number was back above 20 percent. Indeed average CLO equity distributions between through the cycle of 2006-2011 have been close to 18 percent per annum.
Given this history we are seeing renewed interest in the product. Investors who held on throughout the crisis, whilst suffering mark-to-market volatility have generally enjoyed a very good ride. At 3iDM we are an active CLO manager in the US and Europe and believe it’s the most efficient way to enhance returns on an actively managed loan portfolio.
Andrew Bellis is a managing director and partner at 3i Debt Management.