- Critics bemoaned CLOs, a distant cousin of CDOs, as absorbing too much risky corporate debt.
- But the asset class defied skeptics, surviving the pandemic and soaring to record levels in 2021.
- Insider spoke with CLO investors, managers, and arrangers on what’s next.
- See more stories on Insider’s business page.
The coronavirus left a trail of market disruption. One victim still nursing its wounds is Cineworld.
In 2018, the movie-theater chain tapped the frothy leveraged-loan market to expand its footprint and acquire a rival, Regal Cinemas.
It was hard to blame it. Debt was cheap, terms were loose, and 2018 was a record year for the US box office, drawing $11.9 billion from blockbusters like “Black Panther” and “Incredibles 2.”
Investors saw the allure of Cineworld’s $4 billion loan offering, too, including over 100 collateralized loan obligations that bought into the deal. Better known as CLOs, they bundle slices of loans from dozens of low-rated companies into a single investment vehicle.
Regulators and media skeptics have for years criticized CLOs as gobbling up too much risky corporate debt, so when the coronavirus pandemic struck last year and brought swaths of US companies to their knees, it seemed a crisis ready-made to eviscerate CLOs.
As Cineworld and other companies sat empty for months and accumulated losses – Cineworld bled $1.6 billion in the first half of 2020 – their debt cratered, as did the CLOs that owned the debt.
But CLOs didn’t capsize.
They rode out the storm until markets recovered, buoyed by inherent structural protections, swift stimulus from the Federal Reserve, and promising vaccine news, and finished 2020 with impressive results. The savviest CLO managers – those who can actively trade in and out of positions – produced returns topping 20%.
Cineworld was teetering on the precipice of bankruptcy last November but is now on the mend, its battered credit rating rising as customers stream back into multiplexes and revenue returns. Last month, the company said it had received an extra $200 million injection from its existing lenders as theaters around the world slowly reopened.
The remarkable resilience of CLOs in 2020 won over skeptics in the investment world, and now the asset class – one of the few where credit investors like Apollo and PineBridge can reap 15%-plus returns – is on the cusp of a banner year in 2021 that could generate more than $4 billion in management fees.
Insider spoke with a dozen experts throughout the asset class, from the arrangers and managers of CLOs to the lawyers and investors who have been scooping up these securities.
The CLO assembly line came ‘screaming back’ in 2021
Japanese and US banks, alongside insurers, typically buy higher-rated tranches of a CLO. Asset managers or opportunistic hedge funds traditionally absorb the junk debt and equity. Holders of CLO equity earn the greatest returns but bear the brunt of losses if the loans default.
Some equity holders had a harrowing 2020. Roughly $45.6 billion in leveraged loans defaulted last year, nearly triple the amount in 2019, according to S&P Global.
A CLO can hold only a certain amount of junk debt. Once that threshold is passed, CLO managers reset their portfolios by dumping lower-rated loans. During times of duress, that can mean offloading the debt at fire-sale-like prices.
And just like in the crisis of 2007 and 2008, market players thought CLOs would implode corporate credit because of their high leverage and exposure to risky companies. CLOs have been compared to another securitized financing, collateralized debt obligations, and their role in the housing market’s collapse.
But after some concerns, CLOs came “screaming back” as market conditions improved and investors’ losses were not nearly as bad as some had predicted, said Michael Herzig, a managing director at First Eagle Investment Management.
Eugene Ferrer, a senior partner in Paul Hastings’ structured-credit group in New York, said the burst of CLO issuance was a result of a confluence of three factors: a robust supply of loans, acceptable AAA bond spreads, and eager participation from equity investors.
“All three of those are aligned this year. Usually there’s one that’s out of balance,” said Ferrer, whose firm leads the industry in advising CLO underwriters.
And despite the surfeit of low-rated loans in CLOs, investors are confident these securities will benefit from upgrades as the economy recovers further and companies honor their loans’ interest payments.
Fitch Ratings expects the rate of leveraged-loan defaults to be just 1.5% this year. It had peaked at more than 4% during 2020, according to S&P.
“You want to run so close to the line that you get chalk on your spikes,” said David Moffitt, a cohead of US credit management at the alternative investor Investcorp. “Managers are actively trading this stuff. Good managers sell early, never stand pat.”
Equity investors are in the driver’s seat of the CLO boom
Bank of America forecast that roughly $140 billion in new CLOs would be raised this year – a record amount, according to Refinitiv – and that some $220 billion in existing CLOs would be refinanced as managers take advantage of cheap spreads on their CLO liabilities.
While investors were burned by loans for pandemic-hit industries, a selling point for CLOs is their exposure to a variety of companies.
“Other than a systemic market downturn for leveraged credit, one would expect credit stress for single names or even sectors to be generally manageable within the CLO,” said Jerry DeVito, a managing director at the alternative-asset manager Owl Rock Capital.
That diversity means a manager’s skill in trading in and out of portfolios and structure terms can be a make-or-break differentiator among CLOs. Some managers saw an opportunity amid the mayhem last year, navigating their way to heady returns and burnishing their reputation with investors, according to Sean Solis, a partner at Milbank who specializes in providing counsel to CLO managers.
“The managers who really outperformed last year have seen a significant increase in demand, which makes it infinitely easier to print deals,” Solis said.
It’s also a tight-knit asset class. Many market veterans learned the trade at leveraged-finance shops like Credit Suisse or Deutsche Bank. And it’s a relationship-heavy business between investors and managers that not only sell their own CLOs but regularly invest in competitors’ vehicles.
“Because CLOs are actively managed, investors meet with CLO managers to do their diligence. Unlike other securitizations, you’re in an investor relationship for years,” said Laila Kollmorgen, a CLO portfolio manager at the asset manager PineBridge Investments.
That investor base is growing as CLOs near $1 trillion. An influx of entrants has also compressed fees. Managers and bank arrangers clamor for investors willing to absorb the riskier portions of a CLO and will often lower their take to satisfy equity buyers that seldom want their returns diminished.
“Equity investors are savvy. They’re driving the compression,” one lawyer familiar with the deals said. “Their returns are greater if banks’, lawyers’, and asset managers’ fees are lower.”
Typically, managers and arrangers will rake in 0.25% to 0.4% in fees, a dip from roughly 0.5% in previous cycles, market sources said.
Fees for existing CLOs are no better. Underwriters trying to break into the upper echelons of league tables will sacrifice fees to win business for CLOs that need to be reset or refinanced.
On the supply side for the raw materials in a CLO, there’s more to choose from.
CLOs are the biggest buyer of new leveraged loans, absorbing about two-thirds of supply. More than $430 billion in sponsor-backed leveraged loans were launched in the first half of 2021, almost twice the amount a year earlier, according to Refinitiv.
And big-ticket buyouts like the $34 billion acquisition of the medical supplier Medline by Blackstone, the Carlyle Group, and Hellman & Friedman will buoy 2021 volumes.
Private-equity sponsors, after all, are sitting on more than $1 trillion in dry powder. They’re signing megadeals to spend that and looking to the leveraged-loan market and its largest buyer to fund these acquisitions.
‘No one learns how to structure CLOs in school’
There’s also a push for new and experienced talent to tackle deal flow and relieve overworked analysts.
Two senior recruiters told Insider that demand for CLO talent had been intense in the years before the pandemic and had surged again late last year as money flocked to the asset class. As is the case elsewhere on Wall Street, much of the demand has been driven by the buy side, which has plundered the rosters of sell-side banks.
“From Q4 last year to now there has been nonstop demand,” a recruiter said.
Managers are also adding staff to reduce the number of companies their analysts follow – some track more than 90 at any given time – so that they can offer more insightful research, further stoking demand, one of the recruiters said.
Training new staffers, however, takes time. The asset class incorporates portfolio management and credit analysis while learning how to compile a vehicle with strict tests.
“You can’t just jump into the seat and become a CLO professional quickly,” said David Trepanier, the head of structured products at Bank of America. “No one learns how to structure CLOs in school.”
Sell-side professionals told Insider it could take more than a year to train staff on CLOs.
While all the CLO cogs are turning at a record pace, some believe that the wave of CLO resets and refinancing could cool by the middle of next year.
Much of this year’s issuance is pent-up demand for refinancing or resetting CLOs from 2018 to 2020 – and refinancing commands minuscule fees for arrangers compared with brand-new CLOs.
And once that supply of refinancings is taken care of, the boom in overall issuance is likely to abate.
“The record issuance absolutely needs to be put into context,” Trepanier said.