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Asset managers and financial advisors are increasingly discovering the advantages of alternative assets and introducing them into their client portfolios. There is a particular interest in niche strategies within the credit markets that offer enhanced sources of income and further diversify portfolio holdings to help preserve capital. One area of this alternative income space is the $1 trillion Collateralized Loan Obligations (CLO) market which had an unexpected comeback following the 2008-2009 Global Financial Crisis.
To learn more about this area of the alternative income market and its resurgence, we were introduced to Shiloh Bates, Partner & Chief Investment Officer of Flat Rock Global – a Jackson, Wyoming based, employee-owned, boutique credit manager. He recently released a new book, CLO Investing – With an Emphasis on CLO Equity & BB Notes which draws on his 20-year career in the CLO market. Through his book and our interview, he takes us on a journey to explore the opportunities and risks in the growing CLO market.
Hortz: Can you provide us with a quick overview of the CLO market? How did it originate and where are we as to its size, scope, and current market cycle?
Bates: CLOs are a $1 trillion subset of the broader $12 trillion structured credit fixed-income market. The first CLOs emerged in the 1990’s, roughly a decade after the first modern structured products appeared, and CLO issuance continually grew until the financial crisis in 2008. During the financial crisis, investor interest in all structured products dropped precipitously. Leveraged loan default rates peaked at 8% in 2009, prompting widespread concern about the health of underlying CLO portfolios. Despite these challenges, the vast majority of CLO’s not only survived the crisis but performed well. CLOs from the 2007 vintage, for example, delivered investors a 33% return on average, according to Nomura Securities.
After the financial crisis, we have seen new deals implement a number of changes designed to reduce risk to the CLO structure, including lower leverage and stricter collateral and rating tests. We generally refer to instruments issued after the financial crisis as “CLO 2.0,” with those issued before the GFC as “CLO 1.0.” Since then, the overall market has grown from a post-financial crisis trough of $263 billion to roughly $1 trillion today and CLO’s now represent the largest buyer of leveraged loans.
Hortz: What attracted you to these investment vehicles and led you to launch a firm that focuses on the CLO marketplace?
Bates: CLOs have proven resilient through numerous economic cycles, consistently generating strong returns. The CLO structure allows investors to get exposure to first-lien senior secured loans, but on a leveraged basis. By using securitization technology to divide the cash flows received from the pool of leveraged loans, various risk/return profiles can be achieved within the CLO structure. That flexibility to address client risk/reward needs was very appealing to us.
In the past, it has been hard for investors to gain direct access to the asset class – particularly the middle market CLOs that our strategies at Flat Rock emphasize. We launched our CLO funds to provide our investors access to these assets, which we believe can produce strong risk-adjusted returns in an area that has been difficult to gain exposure to in the past.
Hortz: What do you look for to determine the risks and opportunities for CLOs?
Bates: We use a robust internal framework for analyzing CLO’s that incorporates a variety of quantitative and qualitative factors, depending on which part of the capital stack we are targeting. For any analysis, this process involves a top-down assessment of the CLO, which can include factors like the manager’s historical track record and their ability to secure favorable debt execution, the relative strength of credit protection in legal documents, and a variety of diversification, leverage, and overcollateralization tests.
We also spend a lot of time focusing on a bottoms-up assessment, where we assess the underlying loan collateral behind each CLO. For example, we hold regular dialogues with our CLO managers and closely monitor developments at the individual loan level. All prospective CLO investments are modeled using Intex, a quantitative software program, where we analyze CLO performance across a range of different default and recovery scenarios. Our objective is to identify the CLO investments that offer attractive yields and adhere to our high threshold for capital preservation.
Hortz: Why was the creation of a CLO Equity index important in your efforts? How did you construct it?
Bates: Finding public information on the performance of CLO equity has historically been quite challenging. We created the Flat Rock CLO Equity Index in order to provide a public means by which to compare the returns of CLO equity to its market participants and other assets classes.
The index is constructed using the public information filed to the SEC by various market participants that invest in CLO equity. There are currently 5 separate firms with marks incorporated into the index and approximately 470 individual CLO Equity securities included. Results are calculated after the public filers publish their quarterly reports with the SEC.
Hortz: What is behind your reason to choose an interval fund structure for your mutual funds?
Bates: The interval fund structure enables us to provide our clients with the advantages of investing in illiquid assets, while balancing the need for periodic liquidity. All three of our funds deploy capital with a multi-year investment horizon, pay monthly cash distributions, and benefit from the illiquidity premium on middle-market private credit assets.
While some of our competitors have embraced the traditional GP/LP structure which can include a lockup period of up to 10 years, we think it is important to provide our clients with a greater degree of flexibility, which the 40 Act interval structure affords. We offer liquidity on a quarterly basis, in the form of share repurchases for up to 5% of each fund’s NAV, with no upfront or exit fees on invested capital.
Hortz: Why did you decide to offer three different fund strategies to this investment space? What are the differences between them?
Bates: We offer three funds with distinct yet complimentary strategies, all of which provide diversified exposure to middle-market private credit and monthly distributions but vary in terms of target return and risk profile.
We launched the Flat Rock Core Income Fund (CORFX) in July 2017, which focuses on direct lending to middle-market firms and provides exposure to a diversified pool of over 1,250 senior secured floating-rate loans. We believe CORFX compares favorably to industry benchmarks like the Bloomberg Bond Aggregate, for example.
We launched the Flat Rock Opportunity Fund (FROPX), in July 2018. This fund focuses on middle-market and broadly syndicated CLO equity, an asset class where we believe we can generate significant alpha and provide equity-like returns with low correlation to other markets and approximately one third the volatility of the S&P 500. FROPX offers high cash distributions, diversified exposure to over 2,200 senior secured loans, and a unique stabilizing feature for periods of financial stress that we call “the self-healing mechanism” of CLO equity.
The Flat Rock Enhanced Income Fund (FRBBX) focuses on middle-market CLO BB notes, usually the most junior tranche of CLO debt. This fund was launched in January 2023 and provides exposure to over 1,800 first-lien middle-market loans, but with added protection in the form of an equity buffer to absorb first losses on the loan portfolio. We believe FRBBX compares favorably against BDCs and high yield bonds.
Hortz: Please tell us about your book. Who did you write it for and how can it help investors in this unique area of the market?
Bates: The target audience for the book is anyone interested in the CLO market - both financial advisors and investors. It is the only book specifically on CLOs. The industry has long needed a clear, thorough explanation of CLOs and their importance to markets.
Hortz: What are your thoughts on how investment managers and asset allocators can best deploy CLO funds in their portfolio construction for client portfolios?
Bates: We believe CLO equity is an attractive replacement for the S&P 500, private equity, or real estate funds. Middle-market BBs are an attractive substitute for high yield bonds, BDCs, or private credit owned in a GP/LP Fund.
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