The US CLO market is holding up well with new issuance expected to reach USD135 billion in 2019. This has prompted TowerBrook Capital Partners to set up a new platform, CAVU, with LibreMax Capital. And with PineBridge Investments suggesting there is significant relative value in CLOs, it would seem to be a good time to get the CAVU platform off the ground.
The supply dynamics for collateralized loan obligation (CLO) funds – the biggest buyers of leveraged loans – are set to remain favourable for 2019 in the US, with banks forecasting that approximately USD135 billion of CLO new issuance could be seen.
This is good news for CLO managers and investors alike. Indeed, the long-term economics of CLOs, which aim to deliver uncorrelated returns over a five- to seven-year period, on average, and the opportunity to harvest capital gains as well as current yield, are piquing the interest of private equity groups.
This is evidenced by the recent announcement that TowerBrook Capital Partners LP, a multi-billion dollar PE group, have joined forces with New York-based LibreMax Capital, a structured credit specialist asset manager established by Greg Lippmann, to create CAVU Investment Partners.
CAVU will invest in the equity tranches of new issue CLOs managed by Trimaran Advisors, LLC, the CLO management platform of LibreMax. David Moffitt, Head of Tactical Opportunity Investing and CLO Management at LibreMax and President of Trimaran, will serve as President of CAVU.
TowerBrook’s equity commitment will allow the Trimaran team to build out further CLOs, alongside the six it currently manages with an aggregate AUM of USD3 billion, and give TowerBrook an important foothold in the US CLO marketplace.
The investment was made through the TowerBrook Structured Opportunities Fund (TSO), which was established in 2015 to back great management teams and businesses at the inflection point of growth and change where traditional control-oriented attributes may not apply.
“CAVU is an aviation acronym for Ceiling and Visibility Unlimited,” Moffitt tells Hedgeweek. “I’m a commercial pilot and enjoy flying planes in my spare time. CAVU is meant to imply that there are clear blue skies ahead. When you’re a pilot and you say ‘everything’s CAVU’, that means things look great.”
Prior to joining LibreMax, Moffitt was Head of Fixed Income Asset Management at JC Flowers & Co. LLC. During his time at JC Flowers, Moffitt noticed that the asset management industry, specifically structured credit, was evolving towards a private equity model; meaning that the liquidity required to generate alpha is multi-year and not a short-term investment play.
The remit Moffitt was given when he joined LibreMax was to build out Tactical Opportunity Investing – focusing on longer-term, PE-style vehicles that can sustain periods of illiquidity and periods of changes in market value by internalizing volatility, rather than avoiding it.
“When you can do that with longer-term liquidity, you’re able to go through cycles, take advantage of and ride out dislocation periods,” explains Moffitt.
“We bought the Trimaran platform last year and an important part of our investment thesis was to attract dedicated PE-style money to come alongside that investment. We had pre-existing relationships with some of the principals at Towerbrook for many years and believed the firm would be an excellent partner.”
When a CLO is created it will typically comprise hundreds of corporate floating rate loans. The debt issued by a CLO is divided into separate tranches, each of which has a different risk/return profile based on its priority of claim on the cash flows produced by the underlying loan pool. The equity tranche sits at the bottom of the capital structure and is unrated. As such, it is the highest risk tranche, compared to the AAA debt tranche, and represents a claim on all excess cash flows once the obligations for each debt tranche have been met.
The CAVU platform will invest only in the equity tranches of new issuances.
One of the key characteristics of how Trimaran operates is that it will do a lot of the heavy lifting to supplement the underwriters’ syndication efforts, prior to a new issue.
Moffitt refers to this strategy as “capital markets-light”.
“We hope to pre-syndicate most of our new issue transactions, thereby creating greater certainty of execution and the ability to execute when the market offers favorable asset or liability pricing.
“The knock-on effect of that, we hope, is that the economics of our transactions will be increasingly superior to our cohorts.
“Our goal is to prosecute a capital markets-light strategy that gives us an edge in terms of execution, velocity and certainty of deal completion,” states Moffitt.
For investors, there are two components to consider when investing in CLOs: embedded optionality and current yield.
The current yield is the net interest margin the transaction yields at execution. In short, it is the difference between the cost of funds and the yield on the assets. In most transactions, current yield is somewhere between 130 and 150 basis points.
Embedded optionality is based on the notion that you have term liabilities and you don’t have to mark your assets to market. The value of assets can fluctuate greatly but for purposes of a CLO they are all counted as if they were par assets. This means during periods of dislocation there is a lot of optionality where a CLO manager could go out and buy 85 and 90 dollar loans, which will ultimately pull to par.
In that way, the CLO generates not only current yield but capital appreciation as well, during the reinvestment period.
“There are natural limitations (ratings agency and deal structure) on the amount of CCC-rated assets you can have in a transaction,” explains Moffitt, when discussing the composition of a CLO. “If you exceed that, the transaction can start diverting cash away from the equity. That’s typically somewhere between 7 and 8 per cent. It’s important to balance your portfolio in terms of opportunistic CCC buys versus the potential for downgrades, so that you avoid any cash diversion issues.
“We will opportunistically buy some CCC assets which are currently discounted, but which we believe have the potential for capital appreciation; maybe not pull to par, but perhaps go from 60 to 80 cents on the dollar. That strategy is balanced against steering clear of the cash diversion that can occur with excessive CCC exposure.”
CCC-rated assets would, in this context, be referred to as ‘par building trades’.
PineBridge Investments is a prominent CLO manager in the US. The firm currently manages USD59.7 billion in fixed income assets (as at 31st March, 2019). Since 1999, it has issued 27 CLOs in the US and Europe with a par value of more than USD10 billion.
Laila Kollmorgen is Managing Director, Portfolio Manager, PineBridge Investments, Los Angeles.
Her assessment of the new issuance pipeline is that transactions that have come to market in Q2 2019 have to contend with a weighted-average cost of liabilities in the 190 to 210 basis points (bps) range.
“That can be challenging for CLO managers when constructing portfolios given the lean primary loan pipeline and few opportunities to buy loans with a coupon in the LIBOR+400-450bps range,” says Kollmorgen. “The difficulty is for CLO managers to create a CLO given the outstanding coupons/loans in the market in combination with low primary issuance of loans.
“As a result, until the weighted-average cost of liabilities declines, we anticipate CLO issuance to decline in Q2 2019 to USD25 billion to USD30 billion for the quarter; down from USD34.7 billion observed in Q1 2019.”
In Kollmorgen’s view, CLO performance has been very good, generally speaking.
“However, we do believe that managers have significant influence in credit selection and risk mitigation through selling at-risk loans. Not all investors fully understand the merits of the asset class, which is why CLOs trade at such a pick-up to comparatively rated investment grade and high yield bonds,” she adds.
In Q4 2018, managers who were still in the process of ramping up a CLO or who had an active trading style took advantage of the sell-off in the loan market and added loans that were trading at a discount, according to Kollmorgen, but as she explains: “The current market continues to offer some opportunities, but unless a bigger sell-off occurs, we do not see a lot of opportunities for CLO managers to build par.”
One key development last year, which should prove beneficial to active managers, related to the risk retention rule, which required CLO managers to retain 5 per cent of each CLO, either by investing in approximately half of the equity tranche (a “horizontal slice”) or by investing in 5 per cent of each CLO tranche (a “vertical strip”).
Last year, on 9 February, 2018, the United States Court of Appeals for the District of Columbia Circuit (the Circuit Court) reversed a December 2016 decision by the DC District Court that the risk retention rules promulgated under section 941 of the Dodd-Frank Act could not be applied to open market CLO managers.
Moffit says that without the requirements of risk retention, “we can recycle our invested capital. Assuming we buy 100 per cent of our new issue capacity, but then opportunistically sell down to 51 per cent, we can recycle that capital and still maintain a controlling position in each transaction.”
When asked what considerations PineBridge prioritises when investing in CLOs, Kollmorgen says that firstly, it comes down to the manager’s history of managing CLOs through various crises, and secondly, the portfolio composition:
“At PineBridge, we map the loans underlying a CLO through our internal system, which provides us with significant transparency to the CLO. This allows us to understand potential risks in the portfolio. We are also able to apply our 20-year experience of issuing and managing CLOs to CLO tranche portfolio construction through our understanding of how a CLO is managed and the underlying leveraged loans backing that CLO.”
With the rally in investment grade and high yield option-adjusted spreads year-to-date and a more benign expectation of defaults, “we actually see significant relative value in CLOs given the lag in spread tightening,” adds Kollmorgen.
Moffitt says that the goal, going forward is to take a measured, thoughtful approach to growing the CAVU platform.
“We aspire to be a top quartile performing CLO manager, and are hopeful that by year-end, the deals we’ve completed will evidence movement in that direction,” concludes Moffitt.
