CLO debt instruments are historically resilient investments proven to weather economic and credit cycles with near negligible default risk, offering enhanced risk-adjusted returns to similarly rated debt instruments. But market stress, volatility and dislocations in risk assets can produce broad swings in valuations across the capital stack, most notably in CLO equity.
CLO equity returns rely on cash distributions paid after senior fees, and administration fees, debt-servicing and subordinate fees, and can ranging anywhere from 10-20% depending on deal structure, vintage, manager and callability, among other factors. During market turmoil, CLO equity may suffer mark-to-market volatility, but because overall returns rely on cash distributions, versus capital appreciation, they are more robust than market valuations may suggest. They are attractive alternatives to other equity investments that rely on growth, versus income. Still, we believe manager selection and due diligence is key, much of which is achieved via owning control equity.
Control-equity ownership confers a number of benefits to potential investors and is an important variable when considering CLO equity investments.
Manager selection
Different managers demonstrate varying methods of portfolio management. Where some rely on top-down quantitative analysis, others prefer bottom-up credit selection and fundamental analysis. Manager due-diligence ensures alignment of investment strategies and underlying credit selection processes. As an established market player, Fair Oaks can ensure investment strategies align with our internal credit selection processes.
Long-term relationship with managers, open dialogue and active monitoring of portfolio imbues a degree of influence in the portfolio composition (negative selection, etc), further aligning interests.
Optimise calls, refinancings and resets
Market conditions permitting, ie when loan prices are rising, calling a deal and liquidating at such time when market value of collateral exceeds par value of outstanding debt plus accrued interest can be advantageous to CLO equity. Likewise, timing potential refinancings (redeeming outstanding tranches to re-issue at lower spreads thus reducing overall funding costs), and resets (similar to refis but can involve extending re-investment period, non-call period, increase/decrease deal size and/or fees), is at the option of the control equity holder. Control-equity minimises administrative costs and time that would otherwise be required to gather consensus among minority shareholders with potentially conflicting agendas or outlooks.
Structural improvements
Control equity means being closely involved with managers at the arranging phase to improve and ensure equity-holder friendly terms and conditions. This can translate into a number of improvements including potentially lower-OID at timing of syndication, and equity-friendly documentation.
Lower fees
By minimising fees cost savings can be efficiently deployed to reduce the temptation to ‘chase alpha’ when credit and/or market conditions deteriorate and yields widen. As above, retaining a preference for top-tier managers and aligned portfolios aims to minimise defaults, cash deferrals and ultimately, equity returns.
Minority shareholders
Control equity enhances the closed-end financing structure of the equity, minimising capital outflows and potential conflicts with minority shareholders.
ESG
Whilst CLOs lag other risk-asset classes integrating ESG investment criteria, mainly equity, control-equity owners have the ability to improve disclosure requirements and improve and increase ESG inclusion and flow of information. Working hand-in-hand with both CLO managers and borrowers can influence and enhance ESG disclosures, be it through negative screening or more rigorous inclusion of climate-solution oriented investments.
Fair Oaks’ primary ESG-eligibility criteria and initiatives for loans and CLOs involves negative screening environmentally and socially damaging activities (oil/sands/coal extraction, mining, hazardous chemicals production, weapons/firearms manufacturing, tobacco trade, predatory lending).
Since mid-2019, FO have made inclusion of ESG criteria a requirement in our CLO control equity investments/resets and now 65% of our control equity investments are subject to ESG-investment restrictions.