Collateralised loan obligations (CLO)
Date: 13. October 2017
- Asset Managers
- Institutional Investors
“Annual double-digit returns are possible in the long term”
Collateralised loan obligations (CLO) combine and securitise corporate loans. The fact that these products fell into disrepute during the financial crisis can be attributed to a lack of understanding on the part of capital markets, CLO expert Daniel Scharpenack of CreditValue-Partners says in an interview Universal-Investment. He sees structured bonds as an extremely attractive addition to the portfolios of institutional investors.
Universal Investment: Mr Scharpenack, what returns are achievable with CLO funds?
Scharpenack: Based on a conservative estimate, we expect a return of more than 10 percent per year from our pure CLO equity fund. In the past, our return was more like double that percentage figure.
Universal Investment: How much risk is involved?
Scharpenack: CLO equities are equity-like investments with all the potential for upward and downward movements, depending on whether the economy is strong or weak. However, volatility and performance are not necessarily correlated. CLO investments are also generally made with leverage. If an investor, like us, also invests in the lower tranches, the leverage is effectively about tenfold.
Universal Investment: In the course of the financial crisis, it was said that CLOs were used to place risky loans as safe investments in the capital market. Is this no longer a cause for concern?
Scharpenack: It was never a cause for concern. CLOs are first-rate collateralised loans for high-yield companies, usually from the United States. Due to the collateralisation, the investor has access to the assets if a company runs into difficulties. Even during the crisis, 99.9 percent of all our outstanding CLOs were paid back. Back then, the only instruments that became worthless were subprime mortgages, commercial mortgage-backed securities (CMBS) and synthetic securitisations, where nobody knew what was hidden in them. By contrast, CLOs are collateralised with real existing loans, and even if there is a default, the rules according to Chapter 11 of the US Bankruptcy Code are very favourable for creditors. Many investors didn’t understand this structure, which is why CLOs were also punished during the crisis. The over-collateralisation of CLOs has become more precise since the financial crisis, and the ratings agencies are monitoring them much more closely. Furthermore, CLO managers have had to demonstrate their own share of risk since 2016, when the Risk Retention Rule went into effect.
In order to be successful, you need very good relationships.
Universal Investment: Who invests in CLOs?
Scharpenack: Due to the size and tranches alone, CLOs are only suitable to institutional investors, such as pension funds and family offices, but also for hedge funds. Banks and insurers also invest in the upper tranches, depending on their regulatory requirements.
Universal Investment: Apart from the return they generate, why are CLOs interesting as part of an investment mix?
Scharpenack: The collateral security is much better than it is for traditional corporate bonds. The investor is much higher in the capital structure. If the equity market rises or falls a bit, it doesn’t make any difference to CLOs because the investor, in principle, has a credit portfolio. The default rates can certainly rise depending on economic developments, but experience has shown that the investor still gets back between 70 percent and 80 percent of his investment, on average, due to the first-rate collateralisation – even if there are defaults.
Universal Investment: What investment horizon and minimum investment amounts should investors allow for?
Scharpenack: The investment horizon for an investment in the lowest CLO tranches should be seven to 10 years to make it worthwhile. For the upper tranches, four or five years would be feasible because the possibility of an early repayment exists in this case. Due to the illiquidity, we recommend that investors consider CLOs only as an addition to their portfolio mix and limit their CLO investment to no more than 5 percent of all funds. If you want to build up a solid CLO fund, you also need a certain size for diversification. From our experience, 25 million to 30 million euros is the minimum for a fund that is supposed to invest in the equity tranches of CLOs. A fund for debt tranches can be somewhat smaller.
Universal Investment: What access paths do investors use for CLO investments?
Scharpenack: Special AIFs are a possibility. Some of our clients have also launched a hedge fund. In any event, it makes no sense to include CLOs as a direct investment in your own portfolio. It is better to launch a fund in Germany or Luxembourg.
Universal Investment: Why do you see a favourable entry point for CLOs right now, in particular?
Scharpenack: The spreads are still very attractive, while the valuations are more attractive than those on some high-yield bonds and certainly better than on investment-grade bonds. In a BBB- tranche, you are currently getting Libor plus about 350 basis points on CLOs. In addition, a floor is usually included, so the return can’t become negative. CLO portfolios also consist of many, small-weighted corporate loans so that industry- or company-related event risks are minimised by the enormous diversification.
Universal-Investment: Where do you see the most attractive CLO markets regionally?
Scharpenack: In the US, the loan market is about 10 times bigger than it is in Europe, it is much more transparent and liquid there, and due to Chapter 11 the loss given defaults turn out to be lower than in Europe in the long term. For this reason, we quite clearly favour US loans for our clients.
Universal Investment: Could you please explain your investment philosophy?
Scharpenack: It is based on several pillars. We seek the best active CLO managers and we pay attention to good CLO vintages as well as optimal market timing. We also construct our portfolios very carefully and slowly over several years – in a similar way to how it is done with private equity investments – and we draw on client funds when we see good opportunities. History has shown that it is risky to invest everything in one CLO issue and only one manager in one fell swoop. It also produces cluster risks.
Universal Investment: How do you find the best CLO managers?
Scharpenack: We follow the track record of all managers very closely. Over the course of the past 20 years, we have built up good personal relationships with many managers and developed a network, so we know who performs well – and who doesn’t.
Universal Investment: What does CVP do differently from other credit managers?
Scharpenack: The slow building of the portfolio, this private equity-like approach. And, of course, we have a long history – I already began investing in securitised instruments back in 1999 and have since bought more than 1 billion euros worth of CLO equities. We also provided the seed capital of many CLO managers who previously worked at banks or insurance companies and then became self-employed. The CLO market is characterised by relationships. In order to be successful, you need very good relationships with the important players.