Investing In CLOs - Ares Management
Investing in CLOsSpring / Summer 2020 Key Considerations for Today’s MarketThe fundamentals of CLO investing arelargely unchanged since the earliestdays of the market. Analysts must makejudgments about the three keycomponents of any CLO: portfolio,structure and manager. Each of thesecomponents presents a complex mix ofrisk and value that should be evaluatedas an integrated whole. The challengesinherent in making such holisticjudgments can be daunting in the bestof circumstances given the complexitiesof loan portfolios, CLO structures andlegal documents, in the context of amarket defined by sudden shifts in riskand relative value.Keith AshtonPortfolio ManagerHEADQUARTERSAres Management Corporation2000 Avenue of the Stars12th FloorLos Angeles, CA 90067www.aresmgmt.comCompany Locations 1U.S. Los Angeles, New York, Chicago, Boston,Atlanta, Washington D.C., Dallas, San FranciscoEurope/Middle East London, Paris, Frankfurt,Stockholm, Luxembourg, DubaiAsia/Australia Shanghai, Hong Kong, Mumbai,SydneyPlease see the Endnotes and Legal Notice andDisclaimers beginning on page 21.1At Ares, we rely on a rigorousinvestment process that we have honedover nearly twenty years of CLOinvesting experience. Our processestablishes an analytical frameworkwithin which we maintain a consistentstandard while still allowing forsubjectivity and our experience in orderto adapt to different strategies andmarket conditions.Investment processes are often describedas a series of steps, or diagrammed asflow charts or decision trees. At the heartof our investment process are hundredsof questions that we ask and answer –questions that are intended to reveal riskand value.To help us answer these, and hundreds ofother questions, we rely on a proprietaryset of analytical tools and systems, calledINsight. This technology platform wasdesigned and built by our investmentteam specifically to invest in structuredcredit. Without such resources, we wouldfind investing in the CLO market aformidable challenge given the widerange of risks present in today’s market.This paper is intended to provide awindow into our investment process. Wehighlight what we believe are some of thekey questions that investors should beasking today as they participate in thisestablished, yet evolving, asset class. Market Insights
Table of ContentsIntroduction . 2Questions about CLO Portfolios . 2Questions about CLO Structures . 6Questions about CLO Managers .10Factors Related to CLO Supply . 13Amortization and New Issue Dynamics . 15CLO Models . 15Key Issues in European CLOs . 16IntroductionThe fundamentals of CLO investing are largely unchanged sincethe earliest days of the market. Analysts must still makejudgments about the three key components of any CLO:portfolio, structure and manager. Each of these componentspresents a complex mix of risk and value that must then beevaluated holistically – in aggregate.The challenges inherent in making such judgments can bedaunting. Each CLO references a diversified loan portfoliotypically consisting of several hundred individual positions.Each loan portfolio itself comprises a unique subset of theinvestible loan universe. After investing in as few as fifteen CLOsecurities, an investor may find himself exposed to well over1,000 unique corporate credits of varying quality and value.Each CLO is designed (structured) largely according to ratingagency criteria that stipulate minimum credit enhancementlevels necessary to achieve target debt ratings (e.g. AAA, AA, A,BBB, BB, B). Rating agency criteria adapt (somewhat) to desiredportfolio characteristics such that a more aggressive loanportfolio is likely to require higher levels of credit enhancementto achieve target tranche ratings. Certain structural featurescan also be a matter of negotiation with investors and themanager alike each seeking terms that may enhance the qualityor value of their position. Consequently, no two CLOs areidentical. While many of the differences may seem trivial, somecan become critical factors in certain scenarios.Each CLO is managed by a professional credit manager who notonly constructs the initial loan portfolio but also actively tradesthe portfolio throughout the CLO’s life. The manager makesmany other decisions that can affect the quality and2performance of the portfolio over time. In our view, CLOmanagers differ markedly from one another in terms of theircredit selectivity, investment process and competency indifferent market environments. Most CLO managers today alsohave a track record of performance through the recent defaultcycle. Their performance reveals not only skill in managingcredit, but also competency in managing the CLO structureitself. Consequently, most managers have earned reputationsamong CLO investors, and can thereby be perceived differentlyin the market.As CLO investors, our job is to make risk and value judgmentsabout a given CLO’s portfolio, structure and manager, includinga judgment as to how these three components aggregate toaffect the risk and value of a given CLO investment. Suchjudgments rely heavily on our team’s experience and skill insynthesizing volumes of data and other information into aninvestment thesis that can withstand the scrutiny of ourinvestment committee.At Ares, we rely on a rigorous investment process that we havehoned over more than sixteen years of CLO investingexperience. This process establishes an analytical frameworkwithin which we can maintain a consistent standard, whileallowing us to adapt our analysis based on our qualitative viewson different investment strategies and market conditions.At the heart of our investment process are hundreds ofquestions that we ask and answer – questions that are intendedto reveal risk and value. To help us answer these, and hundredsof other questions, we rely on a proprietary set of tools andsystems, called INsight. This technology platform was designedand built by our investment team specifically to invest instructured credit. Without such resources, we would findinvesting in the CLO market a daunting challenge given the widerange of risks present in today’s market.What follows is an overview of what we consider the keyquestions that we are asking today as CLO investors.Questions about CLO PortfoliosFor CLOs to generate equity returns, the underlying loanportfolio must generate interest income (called excess spread)that is meaningfully greater than the amount required to pay alldebt tranche interest payments and fund expenses (includingmanagement fees). Excess spread is an inherent feature of CLOstructures as the average cost of debt capital in the CLO liabilitystructure is lower than the average interest coupon earned onthe underlying loan portfolio. This is what is often referred to Market Insights
as “CLO arbitrage.” Figure 1 illustrates this arbitrage conditionin terms of an income statement.The quality of the arbitrage (i.e. the volume of excess spread)will vary during the life of the CLO. This is largely due to changesin the underlying loan portfolio over time. While CLO liabilitiesare set (fixed) for the life of the CLO, the assets are in acontinual state of flux. Loans prepay, the CLO manager activelytrades the loan portfolio, and market conditions change suchthat the CLO’s loan portfolio may generate materially higher orlower interest income at different times.One of the key objectives of the CLO manager is to manage thequality of the arbitrage. This has an obvious benefit to equityinvestors as they may expect a more consistent stream ofquarterly distributions. Debt investors also care deeply aboutthe quality of the arbitrage. Debt investors can benefit from the‘trapping’ of excess spread as the CLO structure works toprotect (and replenish) credit enhancement levels in times ofstress.CLO managers can enhance the arbitrage by investing in loansthat have higher interest coupons. Subject to certaininvestment guidelines and constraints, managers generallyhave latitude to construct and manage the CLO’s loan portfoliobased on their preferences. Higher interest coupons aretypically associated with riskier loans; consequently, managersmust weigh the trade-off between enhancing the arbitrage(current distribution rates to equity) and the potential fordefaults and losses inherent in riskier credits.Each manager assesses this trade-off a little differently. Eachworks to capture value in the loan market through allocationsto a range of credit risks. This results in a relatively wide rangeof CLO loan portfolio credit profiles, with some reflecting amore aggressive posture in credit and others a moreconservative posture.One of the challenges facing CLO managers today stems fromthe strong investor demand for loans. Whether in the form ofretail funds or institutional allocations, the loan market hasexperienced – and continues to experience – a tremendousvolume of capital inflows. Consequently, loan spreads havecontracted, putting pressure on the quality of CLO arbitrage.We have found that most CLO managers respond in predictableways, by reassessing and refining their credit strategies. ManyCLO managers have found value in second lien loans, high yieldbonds, smaller cap credits, more leveraged credits, cyclical orout-of-favor sectors. Other CLO managers have found value in Market Insightsprimary markets, or among non-US credits. In our view, everyCLO manager feels at least some pressure to stretch a little, tobecome more creative, or to dig a little deeper into the marketto protect the arbitrage.Question 1: Where is the stretch?A common topic found within CLO research articles is thedegree to which CLOs tend to own many of the same loans inother words, credit overlap. Credit overlap is a useful analysisin the sense that it suggests a degree of ‘beta’ within CLOportfolios as an asset class. Overlap tends to be very high withinthe 2.0 CLOs of a given manager, typically over 90%. Howeveroverlap drops to around 50% when comparing loan portfoliosacross managers. That is, when comparing two CLOs from twodifferent managers, only about half of the credits will be held incommon. Finally, when comparing a given CLO’s loan portfolioto a larger number of other CLOs (by different managers), onetypically finds only about 10-20% of the credits are ‘unique’ tothat CLO. 2While high levels of overlap are important indicators ofcorrelation (real correlation, not merely statistical), nonoverlapping credits can be important indicators of what we call“the stretch” – the allocation to credits that represents a higherlevel of risk in the portfolio, and which tend to contributedisproportionately to the arbitrage.One way to analyze the quality of a CLO’s arbitrage is toevaluate each underlying asset’s contribution to equitydistributions. What we typically find is that anywhere from 10%to 30% of a typical 2.0 CLO loan portfolio contributes very littleto equity distributions – the spread of these assets tends to justbarely cover the CLO’s inherent costs. The manager in manycases is compelled to own such assets to meet portfolio qualitycriteria such as a weighted average risk factor (WARF), S&PRecovery Rating, and diversity requirements. The largest shareof loan assets, typically 50% to 75%, contributes meaningfullyto the arbitrage but are insufficient to produce acceptableequity returns. 3In every CLO, some minor portion of the assets makes up thedifference and then some. In fact, in most CLOs we haveanalyzed with this methodology, more than 40% of the equitydistributions can be attributed to only 10%-20% of the loanassets. These tend to be the riskier credits with the highestspreads; they also tend to be the least overlapping credits.These represent ‘the stretch.’3
Put another way, the performance of this relatively small subsetof credits has a disproportionate impact on the performanceand quality of the CLO. Consequently, in our view, one can learna great deal about the manager’s credit strategies and thequality of a CLO’s arbitrage by focusing on ‘the stretch.’about it. Few managers, even those with better foresight, couldarticulate a strategy for managing around this constraint. Thosemanagers who studied the issue seriously and developed astrategy for dealing with it strongly outperformed those whodid not.3Question 2: Has there been a shift in credit strategyor discipline?In our experience, credit strategies tend to drift over time inmost CLOs for three reasons: (a) they are not well defined orarticulated; (b) there is a lack of follow-through or execution; or(c) clear goals or objectives are not established. Monitoring thedrift, and its causes, is a key element to CLO surveillance as itnot only reveals a changing risk profile but may also reveal alack of focus or discipline by the manager.Credit strategies either shift or lack definition more often thanmany CLO managers are willing to admit. In our experience, itis fairly rare to find a manager who can not only articulate aclear strategy for investing within a CLO, but can then alsoexecute on that strategy consistently over time. That isn’t tosuggest that there’s a lack of credit discipline or process,however. Most investment processes among CLO managers canbe articulated and described in great detail, and are followed asa matter of tradition (good or bad).Strategy is a different matter altogether and speaks to theoverall challenges and goals of a given CLO. An example of astrategy may be the observation that a given CLO has beennegatively affected by loan refinancings or repricings, resultingin a weaker arbitrage and reduced distributions to equity. Amanager’s credit strategy for such a CLO might include a planto replenish spread in the portfolio through rebalancing andtrading, or even changing the risk profile of the loan portfolio.While the manager’s investment process produces variousinvestment ideas, the credit strategy should identify which ofthese investment ideas are best suited to improve thearbitrage.In reality, most CLO managers tend to focus their time onassessing credit and give short shrift to fund strategy untilthere’s a real problem confronting them that must beaddressed. There is perhaps no better example of thisphenomenon than to observe managers’ behavior in responseto Weighted Average Life (WAL) Test pressures among 1.0 CLOsbetween 2011 and 2013.Many factors contributed to the erosion of WAL Test cushionsin 1.0 CLOs, all of them identifiable. Notwithstanding, WAL Testcushions were almost universally ignored, despite being one ofthe most easily anticipated and most significant constraints thatCLO managers faced as 1.0 CLOs neared the end of theirreinvestment period. Typically buried on the third or fourthpage of a trustee report, the WAL test simply wasn’t on theradar for the vast majority of CLO managers until it wassuddenly the most significant constraint on their ability toinvest at which point it was almost too late to do anything4While we believe a manager’s credit strategy should be animportant consideration for both debt and equity investorsalike, we find few CLO investors are even thinking about CLOmanagers, CLO portfolios and risk in these terms. One likelyexplanation is that identifying and tracking strategy is difficultin the best of circumstances, and therefore may be too costly(resources, time) for most CLO investors. However, we thinkthis is one area where managers can be effectivelydifferentiated. To the extent that most investors in the markethave difficulty making such differentiations, it creates anopportunity for those who can to add value.Question 3: How big are the tails?Many factors combine within a CLO to create an unevendistribution of risk. Structural features can spring (or not) toshift risk and value within the CLO; credit risk is distributedunevenly across CLO tranches; and loan portfolios (as describedabove) contain a range of risks, not all of which are quantifiablein terms of ratings, spreads and recoveries.One of the biggest challenges facing CLO investors is how toevaluate this distribution of risk within a given CLO, and thenacross various CLOs. The problem is complicated by the factthat the CLO market presents investors with a number of tradeoffs to evaluate. For example, a CLO analyst has to determinehow much more credit enhancement is sufficient to offset therisk of a more aggressive portfolio. We employ verysophisticated quantitative methods to systematically evaluate“risk adjusted” tranche value. These methods consist of highlyeffective tools of differentiation, such as risk ranking.However, such an evaluation also needs to consider qualitativefactors or judgments about concentrations of risk that somequantitative methodologies can understate. Inevitably, in ourexperience, this becomes a matter of evaluating tail risks. Tail Market Insights
risks, which include both risk concentrations and sudden shiftsin credit correlation, require a careful, rigorous approach toidentify, quantify and monitor.Many investors assume that as long as concentrations, or tailrisks, do not present a threat to principal (i.e. there is sufficientcredit enhancement to protect their investment from loss),then there is little to worry about. From a pure ‘principal lossanalysis’ perspective, perhaps this is an appropriate conclusion.However, the development of such risks does pose a threat tomarket price, liquidity and possibly also ratings. Within anactively-managed portfolio, especially one focused onproducing both absolute and total returns, tail risks shouldnever be ignored.Question 4: How does credit risk compare to other CLOs?To many CLO investors, one of the most surprisingdevelopments during the financial crisis was the degree towhich CLO portfolios began to differ from one another. Beforethe crisis, virtually all CLO loan portfolios were free fromdefaulted or distressed credits. The average market price ofCLO loan portfolios was close to par, and there was very littledistinction from one CLO to another in terms of the averagemarket price of the underlying loan portfolio. In fact, one mayhave reasonably concluded that CLO portfolios were largelyindistinguishable from one other, an inference many investorsmade if CLO tranche spreads during that period of time are anyindication. There was very little, if any, difference in debtspreads across the entire market during the first half of 2007,evidence perhaps that the market saw little, if any, differencein risk among tranches of a comparable rating.3The onset of the market cycle created a completely differentpicture. Investors began to see just how different each CLOportfolio really was. We observed enormous ranges in exposureto different indicators of risk. Exposures to triple-C rated assetsranged from under 5% to over 25%. Average market prices ofloan portfolios ranged from over 95 to below 65. Exposure todistressed or defaulted credits ranged from under 10% to over30%.2 These wide ranges shattered the perception that CLOloan portfolios were largely homogeneous in terms of risk.Before the crisis, all of the real differences in credit risk werehidden from view, buried within the financial statements ofeach credit facility.One of the most important functions of a CLO analyst is todifferentiate the credit quality of a given CLO portfolio on bothan absolute and relative basis. Doing so requires an integrated Market Insightsapproach that synthetizes both fundamental credit and marketinformation.We believe there are significant differences in credit qualityacross CLO portfolios today – every bit as significant as existedwithin CLO por
investing in the CLO market a daunting challenge given the wide range of risks present in today’s market. What follows is an overview of what we consider the key questions that we are asking today as CLO investors. Questions about CLO Portfolios . For CLOs to generate equity returns, the underlying loan
Commercial real estate collateralized loan obligations, or “CRE-CLOs,” are growing in . Cathy Cunningham, CREFC 2018: Say Hello to CLOs, Commercial Observer (Jan. 11, 2018), available at . Commercial Mortgage Alert (Feb. 9, 2018), at 1. [3] Special rules known as the taxable mortgage pool rules treat CRE-CLOs as corporations by statute .
Minimal Rewiring: Efficient Live Expansion for Clos Data Center Networks Shizhen Zhao, Rui Wang, Junlan Zhou, Joon Ong, Jeffrey C. Mogul, Amin Vahdat Google, Inc. Abstract Clos topologies have been widely adopted for large-scale data center networks (DCNs), but it has been difficult to support incremental expansions for Clos DCNs. Some prior
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May 28, 2021 · Markets ureau’s Primer on CLOs published in 2018 for more detail. Commercial real estate (CRE) collateralized loan obligations (CLOs) may be considered a “hybrid” of traditional leveraged bank loan CLOs and commercial mortgage-backed securities (CMBS) in that they
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Un additif alimentaire est défini comme ‘’ n’importe quelle substance habituellement non consommée comme un aliment en soi et non employée comme un ingrédient caractéristique de l’aliment, qu’il ait un une valeur nutritionnelle ou non, dont l’addition intentionnelle à l’aliment pour un but technologique dans la fabrication, le traitement, la préparation, l’emballage, le .
