Smaller CLO managers face tiering threat as leverage concerns increase

CLO issuance this year has exceeded all expectations, with GlobalCapital data showing just shy of $60bn in new supply (excluding refinanced deals) this year to date. Amid the search for yield, new managers such as Moelis Asset Management’s Steele Creek Investment Management — currently marketing a $413.5m debut CLO through BNP Paribas — are finding a strong bid for their paper.

“I haven’t heard of a CLO manager that wasn’t able to issue a deal,” said a portfolio manager at a large New York CLO investor and manager. “There is very little risk of people not getting a deal done, it’s just a question of paying more.”

But as leverage in the underlying loan market increases and lending becomes more aggressive, the potential fallout from volatility is increasing, and market participants are seeing increasing differentiation between managers based on their experience. 

The Federal Reserve is concerned that risks are building up in leveraged loans. In a report accompanying chair Janet Yellen’s testimony in front of the Senate Banking Committee on Tuesday, the central bank said “signs of excesses that could lead to higher future defaults and losses have emerged in some sectors, including for speculative-grade corporate bonds and leveraged loans”.

Wells Fargo analysts David Preston and Jason McNeilis in June wrote that while the choice of CLO manager mattered less for senior note investors, mezzanine buyers should pay up for quality, which would aid performance if defaults hit the loan market. 

“Manager tiering is often most pronounced in the mezzanine tranches, and tranches from newer managers may experience a larger sell-off during periods of volatility,” they wrote.

But while manager tiering is occurring, it might not be pronounced enough, said Brian Juliano, vice president and portfolio manager for Prudential Fixed Income’s US bank loan sector team.

“We already see the lower-tier managers printing wider,” he told GlobalCapital in a phone interview. “The question is whether the tiering is severe enough. A good and well-established manager’s double-B tranche trades 20bp tighter than a new manager. Is that enough? When the volatility hits will that 20bp of extra spread really compensate for the amount the bonds trade off?”

Steve Vaccaro, co-president and chief investment officer at CIFC Asset Management, said that newer managers without a proven track record may suffer a sell-off in the secondary market if volatility strikes, even if they are staffed by professionals with years of experience in structured credit.

“Some preconceived notions about bigger being better will be expressed early on, and it will take time for true performance differentiation to become visible,” he said. “The problem is there will be a lag [before investors can judge on performance rather than size].”

Mezzanine paper is where investors should be more discerning about managers, said the New York portfolio manager, pointing out that currently, investors were happy simply picking up a higher return rather than rejecting a manager outright.

“Many triple-A buyers prefer to buy new managers because it is really hard to lose any money as a triple-A investor, so you might as well grab the widest bond you can,” said the person. “The question is why as an equity or double-B investor support one of these brand new platforms. The impact of those wider spreads gets bigger as you go down the stack, and it is most felt in the equity.”

But there is little sign of managers or investors slowing down any time soon, and that is doing little to quell concerns that CLOs are heading into bubble territory — although market participants, Janet Yellen included, prefer to use the word “excesses”.  

“People are willing to just plough forward,” said the portfolio manager. “The bigger existential question is whether that is right for the market, and I don’t think it is. There is some excess building up in the market, and a lot of these ‘three guys and a Bloomberg’ type managers don’t help.”

Steele Creek Investment Management, which is still marketing its debut deal, lists seven investment professionals on its website.

Other small managers that have printed CLOs in recent weeks include Triumph Capital Advisors — a member of the Triumph Bancorp group — which lists six investment pros on its website, and Covenant Credit Partners, which lists 11.

Neither Triumph nor Steele Creek responded to requests for comment by press time. A managing partner for Covenant Credit Partners responded but was unavailable to comment in time for publication.

Given the number of credits that need to be covered within a single CLO, smaller firms like these could find their resources stretched as the cycle turns, market participants speaking with GlobalCapital said. Moody’s Analytics puts the average number of credits per CLO, across all vintages, at 140.

Smaller managers also typically have less in assets under management and therefore make less on fees. That could put margins under pressure, said Vaccaro.

“If you stop growing, are your management fees sufficient to cover the costs necessary to manage the risk of the CLO business?” he said. “The additional issue for new managers is that there is a higher probability that there has been a higher fee-sharing arrangement [with equity investors] and therefore there will be less left over for the manager to adequately cover the cost of their business. Is it a viable amount?”