Blackstone priced its third European CLO of the year in October, the month after it announced plans to combine its credit and insurance business into one.
Alex Leonard, head of European liquid credit strategies at Blackstone Credit, sat down with GlobalCapital to discuss what the news means for his platform, why Blackstone is more optimistic about defaults in CLO portfolios than the wider market, and what a CLO manager needs to be prepared for the unexpected in times of volatility.
GlobalCapital: Let’s start with a short characterization. What makes Blackstone different from other European CLO managers?
Alex Leonard, head of European liquid credit strategies, Blackstone Credit: Firstly, I would say track record and performance.
We’ve been around since 2001. Some members of the senior leadership team have been operating in the European market since 2001. We’ve watched the market evolve from a buy-to-hold market and, as loans developed into a capital markets product, the European loan market has also grown to become a more actively managed loan market. We understand the key levers of active management, and that’s hugely important.
Ultimately, we believe everything comes back to performance. The market has evolved and become more volatile. It reacts more quickly to news, whether good or bad.
As a platform, we are focused on how we think about what’s coming in advance. That could be a view on inflation, which senior leadership within the firm called quite effectively. We also discuss the potential wider and indirect impact of macro or geopolitical events, such as the Russian invasion, on our portfolios. Where do we see potential risks in the event that it happens, even if we view it as a low probability? And if there are names that are going to be negatively impacted that are trading at par, we should consider reducing exposure to those names because there is a real risk, albeit remote.
The platform is very focused on having appropriate forums to openly discuss. I sit on a global investment committee with, among others, Michael Zawadzki, the CIO of Blackstone Credit, Daniel Oneglia, the head of credit research, and Rob Zable, the global head of liquid credit. Senior leadership discuss each name that we believe merits discussion, whether it is a large position or a more topical name in the US or Europe.
Another other key differentiator is our scale. We’re taking advantage of all the insights that the broader firm has, whether it’s how the industry view in the US might get replicated in Europe, whether it’s a European view on headwinds and tailwinds in a sector that can be relevant for the US market.
Which scenarios are you discussing at the moment?
We have been discussing the view that inflation will be stickier, although we’re beginning to see some signs of cooling. Rates remaining higher for longer is clearly something that we continue to stay focused on.
Some of our views are just around specific trends we’re seeing in certain sectors. The performance that we’ve seen in the US might impact our views on some of our European names, whether it’s [in] telecommunications or healthcare, although we do recognise differing market dynamics and levels of regulatory support in the European market versus the US.
Blackstone recently announced the integration of its credit and insurance business. What does that mean for the CLO platform?
Both teams coming together is an exciting piece of news for us. Together, Blackstone Credit and Insurance will be one of the key arms for future growth at Blackstone. We will all be under one roof with the intention to offer clients and issuers credit products of various risk profiles. We’re now having direct dialogue with new clients on potential opportunities. This week is our AGM and LP conference, where I’ll be sitting with Gilles [Dellaert], the new head of the combined business. I’m excited to work with him.
Will you be hiring more people?
At a very high level, I would say we are forming a new platform and Gilles will be focused on growth. He will be looking at what he needs to make sure that the right initiatives are taken to ensure we get there.
You became head of the European CLO business in 2017. People in the market sometimes point out that Blackstone’s reputation as a CLO manager before your appointment was a lot less conservative, in terms of the credit risk approach. How would you define your influence on the business over the past six years?
The big focus — mine but also that of senior leadership — over the last few years has been to take advantage of the liquidity in the market to protect capital to drive performance through the cycle. There are two key strategies.
One is the fundamental focus on credit underwriting upfront and effectively sizing our exposure to protect capital. We have a very disciplined approach to credit approval and a real lens on assessing both business and financial risk. Generally, I would say the top 20 credits within the portfolio need to tick a lot of boxes. We review the loan documentation and value good management and a good sponsor. It also needs to be large and liquid.
The smaller size concentrations in our portfolios are also credit approved at investment committee, so we feel comfortable with the credit, but it might be a new business to the market and we may look for a track record of solid performance before we build our position.
We’re not buying the market, we’re very focused on having optionality to support active management. If you look at our portfolio now versus a few years ago, there is a lot more diversity.
The second piece is putting reporting and a process in place to allow us to actively monitor and manage the portfolios. Every day we review reports that identify which names have moved in price. It’s about having a very efficient investment process, with the view of protecting investor capital. If we do elect to sell something, if we have concerns around headwinds facing a business, we should also be identifying where we feel more constructive to deploy capital in a way that supports investor capital.
Our over-collateralisation headroom and our NAV to equity performance look solid versus peers, which is a good indication of how we protect underlying capital.
How has this process dealt with the situation in the Middle East?
We consider news and what is going on in the broader macro political environment, and we looked at which names were potentially impacted. We looked at various scenarios. It certainly creates more challenging and volatile times, but in terms of direct exposure in the underlying portfolio, we feel comfortable in our liquid credit business.
How would you characterize broader market sentiment right now, and how much primary CLO issuance do you expect for the rest of the year?
You have to look at the market in totality. On the asset side, we saw the market coming back quite strongly through this year. We have now seen a pick-up in volatility over the last few weeks.
Technicals on the CLO side today also feels a bit squishier; there’s been a lot of recent new issuance. But we still see a lot of opportunity. We’ve seen around €2bn per month in terms of CLO issuance on average. I would say we will potentially see a slowdown as we come into the end of the year — not just because the market feels a bit more volatile.
We are seeing on the CLO side that spreads are widening a bit. That’s a challenge. On the asset side I would say there is potential to go marginally tighter. On the liabilities, we’ll see.
Most CLOs priced in the past 18 months were done without third party equity because the arbitrage was so challenging. How long can this type of issuance be sustainable?
Pricing a CLO with minority equity has been challenging. I think one of the key challenges is that secondary market opportunities this year have looked more attractive. But there have been opportunities also on the loan side.
If you look at the evolution of loan pricing this year, there have been pockets in time in the earlier part of the year — and quite recently — to build attractively priced portfolios. We’ve certainly seen benefits where we’ve been able to raise minority equity.
To be attractive for third party equity, the arbitrage should look attractive. If you think about the natural dynamic of CLO supply and demand and we have seen this many times before, when the arb is broken, it tends to eventually come back because CLOs naturally stop getting printed. As you see a slowdown of new issuance, managers tend to demand loans come wider or liabilities tighten, making the arb more attractive.
Do you expect defaults and downgrades to become a significant problem for European CLOs in the next few months?
The market’s view for 2024 is 2.5%-3%. Our own view is more optimistic. We have seen over the last couple of months that issuers continue to have adequate interest cover, albeit in a higher rate environment.
We have seen issuers behave like there’s an expectation that a recession is coming over the last couple of years. They have been managing underlying business costs and they’ve been focused on addressing the refinancing risk. We’ve seen successful A&E activity. We don’t see a material uptick in either the triple-C bucket or downgrades and defaults, certainly when we look forward at our own portfolios versus the expectations of the market as a whole.
The European CLO market has been known for moving as one without much differentiation in spreads. In a market that is facing challenges from a number of directions, do you expect tiering between managers to become more prevalent?
There is definitely more differentiation if you look at the most senior parts of the CLO capital stack. If you see a new manager come into the market, the market typically expects a bit of a premium.
The mezz parts are a bit thinner in terms of the buyer base, even though it is improving. Timing can be an important factor here. When there is large supply of new issuance, you can see that part of the capital stack widen by virtue of the heavy technicals. I think differentiation is good for Europe. In a more benign market, we may expect to be able to build good quality portfolios and hopefully benefit from good execution on the CLO pricing.
You mentioned a slightly improving investor base. I understand that there was some unusual Middle Eastern demand for your CLO. People in the market are talking about the potential of US banks returning as buyers, and Japanese investors have anchored a few deals. How do you expect the investor base for European CLOs to develop next year?
For non-European investors — whether it’s US or Japanese investors — the FX is an important factor, as well as a view on the macro and what is going on in terms of relative value opportunity in their home markets.
Some of the themes we have seen recently I would expect to continue. Banks are stepping in as co-placement agents, whether it’s out of an appetite for triple-As, or to elbow their way into being an arranger. I think we’re increasingly seeing some of that.
The asset class looks attractive in the current market, as floating [rate paper] has also continued to demonstrate strong performance and with a premium through cycles versus similarly rated credit.
In general, although it’s a challenging market, we’re seeing increased acceptance of CLOs. Some of the discussions I have with investors are definitely getting easier in markets that had been slower to open the door on the asset class. When a key large investor steps away, you can still syndicate the deal at points in time in the market. We are seeing more appetite, certainly in the senior parts of the cap stack, from southern European banks. They typically take a smaller bite size, but it allows you to get the triple-A done on a syndicated level.