Partners Group achieved the tightest triple-A spread for a reinvesting European CLO this month at 170bp over three month Euribor on November 1.
Till Schweizer, senior portfolio manager at Partners Group, sat down with GlobalCapital to discuss the underappreciated benefits of buying CLO equity, the growing tiering between European managers, and why consolidation could be necessary but not straightforward.
GlobalCapital: What makes Partners Group different from other CLO managers in Europe?
Till Schweizer: A combination of three factors helped us perform very strongly over the last few years.
The first factor is experience. We issued our first European CLO in 2007 and have managed CLOs through various volatile periods. Second, we have a large pool of risk retention capital available, taking majority positions in each CLO issued since 2017. Access to such capital has allowed us to issue consistently and align us with our CLO investors.
The most important factor is our stable team of experienced credit analysts, portfolio managers and traders. Ongoing bottom-up credit approach and risk management has allowed us to avoid several of the well-known defaults this year.
We are about to wrap up 2023. What are your main takeaways from the past 12 months?
The leveraged loan market has been much more resilient than expected. Default rates have stayed low at around 2%. Sponsors injected equity into companies that were over-levered and A&E deals have really helped to push out the maturity wall. Fundamentally, if we look at our portfolio companies, most have been able to pass on price increases, so revenues and profitability have held up quite well.
But if you are looking at it from a different perspective, you could also say that all these A&Es are just kicking the can down the road. At some point in the next three years, sponsors will really need to think about exits. A lot of that will come down to where rates will be at that point in time.
CLO issuance has also exceeded some of the most optimistic forecasts. Do you expect more, less or the same level of activity next year?
We will probably see a similar number of deals. We see many managers in the European CLO market that aim to be repeat issuers to scale their business. There is also a growing pool of investors looking at CLO liabilities, so that should support issuance in 2024.
Do you think third party equity will return to the market next year?
Raising third party equity has been challenging this year. As a result, we will probably see primarily managers coming to the market with risk retention capital. I think CLO equity is still generating solid double-digit returns. The problem this year was the increased interest rates, at about 4%. Now there are rated tranches — single-B and even double-B tranches — that yield very similar double-digit returns, making them comparatively attractive for third party equity investors. However, we do like the optionality that equity investors get. If the market rallies, then rated tranches can be refinanced after the end of non-call periods, boosting equity returns. Or if the market tanks, then CLOs can buy higher-yielding assets, again to the benefit of equity investors. I think the upside from this optionality is usually not reflected in projected equity returns. It still won’t be straightforward to raise third party equity, but there should be a growing number of investors who appreciate that optionality and might look at equity again.
That means that a large part of issuance will still rely on risk retention funds, though, and raising more money for those funds isn’t that easy, either. You raised yours in 2019 and are a candidate to do it again next year. How will you convince investors to buy into your risk retention fund?
There is a case to be made to invest in the equity of one manager across different vintages, not just one specific CLO, because then you get to benefit from that optionality. Our best performing CLO was the one we launched during Covid, when pretty much no third-party equity investor was willing to take the risk. We have been able to refinance the transaction and take out a large dividend. If you invest with one manager on a recurring basis, you will have most CLOs probably paying the usual mid-teen returns, but then you will have some which pay 20% and more. Before you price a CLO, you often don’t know which ones are the home runs.
I recently spoke to a risk retention lawyer who predicted that managers will increasingly try to convince credit opportunity funds within their own wider firm to invest in their risk retention funds. Do you expect this to become more common while external investors are still cautious?
I cannot really comment. This is not something we focused on.
We talked earlier about the relatively low default rate in 2023. How do you expect defaults and downgrades to develop next year?
I expect default rates to stay low in 2024, certainly for our portfolio. We only have two small positions where I see a potential risk of default next year. Those positions account for less than 1% of our CLOs. Other companies might underperform for idiosyncratic reasons, but we don’t see immediate triggers for defaults. Our portfolio companies generally have sufficient liquidity and no upcoming maturities. We don’t expect a hike in default rates.
There might be additional downgrade risk if rates stay high and economic growth stays low. We see a larger part of the market gravitating towards B3, B- territory. This most likely won’t result in any test breaches because the spreads are also increasing.
In this challenging environment, do you expect to see increased tiering between managers in spreads?
Yes. It’s interesting because tiering has been much bigger in the US historically, given the sheer size of the market and the range of options investors have. In Europe, pricing historically has been fluctuating more based on supply and demand, and the week-to-week changes have been driven by market sentiment. However, over the past months, we have seen so many new CLOs come into the market, and for the first time we have seen proper tiering, at least for triple-As. Some top quartile managers have been able to print triple-As at 170bp. Others printed at mid-170bp, while first-time managers ended up significantly wider than that.
Were you surprised by how big a premium the new managers such as Arini had to pay?
It’s certainly been a good time for triple-A investors because they had such a wide range of managers and structures to choose from. First-time managers, experienced managers, static deals, reinvesting deals — I think that ample supply probably drove significant tiering, much more than historically.
Will a manager’s track record and experience continue to be the most important factor for tiering, or will investors increasingly focus on other elements? When Barings priced its CLO in early November, mezz tranches were priced significantly wider than those of other managers, and investors told me that they were concerned about credit quality.
Triple-A investors mainly take platform risk, so they want very stable platforms to avoid downgrade risk. If you invest in the mezzanine tranches, it comes down more to credit risk: how risky is the actual portfolio? How strong has the track record been? There is some differentiation between the top of the stack and mezzanine investors, but I think, in general, track record and experience will be the main factors for tiering.
Speaking of investors, how do you expect the investor base for European CLOs to develop next year?
In the past, the triple-A market was dominated by large anchor accounts from the US and Japan. Those investors are less active now, despite still selectively investing in European CLOs. Instead, we have seen on the one hand arrangers and co-arrangers offering significant amounts of triple-A notes. In addition to that, we have seen more and more mid-sized European investors entering the triple-A market, attracted by the strong relative value compared with other asset classes. I expect those European investors to remain active in 2024. We also see early signs that more and more Japanese investors are returning to the European CLO market.
The investor base is increasing — but so is the number of managers. It will be interesting to see how that balance of supply and demand will shake out over the coming year.
Consolidation among managers always seems to be just on the horizon, but, as you say, we see the number of them increasing. At the end of next year, will there be more or fewer managers than now?
I agree that there seems to be a disconnect between the talk of consolidation and the actual observation that we see more and more managers come into the market. There are a few managers that haven’t been able to issue this year.
38%, according to Bank of America.
Quite a lot! Some of them will probably need to be consolidated. But then, speaking from the perspective of one of the larger managers, that is not such a straightforward thing to do. Large managers like us already have a very experienced analyst team and we have strong traders, so we wouldn’t need to onboard another team. And if we want to increase AUM [assets under management], we can do that organically, as we have done over the past six years. It remains to be seen how strong the case will be for some larger managers to acquire smaller managers.
Do you have any new year’s resolutions for Partners Group, a vision for where you want to take your platform over the next few years?
For us, the target over the past five or six years has been to issue two CLOs per year in Europe and that’s what we plan to do. We think that is a good run rate, limited by the size of the market. We want to take our time in ramping up CLOs. In the US, I think we can grow a bit faster, given the size of the market.
Anything you want to change, become better at or focus on more than before?
We are always trying to be better at managing our CLOs. We are happy with how we have improved over the past few years, and we will aim to further improve, but I think we are on a good track.
Do you plan to hire more people?
We are quite happy with the team we have. We hired most of the analyst team about five years ago, and since then it has been very stable without any senior analysts leaving us. We certainly hope to keep that experienced team together next year. We might add one more junior resource, but I think, all in all, we have a strong team in place.
Will we see the first European private credit CLO next year?
I know several managers are working on it, but the market is not as deep as the market for broadly syndicated loans. We will have to see if it is feasible or not.
Thank you for taking the time.