The case for European CLOs
Highly diversified and resilient, the European collateralised loan obligation market is attracting increasing attention, say Permira Credit’s Ariadna Stefanescu and Jihan Saeed
Q: First off, for the uninitiated, what exactly is a CLO? What are investors exposed to?
Jihan Saeed: CLOs invest in corporate debt, and by that we mean senior secured loans made to large companies, the majority of which are private equity-backed. When a private equity firm takes out a loan to finance a buy-out, pursue a recapitalisation or buy-and-build strategy, that loan can be purchased by a CLO. That CLO will invest in 90-100 different loans, which means the product is highly diversified. The CLO will issue a range of different tranches, from Triple-A to Single-B, to raise financing to purchase these loans, and the CLO manager will manage the portfolio.
Ariadna Stefanescu: This is one of the most diversified investment strategies that focuses on the leverage finance market – not just in terms of number of credits per fund, but also in terms of sector and geography. Also, these are typically large, liquid credits (the average EBITDA of the companies within our portfolios is in excess of €500 million). CLOs are long-term, non-mark-to-market vehicles. There-fore, what an investor is buying is long-term exposure to a very diversified pool of the largest sub-investment credits in the market.
Q: What is the role of the CLO manager?
AS: A typical CLO is issued with a legal maturity of 13 years, and a four-year re-investment period. The CLO manager builds an initial portfolio when it first issues the fund, then actively manages the portfolio by buying and selling the underlying assets and reinvesting proceeds from repayments. After the end of the re-investment period, the portfolio should slowly start to pay down (unless the fund is reset).
As a result, there can be a significant amount of portfolio management involved and this has become a major differentiator among managers. Some are more passive, while others, such as Permira Credit, are extremely active. We continuously rotate the portfolio to take into account our latest views on investment themes, sectors and companies’ performance.
JS: There are 61 different CLO managers in Europe, but there is a vast difference in how they all manage their portfolios. Take 2020 as an ex-ample – while most CLOs had actively tried to build their portfolios around non-cyclical industries, no-one could have predicted that cinemas or airports would entirely shut. But not only did some managers sell out of some of the credits in sectors heavily impacted by the pandemic, they also rotated into other more resilient ones. That shows that the role of the manager is critical to performance, particularly during a period of market volatility.
Q: What role does ESG play in this industry and what is your own approach?
AS: Permira Credit has actively integrated ESG into its investment process for a while now. We believe our first 2.0 CLO (Providus I) was the first European CLO to specifically include ESG exclusion criteria in the documentation, and we have rolled that out across every CLO we have priced since. We are pleased to see that this approach is now being taken up by other managers.
JS: From an investor point of view, it is exciting to see how many managers have been embracing ESG in relation to CLOs. And it has recently been announced that a standardised survey has been created for the industry, assessing managers’ policies and the role that ESG plays in building their portfolios. As a whole, the CLO market has taken huge steps forward and we are proud to be the platform that first included ESG exclusion criteria in its documentation.
Q: How did the global financial crisis impact the evolution of the European CLO market?
JS: When the European CLO market reopened in 2013 there was one significant change – the introduction of the risk retention rules. That meant that if you wanted to issue a CLO, you had to have the requisite capital behind you.
AS: What the global financial crisis and the past year both highlighted is that CLOs are robust, because they have long-term financing, with no mark-to-market triggers which force managers to sell out of assets at the worst possible moment. This demonstrable resilience has attracted significant interest from investors over the past decade.
Q: How has the evolution of the European CLO market been different to that of the US?
JS: CLO issuance in the US is five times that of Europe. In the US, CLOs also have many more loans in their portfolios – 200-plus credits – so the level of diversity is greater. However, the sectoral exposures are different. In the US, there is more exposure to oil and gas, metal and mining, which means that they are more affected by movements in the oil price – which affected CLOs in 2020 through the covid-19 pandemic and in 2016 during the oil price crash.
Finally, in the US, while CLOs also have no mark-to-market triggers, you have the presence of business development companies in these loans. If there is market volatility, that means loan prices tend to move more quickly.
AS: The US market is also more homogenous. There is a single rule of law, while in Europe we have to take into account the complexity of multiple jurisdictions and what that means in terms of creditor protection. Hence if an investor is looking for exposure to both the US and European CLO market, it is important that they invest in a manager that has feet on the ground in Europe.
In the US, we now also see CLOs segmented by size, with some funds dedicated to mid-market exposure. The US market is more mature, and we have not yet seen that development in Europe, but we may well in the future.
Q: Why do you believe the European CLO market is an attractive investment opportunity today?
JS: Not only are these diversified products, but if you look at what you are ex-posed to, you do not need strong macro growth to perform. The underlying companies only need to be able to service their debt and not default on their payments. The risk-reward profile of CLOs relative to other types of fixed income is highly attractive.
We believe the CLO market can continue to thrive even in a low-growth environment and can also benefit from periods of moderate volatility. Market dislocations result in opportunities for CLO vehicles to buy loans below par, without the risk of being a forced seller if prices drop. Private equity firms currently have large amounts of dry pow-der, which is likely to continue to drive deal activity and demand for leveraged loans. CLOs also have the ability to withstand periods in which default rates rise. Additionally, the underlying assets are senior secured loans, which typically benefit from high recovery rates in the event of default.
CLOs have, historically, been a misunderstood asset class, given their relative complexity and lingering connections to instruments associated with the global financial crisis. However, Permira Credit has demonstrated that CLOs provide an attractive, risk-adjusted return for investors.
Q: What types of returns are achievable?
JS: It depends where you decide to invest in the capital structure. If you are targeting the investment grade part of the CLO capital stack, you can achieve between 2 and 5 percent. If you invest in sub-investment grade debt, that increases to 5 to 10 percent. But if you focus on CLO equity, you are talking about upwards of 15 percent for a cred-it product. That is an attractive place to be when you are gaining diversified exposure to senior secured loans issued by large companies.
Q: How does Permira Credit differentiate itself in the CLO market?
JS: Our key differentiator as an investor is our bottom-up, credit-led approach. Many fund managers operating in this space employ a macro approach to in-vesting in CLOs. But, as we predominantly invest in CLO equity, we know each credit in these portfolios, especially the tail-end credits. This allows us to be more active in our management and drives our funds’ performance.
Having patient capital is also critical in the CLO equity space. We have long-term, closed-end funds, with no further leverage on top. That is how our funds have delivered the returns that they have.
AS: We have more than a decade of experience in the European CLO market, both as a manager and as an investor, with a strong and growing team across both our structured credit and CLO strategies. There are a lot of firms investing in structured credit today, but only a few with our track record. The ability to understand this market from both perspectives is a huge and relatively unique advantage.
Q: What do you think the future holds for the European CLO market?
JS: We have been marketing CLOs for a long time. But, as recently as 2016, the first three slides in a deck would all be focused on explaining what a CLO actually is. Now, investors understand how the product works and are instead looking to delve more deeply into the way managers operate. The way CLOs performed through the financial crisis, and now through the covid-19 pandemic, should only increase investor appetite.
AS: This asset class is definitely growing and will continue to grow. It is a structure that has proved itself through various periods of financial pressure and market dislocation. It is also exciting to see increased differentiation in portfolio management styles.
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