If you were a small, independent firm managing collateralized loan obligations when the financial crisis hit, there’s a decent chance you were swallowed up by a larger competitor. More than 30 CLO managers were acquired following the crisis, according to research done by S&P Capital IQ LCD.
The expectation that the newly approved 5% risk retention rule, which takes effect in 2016, will spell more trouble for the CLO market’s little guys could mean another round of attempts to sell off CLOs. But this time, the wave of consolidation may turn out to be more of a splash, says Oliver Wriedt, head of capital markets and distribution at New York-based CIFC Asset Management. That’s because lower management fees and higher financing costs make an acquisition today less attractive than it was in the 2010 to 2012 period.
Acquiring other CLO managers is something CIFC, which formed in 2005, is familiar with; it acquired four platforms following the financial crisis: CypressTree Investment Management, Columbus Nova Credit Investments Management, Deerfield Capital Management and GE Capital Debt Advisors.
Today, CIFC has the largest U.S. CLO business by number of transactions, according to Moody’s Investors Service’s latest ranking, published in July. The firm’s 29 deals comprise seven pre-crisis CLOs, another 10 taken over following the acquisitions, and 12 priced post crisis—four a year since 2012 for a total of $6.8 billion in post-crisis assets under management.
Leveraged Finance News recently spoke to Wriedt about CIFC’s future and how he believes risk retention will affect the market.
LFN: What do you think the market’s going to look like post-2016?
Wriedt: Big picture, we believe that risk retention is a problem for smaller platforms and is potentially an opportunity for larger platforms. The reason is simply supply and demand. We’ve seen over $100 billion of issuance this year, and that’s meant the debt market has been flooded with CLO offerings. As a result, CLO debt spreads have not had any ability to tighten. Whenever there was new demand, supply drowned it out. So as supply diminishes, we think debt spreads will tighten and equity returns will improve. Similarly, as you shrink the new issue CLO market, the bid for bank debt is reduced at the margin. And we think that with less demand, bank debt will get cheaper, or at a minimum will continue to be extremely attractive, both on a relative and absolute basis.
So will these smaller shops just exit the market or will they be bought?
If you think back to the last consolidation wave of 2010 and 2011, it was a very different opportunity. The managers that were consolidated had two things going for them that made them very attractive. First, they had high management fees and long investment periods. Second, many 1.0 CLOs benefited from an all-in cost of debt that no one in the market today believes we’re ever going to see again. With triple-As locked in at Libor plus 20, 22 or 25 basis points, the entire debt stack in many cases cost managers no more than Libor plus 50 basis points. Today, you’ve got much lower management fees and shorter investment periods; there are not many start-up managers in the last three years that I can think of that have been able to secure 50 basis point management fees. I would anticipate that fees have been negotiated down to somewhere between 20 to 30 bps. So fees are dramatically lower, and the cost of financing is high. We believe that the consolidation opportunity is nowhere near as attractive as it was in 2010 and 2011. We’re not suggesting that it can’t or won’t happen, but economically speaking, it is not the same trade.
How is CIFC poised to deal with risk retention in the U.S.?
We don’t expect risk retention to be a problem for us, but it will change our business, in as much as we have held less than 5% of the CLO capital structure historically. We fully anticipate that from late 2016 on, we are going to be retaining equity in our CLOs so as to be risk retention compliant.
But you have historically held some equity in CIFC CLOs and you recently priced a CLO equity co-investment fund, correct?
We raised a dedicated vehicle to invest exclusively in CIFC transactions. That fund just held its final close on October 31 with more than $50 million in capital. We have a long history of investing in our own deals; we invested in every one of our original seven CLO funds, generally to the tune of 10% of the equity. We were also a secondary market investor in the equity of our CLOs starting in 2010.
Do you invest in other CLOs as well?
We have begun to invest in third-party deals as well. We have a great “credit engine” that allows us to re-underwrite portfolios at a very granular level. Our CLO analytics are fully built out to evaluate structure.
CIFC has been quite busy on the CLO market these past few years. Do you plan to keep up the pace in 2015?
We expect to continue to remain busy. Given the size of our 1.0 business, we have significant run off just through prepayments, amortizations and maturities. We’d naturally like to raise more assets than we lose from our 1.0 book. Since 2012, we have been successful at raising more capital than we lost through prepayments.Any plans to move into the European market?
The European market has yet to become a target for us largely due to risk retention issues, but we are actively evaluating potential access to the European market; we think there is tremendous potential to sell U.S. CLOs into the European market, provided we can get them to be CRD compliant.
Do all of your CLOs look similar as far as collateral and strategy? Are they different in any way?
In our original seven deals, we used a blend of 60% broadly syndicated loans and 40% middle-market loans. Then during the financial crisis we reduced our middle-market exposure, so that our 60/40 blend became more of an 80/20 blend. Today, our middle-market exposure in our original transactions is in the teens. Post-financial crisis we felt that the program needed to focus on broadly syndicated loans, so the 12 transactions that we’ve done since then are entirely broadly syndicated.
Why did you make that decision?
It was really relative value driven. During the crisis the relative value was much more compelling in the broadly syndicated market versus the middle market. Today, we think there is, selectively, interesting relative value in middle-market loans, but we’ve elected to own middle-market loans outside of our CLOs. We’ve raised separate accounts, and we’re creating various non-CLO structures to take advantage of some of these opportunities.
Beyond regulation, what are the main challenges to CLO managers today?
The arbitrage is always a challenge. Debt spreads are far too wide versus where we are in the credit cycle. CLO debt is the cheapest debt of its kind, but we continue to suffer from the structured product stigma. Investors continue to demand wide spreads that are completely out of whack with the actual risk relative to other similarly rated debt. And in the loan market itself, we’re seeing a lot of frothy lending activity. Leverage is increasing; covenant-lite is increasing; banks continue to be very aggressive, not withstanding the leveraged lending restrictions. There are some real risks in the bank loan market today. There are companies that are far too levered and companies that will, we believe, represent the distressed opportunity that we anticipate two or three years from now. We think credit underwriting really matters, and there are a lot of deals you just have to say no to.
