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NEPC

CLO Primer

NEPC Research Team


CLO: General Introduction

• CDOs backed by leveraged loans are called ‘CLOs’


– Mostly corporate floating rate debt
– Majority of the loans in the collateral are senior secured loans
– Many deals may contain small concentrations of high-yield and second lien loans
• Referred to as high-yield or second lien buckets
– Some CLOs may use middle market loans to boost yields

• Collateral performance determines CLO return

• CLOs provide vital source of funding for U.S. non-investment grade


corporations

• CLOs are transparent; most assets have public ratings and audited
financial statements

Source: RBS, Wells Fargo

2
CLO Market: Timeline

First CDO CDO managers Credit High yield CBO CLO markets CLO markets Resurgence of Risk Retention
structure started issuing downturn market flourish and temporarily CLO markets Regulations go
created backed securities practically become the shut-off in (CLO 2.0) into effect in
by a pool of backed by a ended primary buyer wake of credit the US
high yielding, pool of only of new issue crisis
speculative leveraged loan levered loans
grade bonds portfolio
(CBOs) (CLOs)

CDO managers CLO issuance Low recoveries CLO market New peak On-going
started gains in speculative continued to issuance in the changes from
including momentum grade bonds gain US during 2014 US and
leveraged loan momentum European
in the collateral Fixed to Risk retention regulatory
pool floating asset- At one point, regulations go bodies with
liability mis- nearly 50-60% into effect in respect to risk-
Leveraged loan match of new loan Europe retention and
as a collateral increases issuances were CLO
became more securitized via composition.
appealing due CBOs backed by CLO structures
to: high yield
- Higher speculative Loans
recoveries grade bonds continued to
- Floating fall out of favor trade close to
rates which 90 cents
reduced despite market
interest risk recession
and
obviated the
need for a
interest rate
swap

1988 1990 Early 2000 2002 2004-Early 07 2008-2009 2010 - 2015 December 2016

Source: ING, Wells Fargo

3
General Introduction to Arbitrage CLOs

• Arbitrage CLOs exist to earn a spread between their assets and liabilities
– “Funding Gap” = Return on Assets – Defaults – Cost of Liabilities – Expenses
– Return on Assets determined by average leveraged loan spread and active portfolio
management by CLO manager
– See slide 6 for a detailed history of default and recovery rates for leveraged loans
– Cost of Liabilities for a CLO structure referred to as the Weighted Average Cost of Funding
(WACF). See slide 7 for a recent history of WACF

• Collateral performance determines return for CLO Equity


– Mostly corporate floating rate debt, primary or secondary issuance
• Broadly syndicated, single B rated paper on average
– Majority of the collateral (≥90%) is senior secured loans
• Many deals may contain small concentrations of high-yield and second lien loans
• Some CLO’s may use middle market loans to boost yields
• Exposure to non-senior secured loans is limited by a CLO’s indenture

• CLOs are transparent; most assets have public ratings, disclose loan level
holdings monthly, and hold annual financial audits

• CLOs provide vital source of funding for U.S. non-investment grade


corporations

Source: RBS, Wells Fargo, Credit Suisse

4
CLOs: General Introduction

• CDOs are backed by a variety pool of debt depending on the type of CDO
– CDOs backed by leveraged loans are called ‘CLOs’, Collateralized Loan Obligations
– CDOs backed by bonds (HY/speculative grade) are called ‘CBOs’, Collateralized Bond Obligations

CDO
Issuer Class A Notes
[Aaa/AAA]
Diversified (Offshore Weighted
Special Purpose
Portfolio Vehicle)
Average
Cost of
Class B Notes Funding
(Assets [A2/A]
dependent on
type of CDO) Class C Notes
[Baa2/BBB]
Collateral
Manager Equity
[Not Rated]
Residual Cash Flow, First Loss

Principal & Interest proceeds on an ongoing basis. Principal & Interest proceeds passed to Note holders on
a monthly basis.
Collateral Purchase

Fees paid to the Collateral Manager.


Cash distribution waterfall.

Source: Wells Fargo Securities, LLC

5
Leveraged Loan and High Yield Historical Default and Recovery Rates

Defaults Remain Low & Recovery Rates High

18% 100%
94%
16% 86% 89% 90%
83%

78% 80%
14%
74% 73%
70%
12% 67%

Recovery Rate
66% 61%
Default Rate

63%
57% 57% 9.6% 60%
57% 55% 57%
10% 56%
54%
51%
8.1%
51% 50%
8% 43%
6.8%
40%
6% 5.3%
30%
3.8%
4%
2.9%
2.6%
3.0% 20%
2.5% 2.6%
1.6% 2.1%
2% 1.3%
1.0%
1.4%
10%
0.9% 0.7%
0.5% 0.6% 0.4% 0.2%

0% 0%
1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015
Credit Suisse US Institutional Leveraged Loan Default Rate Credit Suisse High Yield Index Default Rate

Credit Suisse US Institutional Leveraged Loan Recovery Rate Credit Suisse High Yield Index Recovery Rate

Source: Credit Suisse, Leveraged Finance Default Review, October 2015


Leveraged loan default analysis is restricted to institutional leverage loan tranches that could be sourced in the public domain with an initial issuance size greater than $25mm. The majority of these loans had
public debt or equity. A loan is considered to be in default if it has either missed a coupon or principal payment (including a cross-default provision with other debt) or filed for Chapter 11.
The default rate is calculated by summing the amount of institutional leveraged loans that have gone into default over a 12-month period, and dividing this by the average size of the institutional loan market
over the same period of time. The defaulted amount is determined based on the initial amount of institutional debt issued.
The recovery rate is calculated from the issue’s default price and issuance price. This represents the amount of an investor’s original investment that survives the average default event.

6
Median Weighted Average Liability Costs for US CLOs by Vintage

CLO Arbitrage Attractiveness Varies by Vintage

250
Weighted Average Spread of CLO Debt (bps)

200

150

100

50

0
2004 2005 2006 2007 2008 2010 2011 2012 2013
Vintage

Source: Libremax, Intex, RBS

7
CLOs: US Historical Issuance & Average Leveraged Loan Spreads1

CLO Market Emerges from 2008 Crisis & Achieves New Peak Issuance in 2014

$140 2500
L+2373

$120 $123.8

2000

$100 $104.7

$95.6

1500
USD in billions

$80
$81.8

L + bps
$78.3

$60
$60.7 1000
$53.5
L+703 L+717
$40 L+6004
L+568 L+592 L+555 L+559 L+532
$38.7 L+509
L+488 L+461
L+435 500
L+355
$20 L+276 L+257 L+237 L+250
$20.3 $19.8 L+365 $20.6
$24.2 $16.8 $16.6
$4.3 $12.7
$23.7
$7.1 $0.2
$0 0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

1. Original Source for Graph is Octagon Credit Investors.


2. Sources: Intel, S&P’s/Leveraged Commentary & Data, Moody’s, Wells Fargo Securities LLC. YTD 2014 as of September 30, 2015.
3. Source: S&P’s/Leveraged Commentary & Data. Represents average discounted spread for the S&P/LSTA Leveraged Loan Index as of December 31st of the respective year. Assumes discount from par is
amortized evenly over a three-year life. Excludes facilities in default.
4.Represents current average leveraged loan spread (as described fully in note 2 above) as of September 30, 2015.
5.FY 2015 CLO new issuance forecast is $100B, which represents the straight average based on published market participants’ estimates (J.P. Morgan, Morgan Stanley, Barclays Capital and Bank of America
Merrill Lynch). This projection is a forward-looking statement, subject to change, and does not represent a guarantee.

8
CLOs: New vs. Legacy CLO Issuance (1.0 vs. 2.0 deals)

CLO 1.0 CLO 2.0


Pre 2008/2009 Credit Crisis Post Credit Crisis

Size $300 - $1,000mm Par Value $300 - $500mm Par Value

200 – 300 Loans, 100 – 150 Loans,


Number of Loans
15 – 25 Industries 15 – 25 Industries

Predominately BB, B Predominately BB, B


Ratings
90% Senior Secured Corporate Loans 95% Senior Secured Corporate Loans

5% HY Bonds, and Second Lien


10% HY Bonds, Other CLOs, and Obligations
Other Composition
Second Lien Obligations Investments in other CLOs typically
not allowed

Weighted Average Cost of


50 – 100bps 150 – 200bps
Liabilities

Reinvestment Period 5 – 7 years 2 – 4 years

Non-Call Period 3 – 5 years ~2 years

Indentures Less Restrictive More Restrictive

Tranche Refinancing Option Not Permitted After Non-Call Period

Source: RBS, Octagon, Wells Fargo

9
Collateral Management over the Life of a CLO
Collateral Balance

1. 2. 3. 4.

CLO Closing Date Ramp Up End Date Amortization Period

Time

CLO Timeline
Warehouse
1. Warehouse Bank provides CLO Manager financing to acquire assets.
Period
0-18 Months
Ramp-Up
2. Proceeds from CLO Issuance used to purchase additional assets.
Period
Collateral Manager permitted to actively trade underlying assets.
Reinvestment Old Issuance: 5-7 years
3. Principal cash flows from underlying assets can be used by Collateral
Period New Issuances: 2-4 years
Manager to purchase new assets.
2-4 years or
Amortization
4. Cash flows from assets are used to pay down the outstanding notes. Stated Maturity
Period

Source: Wells Fargo

10
How is a CLO Manager paid?

– CLO Manager takes a 10-20bps Senior


Fee before notes are paid.

– Debt notes are paid in order of seniority


Loan
– CLO Manager takes a 20-40bps Portfolio
Rating % of Stack Coupon
Subordinate Fee if all notes are paid Senior Fee
Interest &
Principal
AAA 65% L+ 130bps Payments
– Equity tranche receives excess
payments.
AA 9% L+ 200bps

– CLO Manager takes an additional


A 8% L+ 300bps
Performance Fee (typically 10-20%) if
certain IRR hurdles are met (average
ranges 8-12%) BBB 5% L+ 400bps

BB 4% L+ 600bps
– Waterfall structure is typical Subordinate Fee

Equity 9% Residual Cash Flow


– AAA, AA, A notes are referred to as Performance Fee

Senior Tranches or Senior CLO Debt

– BBB, B notes are also known as


Mezzanine Tranches

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CLOs: Marking Policies

• Underlying assets in CLOs are marked at par and are not subject to
mark-to-market volatility, EXCEPT under the following circumstances:
– Default: When a default occurs, the asset is marked at the lower of market value or
anticipated recovery value.
– Excess CCC Assets: When the CCC basket exceeds a predetermined test level
(normally 7.5%), the excess CCC assets are held at market value.
– Discounted Obligations: Loans purchased below 80 – 85 (depending on the rating).
Initially carried at purchase prices as opposed to par until they trade above 90 for more
than 30 days.
– These valuations are used to determine whether coverage tests are failed NOT monthly
pricing for the CLO tranche. All other assets are marked at par.

• CLO debt and equity tranches are marked on a regular basis (at least
monthly) by dealers and are subject to market volatility

• Many long-term CLO equity investors use a “mark-to-model” approach


– CLO Equity is generally considered a Level III asset.
– Investors maintain their own pricing models with embedded assumptions instead of
relying on dealer marks. Operational Due Diligence and comfort with a particular Firm’s
marking policies are key for this strategy.

12
CLOs: Structural Enhancements
Protection Types

Interest Diversion Test


• Usually trips before the OC or IC tests
• Measures the adequacy of collateral supporting each class of notes
• If triggered, interest payments to junior tranches are suspended and used to purchase additional collateral. In some
cases, interest payments may be used to down subordinate notes
Overcollateralization (OC)
• Usually trips before the IC test
Coverage Tests • Measures the adequacy of collateral supporting each class of notes
• Expressed as a ratio of the principal collateral value over the outstanding liabilities
• Determines if senior • Subordinate tranches have lower OC thresholds compared to senior tranches
tranches are • If OC test is failed, interest and principal cash flows are diverted from more junior classes of notes to pay down the
sufficiently protected liabilities in order of seniority until the deal is back in compliance with the test.
• Deleverages the portfolio and reduces the possibility of greater losses in the future.
• Thresholds vary by • A CLO manager no longer receives subordinate fees when an OC or IC test is triggered.
individual CLO
indentures Interest Coverage (IC)
• Measures the sufficiency of the interest income of the underlying collateral to cover the scheduled interest payments
• If a CLO fails a test, to the note holders. Like OC tests, each class of notes has its own IC test.
cash flows are • If IC test is failed, interest and principal cash flows are diverted from more junior classes of notes to pay down the
directed to senior liabilities in order of seniority until the deal is back in compliance with the test.
tranches until a deal • Pay-In-Kind: if IC test is failed, subordinate bond holders may be compensated with more bonds equivalent to unpaid
is back in compliance interest (dependent on a CLO’s indenture).
with the test
Turbo Trigger
• Not standard for most CLOs, interest cash flows are used to accelerate repayment of subordinate (expensive) notes
• Subject to all coverage tests being met and a minimum IRR on the equity tranche being achieved
• De-leverages the structure, reduces rated note subordination, reduces cost of funding
Par Preservation
• Usually trips before the OC trigger or based on OC trigger
• Equity cash flows are used to purchase additional collateral
• Increases Leverage, extends equity maturity, impedes manager’s ability to game the OC tests

• Typically when OC falls below a second threshold, a deal is in EoD


Event of Default (EoD) • Reinvestment period is terminated and all cash flows are used to retire liabilities in order of seniority
• No standard deal has ever hit EoD because of this clause in the indenture

• Includes tests to ensure collateral quality is per guidelines (weighted average rating factor (WARF), diversity scores,
Collateral Quality Test weighted average life of collateral, weighted average spread, etc.)
• If any test fails, CLO manager can only trade the collateral to bring that test in compliance

Source: RBS, Collateralized Loan Obligations 101, September 2012


13
CLOs: Equity Tranche Redemption Features

• Optional Redemption Call


– Equity tranche holders have the right to redeem their notes after a stated non-call period
– Non-call periods have varied based on CLO vintage
• 2003-07 vintage had call protection extending 3-5 years
• 2010-11 vintage had call protection extending 1-3 years
– Equity holders typically choose to redeem when funding gap decreases

• Call options vary between CLO 1.0 vs. CLO 2.0


– Legacy issues (CLO 1.0): Options to call or refinance a deal
– New issues (post 2008 2009, CLO 2.0): Options to call, refinance, or re-price a deal

• Call options defined:


– Call: the CLO manager must liquidate all collateral at the existing market value and repay
note holders with sale proceeds
– Refinance: the CLO manager to obtain a loan or issue new notes to replace existing notes
– Re-price: the CLO manager reduces the spread over Libor for an entire class of notes
• Does not require full par value or redemption to be there for the entire class of notes that are
being re-priced (but is there for investors that disagree with the spread reduction)
• Less time consuming than refinancing
• Typically not allowed for AAA tranche

14
CLO Equity
Understanding CLO Equity Return Components

• CLO Equity Total Return: Primarily includes two main components:


– Interest-Only Yield Spread
– Principal-Only portion

• Interest Only Spread (IO):


– Asset Yield – [CLO Fees (management and deal fees) + Interest Cost]
– Interest Cost is also called ‘weighted Average Liability’ (WAL)
– Asset yield changes over time, but cost of liability is typically locked
– This spread, also known as ‘Funding Gap’ is leveraged, generally in 10x range for 2.0
CLO structures
– Portfolio losses and defaults affect this spread by reducing the total interest paying
asset

• Principal-Only Portion (PO)


– PO is typically valued as an NAV [market value of the collateral assets - principal
value of the notes/debt issued]
– NAV is typically expressed as a percentage of the equity tranche notional value
– Portfolio losses and defaults affect this return by reducing the value of the collateral

• In summary, CLO equity receives cash flow from the underlying


assets, less fees and CLO liability interest payments (WAL)

16
Key Return Drivers For CLO Equity

1. Timing of the reinvestment period:


– Since CLOs are actively managed deals with a finite reinvestment period, the
performance of equity tranche greatly depends on the future path of asset spreads
– Reinvestment period benefits from spread volatility
– Refer case study : 2003 vs. 2007 vintage performance in the next tab

2. The arbitrage spread (Asset spreads - Cost of Liability)


– All else equal, deals with lower liability cost can generate higher equity returns

17
Key Return Drivers For CLO Equity

3. CLO Manager Skill: Wide gap between top and bottom quartile equity
returns
Average Cash on cash Returns of CLO Equities*
30% 160

140
25%
120
20%
100

15% 80
10.80%
60
10% 8.80% 8.50%
7.40%
6.50% 6.10% 40
5% 3.90%
20

0% 0
2002 2003 2004 2005 2006 2007 2008
Bottom Quartile* Top Quartile*
Difference [Top-Bottom]* Number of Deals
Source: Credit Suisse, Intex
As if 2/15/12. Representative universe excludes CLO squared deals, deals with Lehman Par Building structure**, middle market CLOs and other CLOs with non-standard
features
**Lehman Par Structure: when a default occurs or a loan is sold at a discount, payments are diverted from equity holders to buy new loans so the collateral does not shrink

18
Key Return Drivers For CLO Equity

4. Default rate specific to the CLO


– It will also depend on the manager’s skill for analyzing underlying collateral and
navigating the asset pool during reinvestment period

12%
10.71%

10%

8%
5.91%
6%

4%

2%

0%
Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13
May-06
Sep-06

May-07
Sep-07

May-08
Sep-08

May-09
Sep-09

May-10
Sep-10

May-11
Sep-11

May-12
Sep-12
CLO Exp to LD LCD Loan Default

Source: LibreMax,RBS,Intex

19
Importance of Vintage Diversification: Cash On Cash Yield By Vintage

40%
Payments to Equity were not entirely shut off during market crisis
35%

30%

25%

20%

15%

10%

5%

0%
2004 2005 2006 2007 2008
Vintage
2005 2006 2007 2008 2009 2010 2011 2012 Sept YTD - 2013
Source: Morgan Stanley CLO Tracker September 2013

20
Gaining Exposure to the CLO Market

• Types of manager participation in the CLO market

– Primary Issuance – managers investing in new issue CLOs

– Secondary Issuance – managers buying stakes in CLOs on the secondary market

– Active Investment – managers taking majority/control stakes in CLOs in order to


maintain the ability to call a deal

– Passive Investment – managers purchasing minority/non-control stakes in CLOs

– Risk Retention – Typically closed-end fund in nature, investors invest directly with CLO
managers for the life of the CLO. This satisfies the US and European regulators as it
pertains to 5% stake CLO managers must invest in new issue deals.

• How to access these strategies


– Multi-Strategy:
• Dedicated CLO Funds
• Multi-Strategy Structured Credit
• Multi-Strategy Credit

– Closed End & Evergreen


• Increased liquidity is not always better

21
Case Study: CLO 2003 vs. 2007 Vintage
2003 Vintage CLO : Performance

2003 Vintage CLO Performance

Issuance Environment Reinvestment Environment

• High relative funding gap at issuance, ~ at or • CLOs had relatively high liability spreads and
above 300 bps faced several years of reinvesting in a
tightening market
• 80%/20% mix of single-B/BB loans produced
an average spread of approximately 400 bps • Loan spreads were approximately 150 bps
tighter than at issuance
• CLO financing costs were approximately 90 bps
(AAA spreads were 50 bps–60 bps) • CLOs could not reinvest since they were already
in amortization period
• Issuance occurred at the cusp of a four-year
tightening of loan and credit markets

Source: Wells Fargo

23
2007 Vintage CLO : Performance

2007 Vintage CLO Performance

Issuance Environment Reinvestment Environment

• Low Funding gap (low arbitrage spreads) • Financial crisis caused the loan spreads to
widen out considerably
• Typical deal had a seven year reinvestment
period • Deals could reinvest in loans with much wider
spreads than at deal issuance
• Issuances occurred at a cusp of financial crisis
• Some deals experienced a temporary shutoff of
• equity distribution in 2008-09, but most
managers could navigate through that since the
CLO’s were still in reinvestment mode.

Source: Wells Fargo

24
Historical Performance – CLO Equity
CLOs: Volatility of CLO Equity

Since 2008, total returns have been quite volatile mainly due to a high
price volatility. On a monthly basis, a CLO equity investor could lose as
much as 40-50% during the fall of 2008, but the investor could later earn
more than 50% each month in mid-2009.

Credit Suisse CLO Equity Monthly Total Returns and Price Index*
80% 100

90
60%
80
40% 70

60
20%
50
0%
40

-20% 30

20
-40%
10

-60% -
Oct-08

Oct-09

Oct-10

Oct-11
Feb-08

Feb-09

Feb-10

Feb-11

Feb-12
Dec-07

Apr-08

Jun-08

Aug-08

Dec-08

Apr-09

Jun-09

Aug-09

Dec-09

Apr-10

Jun-10

Aug-10

Dec-10

Apr-11

Jun-11

Aug-11

Dec-11
Total Returns Price Index

Source: Credit Suisse, The CDO Strategist, February 2012


Primarily 2005 to 2008 vintages.

26
CLOs: Forecasted IRR of CLO Equity

Deal Universe by Vintage Average Forecasted IRRs


2002 7 18%
16%
2003 27

Percent of Deals
14%
2004 51
12%
2005 82 10%

2006 155 8%
6%
2007 155
4%
2008 16 2%
2009 0 0%

12.5 to 15

17.5 to 20

22.5 to 25

27.5 to 30
Less than 0

10 to 12.5

15 to 17.5

20 to 22.5

25 to 27.5
7.5 to 10

More than 30
0 to 2.5
2.5 to 5

5 to 7.5
2010 9
2011 22
Total 524

• 96% of CLOs issued from 2002 to 2011 are expected to return at least full
capital to the equity holder

• 49% are expected to generate IRRs of at least 15% for the equity holder

Source: Citi Research, Global Structured Credit Strategy, September 2012


Forecasted IRRs assume a 2% annual default rate, a 75% recovery rate, and a 20% prepayment rate for the collateral loans

27
Risk Factors
Key Risk Considerations: Investment in CLO Equity

• Warehousing period MTM risk


– Typically applicable for primary market control investing
– Not applicable for secondary market investments

• Timing of the reinvestment period


– Refer case study 2003 vs. 2007 vintage

• Increase in the cost of leverage will reduce the arbitrage spread


available to the equity tranche

• Equity tranche is the first loss security, therefore it is important to


note the key default/recovery assumptions of a particular CLO

• Manager skill set varies considerably from collateral analysis to


structuring capabilities
– There is a considerable difference in performance of top and bottom quartile
managers

• Consider diversifying investments across different vintages to reduce


exposure to a single reinvestment period

29
Disclaimer

• Past performance is no guarantee of future results.

• Data used to prepare this report was obtained directly from the
investment manager(s). While NEPC has exercised reasonable
professional care in preparing this report, we cannot guarantee the
accuracy of all source information contained within.

• This report may contain confidential or proprietary information and is


intended only for the designated recipient(s). If you are not a
designated recipient, you may not copy or distribute this document.

30
Alternative Investment Disclosures

It is important that investors understand the following characteristics of non-


traditional investment strategies including hedge funds and private equity:

1. Performance can be volatile and investors could lose all or a substantial


portion of their investment
2. Leverage and other speculative practices may increase the risk of loss
3. Past performance may be revised due to the revaluation of investments
4. These investments can be illiquid, and investors may be subject to lock-ups
or lengthy redemption terms
5. A secondary market may not be available for all funds, and any sales that
occur may take place at a discount to value
6. These funds are not subject to the same regulatory requirements as
registered investment vehicles
7. Managers may not be required to provide periodic pricing or valuation
information to investors
8. These funds may have complex tax structures and delays in distributing
important tax information
9. These funds often charge high fees
10.Investment agreements often give the manager authority to trade in
securities, markets or currencies that are not within the manager’s realm of
expertise or contemplated investment strategy

31