Why CLO Managers Babson Capital Perspectives

Babson Capital Perspectives
January 2014
Why CLO Managers
Matter
The tepid economic recovery in the post-2008
credit-crisis era provides investors with unique
opportunities in the CLO market.
Evaluating a CLO manager’s historical performance
provides key insight into their investment-style,
upfront portfolio construction and ongoing ability
to manage credit risk during turbulent markets.
During the 2008 credit crisis, the disparity
between strong and underperforming CLO
managers widened dramatically.
OVERVIEW
Developing a sound investment strategy begins with comprehensive
research, and the intricacies of investing in structured credit underscores
the need for rigorous upfront analysis. When evaluating a potential CLO
investment, there are three primary areas that should be examined, as each
factor influences the CLOs overall performance and risk profile. These
areas include: the creditworthiness of the CLOs underlying collateral, the
components of the CLO structure, and the behavioral characteristics of
the CLO manager. Each factor is important and merits close evaluation
but, surprisingly, the manager -analysis phase tends to get short shrift from
many CLO investors in comparison to the other two. At Babson Capital
Management, we believe this can be a costly mistake, as manager behavior
can have a dramatic impact on performance during volatile markets. This
was abundantly clear during the 2008 credit crisis, when the investment
decisions by the CLO manager had a greater impact on the performance
of CLOs than structure or credit quality.
Evaluating a CLO manager’s historical performance provides key insight
into their investment-style, upfront portfolio construction and ongoing
ability to manage credit risk during turbulent markets. It also highlights
their success (or failure) to mitigate losses within the restrictions of a CLO
while considering the interests of debt and equity investors. Further, by
closely monitoring a manager’s actions during volatile markets, investors
may uncover the manager’s investment-style weaknesses and possible
biases towards equity-friendly or debt-friendly management.
CLO MANAGER PERFORMANCE IN VOLATILE MARKETS—SEPARATING THE
WHEAT FROM THE CHAFF
It has long been understood that a CLO manager’s investment style and
decision-making process has an impact on performance, but prior to
2008 there was little empirical data to evaluate a manager’s performance
during times of severe market dislocations. The credit crisis eliminated
that data gap, however, and provided a unique window to evaluate
performance in times of extreme market stress. What the data showed
put manager performance directly in the spotlight. During the crisis,
the disparity between strong and underperforming managers widened
dramatically, from both a default-rate perspective and a cash-on-cash
(COC) perspective. This historic period of volatility brought a new level
of transparency to CLO manager performance, because until then, the
default rate had remained at such a depressed level that a CLO manager
could not distinguish their performance versus their peer group by
highlighting their ability to minimize collateral losses within the CLO
structure. This reinforced the need for proper due diligence during the
manager evaluation phase of CLO investment analysis.
The chart on the following page highlights the sizable dispersion between
top-tier and bottom-tier managers during the 2008 credit crisis. Bottomtier managers witnessed credit default rates soar as the market tanked.
This led to an increased dispersion in losses, which in turn widened the
gap on COC returns among managers.
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For Investment Professionals Only
1
DEFAULT RATE OF CLOS MANAGED BY TOP & BOTTOM
TIER MANAGERS1
EQUITY CASH-ON-CASH RETURNS OF TOP & BOTTOM
TIER MANAGERS1
12%
40%
30%
6%
4%
2%
25%
20%
15%
10%
5%
0%
Apr-08
Jul-08
Oct-08
Jan-09
Apr-09
Jul-09
Oct-09
Jan-10
Apr-10
Jul-10
Oct-10
Jan-11
Apr-11
Jul-11
Oct-11
Jan-12
Apr-12
Jul-12
Oct-12
Jan-13
Apr-13
Jul-13
Oct-13
0%
All CLO Managers
Top Tier CLO Managers
Bottom Tier CLO Managers
Performance dispersions
increased significantly as
the credit crisis unfolded
2004Q4
2005Q2
2005Q4
2006Q2
2006Q4
2007Q2
2007Q4
2008Q2
2008Q4
2009Q2
2009Q4
2010Q2
2010Q4
2011Q2
2011Q4
2012Q2
2012Q4
2013Q2
8%
Avg. COC Return
Avg. Default Rate
35%
Performance dispersions
increased significantly as
the credit crisis unfolded
10%
Top Tier CLO Managers
Bottom Tier CLO Managers
Source: Credit Suisse as of September 30, 2013.
1. Market data taken from 480 CLOs from 134 managers. Past performance is not indicative of future results.
A TALE OF TWO DEALS
The table below highlights how a CLO manager’s actions can lead to a significant performance variance.
These two deals were issued in July 2006, roughly eight days apart. Each deal was structured with a similar
initial credit profile, average spread and Moody’s Diversity Score. Despite a slightly more conservative
portfolio, Deal 1’s collateral pool incurred 3% greater losses and paid investors 43% less of their equity
investment—due to the divergence in collateral performance, and the manager’s decision to take considerable
trading losses.
DEAL 1
DEAL 2
Manager
Manager A
Manager B
Close Date
7/18/2006
7/26/2006
Average Spread of Collateral at Closing
Average Collateral Rating at Closing
Moody's Diversity Score
Collateral Gain / (Loss)
% of Equity Investment Repaid
Projected Equity IRR
227
247
B1/B2
B1/B2
38
53
(5.3)%
(1.1)%
137.1%
180.5%
12.1%
20.0%
Source: Babson Capital as of October 4, 2013. For illustrative purposes only. Projected Internal Rates of Return (IRR)
were calculated by combining historical and projected future cash flows for each portfolio’s investments and subtracting
estimates of projected management fees, technology reimbursements, expenses, incentive fees and other expenses.
There can be no assurances that the projected IRR will be met.
What drove the performance disparity? Deal 1’s manager decided to liquidate many of the portfolio’s
distressed credits and reinvested the proceeds in higher-quality loans trading closer to par—which locked
in losses within the CLO structure, hurting equity shareholders by reducing excess spread and COC returns.
Deal 2’s manager, however, took a different route. The manager decided to either hold the CLO’s lowerpriced loans, or sell and replace them with similarly priced issues. In doing so, the portfolio reaped the
benefits when the market rebounded, as greater excess spread remained and COC payments were higher.
2
For Investment Professionals Only
Babson Capital Perspectives January 2014
BABSON CAPITAL’S DEEP EXPERIENCE WITH CLOs OFFERS UNIQUE INSIGHT INTO MANAGER ANALYSIS
As an active investor in the structured credit market since the early 1990s, Babson Capital understands
the critical importance of strong management from both a risk and return perspective. Our structured
credit team manages over $13 billion in structured-credit investments, including $10.7 billion of cash
flow CLOs as of September 30, 2013, for a variety of institutional clients, including insurance companies,
endowments, pensions and banks.
The chart below shows the average COC return for 63 managers and 206 unique deals from 2004-2007
vintages, as of July 15, 2013. From deal issuance through July 15, 2013, the average COC return was
20%, with an average loss rate of 3%. The chart highlights how certain managers did a much better job
of delivering higher returns to equity investors, as they minimized losses through the 2008 credit crisis.
Thus, manager selection is paramount in generating strong returns—especially during volatile markets.
MANAGER LEVEL CLO PERFORMANCE
-2.5% Sample Avg
Average Annualized Cumulative Equity Distribution
30%
28%
26%
24%
22%
19.9%
Sample
Avg
20%
18%
16%
14%
12%
10%
8%
-11% -10% -9% -8% -7% -6% -5% -4% -3% -2% -1% 0%
1%
2%
3%
4%
5%
6%
Average Par Change Since Inception (net of Interest Diversions)
Source: Babson Capital as of July 15, 2013. Simple average for each of the 63 managers from 2004-2007 vintages,
where Babson Capital owns any manager with two or more deals. Past performance does not guarantee future results.
The tepid economic recovery in the post-2008 credit-crisis era provides investors with unique opportunities
in the CLO market, and CLO equity can be a particularly attractive option. CLO equity survived the
crisis better than many structured products, since they are term financed and generally well managed by
experienced loan managers. CLO equity is also considered less risky than other leveraged investments in
challenging economic environments, due to structural features like front-end loaded cash flows, a lack of
mark-to-market volatility and CLO liabilities that are match funded with the underlying assets. For these
reasons, and the fact that a large portion of the underlying loan collateral has LIBOR floors while the CLO
liabilities (tranches) do not, CLO equity returns have roared back as well after a sharp downturn in late
2008, demonstrating the segment’s resilience in the face of economic headwinds.
MANAGERS DO MATTER
Investing in CLOs can provide the potential for strong risk-adjusted returns through exposure to a wide
array of asset classes and risk levels, and the current ultra-low-interest-rate environment continues to fuel
interest in these investment vehicles. CLO investing is, however, an area that requires proper due diligence,
with particular emphasis on manager analysis. Since the manager’s behavior will have a significant impact
on the portfolio, it’s critical to evaluate his or her historical performance through different market cycles—
and heed the painful lessons learned in the 2008 credit crisis. Ignoring those lessons can have unintended
consequences, and with the continued overhang of market uncertainty, it’s vital to have experienced, proven
managers at the helm.
Babson Capital Management LLC
For Investment Professionals Only
3
IMPORTANT INFORMATION
Babson Capital Management LLC, Babson Capital Securities LLC, Babson Capital Europe Ltd, Babson Capital
Australia Pty Ltd, Wood Creek Capital Management, LLC, Babson Capital Cornerstone Asia Ltd. and Cornerstone
Real Estate Advisers LLC, each are affiliated financial service companies (each, individually, an “Affiliate”),
together known as “Babson Capital” and members of the MassMutual Financial Group*. Each Affiliate may
act as introducer or distributor of the products and services of the others and may be paid a fee for doing so.
ADDRESSEE ONLY: This document is issued to investment professionals and institutional investors only. It
is intended for the addressee’s confidential use only and should not be passed to or relied upon by any other
person, including private or retail investors. This document may not be reproduced or circulated without
prior permission.
NO OFFER: The document is for informational purposes only and is not an offer or solicitation for the
purchase or sale of any financial instrument in any jurisdiction. The material herein was prepared without any
consideration of the investment objectives, financial situation or particular needs of anyone who may receive
it. This document is not, and must not be treated as, investment advice, investment recommendations, or
investment research.
Unless otherwise mentioned, the views contained in this document are those of the Affiliate producing it. These
views are made in good faith in relation to the facts known at the time of preparation and are subject to change
without notice. Parts of this presentation may be based on information received from sources we believe to be
reliable. Although every effort is taken to ensure that the information contained in this document is accurate,
Babson Capital makes no representation or warranty, express or implied, regarding the accuracy, completeness
or adequacy of the information.
Any forecasts in this publication are based upon the Affiliate’s opinion of the market at the date of preparation
and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is
not necessarily indicative of the future or likely performance. Past performance is not a guarantee of future results
or a reliable indication of future performance. The investment results, portfolio compositions and examples
set forth in this document are provided for illustrative purposes only and may not be indicative of the future
investment results, future portfolio composition or investments. The composition, size of, and risks associated
with an investment may differ substantially from the examples set forth in this document. No representation is
made that an investment will be profitable or will not incur losses. Where appropriate, changes in the currency
exchange rates may affect the value of your investment.
In making an investment decision, prospective investors must rely on their own examination of the merits and
risks involved and before making any investment decision, it is recommended that prospective investors seek
independent investment, legal, tax, accounting or other professional advice as appropriate.
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INFORMATION: Babson Capital Management LLC is a registered investment adviser with the Securities and
Exchange Commission under the Investment Advisers Act 1940, as amended. Babson Capital Management
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Commodity Futures Trading Commission under the Commodity Exchange Act, as amended.
Babson Capital Securities LLC is a registered limited purpose broker-dealer with the Financial Industry
Regulatory Authority, Inc.
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Kingdom (Ref No. 194662) and is a Company registered in England and Wales (No. 03005774) whose registered
address is 61 Aldwych, London, WC2B 4AE.
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its Australian Financial Services License (No: 342787) issued by the Australian Securities and Investments
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(asset management) in Hong Kong in accordance with the requirements set out in the Securities and Futures
Ordinance (Cap 571).
Wood Creek Capital Management, LLC is a registered investment adviser with the SEC specializing in
investments in real assets.
Cornerstone Real Estate Advisers LLC is a registered investment adviser with the SEC specializing in real estate
related investments.
COPYRIGHT: Copyright in this document is owned by Babson Capital. Information in this document may be
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CONTACT
SALES
U.S.
Jeff Stammen
Managing Director
+1.917.542.8308
jstammen@babsoncapital.com
Europe
Andrew Godson
Managing Director
Head of Distribution
+44 (0)20 3206 4574
agodson@babsoncapital.com
Australia
Duncan Robertson
Managing Director
+61.2.8272.5044
drobertson@babsoncapital.com
Asia
Giselle Lee
Managing Director
+85.2.3515.8025
glee@babsoncapital.com
CONSULTANTS
U.S.
David Acampora
Managing Director
+1.917.542.8375
dacampora@babsoncapital.com
Glenn Weiner
Managing Director
+1.704.805.7350
gweiner@babsoncapital.com
Europe
Neil Godfrey
Managing Director
+44 (0)20 3206 4576
ngodfrey@babsoncapital.com
Asia / Australia
Duncan Robertson
Managing Director
+61.2.8272.5044
drobertson@babsoncapital.com
*MassMutual Financial Group is a marketing name for Massachusetts Mutual Life Insurance Company
(MassMutual) and its affiliated companies and sales representatives.
For Investment Professionals Only
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