Talk Your Book: The CLO Playbook

0:00Today's Animal Spirits Talk Your Book is brought to you by Flat Rock Global. Go to flatrockglobal.com to learn about their suite of credit funds, CLOs, private credit. flatrockglobal.com to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:35Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:43Welcome to Animal Spirits with Michael and Ben. On today's show, we talked to Shiloh Bates, who is a partner and CIO at Flat Rock Global. I have to admit, a brand new one to me. This is, I think you would say, a boutique firm. Is that correct? Yes. Right? I don't know who came up of that as a name, but it just, if you say I work for a boutique asset management firm, I don't know. You get like a premium in my eyes. You know what's interesting? You say boutique, I say boutique, but Kobe. Like finance and finance? In kindergarten, he went to a boutique. He called it a boutique and we thought it was the cutest thing in the world.

1:14I don't even know what boutique means. Let's see. A small store selling fashionable clothes. Yeah, it's a smaller, It's not one of the big, huge brand names. It's a smaller. Anyway, we spoke a lot about CLOs today. And at the end, I finally got it. I got it. I get it. I get it and I got it. These are, so Flat Rock is essentially the bank that is making loans to these alternative asset managers as their debt financing to do these private equity deals. Yes. Right. Banks can't do it anymore because all the regulations from 2008. It is kind of weird. You could do the meme of the guy knocking the dominoes over, right?

1:55Great financial crisis, 10 % yields for advisors and private credit funds. 10 %? I don't know, yeah. Higher in some cases, right? So anyway, we've had a handful of discussions about private credit and CLOs recently, but I think bringing this together, it is kind of slowly but surely becoming clear to us. Because this stuff is, you know, you and I track this stuff pretty closely, and it's still not always easy to understand. end. So I think if you're going to invest in this stuff, you have to make sure the firm you're working with is really good on it, on the education piece. Yes. And so Shiloh actually, he wrote a book on this.

2:27He hosts a podcast. So he's like, he's on the content piece, which obviously you and I are very familiar with. I think an educated makes for a good, an educated investor, excuse me, makes for a good investor. And we covered a lot of it today. Like you asked a good question, which actually I was going to ask, but great minds think alike. You got to it before I could. What are some of like the unknown risks? What are some of the risks that advisors might not be thinking about. So this was an instructive conversation with Shiloh Bates from Flat Rock Global.

2:56Shiloh, welcome to the show. Great to be with you guys. We are recording this. It is Monday, April 21st. And once again, there was a lot of volatility in the stock market and in the bond market for that matter. Anything that is liquid, with anything with a ticker, it's going up and down violently. One of the appeals to private markets and CLOs, which we're going to talk about today, are two things. Number one, high income, people love that. Number two, I'm looking at a chart of your total return, and it is basically up and to the right with very minimal blips in between. I mean, the drawdowns are not existent.

3:37anytime I see something like that, my antennas go up. So why is this? How does that happen? Like, where's the free launch? How do we get big income distributions and very little price volatility? Sure. So we manage three different funds. And if you're talking about the CLO equity fund, basically it's been around for about seven years and it's lagged the S &P 500 by about 150 basis points since inception, but it's had a third of the volatility of the S &P. And the reason that I think we can offer attractive risk-adjusted returns versus the S &P are a few things. So one is really across all three of our funds, we provide exposure to private credit loans.

4:24And so these loans, they start their lives with like a 50 % loan to value. They're senior, They're secured, but they pay floating rates of interest. So SOFR is the rate in my market. And if you go back to 2021, SOFR was basically zero. Now SOFR is at four and a quarter. So that's meant more income into our funds, more income into the CLOs. So that's one dynamic that we benefit from. Sorry, when did SOFR take over from LIBOR? So that was about a year and a half ago. So LIBOR was fixed. There was a big kind of scandal about that. And SOFR, LIBOR was basically like a theoretical rate where they pulled banks and said, hey, if you needed to borrow overnight, what would the rate be?

5:16And there was like a shenanigans scandal, right? Yes, out of the UK. And so now we use SOFR, which is a real rate where banks lend to each other on a secured overnight basis. All right. So that's a terrible, terrible first question on my part. Forgive me. I should have started here. Who is Flat Rock Global? Sure. So we started in business about seven years ago. We manage a billion five of AUM and our three strategies are in interval funds. So that's one thing that's unique about us. and across three of our funds we provide exposure to private credit loans so really the only question is do you want to own the loans directly on your balance sheet or do you want exposure to them through the clo structure and then within clo's we have private credit loans owned in clo double b's double b notes and also clo equities so those are our three strategies and i think what's one thing that's different about our firm is, again, being in business for about seven years, growing to a billion five of AUM, it's been like nice, steady growth.

6:27And along the way, we've been hyper-focused on our track record. So I've seen months and quarters where other firms have raised almost the totality of our business. And that might be good for the asset management firm they work for, but we're really just more focused on our track record. That's kind of our DNA at FlyRock. Mike and I have talked about this before, but I think it's good for a refresher. Explain to the audience what an interval fund is and how it works. Sure. So it's very similar to a mutual fund. You can buy a share any day using a public share price or NAV. But the key difference is that because what we own, the underlying assets are illiquid, we're not in a position to do redemptions daily.

7:15So how we set it up is that people buy shares using the NAV. And if people want out of the fund, we agree to buy back 5 % of shares each quarter. So those are the tenders. And that's a fundamental policy of our funds. So that's not something that's at our discretion or at board discretion. So that's basically how an interval fund is different from a U.S. mutual fund. Where can you buy an interval fund? Any brokerage firm, where can you buy them? Yeah, so our funds are on all the custodial platforms. So if you're an RIA, it's just point and click. And then if you're not an RIA, you can send in, mail in a subscription document.

7:59All right, dumb question. Where does the NAV come from? Because the point that I opened with, it just seems literally up and to the right. Is that who's making that? Is that the market? Is that you? Is that an auditor? Where does the price actually come from on a day-to-day basis? So if we're talking about CLO equity, it's not always up and to the right. So during COVID, for example, our peak to trough drawdown was 22%. So we captured about two-thirds of the drawdown of the S &P. and how we do the daily nav is that our CLOs are marked by a third-party daily so they send us an excel file with all the marks for our securities and then that flows into Ultimis is our fund accountant and they they calc the nav using those third-party prices that's how it's done okay so the the big question right now for everyone is okay the economy is slowing Recession is perhaps at our doorstep.

8:58Who knows? But it's possible. What does that do to this type of strategy? So you mentioned in the COVID period, and that was interesting because, yes, that was a recession, but you also had this credit event where spreads were blowing out and people were selling treasuries too. Like everything was getting sold there for a little bit until the Fed stepped in. So it's hard to know if we get a recession, if that would be some sort of credit event like this where this happens. But what sort of baselines and expectations do you set for investors if we do go into a slowdown period? So when we invest in CLO equity, we provide exposure or we get exposure to 200 different private credit loans.

9:37And the loans are rated single B on average by Moody's and S &P. And we know that not all of the loans are going to be money good at the end of the day. So looking back over the last decade, we see roughly a 2 % default rate on the loans and a 70 cent recovery. And so we bake that into all of our financial projections, and you could think of that as a loan loss reserve. So one thing to keep in mind is we already have a loan loss reserve, and that's very different from other asset classes where if you're in a loan fund like a BDC or a separately managed account, and a loan defaults, there's no loan loss reserve and you just kind of take the hit on your nap.

10:22So then what we've seen in CLOs is that when you hit pockets of instability or higher recessionary risk, that the overall loan market tends to trade down. And loans in the CLOs are constantly prepaying at par. And with those par proceeds, the CLO manager goes out into the market and they buy new loans, often at discounts to par. And so when you hit a recessionary period, on the one hand, you expect to take more losses on loans, which is negative for your returns. But at the same time, lots of loans are still prepaying at par. And the expectation is that you can buy discounted loans that can offset the higher loan losses that you might experience.

11:06What is CLO equity? So think of it like this. So basically the CLO has 500 million of assets in it. So let's call it a loan pool of 200 different senior secured loans, floating rate. The loans are created in leveraged buyouts. So imagine Aries, Apollo, KKR, they buy a company, they put up about half the purchase price in equity, and they finance the remainder with a term loan. And that term loan today might end up in literally dozens of different CLOs. So that's the vehicle that owns these loans. And then, so that's the CLO's assets. And then we finance this CLO by issuing debt that's rated AAA down to BBB.

11:57And that's long-term non-marked market financing. And then CLO equity, you could think of that as like the owners of this pool of loans. So it's kind of imagine if you bought a stock in a bank today, except the bank is only a pure play lender. That's the way to think about CLO equity. And so in this investment strategy, kind of how it works is the CLO is very profitable. And so it distributes to the equity very large payments each quarter. But then the risk is that you're on the hook when loans default. that's the risk that you're running there. So I'm curious, who are your investors in a fund like this?

12:41Is it retail? Is it mostly advisors? Who's coming to your door and asking for help with this? Yeah. So it's large RIAs who their clients go to them and might say, hey, listen, I'm not sophisticated in how I should allocate my portfolio. And a lot of RIAs would have funds like ours in a model where, say, we're 5 % or something of their assets. And as those clients kind of increase their exposure to the markets or decrease, that's funds that might make their way into the Flat Rock funds. Hey, I apologize for the mischaracterization of the line go up earlier, twice earlier. I was talking about the enhanced income fund as well as the diversified private credit fund.

13:29So those are legitimately up to the right, but this is a different animal. So apologies there. Happy to describe the enhanced income fund. If you'd like, that's the other CLO strategy. I guess before we get there, just sticking with the CLO equity. So you're investing, like you're loaning money to the areas of the world who are then loaning money to the deal sponsors. Is that, am I misdescribing it? So think about it like this. So at Flat Rock, we're not a CLO manager. So we're not picking the underlying loans that go into CLOs. So we hire a CLO manager to do that. And at Flat Rock, our biggest CLO managers are people like BlackRock, like New Mountain, like Jeffries, Barings.

14:16A lot of the big alternative asset managers are our CLO managers. So how does that process work? What are you looking for to determine, all right, we're giving BlackRock 8 % of the portfolio. This company is getting that. What are some of the characteristics that you're looking for? So in CLOs, there's roughly 130 different CLO managers. And one of my jobs is to kind of distill that list of 130 to about 20 or 25 that we want to work with. And then within that list of who we think are the top performers, my job is to buy the CLOs that offer the best risk-adjusted returns. And part of that is trying to buy CLO securities as cheaply as possible.

15:01So there's a ton of money going into private credit these days. And working in the wealth management space, Michael and I are inundated with emails all the time. How do you try to stand out in this space and get people to trust you? Because it seems like there's an endless opportunity to find managers in this space. Sure. So in our CLO funds, I think the opportunity is that I go to a lot of private credit conferences, and the conclusion of all the panelists and I think people in the audience is that they think private credit is pretty attractive. And if you come to that conclusion, CLOs are one way to implement that strategy.

15:42So, for example, we have a CLO BB fund. And how that works is that if people want exposure to, today, 2 ,000 different private credit loans, they can do that through the CLO BB note. And the attraction of doing that is that in the CLO structure, there's a third-party equity investor who signed up to take the risk on the underlying loans. And so, again, if you invest in a GPLP fund or a BDC and loans default, that's the risk that you're taking, right? But if you do CLO BBs, it's, again, exposure to this diversified pool of loans. But there is a CLO equity investor who signed on to take the primary risk of loan defaults.

16:29And so if you look back over 30 years, CLO BBs have basically a de minimis default rate. It's about 25 bps. And so what we found from our RIA clients is that for people who are either concerned about the economy in general or they think maybe too much money is flown into private credit, the CLO BB space is a way to invest in that in a more conservative way. So you mentioned that the CLO equity, the ticker is FROPX. Yes. It did have a 20-ish percent drawdown during COVID. But it's, I don't know, it's given you like, you can fact check me here, 85 % of the upside of the S &P with a much smoother ride.

17:18I mean, I guess if you're investing in equity, then an equity benchmark is appropriate. That's right. There's also no other great benchmarks for, I mean, we benchmark against the S &P 500. We could also benchmark, I guess, against the Russell. If we did that, we'd handily outperform the Russell. Sorry to cut in. How often do you get distributions of this? Is it monthly, quarterly? So this pays monthly distributions that are covered by the fund's net investment income. You know what would be a good benchmark for this? I'm an ideas guy, so I got to lay it out there. I feel like a covered call strategy is a pretty good benchmark for something like this because it's probably lower volatility.

17:54You're getting the higher income, but you also have equity-like characteristics. Thoughts? That's an interesting idea, but I'm not an options guy, so something to consider. All right. Just the kind of stuff that we hear a lot. I'm curious, how often do you have advisors coming to you and they're just focused on the yield piece of this? Like they're picking the fund based on the yield versus how much do advisors actually understand the different fund structures in the different variations among the funds that you're getting to? I guess what I'm trying to get at here is how much education is necessary when you're helping people figure out what fund is right for them.

18:30Yeah, so it's a very big educational process. So I don't think our end clients are buying for yields. In fact, because we have three different strategies, they rank from a distribution yield of 9 % at the low end to CLO equity at 15.5%. And we're not just seeing people buy the higher one. That's not what they're doing. In my strategy, I like to and have to do a lot of education for folks. So I wrote a book on CLO investing, and I wrote it really with kind of the target reader is like an RIA, somebody with financial knowledge, but not in the CLO space. And I think that it's very comprehensible.

19:22And then also, you know, like you guys, I have a podcast where, you know, once every couple of weeks, I have somebody on from the CLO market to talk about the performance of the underlying loans or anything that's really kind of topical in the space. I like to do that kind of education. Hey, we're all about plugs here. What's the name of the book and the podcast? Give it to us. So the podcast is The CLO Investor by Shiloh Bates, me. And the book is CLO Investing with a focus on CLO equity and double B notes. And the book's on Amazon and the podcast is on Spotify and everywhere else. So what's the pitch for investors?

20:03If somebody's like, hey, why do I need this? Why can't I just buy anything else? What's the pitch? Yeah, so the pitch is that our funds have pretty low correlation to other asset classes like the S &P 500 and high yield or the ACK. And they also offer pretty favorable returns. So by including our funds in an investor's portfolio, if you think about it in the parlance of economics or whatever, it's like basically you're pushing out your expected return and lowering the overall risk of your client's portfolio. That's what our funds are designed to do. When you have conversations with advisors, do you get the feeling that they're using these strategies and taking from fixed income and having that be just a diversified portion of that?

20:51Are they taking a little from stocks and bonds? What is the asset allocation decision here? Sure. So for CLO equity, we see it kind of as a one-to-one into our fund out of the S &P 500. We see it as a way to get equity-like returns, but with, again, a fraction of the volatility of the S &P. One piece of research we've looked at is over the last 20 years or so, CLO equity, there's only like 5 % of deals that have had negative returns. So it's a great way to try to get that equity return you want, but with limited or reduced downside exposure. And then for our CLO BB fund, I think people allocate to that fund in lieu of private credit funds where they own the loans directly, where they're taking the first loss risk on the loans, and also high yield.

21:43That's another asset class where we think our funds can really kind of shine in comparison. What do investors need to believe for this to make sense? Do they need to believe a story about interest rates, a story about the economy, the growth in private markets? What's the thesis that drives this investment making sense? I don't think you need to believe a lot because the loans, again, that we provide exposure to, they start their lives with a 50 % loan value. These are companies that a sophisticated private equity firm wanted to own the equity, thought the business would be able to grow revenue and profits over time.

22:24And because the loan is senior and secured, if the business has problems, if there's a restructuring, if there's a bankruptcy, we're first in line in that senior secured position. And so the underlying loans that we provide exposure to, we see them as much more conservative than other investments like the S &P 500 or like high yield bonds, which are unsecured. And so our asset classes can definitely underperform at times in like an absolute sense. But in periods of heightened economic risk or potential recession, we think people want to be first lien senior secured and not unsecured or not owning equity.

23:10We think in a recession, our underlying loans will certainly outperform other sort of corporate securities. When you have your conversations with advisors, do you get the sense that they are using multiple private credit strategies? Because you keep talking about comparing and contrasting your strategy with other private equity or private credit strategies. Do you get the sense that they're doing that? Or are they pretty much picking one and sticking with it? So I think they're taking a portfolio approach. I mean, there's like one or two very large funds in interval funds that are private credit.

23:43And when I talk to RIAs, they usually have exposure. A lot of times they have exposure there. And then there's probably five other private credit-focused interval funds that are also very popular. So we're often compared, burst them, and kind of pitching against their products. But I don't think there's anybody where we get 100 % wallet share. And I don't think our competitors do either. If an investor were to look under the hood into the pool of loans themselves, and I know it's like a diversified pool of loans, what are we investing in? In terms of, are these US-based only? What sort of sectors, industries are we talking about?

24:26What size are the companies? Sure. So each CLO might have 200 different borrowers in there. And it's going to be diversified also by industry. So there's going to be a cap on how much the largest industry in there. In CLOs, generally, the biggest industries are going to be technology, healthcare, and business services. And then these are going to be companies, US-based companies, where they're doing, call it, 20 million of EBITDA or cash flow per year up to 100 or 150 million of EBITDA. So they're not going to be companies that are on page one of the Wall Street Journal, but they're going to be companies that provide a material product and service in the economy.

25:14The recession risk is the obvious one to everyone. Like what could be a problem for some of these types of strategies? What are the other risks you think that advisors aren't really considering when investing in private credit? Is there anything that people are overlooking? Sure. So I think a challenge now is not just the performance of the loans, but also just staying fully invested, right? So if you're an interval fund and you've raised a lot of money for a private credit strategy, it turns out that these loans, the underlying collateral, is created in leveraged buyouts. And since 2022, interest rates went up and LBO activity has gone way down.

25:55And so I think it's very hard for private equity firms to find companies that they believe in, that they can acquire at a price where they can pencil out the 20 % plus returns they're going for, especially given the higher SOFR base rate, right? So they're paying their lenders. Again, the loans are floating rate. They're paying their lenders much higher interest expense. And so there's a risk that you fund into, say, an interval fund and sit in cash for longer as it takes time to deploy. And I think kind of one of the benefits of our slow growth hyperselective approach is that we just don't see those kind of inflows that would give us concern on just kind of the negative cash drag there.

26:45So what if you were to triple overnight in terms of the assets that you manage? Like you mentioned that you're very focused on performance and not overextending yourself. Would you not be able to deploy that? Or what would be the risk of you getting too big? Well, I mean, basically we raise in all of our funds in the interval fund structure, we might raise one or 2 million a day in each of our funds. You know, it's something like that. And if more money came in than we could accretively deploy, we just put the brakes on it. That's how we think about it. So I'm a big investor in our funds and other members of management as well.

27:31And so we're aligned alongside our investors. And if more money came in than we could handle, we just put the brakes on it. Meaning you could actually prevent money from... You could gate it on the way. Oh, interesting to know that. Yeah, we could. One of the things that caught my eye as looking through the material was there's a big gap between, and I want to get your compliance in trouble here, but the gross expense ratio versus the management fee. Sure. Could you talk about that? Yeah. So basically, the way the SEC requires you to disclose your expense ratio, in that they would include, for example, if you borrow or if you have preferred shares, the interest expense for both of those would be in the expense ratio.

28:18And so we borrowed, let me give you an example of our CLO equity fund. So we have preferred shares that were put in place during the zero interest rate period that have their fixed rate in the 6 % area. And we're going to enjoy that cheap cost of capital for years in that fund. And it's a huge benefit to fund returns and to our return on equity. Well, in our expense ratio, all the distributions from preferred are captured in the expense ratio there. So it looks skewed. I mean, what investors should care about is what's the amount of profits that are leaving the fund in a way that doesn't kind of benefit them, right?