Shiloh Bates – CLO Investing at Flat Rock Global (EP.379)

0:04Hello, I'm Ted Seides, and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at CapitalAllocators .com. All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of capital allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

0:44Clients of capital allocators or podcast guests may maintain positions in securities discussed on this podcast. My guest on today's sponsored insight is Shiloh Bates, the chief investment officer at Flat Rock Global, an alternative credit manager specializing in the junior tranches of CLOs. Last year, Shiloh published CLO Investing, a comprehensive review of the structure, payoff rules, and historical performance of the space. Our conversation covers Shiloh's 25 years spent in and around the space, an overview of the market, characteristics of CLOs, attractiveness of CLO equity relative to other credit opportunities, and Flat Rock's approach to investing in CLO equity and double Bs.

1:32Before we get going, it's springtime in New York, and that means it's time for Yankee baseball. Like each of the last 53 years, I've started dreaming about a perfect season with the Yankees finishing 162 -0. Now, that's never come remotely close in the history of Major League Baseball, and it never will. But after watching the Yankees sweep the Astros on the road the first four games of the season, thanks to the fielding and hitting exploits of star signee Juan Soto, I'll quote the great comedian Jim Carrey in the movie Dumb and Dumber. So you're saying there's a chance. It's highly likely by the time you're listening to this that the perfect season will have ended.

2:16But in this moment, I'm still dreaming. So as the weather turns and you find yourself outside enjoying the sunshine, but a little sad that your baseball team, hopefully the Yankees, won't be perfect again this year, at least you can turn to that podcast app on your phone and listen to Capital Allocators for about as perfect an hour as you can get each week. Thanks so much for spreading the word. Please enjoy my conversation with Shiloh Bates. Shiloh, great to see you. Thanks for doing this with me. Yeah, great to be here with you. Why don't you take me back to your background and how that brought you into the world of structured credit?

2:57Sure. So I went to graduate school at Harvard and after graduating, I went to work for Wells Fargo as an investment banking analyst. And then at Wells Fargo, basically, I think somebody in HR takes a pool of 100 different investment banking analysts and just assigns them to different groups. I was in financial institutions, and one of my initial projects in the group was to work on a financing for a CLO manager. And then two years later, I actually found myself working for that same CLO manager in Los Angeles. So I worked as a business bank analyst for just a little bit and then quickly transitioned to the buy side.

3:33When was that? 1998. That's when I graduated from grad school and started in the business. What did the CLO world look like in 98? So it was a very small little niche of finance. So there was basically about $6 billion in AUM when I joined, and there was six different CLO managers. And today there's really over a trillion in CLO AUM and about 100 different active CLO managers. So within the $1 trillion of CLO assets, how big is the CLO equity tranches across the industry? Of a trillion of CLO AUM, the CLO equity tranche is about 10 % of the CLO's financing. So it's a hundred billion asset class for CLO equity in particular.

4:17So what was your early experience like in that niche market at the time? So basically I was a credit analyst picking loans for the CLOs. So there might be 10 or so different loan opportunities that would come across your desk in a month and your job is to sort through the best opportunities. So the typical loan that goes into a CLO is going to be a first lien senior secured loan. Today, the loans pay around SOFR plus three and a half to 4%. And basically the idea is that if you're investing in first lien loans, you're starting off with a loan to value of around 40%. So you're not so sensitive to whether or not the economy grows at 2 % or 3 % or even shrinks a little.

4:58You're exposed to is really the situation where the wheels fall off the cart in terms of the company's business model. So loans with a 40 % initial loan to value, they do default rarely, fortunately. Usually it's due to some regulatory or technological change or loss of big customers. But as the credit analyst job to sort through the downside risks of the loans that go into the CLO and figure out the ones that survive really if there's a pretty substantial downturn in the economy. So from that early experience, looking at a very niche market at the time. What did you see in the evolution of CLOs alongside the rest of structured credit between then and when you started Flat Rock?

5:38The growth of CLOs has really been driven by a few factors. So one is that investors, they find first lien loans very attractive. Today, the yield on these loans are close to 10 % or higher. So people look at that and say, hey, if I can get an equity -like return and I'm at the top of the capital structure, I'm first lien and I'm secured, that's an opportunity I want to participate in. So in CLOs, people are looking for actively managed exposures to these pools of loans. And then the CLO securities really up and down the stack have performed very well over the last 30 years. So a lot of people have seen the movie The Big Short.

6:18The CLO industry is sometimes painted with the brush of the performance of CDOs, where during the GFC, you saw defaults really all the way up to AAA. Security is initially rated AAA. And then if you were, in contrast, an investor in CLO equity through the financial crisis on a buy and hold basis, a lot of the equity in those deals return high 20 % returns and the debt in the CLOs defaults rarely as well. So performance has been very good over the last 30 years. So that's going to attract a lot of investors. And then I think the final thing is that pretty much every security in the CLO market is floating rate.

6:57So we've been benefiting as the Federal Reserve's been increasing rates. And when you buy a CLO security, you just don't have the interest rate duration that you might have if you're buying a high yield bond or an investment grade bond. If you look at the banking crisis of the spring of last year, look, if banks would have owned AAA rated CLOs instead of some of the bonds that might be in the Bloomberg aggregate bond index, CLOAAs might have traded to 97 cents on the dollar or something like that. Investment -grade IG bonds traded into the 80s and sometimes lower. So I think it's a confluence of all those factors drawing people to the asset class and the reason that I think it'll continue to grow.

7:36What was your path from that early experience alongside those cycles in CLOs? So initially, my job was, again, just picking the loans that go into the CLOs. So I did that for about 10 years. And then I had an opportunity to start investing instead of the loans, investing in CLO securities directly. So I started buying CLO BB notes, which are backed by pools of leverage loans, and then eventually made my way to investing in CLO equity, which is the riskiest part of the CLO trade, if you will. And then the firms that I worked for, fortunately, just saw a lot of growth. And that enabled me to expand my skillset and to be one of the larger players in the space over time.

8:19So that's been a lot of fun and I've been fortunate in that. What was the genesis of writing a book on CLO investing? So in my role, I spend 80 or 90 % of my time investing, but I do need to do some investor education. And during the COVID period where I had some extra time on my hands, I decided to just write a little ebook that was 60 pages and we put it on my firm's website and described how I go about CLO equity investing. And after I did that, I was really surprised by how many people read it. It was widely circulated in the market and that gave me the idea of doing a full book. So the book's 220 pages.

8:58A lot of the writing from it, at least initially, just came from stuff that we use to educate investors in our pitch decks or Q &As with them. And at the end of the day, it's like a trillion dollar asset class market now. There should be a book. So we wanted to lead with that. And I wrote it in a way where I think people that are familiar with financial concepts, no CLO knowledge is required, just the basic financial concepts. And I think people can benefit from it. And it's all in there. If you wanted to learn about CLOs a different way, you could do Google searches. And there's tons of different articles.

9:31But I tried to make this book the one -stop shop, if you will, for all your CLO knowledge needs. I'd love to dive in a little bit, maybe through your book, about what these investment opportunities are today. So we talked about what the assets are in these pools. Why don't you talk some about what is involved on the right -hand side of these balance sheets? So the easiest way to think about a CLO is that it's a simplified bank. So if you buy a share of, for example, Bank of America or JP Morgan stock today, basically you're going to get exposure to maybe 20 or 30 different lines of business. But in a CLO, it's really just a pure play lending vehicle.

10:08So the CLO might have 500 million of assets in it. Again, the loans are almost exclusively first lien floating rate loans. And then to finance that pool of loans, there's long term financing and it's sold in tranches, which are rated AAA at the top and that's most senior and secured. And then down to double B, which is the junior most CLO debt tranche. And then there's the CLO equity. Similar to my bank analogy, the loans that the CLO owns, its assets, they pay a much higher rate than the CLO's financing cost. So that means each quarter there should be a nice amount of profitability that flows to the CLO equity after all the CLO's debt has been paid.

10:50And there's a CLO manager as well that earns a fee to look after all the loans in the CLO. So if you're an investor in CLO equity, today you're targeting returns in the mid to high teens. And basically you're exposed to any loss on the CLO's loans. So the risk that you're taking is loans in the CLO default. But fortunately, it's not a unquantifiable risk. You can look back 30 years and by our estimate, the default rate in CLOs is about 2%. So whenever somebody buys a CLO equity tranche, we budget in a 2 % default rate into all of our profitability projections. So in a CLO, you might have 200 different loans in there.

11:32I've never met a CLO manager who goes 200 for 200, unfortunately. So you kind of budget in a 2 % default rate. That's the game in CLO equity, and that's supported by very high quarterly cash distribution. So unlike owning a stock in the S &P 500, where you're counting on capital appreciation maybe as being the biggest part of the return you get. In CLO equity, it's actually the quarterly distributions that come to you right away. So that's the equity trade in a nutshell. We're also investors in BB rated notes. That works differently. That's just a debt security where all the loans in the CLO are pledged to you as collateral.

12:10There are other debt investors in the CLO that are ahead of you. But if you look back over 30 years, the default rate on CLO BBs is around 20 basis points. So if you compare that to high yield bonds or to levered loans, if you're just talking about the default rates of indices in general, not what's in CLOs in particular, but high yield bonds default to like 3 % per year. Loans in the loan index default around 3 % per year. So this is really just a small fraction of the default rate. And then today, because CLO BBs are floating rate and because the Fed has hiked so much, we're getting yields in the 12 % plus area, and defaults have been really, really minimal.

12:51So that's a pretty compelling opportunity that we're going after today. How do you pencil out on the one hand, most of that 30 -year history was in a declining rate environment, a pretty stable economic environment with lower defaults. So that could be a negative if defaults go up. On the other hand, with rates going up and you own floating rate paper, you're going to have a higher yield. How do you think about going forward the balance of those two? For an owner of the underlying loans, higher rates is great to the extent that the borrower can make the payments. How we think about that is, well, the initial loan of value is around 40%, maybe 50 % at the max.

13:29So there's a lot of junior capital and equity that supports the business. So these loans are created in leveraged buyouts where a large private equity firm, they're buying a company and they might put up, call it half of the equity or purchase price. From the perspective of the borrower, they can either make their interest in principal payments or they can toss the lenders the keys. Those are really the only options. So because the loan -to -value starts off, we think, a pretty attractive place, even as rates have gone up, borrowers still have the capacity to make the payments. And even if they didn't, from the perspective of the private equity firm that owns the company, they're looking at a future interest rate environment that should be decreasing.

14:09At least that's what the SOFR forward curve would say. So they would be highly incented to support a business that has decent prospects, that has a good business model, help them make the higher interest payments rather than just turning over the keys to the lender. So that's for the underlying loans that are in the CLO. Depending on the pool of loans in the CLO, you're still going to see interest coverage ratios. So that compares the amount of cash flow the business produces each year to its annual interest expense. For the most part, the loan pools are going to be above two times, which is still pretty comfortable.

14:43What are some of the nuances in investing in this space that led you to select the areas that you have? One of the things that's interesting to me about CLOs and why I gravitated to this segment of the leveraged finance market is it's very quantitative. In graduate school, I studied statistics, among other things. When we're buying a double B note, instead of asking ourselves, hey, is this one loan a great loan? Is it a defensible business model? Does it have a good management team? Does it have a good competitive position? These are things that we could debate, you and I, for hours. I don't know if there'd be a right answer or wrong answer at the end of it.

15:21But in CLOs, it's very different. Hey, I have this pool of first -lane senior secured loans. And as long as 7 % or 8 % of the loans don't default each year for the next seven or eight years, I'm going to be money good. That's the analysis you can do as a debt investor in CLOs. And I've always found that the analysis of pools rather than one specific outcome to be more interesting to me. You mentioned at the onset that there are now a hundred different managers of CLOs. I'd love to map out what this investment universe looks like. So of these hundred that create these and manage the CLOs? Who are these organizations?

15:56So the biggest alternative asset managers are all going to have large CLO groups. So Blackstone, BlackRock, KKR, Aries, they all have CLO management teams. They earn, call it, 30 to 50 basis points to put together the initial loan portfolio to keep the CLO fully invested during its reinvestment period, and really to make sure the CLO is passing all of its tests. So the CLO managers are competing amongst themselves for capital from people like me. So they do that by having the best performance of the underlying loans in their CLOs. And they also do it by getting the best debt execution on their CLO.

16:36So for me, that's the two things. Those are two really of the key ingredients that make for good CLO equity returns and also for a nice stable performance of double B rated notes. What drives the ability of the manager to get attractive financing? So the best financing for CLOs comes out of Asia. It's large Japanese banks and insurance companies that like to buy the AAA. And basically they have approved lists. So they have 10 or 15 guys that have somehow made it onto the list. A lot of the criteria it looks to me like from afar is just name recognition. So if it's a big household name, then that puts them pretty close to the top.

17:17But then if you're not on the list in Asia, issuing CLOs is a much harder business because your initial cost of capital is higher and that means less equity distributions over time. So a CLO management firm might say, hey, I didn't get a good debt print for the CLO, but I'll cut my management fee or I'll do something else for you. But the good debt execution really puts the top quartile of managers significantly ahead of anybody else who's in the business or trying to enter the business. When the manager goes to the market to create one of these, how do they address the buying market beyond what, say, that most senior tranches coming from Asia?

17:57So to form a CLO, really the first thing you need is a CLO equity investor like myself. So without the equity, there's really not much that can be done. Maybe the manager can put up the equity themselves. Sometimes it's going to be part of the CLO's permanent financing. Other times it's maybe a bridge until they locate a third -party CLO equity investor like myself. But once you have the equity, then you can set up what's called a CLO warehouse, and that's used to acquire loans prior to the formation of the CLO. And then you start marketing the CLO's debt. So the AAA then is the most important.

18:32And then the other CLO securities, the ones rated AA down to BB, those are important, but less so. The AAA is 65 % of your funding costs, so you need to get good debt execution there. And then later in the process, the other tranches get filled out. So each CLO has a CLO arranger. They have a team that puts together an indenture, which has the rules that the CLO is going to follow, and that negotiates economics with people up and down the CLO capital stack. So when you're looking at this CLO equity and you want to know that they have that attractive debt financing. It sounds like there's a chicken and egg if you're supplying the equity before you know what the terms of the debt will be.

19:14How do you resolve that in your research? The equity needs to be first, but the AAA is probably on deck and there's probably already been a number of conversations there. So that's part of it. But another thing is that in my market, it's very transparent as to which managers are getting the best debt execution. A CLA manager might come to me and just say, hey, I print the tightest AAA in the market. I did it last month and three months before that. And I was talking to a Japanese bank and they seemed pretty interested. And so that gets the conversation going. But the other part of it is once you have the equity, you're in a CLO warehouse and you're buying loans prior to the formation of the CLO, you have three to six months to figure out the full commitment on the AAA.

19:56So if it comes back maybe wider than you might like as an equity investor, you can always just stay in the warehouse and just wait for a better time or better execution. What is the universe of the initial equity providers? So I think there's about 15 of us. One of the common jokes in the CLO industry is that you go to CLO conferences, of which there's many, and it's a common theme that, oh, you know, there's new investors coming into the market and you kind of always hear this, but really I see the same 15 guys. We are often sharing in the same deals. We're speaking at conferences together. It is a niche asset class, although it's grown to be a trillion.

20:36And it's just a little bit more complicated than owning a high yield bond directly or a S &P 500 stock or a mutual fund. So it does take a little bit of learning to get up the curve. But I think for people who spend the time, I think the risk adjusted returns are very favorable. So when you are discussing the value of CLO equity relative to other alternatives of someone who's looking for a certain type of risk return profile. How do you compare it to the other ways people might get exposure to credit markets? Great question. So if we're comparing private credit owned predominantly unlevered, a lot of times you're going to get in a CLO exposure to the same underlying loans.

21:14But the difference is in the CLO, we're employing this long -term attractive funding cost that comes along with the CLO vehicle. So if you own traded loans, they might pay today a call to yield of around 9%. So if you're an unlevered fund, that's the yield, and what investors would get would be less management fees and some loan losses. Now, if you're investing in CLOs, the CLO comes with attached leverage to it. So it might be the same underlying pool of loans, but you have seven to nine times leverage associated with that. So that's a leverage that would be similar to US bank today. So in my business, whenever you see a diversified pool of loans.

21:56Usually somebody is financing against it. And the reason is that banks and insurance companies and CLO AAA investors will give you such attractive financing against a diversified pool of loans that usually people take it. So it's that leverage in the CLO that bridges you from the unlevered return to the levered one. And we think for an investor that can have a little bit more volatility on their nav, that at the end of the day, doing it with leverage is probably the best way to do it. I think the attraction of CLO equity is that the returns that we're expecting to earn should pretty much rival what we think you get from the S &P 500.

22:31But we also think that you can get the returns with a lot less risk. So somebody putting together a diverse portfolio of assets would find CLO equity can push out their efficient frontier or just have a portfolio with better returns and lower risk. So I think that's the selling point for CLO equity is that the distribution of returns around what I'm targeting should be, I think, a pretty tight distribution. So if you invest in CLO equity, you're never going to triple your money unless you're buying something very distressed in a real severe downturn. But at the same time, the probability that you have a negative IRR is extremely low.

23:10So by our math, it's about 6 % of CLOs that have had negative IRR. So it's for somebody who wants to be in the mid to high teens and then not have as much downside risk as they might if they just own individual stock, I think it's a compelling opportunity for them. I'd love to dive into how you go about implementing the investment strategy. How do you start to filter what you'd like to have in your portfolios? So if you want to buy a CLO equity tranche, your options really are to do it in the primary market where CLOs are being created, or you can buy CLOs in the secondary market. So broker dealers, They make markets in these securities.

23:49The securities also trade in auction processes. So for example, a seller of CLO equity might put out a notice to the market that says, hey, in two days, I'm going to sell these three securities and I'm looking for the best bids. And people put in bids through broker dealers for that. So the first thing that you need to decide is just where you're seeing more interesting opportunities, the primary or the secondary market. So what we do is we basically have a tracking sheet, which has every CLO opportunity that we've ever been shown in it. And the first screen is just, well, you buy a CLO equity tranche very simply.

24:26You put in the price and you put in your 2 % expected default rate on the loans, and then you're screening highest to lowest return opportunity. But it's much more complicated than that. So if the CLO equity has a higher return associated with it, then you need to delve in and be like, okay, well, what's the reason? And sometimes it's reasons that are good and that are gonna lead to pursue the opportunity. And then other times, it's just not gonna be an opportunity that you wanna chase. Great reasons to get a high IRR would be I'm buying at a good price. I have good debt execution out of Asia.

25:01The CLO manager's working for a reasonable fee. There's some deal -specific things. If the CLO equity offers high returns, but the reason is that the loan pool is very spready, Well, that means, okay, that's nice for the equity, but a higher spread loan portfolio could result in higher loan defaults over time. So that's the opportunity that we would screen out, for example. As you're diving into any one of those opportunities, you've got a different capital stack on the right -hand side of the balance sheet of the CLO, and then you've got, say, 200 loans on the left -hand side. How do you go about doing your research to determine whether you think it's an attractive opportunity?

25:40So one of the things that we don't do is deep dive due diligence on the underlying loans. And the reason for that is a few. So one, there's going to be 200 or 300 different loans in the portfolio. Usually the max loan size is going to be 1 % of AUM or thereabouts. And then if we're talking about broadly syndicated CLOs, the loans are traded. So you could do due diligence on underlying loan. It's 50 basis points of the loan portfolio. And then you found out three months later, the CLO manager traded it and replaced it with another loan. So you're not really going one by one through loans and asking the CLO manager to explain themselves.