Editor’s Note: Below is the latest in Reorg’s Expert Views series: Adelene Lee, managing editor of Reorg Americas, recently sat down with CLO fund investor Lakemore Partners to talk about its strategy, particularly in regard to helping the CLO funds they invest in navigate distressed credit risk.
Continue reading for the full interview with CLO fund investor Lakemore Partners, and request a trial for more information on Reorg's proprietary solutions for CLO investors.
1. Can you give us a brief overview of Lakemore Partners’ strategy?
Lakemore Partners is a private credit investment firm with an objective to provide its investors with reliable and resilient returns through market cycles. Lakemore is one of the largest supermajority control equity investors globally and our team has a long-term track record of investing and managing U.S. CLOs since 2000.
Lakemore’s flagship Aquatine platform invests in supermajority control equity in U.S. broadly syndicated CLOs. As part of Aquatine’s supermajority control strategy, Aquatine Funds, together with the CLO manager, own 100% of the CLO equity tranche of each deal. This strategy provides Lakemore key advantages, including 100% control on all embedded optionality within a CLO structure as well as full control on deployment timing and efficient execution from the initial warehouse ramp through to ultimate liquidation.
2. What is a supermajority control CLO equity strategy, and what edge does it give you versus other CLO equity investors?
A simple analogy compares CLO equity investing to being a shareholder in a company. The more of a stake you hold in the company as a shareholder, the more influence you have over the decisions of management. The same holds true for CLO equity investing: The larger the investment, the greater the decision-making optionality. As a result, we believe a supermajority control strategy provides the maximum influence for the CLO equity investor.
Lakemore, as a supermajority control equity investor, and the CLO’s collateral manager typically hold 100% of each CLO portfolio investment. This provides both strategic and economic alignment of interests between the supermajority investor and the collateral manager. Supermajority equityholders have significant influence over the portfolio construction in addition to the structuring and negotiation of the broader CLO structure.
In comparison, CLO equity investors that opt to take simple majority or minority positions have significantly less or (in the case of a minority investor) no influence over these aspects. For example, minority investors have no material influence over key structural decisions that can notably affect the CLO equity return over time, such as refinancing debt tranches or resetting fundamental terms of the CLO.
Furthermore, the most difficult tranche to syndicate in a CLO tends to be the equity, due to its complexity, and in the case of a simple majority (51%) controlled CLO, 49% of the remaining tranche must be syndicated. In times of market volatility, syndicating the minority can be time consuming and, in more adverse markets, unachievable. This may lead to a loss of execution efficiency or subpar loan portfolios, as liability and loan markets move rapidly.
We estimate the value of controlling the entire equity tranche to be around 7% to 10% (in absolute terms) in incremental equity return compared to a minority position.
3. Lakemore exclusively works with best-in-class CLO collateral managers; why is this important for your strategy, and how does the collateral manager also benefit?
We view best-in-class managers as those who have demonstrated a strong track record of performance through multiple credit cycles. These managers, in our experience, have a high-quality defensive portfolio construction and a proven ability to trade effectively through all market conditions.
Having a strong defensive portfolio with the ability to trade effectively is fundamental to CLO equity performance, especially as markets go through dislocations and recessions. CLO equity as an asset class has consistently outperformed other alternative asset classes during recessions due to its structural features (source: Wells Fargo, as of June 2021). As an example, 2001-2002 CLO equity vintages returned an average 18% IRR because its lifecycle encompassed the early 2000s recession, while 2005-2007 CLO equity vintages returned an average 19% IRR due to the Global Financial Crisis (source: Wells Fargo, as of June 2021). Additionally, during volatile market conditions like those we see today, manager tiering is prevalent, and pricing is challenging for all but the best managers in the market.
In our view, partnering with the best CLO managers is essential to generate persistent alpha within the portfolio, and we typically account for a significant portion of the overall issuance pipeline of our collateral manager partners (source: LCD).
In all market conditions, we find that many of these best-in-class managers prefer to engage in repeat control equity deals, with a trusted, knowledgeable and highly aligned equity partner. In addition to maximizing refinancing, reset, amendment and liquidation optionality, partnering with a repeat supermajority CLO equity investor reduces structuring and distribution work for the collateral manager and the arranger, which can lead to lower arranging and distribution costs overall. This repeat partnership also helps facilitate timely and efficient decision-making.
4. What is the primary role control CLO equity investors play in the distressed loan market? Can you provide a recent example?
CLO equity investors are not sensitive to price movements due to the non-mark-to-market nature of CLOs.
However, CLO equity investors are strongly incentivized to manage and contain potential par loss within the underlying portfolios. Supermajority control equity investors, therefore, monitor early warning signals closely and engage with managers at the first signs of fundamental deterioration.
Collateral managers and supermajority control equity investors work in close partnership; while the collateral manager is ultimately responsible for portfolio construction and management, the equity investor’s investment and portfolio management views can provide valuable input to support the collateral manager’s decision-making on topical credits and sectors. Equity investors offer an additional layer of independent analysis on the collateral manager’s investment theses, with the goal in each situation of both parties being aligned on the trading strategy going forward.
A recent example relates to a sector-led engagement. Amid early inflationary headlines and disrupted freight/shipping ports, we engaged with one of our collateral managers to discuss their thesis on core retail sector exposure. Together we identified a U.S. retailer as an issuer vulnerable to these risks and subsequently analyzed potential baskets and loopholes in the credit documents due to a historically opportunistic sponsor. The company reported very weak earnings and free cash flow due to a deterioration in sales and supply-chain disruptions. The issuer’s loan sharply declined in the days following the earnings release. We aligned on near-term risks and negative triggers on the credit with our collateral manager and agreed to revisit the trading strategy ahead of the next earnings release based on developments on key supply-chain and revenue-generation trackers.
5. How does Lakemore track developments and get access to information in stressed and distressed loans?
Reorg is our go-to resource for information on stressed and distressed issuers through earnings summaries, transcripts, and critical news flow on topical names and situations. Most importantly, Reorg’s legal analysis of credit documents helps us better define the subordination and impairment risks that exist within stressed and distressed names held in our CLO portfolios.
6. Can CLO equity investor incentives affect capital flows in a distressed loan restructuring?
In short, yes. Most investors believe that downgrades on stressed and distressed names are likely to trigger selling from CLOs; on the contrary, CLOs are non-mark-to-market vehicles, meaning equity performance relies predominantly on actual credit expense. As a result, often holding a name through restructuring or a period of volatility is the most optimal outcome for CLO equity. Having said this, some CLO equity investors are more focused on downgrades and CCC buckets at the expense of par losses, which can result in a CLO manager taking portfolio actions that trigger a capital outflow. We believe having steady and knowledgeable CLO equity investors is critical to maintaining process integrity for collateral managers.
At Lakemore, we focus predominantly on the projected loss given default outcomes and the paths to optimization of such outcomes. At certain times, this requires holding an exposure - not selling it. In early 2020, we initiated and executed on CLO documentation changes with our CLO managers, to allow for holding restructured assets. Amid significant Covid-19-related volatility, this enabled us to hold on to credits we and our managers had conviction on and participate in restructurings, with the objective of protecting par within our CLOs.
Additionally, by aligning on a trading strategy on a topical name or sector with our collateral managers, we are indirectly impacting future capital flows. Usually, this engagement would result in lowering the traded price of the security within a short period of time, because our collateral managers typically opt to reduce exposure across their platforms rather than on a deal-by-deal basis. Conversely, when we align on a constructive view toward gaining par in a name, our involvement as CLO equity investors can be a positive driver to support value creation.
7. Can CLO supermajority control equity investors participate directly in a restructuring?
Yes. While it is not standard for CLO equity investors to participate in a restructuring, as a supermajority control equity investor, we can negotiate direct participation in restructuring securities (filings, distressed exchanges and maturity extensions) via qualified interest proceeds, principal proceeds or capital contributions. The amount is usually constrained by negotiated percentage limits of target CLO par or collateral principal amount. Given the potential impact of workout scenarios on CLO equity IRRs, we look closely at these terms within the credit agreement and negotiate flexibility that we view to be equity friendly. In our strategy, we would only participate directly in a restructuring if the range of expected outcomes was very narrow, and we could assign a high probability to achieving our target recovery within a stipulated period. This period is deal dependent but would not typically exceed three years.
8. Given current market conditions, in your view, what does the opportunity set look like for CLO equity over the coming 12 to 18 months?
In our view, the volatile market environment seen year-to-date - and, indeed, any further decline in economic outlook - could result in some of the best opportunities for CLO equity on record. We expect market volatility to persist through the second half of 2022 and potentially into 2023, as the economic and geopolitical factors that are driving the current market dislocation continue to play out.
As a long-term, non-mark-to-market arbitrage vehicle, CLO equity benefits during periods of widening asset spreads (average new issue first lien spreads: SOFR+495 bps, as of June 9, 2022; source: LCD), with highly attractive asset prices and strong reinvestment opportunities offsetting a higher liability cost. Meanwhile, high-quality BB loan secondary prices have fallen to about 96 (as of June 14; source: LCD), which makes secondary ramps in CLOs very attractive on a risk-adjusted return basis for those CLO equity investors and collateral managers that have access to open, minimally ramped warehouses and the ability to price in volatile markets.
The combination of fundamentally high-quality loans trading at significant discounts and best-in-class collateral management means we anticipate extremely attractive CLO equity IRRs for 2022 and 2023 vintages. To put this into context, current new issue CLO equity arbitrage (year-to-date, as of May 31, 2022; source: LCD) - calculated as new issue loan spreads minus weighted average cost of capital multiplied by 10 - is running at a record level of about 21%, compared to a 17% average between 2013 and 2020. U.S. CLO equity has a proven track record of strong performance through market dislocations and recessions.
We believe that efficient CLO equity investing in dislocated markets requires partnering with high-quality CLO managers and adopting a disciplined and defensive strategy that is able to move quickly to capitalize on the opportunities presented by volatility. For this reason, we favor primary supermajority control CLO equity over buying smaller equity pieces in the secondary market.