A high-stakes trade in the riskiest corner of a $1.3 trillion credit market is enticing some of the world’s most conservative investors, raising concerns that in their aggressive hunt for higher yields they may be discounting some pitfalls.
Pension plans and insurers have been piling into funds that invest in equity tranches of collateralized loan obligations in recent months, according to several asset managers who spoke on the condition of anonymity. The inflows have helped a slew of hedge funds and other money managers, including GoldenTree Asset Management, Sculptor Capital Management, Carlyle Group Inc. and CVC Credit Partners, to raise at least $3.1 billion in less than a year for strategies solely dedicated to these investments.
CLO equity — a small slice of the resurgent market for CLOs that bundle leveraged loans into bonds with varying safety ratings — is actually a form of deeply subordinated debt. It’s highly risky because it’s last in line to receive payments and the first to take any loss. Yet it has an appeal because of its greater claim to profits depending on the strength of the underlying collateral. It promises returns as high as the mid- to high-teens.
While investors have typically included other hedge funds, family offices and sovereign wealth funds, the prospect of higher yields is now luring more money that’s been traditionally risk-averse. The recent increase in demand from pension funds adds a potentially large buyer to the mix and these CLO equity pools, which were harder to raise earlier because of the inherent risks, are getting bigger.
Those raising CLO equity funds say the risks are well flagged, but some investors are concerned that pensions flocking to these investments may be taking on too much risk for returns that haven’t always lived up to expectations.
New York-based Dan Zwirn, founder and chief executive officer of Arena Investors LP, an institutional manager overseeing more than $3.5 billion in assets, said the attraction of low default rates for leveraged loans, estimated at 1.5%-2% by Bloomberg Intelligence, may be masking the asset class’s broader drawbacks.
There’s this “pretend notion that because default rates are low, everything’s fine,” Zwirn said. “But it’s not about defaults, it’s about recoveries and actual losses and that’s what people miss.”
Zwirn said default rates are low because creditor protections have deteriorated over the years, making it harder for borrowers to breach debt terms and trigger a default. Recoveries for high-yield bonds and loans on a last-twelve-months basis have fallen to 33.1% and 41.7%, respectively, from their 25-year annual averages of 40% and 63.5%, according to JPMorgan Chase & Co.
“There’s a lot of extending and pretending, as well as ‘liability management exercises,’ which means that pain is being pushed out, and recovery levels are going to be much lower than expected,” Zwirn said. For returns in the low-teens, CLO equity actually has a terrible risk-reward, he added.
CLO Resurgence
The market for CLOs is coming back to life after languishing for much of the past two years due to a weak economic environment. Sales of new US CLOs have surged 64% this year from the same period in 2023, according to data compiled by Bloomberg News.
Pension inflows into CLO equity, for which no public estimates are available due to the opaque nature of the strategy, aren’t entirely new. Canada Pension Plan Investment Board was present as far back as 2018. Recently, however, there’s been a growing interest from others as well, according to Loic Prevot, who manages CLOs as the head of European leveraged credit at Polus Capital Management.
GoldenTree, which beat its target to raise $1.3 billion to invest in first-loss equity tranches of CLOs, received reverse inquiries from some investors and won backing from existing as well as new investors, including pensions, according to a person with knowledge of the matter. The strategy “optimizes returns in both volatile and benign environments,” Chief Executive Officer Kathy Sutherland said. Sculptor, Carlyle, CVC and CPPIB didn’t respond to requests seeking comment.
Alternative investment platform Sagard and CLO manager Irradiant Partners LP have also raised CLO equity funds in the last year, Bloomberg News has reported previously.
The so-called total arbitrage, a key metric that’s an indicator of the net income for CLO equity, has shown a premium of more than 200 basis points over the last six months. If that stays, more funds will continue to chase the strategy, according to Mahesh Bhimalingam, chief European credit strategist at Bloomberg Intelligence.
Europe Regulations
There’s been a historical aversion to CLO equity because of the negative sentiment toward securitized products following the global financial crisis, but the asset class has performed well over the years, including during periods of heightened volatility, said Polus Capital’s Prevot. Newer entrants do have an understanding of the risk profile and how it fits into their investment strategies, he said.
In Europe, insurers and pension funds are restrained by regulations on how much they can allocate to these higher risk strategies. As a result, their direct participation has historically been quite low, according to Dan Robinson, head of alternative credit for Europe, the Middle East and Africa at Deutsche Bank AG’s asset-management arm DWS Group.
They “can’t be casual about investing into CLO equity,” Robinson said. “For example, there can be deep draw-downs and market liquidity has been volatile for first-loss pieces.”
Pension funds looking for beefier returns place bets not just on the broader market swings but also on the manager who can better select the individual loans that get bundled up.
Some money managers have exceeded expectations, helping stoke such interest in the product. For instance, CVC’s €400 million ($431 million) European leveraged loan fund launched last year achieved a 47% internal rate of return.
But that doesn’t mean all funds would be able to mitigate potential losses on loan portfolios to deliver attractive CLO equity returns.
Craig Bergstrom, chief investment officer at New York-based Corbin Capital Partners that invests in credit funds, says that these strategies have returned only around mid- to sometimes high, single- digit annualized returns over the last eight years across the industry, amid bouts of high market volatility. The business will largely likely come under pressure if investors aren’t eventually paid for the risks, he added.
A lot of big owners are going to wake up one day and ask “Wait! We’ve taken 10 times levered first-loss risk in an OK credit environment and we’ve made 6% or 8% returns?” said Bergstrom.
