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The CLO Manager: a Core Function
At the heart of the complex structure of CLOs lies the CLO manager, a crucial figure responsible for its performance and risk management. The CLO manager has the authority to trade individual bank loans within the collateral pool. This activity is aimed at realizing trading profits and reducing losses from declining credit quality. The majority of CLOs do not operate on a mark-to-market basis and have stringent criteria to fulfil before initiating collateral liquidation, which makes them more robust in the face of market fluctuations.
The CLO Manager’s role entails the following key activities.
- Optimized Portfolio Construction: CLO managers are tasked with assembling portfolios of loans that align with the investment objectives and risk appetite of the CLO. Through meticulous analysis and selection, they strive to optimize the composition of assets, balancing risk and return considerations to enhance overall portfolio performance.
- Portfolio Management: The CLO managers actively engage in ongoing portfolio management. This involves selecting the right loans which will make up the CLO, continuously monitoring loan performance, buying, and selling assets when necessary and restructuring the portfolio to optimize returns and mitigate risk. It is a dynamic process requiring constant vigilance and strategic decision-making.
- Cash Flow Management: Another critical aspect lies in cash flow management. The manager ensures timely and accurate distribution of interest and principal payments from the underlying loans to each tranche, adhering to the established waterfall structure. This meticulous process guarantees fair and transparent returns for all investors, irrespective of their chosen risk category.
- Risk Mitigation: Beyond these responsibilities, the CLO manager also actively works on risk mitigation. The manager proactively monitors the borrower’s creditworthiness, anticipates potential defaults, and implements strategies to minimize losses. This involves stress testing scenarios, analysing economic indicators, and even engaging with struggling borrowers to find solutions. CLO managers are not forced sellers during periods of market volatility and can buy and sell bank loans to take advantage of opportunities in the market to find value or minimize losses on deteriorating credits. There is also a mechanism of coverage tests, which if not fulfilled as per pre-set requirements, result in cash flows being redirected from the lower tranches to the senior most tranches within the capital structure.
- Value Creation and Optimization: Through opportunistic loan purchases and sales, CLO managers seek to enhance the value of the portfolio over time. They leverage their expertise and market insights to identify undervalued assets or capitalize on favourable market conditions, driving incremental returns for investors.
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Strategies Employed
CLO managers employ proactive strategies to widen the spread of their portfolios. One such strategy is the active trading and reinvestment of payment proceeds from their current loan portfolios during the reinvestment phase, which can significantly enhance cash flow.
In the reinvestment phase, CLO managers can utilize the repayment proceeds from robust loans, which are repaid at par, to purchase new loans in the secondary market at prices below par. The volatility of the economy and financial markets often results in greater discounts on healthy, performing loans.
CLO managers have the ability to effectively prolong the reinvestment phase and delay the start of the amortization phase by performing a reset, which is essentially a reissue of the CLO with new terms and an extended maturity. This extends the reinvestment window, offering the CLO additional opportunities to collect payments at par with its existing portfolio and reinvest at more favourable terms or at a discount. Simultaneously, it might enable CLO managers to secure less expensive funding.
The active management of CLOs not only enables trades to be executed to further safeguard the portfolio from losses but also boosts returns. Therefore, the final returns of a CLO for investors are influenced by the CLO manager’s skill at every stage, including portfolio construction, analysis, risk mitigation, as well as the active management of the portfolio.
For CLO investors to understand and evaluate different CLO managers, some important considerations include:
- Portfolio turnover: Is the manager actively trading or running a “buy-and-hold” strategy?
- Credit selection: Does the manager have a robust credit selection process and a proven track record?
- Is the manager running a high-risk/high-reward portfolio or vice versa?
- Facility size: Do the loans in the deal portfolio have a large concentration of small facility sizes, which may warrant higher spreads as compensation for company size risk?
- Portfolio liquidity: Do the loans in the deal portfolio have a highly liquid secondary market?
- Active exposure: Is the manager running a portfolio that is closer to loan indexes or are they taking active exposure and/or concentration risk?
- Specific concentration: Is the manager running a portfolio with a specific concentrated risk bucket (second liens/first-time issuers/industry) to generate excess spread?
- Going concern: Does the manager have strong backing and long-term commitment to the CLO business?
Conclusion
The key differentiator lies in the expertise of CLO managers, who meticulously select and continuously monitor the loan portfolio, seeking to optimize returns while mitigating risks.
By actively managing the loan portfolio, CLO managers can:
- Enhance diversification: They can dynamically adjust the portfolio composition to align with market conditions and risk profiles, spreading exposure across diverse industries and credit qualities.
- Navigate market shifts: Proactive trading allows managers to capitalize on advantageous opportunities, buying high-potential loans during downturns and selling off troubled assets before significant losses materialize.
- Protect investor interests: Continuous credit analysis and portfolio stress testing enable managers to identify and address potential defaults early, safeguarding investor capital from unforeseen risks.
The combined impact of these activities translates into several benefits.
- Increased efficiency: CLOs facilitate broader investor participation in the leveraged loan market, unlocking capital that may not have been accessible otherwise.
- Improved liquidity: Active trading by managers enhances market liquidity for leveraged loans, benefiting both issuers and investors.
- Return optimization: Skilled management can extract additional value from the loan portfolio, delivering attractive returns to investors across various risk tolerances.
YouTube Video
Let’s engage in a conversation with one of the fund managers of Avenida CLO Funds, Alberto De Micheli. We will take a look at the main elements to watch out on when talking about CLOs and in particular the numbers of Avenida, where the managers have an experience of around 23 years in the sector.
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