GlobalCapital: Does the Fire and Police Pension Association of Colorado traditionally invest in CLOs?
Ben Bronson: We had some exposure through multi-sector fixed income managers, and we completed an opportunistic allocation about a decade ago, but we have never had a strategic allocation allocated directly until Palmer Square Capital Management.
Historically, we had just one fixed income allocation that covered everything from US Treasuries to full active management multi-sector credit. This year we determined that it made more sense to have a more formal split between a rates and credit portfolio. The credit portfolio opened up a wider universe to consider, and we thought the CLO market had potential for an allocation.
How did you pick Palmer Square Capital Management?
It was a combination of Cambridge Associates, which is our consulting firm, and our network. We didn’t have a request for proposal process.
Our question was “Which types of manager and strategies in the CLO market would be interesting?”
My colleague, Jessica Hsu, did a lot of great work on CLOs broadly, and as we moved towards Palmer Square it become clear that we liked the idea of a manager that could dynamically allocate throughout the quality stack.
Based on our risk and return target, our initial questions were “How much do we have in structured credit, and how much would we consider?” and “How much do we need to have to embrace non-IG risk — for example, lower quality, non-US, or a manager trading component?”
With these objectives in mind, we began condensing the list of potential managers down, and found Palmer Square stood out for different reasons. What we liked specifically is its experience across the rating structure, and in issuing CLOs, its historical performance, the quality of which gave us more confidence in the firm. We also like that Palmer Square has been active in taking advantage in dislocations and actively rotating across the rating spectrum. Finally, we appreciated their flexibility in crafting a mandate to meet our objectives.
When did you start thinking of investing in CLOs?
We identified CLOs as an interesting area in January and February, and had a rough project plan entering March. Then, the market had a huge sell-off with Covid-19, but we found our plan intact after the dust settled. It was a good live example of the sort of price impact we could expect from the class and, as long as we weren’t forced to liquidate or the manager wasn’t forced to sell, we would be compensated. We completed our diligence in the autumn and began allocating the money in November, which was a very different environment.
But the Covid-19 shock didn’t change your mind?
We heard comments about CLOs being the new CDOs, and that is certainly a valid concern. We definitely wanted to get comfortable that we were not engineering a bunch of low-quality stuff into something ‘perfect’.
However, our research kept bringing us back to the structure and ultimately the crisis didn’t change our mind. Another reason we liked Palmer Square is that their credit quality was high and their ability to rotate within the credit made sense to us.
What was yours investment committee’s knowledge of CLOs?
We have different levels of oversight and it was important for us to tailor our education pieces to each. We started with describing the structure, and our consultant (Cambridge) was very helpful in this phase. Then we moved into manager-specific work, tying back to expectations set in the education pieces. It was a process, but a vital one given the complexity of the market.
Which part of the capital stack did you want Palmer Square to focus on?
We want them to focus across the stack, with an emphasis on higher quality, from triple-B up. We would allow Palmer Square to take some lower quality exposure if the manager thinks the risk/reward is appropriate. This does not include CLO equity today but that could change over time.
What structural features or deal terms do you consider most important, either to avoid or to seek out?
We leave the day-to-day to our managers as they are closer to the market and we value their expertise.
However, we spent a lot of time reviewing their credit underwriting and portfolio monitoring, as well as looking through historical default trends and experience. Ultimately, as we are placing confidence in the CLO structure itself, we want to make sure the level of risk assumed matches our goals and guidelines.
How did the extraordinary conditions this year affect your investment process?
This has been a great year for stress tests, that’s for sure!
We adapted fairly quickly to remote diligence, with a significant increase in calls with existing managers. As we moved into Q2, we were able to shift to new manager diligence, culminating in several managers we hadn’t visited. This is where managers have done a good job adjusting to our diligence needs, and our consultant providing another set of eyes on our actions.
How do CLOs fit into your overall investment portfolio? Which other assets do you compare with in terms of relative value?
We hold CLOs in our credit portfolio, and think of them as a key part of our revised class. We compare them with public credit, most notably investment grade and high yield debt. We review our overall allocations to each fixed income segment on a regular basis, but by and large prefer to leave the underlying asset allocation to our managers. We will occasionally consider an opportunistic-type trade, but those tend to fall in our hedged or private market classes.