Captive equity is evolving from a quick fix for Europe’s CLO arbitrage struggles into a permanent fixture in the market.
For most of last year and half of 2022, CLO managers had to rely on their own funds to buy the equity tranches of their deals. The spreads required to place CLO liability tranches were so wide that the arbitrage between a CLO's funding costs and the margin on its assets left too little yield for the equity to attract external investors.
They had no choice but to use their own resources — or at least so-called captive funds, contributed by investors for this purpose over the long term.
After the CLO spread rally at the start of 2024, the arbitrage is no longer “a bucket with three holes”, as one CLO manager put it. It is not spectacular either.
Nevertheless, investors have told GlobalCapital that managers are sending out marketing materials for the equity tranches again. Last year they did not even bother.
Sound Point Capital Management, on its €453m CLO in January, managed to sell most of its equity to seven or eight investors, but most other deals this year had perhaps one or two external buyers taking minority stakes, according to market sources.
This is unfortunate for managers stuck on the sidelines for lack of equity, but it is fine for the market.
Keeping things running
Ultimately, the purpose of a CLO is to connect companies that need money with people who need to invest money to build up to a pension.
If CLO managers can keep issuing, even when the arbitrage looks poor, the broadly syndicated loan market remains open through times of volatility. It is good for an economy if borrowers have different options to fund themselves rather than, for example, having to rely solely on direct lending in times of crisis.
Throughout last year, CLO managers that kept issuing deals with retained equity were accused of keeping spreads wider for longer. Shutting down issuance altogether, the critics claimed, would have helped bring spreads back in.
But tightening based on a fall in supply would have been a short-term fix, reversed the moment activity picked up again.
Continual issuance kept the door open for loan origination to return and drive a more sustainable recovery of the arbitrage. It meant there is now an eager BSL market ready to welcome deals back from high quality borrowers that turned to private credit in the difficult market after central banks began raising interest rates.
Open door
Lawyers have told GlobalCapital that demand to raise risk retention and other equity funds remains high among CLO managers, and that finding the money is straightforward in many cases.
That seems a contradiction. At a time when no one wants to buy CLO equity tranches, investors should intuitively not be happy to provide captive equity to managers.
But the two approaches are aimed at different groups of buyers, said a CLO manager at the European CLO Forum 2024 last week.
A risk retention fund might appeal to investors looking for “a high yield context with a really nice distribution”, said the manager, whereas traditional CLO equity investors tend to be after an “acute yield structure”.
Third party investors in CLO equity tranches may be hedge funds. Typical investors in a CLO manager’s captive equity vehicle are sovereign wealth funds, big insurance companies and pension funds or family offices.
If the CLO platform is part of a bigger firm, asset managers tend to get investors they have a relationship with elsewhere to buy into their CLO equity funds. These buyers may be satisfied to participate in an equity fund with the promise of 15% returns rather than chasing for 20% or more on a single tranche investment.
Keeping the peace
A CLO structure brings together investors whose interests are imperfectly aligned. Both fundamentally want the portfolio to perform well. But equity investors are directly hit by any defaults in the underlying loans, while benefiting from any increase in returns. They want the manager to have flexibility to trade, and they want the option to call a deal when CLO spreads tighten, so that the pool can be refinanced more cheaply.
Senior debt holders have a big cushion against losses. They want their interest payments for the agreed-upon lifetime of the bond, so are hostile to calls.
Mezzanine investors share some interests with both.
Managers must negotiate the terms of each deal with all these parties. Depending on mechanics of supply and demand, one or the other side may have more power, which leads to more debt- or equity-friendly documentation.
Anyone who puts together a highly leveraged structure like a CLO should have skin in the game. That is the purpose of regulation that requires managers to retain 5%, either of the first loss tranche or across the capital stack.
Pension savers' money tends to go into triple-A notes. If the equity goes to a captive fund full of sovereign wealth cash with a 15% return goal rather than hedge funds on the hunt for maximum profits, the manager is under less pressure to take risks.
Benefits to be had
Pricing CLOs with the help of captive equity links deal activity to growth of assets under management for the issuer, because the manager is managing the equity fund as well. This might create a conflict of interest for the manager, for example incentivising it to favour the equity investors, and could lead to market inefficiencies.
However, as many in the market like to point out, CLO investors are a sophisticated bunch and the European market is fairly small. Managers with a reputation of issuing purely for the sake of AUM would risk losing investors' favour.
Additionally, a hostile market for new CLO issuance can coincide with excellent buying opportunities in the secondary loan market. Captive equity gives managers the chance to take advantage of these situations.
Owners of the equity of CLOs issued in late 2022 and early 2023 made a killing. Yes, spreads were incredibly wide. But loans were cheap and those who bought them at a steep discount profited from the subsequent rally.
Equity arbitrage at the time of issuance looked terrible, but the returns for those deals have been so good that Fidelity recently decided to crystallise them on their track record and reissue its 2022 CLO rather than resetting the debt.
There is nothing wrong with third party equity investors participating in deals when the market is booming. But in the volatile and difficult market of last year, captive equity funds proved their merit. They deserve to keep playing a more prominent role.