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CLO Values: Implications for BDC Earnings Season

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Introduction

S&P Global Rating has just published its Global CLO Round-Up  on October 21, 2019.

The ratings group – like others we have been reading – has concerns about CLO market conditions.

Here is an extract from the article:

…”investors in junior mezzanine tranches have certainly become more conscious of potential pitfalls over past few months, as pricing has widened noticeably in both the primary and secondary.

A handful of CLO equity tranches were offered in the secondary last week, according to data from Empirasign Strategies, including a control equity piece on a 2015 vintage CLO. Price talk on these tranches has generally ranged 10–15 points lower than where a number of these tranches were previously talked or traded, though ultimately none of those offered within the BWICs ended up transacting.

Both the CLO and loan markets are seeing a more distinct bifurcation in pricing between higher and lower quality names.

CLO managers, in an effort to avoid getting closer to CCC limits at this stage, have been purchasing BB through B+ rated credits, several of which now trade above par as a result, while B–/B3 rated credits have been seen selling off 8–10 points over the past few months.

Loan investors have also been attributing the weakness in lower-rated names to the risk management features embedded in the CLO structures, namely tests such as the weighted-average-rating factor (WARF), that are leading many to push back against loans rated B–/B3 without sufficient spread.

But going into year-end, questions remain over how much liquidity may be available to CLO managers in the secondary, especially with third-quarter earnings coming in and a handful of credits on a short leash from both antsy investors and rating agencies.

“There are definitely instances where [dealers] won’t offer liquidity,” one CLO manager said. Namely in lower-rated loans that have little room to miss on earnings and those that have been or are understood to be vulnerable to being downgraded to CCC, additional managers have commented”.

First, A Caveat

The BDC Reporter does not hold itself out to be an expert either in the CLO structure or the market for its equity tranches.

We have forsworn in the BDC Credit Reporter seeking to evaluate the value and credit status of CLO investments held by the BDCs we track.

After all, just one CLO can contain hundreds of portfolio companies and more regulations than an NFL referee’s  rule book.

Knock On Effect

Nonetheless, what happens in the CLO market can have both direct and indirect impact on the BDC sector.

In an indirect sense, CLO appetite levels for new investment acquisitions can affect market pricing and transaction availability in large segments of the market.

That can translate very quickly through to BDC investment originations and pay-off levels as well as into pricing on new loans.

Direct Action

Here, though, we are more concerned with the direct impact that changes in CLO income and values on those BDCs that have material exposure.

In recent years, most BDCs that did have a portion of their portfolios in CLO equity and debt tranches have divested themselves of them.

Nonetheless, some will own a few positions – often for a short term – to boost income levels.

A select few, though, continue to have an abiding and material exposure to CLO investments and are – in theory at least – subject to its vagaries.

Memory Lane Trip

Those vagaries – as anyone who was around in 2008 – 2011 will remember – can cause wide fluctuations in BDC prices in the secondary markets.

At the height of the Great Recession, the buying and selling of CLO equity stakes almost froze up, and some transactions that closed did so at 80% discounts.

Ultimately, the Fed threw a very large amount of “quantitative easing” at the markets and CLO actual credit losses and recoveries were much better than anticipated.

This helped the CLO industry recover very quickly and – subsequently – go from strength to strength.

Vulnerable

Nevertheless, during periods of market uncertainty or when credit losses move up from the low base level incurred in the last 10 years or when interest rates change direction, CLO investments can be inordinately impacted.

Of course, that has to do with the structurally high leverage contained in the CLO format, where debt is a 8x-14x multiple of equity, amplifying the potential or actual impact.

For several months we’ve been hearing about – and confirming in our data review – a new period of weakness in CLO prices, as illustrated above.

This time the concern is about the impact on the cash flows of CLOs from lower LIBOR; higher anticipated credit losses in the future than in the past and other factors.

With third quarter BDC earnings season right round the corner, chances are high pressure on CLO values could translate into lower valuations for equity stakes held, and lower BDC NAV.

There are three BDCs worthy highlighting for their substantial CLO exposure, even though each is very different than the other.

Named Names

The BDCs involved include Oxford Square (OXSQ), which has $162mn of investments assets at FMV out of $447mn in CLO equity tranches.

Last quarter, the BDC wrote down ($20mn) of CLO investments.

Potentially, the number could be higher in the third quarter.

As we’ve noted in earlier articles, OXSQ’s stock price has dropped (20%) since February of this year, some of which may be associated with CLO value concerns.

Go Your Own Way

Then there’s Prospect Capital (PSEC), which has $5.653bn of investment assets, of which $0.851mn is in the form of structured products, aka CLOs, or 15%.

Historically, PSEC has valued its CLO investments in an idiosyncratic way and using a different methodology than its peers, so there may be no material impact on its IIIQ results.

The stock price of PSEC has not changed significantly in recent weeks.

CLO Manager

A third BDC with substantial CLO exposure is Saratoga Capital (SAR).

For ten years SAR has managed its own CLO, and served as the funding source for the junior capital required, and with substantial success.

SAR has already reported quarterly results through August 2019.

In its 10-Q, the BDC indicated its CLO yield has declined from “16.0% to 14.7%”.

The decline is laid at the door of ” the 36 basis points reduction in LIBOR here in Q2, while the reduction of the weighted average effective interest rate generated by the CLO valuation is driven by the 2% discount rate increase also this quarter”.

The value of the SAR’s investment in its long standing CLO – which the BDC manages and serves as the equity investor off – dropped (5.3%) in the quarter ended August.

If the current malaise continues, both the forecast yield and the market value – two loosely related items – might drop when SAR reports November 2019 results.

After all, the BDC will be closing its books in just 5 weeks…

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