For years, the market for U.S. CLOs (collateralized loan obligations) has mostly been limited to a clubby group of asset managers, hedge funds, and banks participating in the often arcane, private syndicated loan market.
But as the segment continues to heat up – CLOs now hold some $450 billion in outstanding leveraged loans – that club has opened to insurance companies and pension funds across the U.S., China, Korea, Japan, and Australia, as investors grow more comfortable around the CLO asset class, after it perhaps unfairly received negative attention following the 2007-08 financial crisis, thanks in part to a phonetic similarity to CDOs (collateralized debt obligations).
Issuance of collateralized loan obligation vehicles in the U.S. this year already has surpassed full-year 2016 activity, and is on pace for some $110 billion, making it the second-busiest year ever for the market.
To be sure, there’s a big difference between the two. CLOs are special-purpose vehicles established to hold and manage pools of leveraged loans. Such credits are secured, and historically experience a relatively high recovery in cases of default (you can read more about CLOs in LCD’s Loan Primer). CDOs, of course, are structured vehicles whose assets, shortly before the financial crisis, were often based on sub-prime mortgages.
In recent years, the investor base for CLOs has expanded rapidly, to some of the most coveted and prominent pools of capital worldwide, namely sovereign wealth funds across the Middle East and Asia.
Funds that have invested with CLO managers or have expressed interest so far entail some of the world’s largest, including the $828 billion Abu Dhabi Investment Authority, the $359 billion Singapore GIC, and the $900 billion China Investment Corp., according to market sources. Spokespeople for those firms declined to comment on their investment plans.
Because a number of those entities do not have the in-house expertise or the pre-existing relationships to access CLOs in the new-issue market, sovereign wealth funds have instead been getting involved as limited partners in the risk retention funds of CLO managers that purchase the equity. The risk retention rules under Dodd-Frank currently require CLO managers to retain at least 5% of the market value for each transaction, and in response, a number of managers have gone out to fundraise for the new entities that will provide capital towards complying with the rule.
“We’ve met with a number of sovereign wealth funds, and it’s pretty clear that they already have had multiple meetings with a number of the larger CLO managers in the space,” one CLO manager said.
GoldenTree Asset Management, for example, has raised capital from 20 different investors in the U.S., Europe, and Asia-Pacific, for its $600 million risk retention vehicle, of which a few sovereign wealth funds participated.
Two sovereign wealth funds were also involved in one private equity firm’s fundraise of over $500 million for its risk retention fund earlier this year, sources said.
And in a sign of how the risk retention rules have actually broadened the investor base, half of that fund’s investors were first-time investors in the CLO market.
The move from these funds, which were formed to reinvest their government’s savings or proceeds from excess oil reserves, comes as a number of them have indicated interest in allocating greater amounts to alternative asset classes, especially as their returns have declined following the compression of yields across other asset classes over the years.
For example, the Abu Dhabi Investment Authority (ADIA) has stated in its most recent annual review that it would seek direct investments in private equity and alternative assets after its returns have been falling the past few years. Its rolling 20-year returns declined to 6.1% last year, from 7.6% in 2012, according to the company’s annual report. In addition to its Alternative Investments Department that it formed last year to co-invest in special situations alongside its external managers, ADIA launched its Emerging Opportunities mandate to invest in asset types outside of its normal realm this year.
Temasek, which is owned by the Government of Singapore and which manages around $275 billion, has also found other ways to get indirect exposure to private credit and CLOs via its 5% equity stake in €12.6 billion AUM French credit manager Tikehau Capital last year. Temasek’s rolling 20-year returns have also followed the same pattern, declining from about 15% in 2012 to 6% last year.
CLO equity typically annualized can return anywhere between the low teens to high 20s, and in 2016 averaged about 18.34%, according to data from J.P. Morgan analysts. — Andrew Park
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