SPEAKER_00 0:07

Hello and welcome to another fine men. I'm Thomas Hopkins, Global Capital's European CLO reporter. Now, as regular listeners will know, I usually present this podcast with my esteemed colleagues George Smith and Tom Hall. But this week's podcast is going to be a CLO special in which you're going to be taking a detailed look at CLO equity. Now, helping me navigate this topic will be Matthew Leighton, a partner at Pearl Diver Capital. Matthew, thanks so much for joining me on the podcast today. Hi, Tom. How are you? I'm doing very well, thank you. And yeah, it's it certainly seems like uh CLO equity is going to be something that's quite topical to talk about, I think, at the moment.

SPEAKER_01 0:46

Yeah, yeah, no, I would certainly, certainly agree. Um, yeah, it's captured captured so um several headlines this year, and I think it will continue to do so. Um but we've got uh we've got 20 odd years of uh data and track record to mull over as well. So so we'll try to uh we'll try to get to to to to the bottom of it, shall we, over the next uh sort of half an hour or so.

SPEAKER_00 1:07

Yes, exactly. And I'm sure half an hour is is long enough to to solve all of that. But yeah, it is great to have you on the podcast. Um and before we sort of dive into all things CLO equity, um perhaps you could just tell us a little bit about your professional background and your role at Pearl Diver.

SPEAKER_01 1:22

Yep, brilliant. Thank you. So my name is Matthew Leighton. Um, I'm a partner at Pearl Diver Capital. Pearl Diver is a boutique investor in CLO tranches. We have a 17-year track record. We actually have one of the one of the longest dedicated track records uh across the CLO tranche investing. And we take a global view of the world as well. Um, so approximately 60% of all of our investments are are in the US markets and 40% in Europe. We are headquartered in London, but we have offices also in New York and in Dubai, and the team is spread across those three regions. Then historically, I guess we have been known for certainly investing towards the bottom of the CLO capital structure. So that is um in the CLO equity and the CLO junior mezzanine bonds. So that would be the double B and single B rated bonds. Um but over the last three to four years, we've also increased our scope and we now invest in AAA's, double A's, and single A's. So essentially all over the capital structure, all over the globe. Um so we have a view. So as we talk today about CLO equity, our perspective on the CLO equity market is not as an issuer, not as a manager of the underlying loans, but as a third-party investor. So this gives us a slightly nuanced view, and we have freedom to be able to invest in the primary market, but also in the secondary markets as well. And as I said before, up and down the CLO capital structure. And by what I what I mean by that is a CLO capital structure can have six to seven tranches, and subsequently, we're able to invest across different mandates across all of those tranches. And it's true to say that what can be good for the debt tranches is not necessarily so good for the equity tranches, and what's good for the equity tranches is not so good for the debt tranches. So again, investing across across both sides, and we have dedicated equity mandates and dedicated equity funds, and we also have dedicated debt funds. So we've really got a you know a great view of the overall market, and we can see the current trends and what managers are doing and uh so on and so forth to be able to nav navigate these uh current market conditions.

SPEAKER_00 3:31

Thanks very much, Matt. And yeah, I think it would be really, really interesting to get your perspective on sort of you know what exactly is kind of attractive about CLO equity right now, where there are risks, where there are complications. And I think you're sort of very well placed to do that, as you say, given your sort of background investing as a third-party investor. So I think actually just sort of diving into this topic a little bit, I am going to start with that first point. If you're looking at CLO equity sort of relative to other asset classes as an investor, what makes it attractive?

SPEAKER_01 4:02

Yeah. So I think one of the important points is to when when when thinking about CLO equity, thinking about any asset class really, but certainly CLO equity, if a CLO is issued into the market today, in all likelihood, even without extensions and so on and so forth, and an extension for a CLO can be a healthy thing, just to be clear. A CLO would naturally have a seven-year life anyway. The reality is most CLOs would do one round of what we call a reset where the portfolio is is is is cleaned up, the reinvestment period is extended, and that CLO would would be expected to run for sort of 10, maybe, maybe 10 years, nine to eleven years, some some something around that period of time. And that's that's natural for a CLO. So I think it's important when you sort of look at CLOs and say, oh, you know, the arbitrage and the the cash on cash returns from the equity tranche today is not so good. You know, what does that actually mean for the life of that equity tranche? But I think taking a step back, what we it's also very important to understand exactly what a CLO equity is. And essentially it's a levered play on a pool of underlying, firstly, in senior secured bank loans. And these are actively managed pools, and there's approximately 200 credit managers in the market that issue and manage these CLOs. Some of these credit shops, you know, exceptionally good managers, some not so, many sit in the middle. And understanding the the different profiles and different quality of of CLO equity is not necessarily the most straightforward. Um, and this is where uh specialists such as ourselves, such as at Pearl Diver Capital, we're able to come in and we're we're able to analyze this market and understand who's got the track records and and and and understand how to construct and build a balanced portfolio across these different managers. Now, I think that the the actively managed component is very, very important for a CLO equity as well. You know, unlike certain other ABS asset back products, uh, where there'll be a portfolio on day one, here that portfolio is constantly being managed, rotated essentially. Um, you're really trying to do two things by by rotating the portfolio. The first one, first and foremost, is try to avoid credit losses, okay, within the underlying these two to three hundred uh senior secured bank loans. And some credit managers are better at doing doing that than others. And that ultimately comes through in the NAV of the CLO. Now, the other aspect is trying to drive returns, okay? And there's two ways to try to drive returns. You could either try to sell a loan for argument's sake at 100 in the secondary market, buy a loan at 97, it rallies to par and you're able to grow the NAV like that. The other way is to increase or drive the spread of the underlying loan portfolio. And this is where CLO equity can become very attractive. Because really, in a world today where we see a lot of, I'm going to use that word again, extensions on on private private asset portfolios, whether that be in private credit, private, um, what CLO equity actually does is gives you a really healthy double-digit cash on cash distribution that's paid quarterly to the investors. And that gives some form of cash liquidity. And investors really, really like that. There's good visibility over it. It can vary, it can go up and down, and we're going we're going to touch on this spread compression being the main driver of that. But spreads can go the other way and widen as well over time. And these are kind of you know pretty gradual processes. But a lot of people are attracted to, and beyond the what we would classify as the historically normal investor base into CLOs, you know, the CLO market itself is a $1.4 trillion market now. So there's a there's a huge range and wide profile of of CLO investors away from the traditional base that we certainly saw kind of up until three to four years ago.

SPEAKER_00 7:54

And I just want to sort of pick up on something you uh you mentioned. Obviously, you were talking about like the day one arbitrage. And obviously, I know that this is something that is certainly relevant when third-party CLO equity investors are thinking about sort of going into a deal. But I mean, how crucial is this as you know a consideration for whether or not you sort of invest in a particular CLO? Yep.

SPEAKER_01 8:18

Certainly. So look, this is an area of great debate, and many CLO issuers and CLO managers, they will argue, and there's some ext to some extent that they're correct, that that they want arbitrage has very little correlation to the overall return of the CLO over the next say say 10 years. This is true. This is true. Now, however, if you're starting in a bad place, it doesn't necessarily always get better. Now, the other nuance is that CLOs are often outperformed during periods of volatility because these are periods where CLOs, again, because they're actively managed, they're able to invest in discounted loans and able to build par, but also during those periods you'll see spread widening. And you know, one of the great advantages of a CLO is once you've locked the liabilities at issuance, the debt tranches at issuance, then that that cost of debt is actually stable. And it's the interest on the underlying loans that can actually tighten or widen. So coming back to your original question, day one arbitrage. So the arbitrage is actually the difference between if the loan pool is paying a spread of X and it costs uh Y to be able to finance the AAA, AA, single A, triple B, double B, potentially single B in the liability capital structure of the CLO, there's a difference between the funding costs there and you're getting excess spread from the loans. That excess spread falls all the way down to the CLO equity. That's what it's a residual and it captures those residual cash flows. Those residual cash flows in a healthy market can run anywhere between 15 to 20 percent cash on cash. So that's fantastic. Now, the day one arbitrage might say, actually, today, if you were to issue a CLO today, that cash on cash might be closer to a very low double digit number. And therefore, there's two things that are happening. The loans themselves are relatively tight in their spread. The other component is, you know, what's going on, what's the pricing on the capital structure? And the fact and the reality is today that the capital structure is also relatively, relatively tight. You know, it's difficult to see that it goes much lower than where we are today at at all tranches and we trade these tranches. So subsequently, it feels like something has to shift here in order to get back into that state of equilibrium. Now, as a debt tranche investor, I know that there's limited appetite for debt tranches to go much tighter. Okay, then starts to doesn't work on a risk, risk-reward basis. And I know people have been saying that for you know several months, but it kind of feels like when we are actually now getting to a position where it's hard to see how how it materially gets tighter from here. So how does it fix itself on the other side? I think this is where we've really got to start to look at the loans. So you've locked almost record-level cheap liabilities, and they will run for the permanence of the threat until the end of the life of the of the CLO. Now, if we start to get a little bit of volatility um as we come through the summer, as we come through the back end of 2026 and into 2027, and that can be driven by myriad of we've got the Iran-US situation that is um extended further than we we anticipated, but we're also kind of looking at the macro situation at the moment as well. And it feels like we could be on the, not necessarily the precipice, but we could be on the edge of something that sees a little bit of a normalization. Now, what that means is you've already locked your liabilities at record tight. So if loans start coming to the market over the next six, twelve months at a more normalized spread, i.e. a little bit wider than where we are today, this CLO is still going to be investing in those loans and trading in those loans and rotating into those new loans that come into the market at a wider spread. So the returns will grow. Okay, so that's that's kind of kind of the interesting point there. Now the other factor is if the if the if loans in the market are performing loans that should sort of basically trade around around 100, 100 cents in the in the dollar, if they start to trade at sort of even 99 cents in the dollar, 98.50, 98, okay, these are small adjustments. You don't need a significant sell-off. Again, the CLOs will be buying those and then just making those incremental gains, and that builds the nav and that really materially builds the return. So over the course of the life of the CLO, there's plenty of you know, many different reasons that you know, CLO is going to go through many, many different cycles as well. I mean, even in the last 12 months, you look at we've had tariffs, we've had, we've had um Iran, you know, that that's to be expected now going forward. So you're gonna get these little pockets of volatility. It's about being able to identify which managers trade through those periods the best and add value. So day one arbitrage, I think it's important, but I think you've got to overlay that with understanding I'm getting tight liability funding, but which of these roughly 200 credit managers that exist out there globally, which are the ones who are going to add value over the following years? And that's really the important part, and that becomes the science of uh investing in in CLO tranches.

SPEAKER_00 13:31

And Matthew, you mentioned obviously that the average arbitrage has been a little bit compressed over the last few months. I sort of wondered if you saw that maybe improving later this year. I mean, you spoke about some of the kind of market volatility we might see, which which could have an effect on maybe sort of normalizing loan spreads. I mean, do you think that there is a substantial chance that trants that we'll sort of see a slightly better ARP later in the year?

SPEAKER_01 13:56

I do, but I also I also think it's capped. If if the arbitrage goes from a low double digit, for argument's sake, just to exaggerate the point, loans loans widen out and the the natural arbitrage would become a circa 20% cash on cash, would to the arbitrage would provide a 20% cash on cash. That doesn't happen in the loans don't widen without the liabilities widening, okay? Usually similar, you know, this the similar rationale, the macroeconomic environment, which is driving the loans wider, is also going to drive drive the liabilities wider. If I'm if I'm investing in a in a in a CLO double B tranch, okay, if if you've seen B rated credits widen out in the at the issuer level, you know, we're going to we're going to overlay that and adjust our pricing in the double B's. But what will happen is once that arbitrage gets to say 15%, you'll see more issuance of CLOs coming into the market, okay? And then subsequently those loans will will be bought, whereas they were going to provide you a 20% cash on cash return, those loans will will rally because of the demand that's coming in, and they'll come back to a 15%. So the market kind of adjusts, it finds its equilibrium and it finds its, you know, water, water flows to the nearest exit. Okay. And that's what the loan market and the CLO liability market does consistently over time. Now, I think one of the key things when thinking about the back end of the year, and I touched on it before, is like if we're looking at the macro environment, there's a number of situations that are that are kind of rumbling on in in the background. And I think, you know, we're looking at sort of inflation repressures, what that means for the underlying corporates. Some of this is going to come through in terms of additional risk in in the market. So one of the important things I think is like coming back to your original questionnaire around arbitrage is is identify managers that are kind of, you know, they're still they've they're going up in quality. They're not chasing that arbitrage by adding additional risk into the portfolios today on day one just to get just to get the transaction away, because that risk could potentially sort of really come to the fore, should we say, in the back end of the year and the back end of back end of next year. I'd say generally speaking, on the whole, managers are and the market is being pretty disciplined when when it comes to that ramp up. But I think spreads can widen towards the back end of the year. And there's another key reason why. We've had not record low, but very low fresh loan issuance, supply of loans coming through the market from the back end of last year, mainly through through this year as well. Offsetting that, we've got significant demand, and we're going to touch on this with um affiliate equity funds. There are many warehouses open, um, and those warehouses are poised in their position to be able to absorb these new issue loans as they as they come come to market. So this means that the few loans that do come to market, you know, there's a scramble for them, essentially, at the moment. And again, I I I sincerely I I think that this will normalize over time, but these are these are all kind of, you know, these are reasons why the arbitrage and why the market has kind of ended up in the position that that that we are today. But that doesn't mean to say that it's permanent.

SPEAKER_00 17:13

Of course. And um, Matthew, you you mentioned obviously that, you know, at Pearl Diver, that you would sort of consider opportunities in both the primary and secondary market for buying CLO equity. I just wondered obviously comparing those two markets or ways of buying CLO equity as a third-party investor. Is the secondary market currently offering better opportunities than the primary market or vice versa? I wondered, yeah, just a comparison between those two opportunities, really.

SPEAKER_01 17:41

Yeah, that's a great question. Um, in any normal market environment, I would say that 80% of our investments are made through the secondary market as opposed to the primary market. To your question, actually at the moment, um, not necessarily dedicated for CLO equity, just to just to clarify. But I think in the overall, um, what we're seeing in the in the bond space, even from the AAA's, primary AAA's are trading a little bit wider than secondary triple A's. There's some technical reasons for that. And we're kind of seeing on a quality basis a similar thing in the junior debt tranches as as well. So, you know, again, it kind of comes back to a point I made earlier. What can be good for the debt tranches is not necessarily so so good for the equity. And that manifests itself in seeing better value, um, relatively better value in primary debt issuance today. Like we in our investment committee today, we've looked at a number of opportunities versus the usual. In a normal normalized market, the secondary market for debt tranches definitely makes more sense. Equity, slightly different again. Um, you know, you have to change your hat. You have to, you, you you have to sort of uh uh approach the equity market with a with a different pair of eyes. The equity market, you do see better value in the secondary versus primary, undoubtedly. And and a lot of the primary paper is is is certainly being taken up um by the affiliate equity funds. But also, I think if you look at specialists such as ourselves, you can really start to. I mean, there's so many different shapes of a CLO secondary equity. You can have a six-month-old equity, uh, which an affiliate fund might it may have backstopped and they may also may sell some some of the position down, a small minority position in the secondary market. That's one profile. You might have another profile where the CLO is coming towards the end of its reinvestment period and it's actually ready and being primed to actually be liquidated and called at the end of its life. Okay, so that takes a different degree of underwriting and understanding the the watch list credits and the tail within the portfolio and where you can actually transact and realize there. So that's that's that's that's a much more technical aspect to investing in in CLO equity, and that's where that's where the specialists come to the fore. So it's never a straight answer, or or you know, that there's always nuances. But for equity, um, I think to to your question for equity, better opportunities in the secondary market than the primary market. For the debt tranches from double B's all the way up to AAA's, it's it's the it's the reverse. That's that's the way we see see the market today.

SPEAKER_00 20:15

And uh Matthew, you've spoken also, uh you've mentioned these sort of affiliate equity funds. I know they these funds take on uh a number of different names. I mean, uh some, you know, there's sometimes called captive equity funds, historically called risk retention funds, you know. But uh, I suppose I wanted to touch on them because obviously there are, you know, there's more than one way for an investor to sort of you know get exposure to CLO equity. You could invest in a captive equity fund or you could invest in CLO equity directly. Now I wondered kind of from an investor perspective, kind of what are the sort of advantages or or disadvantages of investing, you know, um in a captive equity fund versus investing in a in a CLO equity kind of directly?

SPEAKER_01 20:55

Yeah. So to invest in a CLO equity directly requires a pretty technical skill set, requires a certain level of infrastructure. You need to be able to underwrite and understand what is in the existing portfolio, and subsequently, you need to be able to price that credit risk. And the way that you do that is by running the underlying credits, two to two to three hundred loan issuers. You need to run various scenarios through states of different states of the economy. Then you need to be able to understand what your losses will be, your your nav losses essentially in that credit portfolio, and how that then relates and interacts with the capital structure of the CLO and run that through the CLO waterfall. That's a pretty technical set of skills. And not everybody has the capability or the wish to put the resources, manpower, and so on and so forth into into being able to do that. Now, investing in a third party fund or in a or or in an affiliate equity fund kind of takes away the need to be able to do that. So I think one of the attractions. For equity investors in the affiliate equity funds is, you know, they know that there's going to be a certain cadence to the deployment and getting invested in the market. And they might be able to work with a manager who, you know, that they know they, you know, they've done their due diligence on and so on and so forth. And then they effectively hand out hand over the keys. Now, the potential disadvantages are, and I mentioned this before, across the spectrum of these, you know, close to 200 different credit managers, you know, they're not all good. And a lot of investors who are, again, non-specialists in this area, they want to be able to hand over the responsibility too. But some of these, you know, there are CLO managers there who are underperforming the market. Let's let's let's let's put it that way. And a lot of investors in these affiliate equity funds don't have the resources or the knowledge or the manpower, the resources to actually properly underwrite the manager themselves in which they're in which they're investing. So I would say that. Now the other components are, and you know, again, it's it's it's pros and cons, okay? So with that cadence of issuance that that comes forward, that can be certainly beneficial for the issuer, for the CLO manager. They have some some visibility on on revenue streams that are coming forward and they can determine that. I think then there is a danger that, and not every CLO issuer or manager does this, but there's a danger that they will print transactions during periods where maybe they should just pull back from the market a little bit. Again, coming back to this arbitrage conversation. I know we, you know, I just presented the case that, okay, the arbitrage today is not, you know, is not the determinant of the ultimate outcome, but there are still better periods and worse periods on a relative basis, and and practitioners understand that. So I think it's better for investors to be able to understand the cadence with which their managers are going to invest. The other thing is you you can end up with a lot of crossover. So if uh if if if a manager, for argument's sake, is going to invest in sort of six deals in any one year, there's a lot of vintage crossover there. But if you're with a manager who's very thoughtful about their timing and so on and so forth, so it all really comes down to who the manager is, then there's a sort of liquidity. Some investors want liquidity and other investors prefer to not have liquidity and that necessarily that mark coming through. And again, CLO equity is a long-term vehicle. Okay, so you know, there is an actively traded secondary market, and you have some visibility on that. But many investors will want to take a longer-term view as to the prospects of of of the CLO. Um, and I think that that's a reasonable assumption. The other component is simply concentration in in one manager. And again, this comes back to making sure that and having that capability of being able to underwrite those 200 managers. And if you say, right, I'm going to invest in one, why are you investing in that one? What's the clear case? What's the what's the strength of that manager, not just their issuance and so on and so forth, but their actual performance over the last number of years. One of the interesting components is in the last three years, we've seen a lot of new managers coming to market. And I think that I actually think this is a really healthy thing. And often it's kind of people will sort of say, oh, you know, new managers, new managers, we don't need we don't need another new manager. On the whole, a lot of these new managers have actually performed very, very well in in their early transactions. They've said that they'll go up in credit quality and they have gone up in credit quality. And I think partially the rationale for that is the understanding that if you can allow the loan pool to kind of run with the structure, okay, there will be returns. Okay. Now you might not maximize to to every every basis point of IRR, but if you can avoid losses, okay, then one of the great things that it does, and again, this is us wearing wearing our desk investor hat, is you can start to get better pricing on your liabilities, your second, third, fourth, fifth CLO. Now, then you can take that same level of risk because your liabilities are getting incrementally cheaper, your returns are getting incrementally better. Okay. Um, and subsequently, we've seen a lot of new managers come into market who've taken this very conservative and sensible approach, and it's really really played out, played out very, very well. They've also, you know, newer newer CLOs, they've had, you know, if you're if you're for argument's sake, the you know, the best example is if you're going to print a CLO today, you've got full visibility on the software situation. Okay. Now, if you printed a CLO in 2022, you didn't necessarily have that. Okay. So today you're a kind of you're able to, you're able to pick your battles, avoid certain sectors that, and there will be other sectors around the corner. That's that's that's always the case. But but I think that I think that there's a real opportunity at the moment for um some of the younger, newer, newer managers to actually differentiate themselves from some of the sort of longer historical trap trap records that you know may be carrying a little bit of of a tail across across their portfolio, should, should we say. But yeah, affiliate equity funds, they're here to stay. They both have their benefits and their disadvantages. And I think it's up for the up to the investor to educate themselves and make sure that they're sort of you know, you know, they're they're backing the right horse.

SPEAKER_00 27:29

Of course. And Matthew, one last thing I wanted to sort of touch on in this podcast was obviously, so we've talked about, you know, the hour charge, we've talked about the the nav, both of which are sort of important considerations for scalar equity investors. But one thing I think also that obviously investors are very interested in is cash on cash distributions, which is very important to sort of seal their equity returns. Now, I I wondered, so, because certainly in the European market, you know, over the course of this year, we've seen quite a lot in the way of loan repricings. And I think yeah to date it's somewhere in the region of about 70 billion, I think, um, euros of loan repricings we've seen in in Europe. So I wondered to what extent loan pricings were kind of currently sort of impacting these cash on cash distributions to CO equity, and to what extent this was kind of a a concern for investors, really.

SPEAKER_01 28:16

Yeah, and look, this this question, Tom, is kind of boiling under the surface in terms in terms of you know several several of my answers. And and you're right, loans can come back and re refinance tighter. That's the reality of it. And they'll only come back and refinance wider when they hit their maturity. And loans are structured as a seven-year bullet. Um, so for the first five years, if that loan was able to price during a you know good market environment, then they're going to enjoy that spread. Um, that spread is is is going to continue. And there are a number of ways of tracking this situation. You can you can constantly, and we do this is continuously track the arbitrage across every single CLO within the market individually and then aggregate that. You can also break it down by vintage as well. Vintage effect is really, really important when building out a CLO portfolio. But we we certainly saw a uh a real you know the heavy flow of of repricings in the early part of the year. But then obviously that backed off um certainly around February when it was actually public markets uh to my mind that suddenly woke up to the threat, should we call it, or you know, some would say it's an opportunity, whatever, of of AI. Whereas actually across the CLO market, we we we saw really through back into 2024, 2025, the smart managers, and again, not every manager acts the same, okay, you know, need to emphasize this, but the good managers were already starting to maneuver their portfolios. And and in that way, it wasn't just a case of just blindly selling all software, but picking out the names that were most at risk from disruption and being able to slowly start to sell out of those positions in a way with it where they wouldn't necessarily alert and spook the market and move move market pricing against them. So, but when when we saw the public markets in in February of this year, uh kind of really wake up, and then we saw software loans within the the senior secured loan space sell off around around three percentage points. There was a little bit of a drag on the rest of the market as well, as one would expect. Um, and subsequently you saw a slowdown in the repricing. So then the repricing pressure built up again, and it does this, it goes goes through these cycles. You know, loans themselves have a six-month non-call, and subsequently, the loan has to wait for six months before it can come back and reduce its thread, usually by by another 25 basis points. Again, I think that most of this activity is now behind us. I think that as we come through, you know, we're starting certainly starting to see a lot of market nerves in sort of broader indexes, stock in the indices globally as well, which is, you know, can often be the canary in the coal mine. Um, I I think I think that this trend is about to is about to plateau. Um, and then potentially, you know, do we see widening? I don't have a crystal ball, but my sense is that certain credits, yes, we could see some widening towards the back end of this year and then 2027 could, and again, uh I I'm gonna use the phrase actually throw up some opportunities because that is that is what we're all we're all looking for.

SPEAKER_00 31:25

Of course. And uh, Matthew, I'm very sorry to say that that's all we're going to have time for on this episode. But thank you once again for joining me on the podcast.

SPEAKER_01 31:34

Thank you, Tom. Thank you for having me.

SPEAKER_00 31:36

Yeah, it's been certainly great to have you on, and I think it's been a really interesting discussion of this very topical kind of CLO equity topic. But beyond that, I just wanted to thank everyone for listening. And you know, please do join us again next week for more insights into the latest trends across the European securitization market. Goodbye for now.