CLOs: Past, Present & Future

Greg Campion: Collateralized Loan Obligations, or CLOs, have come a long way over the last 25 plus years. From the emergence of the asset class in the late nineties as a way to securitize leveraged loans and segment different risk profiles, to the challenges of the global financial crisis, all the way through to more recent innovations, including private credit CLOs. My colleague Adrienne Butler, has had a front row seat to all of it.

Adrienne Butler: It's really been exciting to see the growth of the asset class over time, as well as the widespread acceptance of it by investors.

Greg Campion: That was Adrienne Butler, Head of Global CLOs at Barings, and this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion. Coming up on the show, we're diving into the past, present, and future of CLOs. Before we get into it, just a quick reminder that you can follow Streaming Income on Apple Podcast, Spotify, and if you want the full video episodes, on YouTube as well. With that, here's my conversation with Adrienne Butler. All right, Adrienne Butler, welcome back to Streaming Income.

Adrienne Butler: Thank you. It's a pleasure to be here.

Greg Campion: Awesome to have you here. And so today we're going to be talking all about CLOs. And the theme for our discussion today is the past, present and future of CLOs. So I'm excited to dive into all of this with you. You've been operating in this market for 25 plus years. You've seen the market change a lot. I feel like there's a lot of great context there to really understand today's market, sort of look back a little bit. So I know that you and the team started around'98 in terms of launching the presence in the asset class. I want to talk about that and understand what was going on in'98. But I thought maybe just to help jog your memory a little bit, I would bring up a couple of pop culture references so you can understand.

Adrienne Butler: Okay. Trying to date me.

Greg Campion: Yeah, let's get back into the vibe here.

Adrienne Butler: All right. Let's see if I can do it.

Adrienne Butler: This

Adrienne Butler: will help me get in the groove.

Greg Campion: Okay. So Titanic became the first movie to gross over a billion dollars at the box office in'98. At the top of the charts were Will Smith's Getting Jiggy With It.

Adrienne Butler: Oh yeah.

Greg Campion: As well as Britney Spears with her iconic debut single" Baby, One More Time".

Adrienne Butler: Oh yeah.

Greg Campion: Who could forget that one? On a sad note, Seinfeld aired his final episode.

Adrienne Butler: And we're still watching it. Right? I still watch it all the time at home. So crazy.

Greg Campion: That's right. 76 million people tuned in to watch it. Hard to get an audience like that these days with everyone on their phones. But on a happier note, Sex in the City and Dawson's Creek both premiered that year, so we had a lot to look forward to.

Adrienne Butler: Iconic.

Greg Campion: Yes. And then of course, probably the biggest thing that was going on was President Bill Clinton was embroiled in the Monica Lewinsky scandal. So tons going on. My question for you to start is, with all that going on, how were you focused on CLOs?

Adrienne Butler: That is a good question. It was a busy time I guess. But I look back on that time and it was exciting. At the time, you didn't really know what you were creating. It was so early in the history of CLOs. And my understanding is CLOs kind of started back in the eighties, but really took off in the nineties. And if you put yourself back in that timeframe like you just did, and we eliminate Britney Spears and Bill Clinton, you think about the repeal of Glass- Steagall. You think about the difference between commercial and investment banks. You see commercial banks reaching for fee income. You see bank loans taking off as an asset class. They're trading. They're liquid. They're syndicating more. All of that was happening, and I don't know that anybody knew what they were creating at the time, but we were leaning in to what was happening. And what was happening was kind of a takeoff in the bank loan market. And just to set the stage, I think the bank loan market in'98ish was about$ 300 billion in size and CLOs were about 10% of the market. And you know today, I'm going to go ahead and give you the punch line, it's about a$ 1. 4 trillion market and we're about 70% of the market. So that's the growth that's happened over this 25 years.

Greg Campion: Yeah. So just take me back there for a minute, because you were part of IDM, which was Institutional Debt Management, which was a business under the first union umbrella, right?

Adrienne Butler: Correct.

Greg Campion: That ultimately Babson, a predecessor firm of Barings acquired. But take me back there because my understanding was that the bank loan market was just really kind of emerging and becoming an asset class. And I know you and the team were a big part of that. And you kind of referenced that CLOs existed. In my understanding, there were basically mortgages packaged as CDOs, so that secure, that kind of waterfall framework had kind of been established. But to your point, not really broadly proliferated, certainly for corporate loans and as an institutional asset class. So talk to me a little bit about what was the opportunity there? You and the team were among the real pioneers there that were developing this asset class. Tell me a little bit about what was the opportunity. What did you see there that was interesting to kind of dive in and develop this asset class?

Adrienne Butler: Yeah, I think most of us who found themselves in the CLO market had their roots in bank lending. I grew up lending in two institutions. I was a commercial loan officer, so understood bank loans, understood credit agreements, and I'd say most of us who got into the CLO market had that kind of background. We were fortunate enough to find other players who wanted to grow the space, in particular, Babson and Mass Mutual who were working with us and also growing this asset class. And together we had the size and the girth and the strategy to kind of grow the market. And we spent a lot of time on the phone with bankers explaining what we needed, because they didn't understand what a CLO mark was. So we were saying, " Here's what a term loan B is." We need amortization. We need a fixed maturity. We need a fully funded tranche. It can't be a revolving facility. We need something that gives us current interest. We need ratings, and we need a certain kind of ratings and we want bite- sized pieces. That was different because prior to that time, most of the loan syndication was between banks and they were taking down large components of each facility. So we were really trailblazing, but we did it because we had enough size to have that kind of influence and talk to the market. And we had the experience in the market that we were able to translate what we knew into what the bankers could understand.

Greg Campion: Okay. Okay. Now, was there a third- party investor base for CLOs at that point, or did that come later?

Adrienne Butler: No, there was. It's not as deep as it was today. It was a more limited group, but I would say it was still people looking for good risk- adjusted return. If you wanted to invest in the loan asset class, this wasn't very efficient way to do it. Loans are clunky, right? They come with interest rate contracts. They come with prepayments. They come with credit agreements. If you want access to a senior- secured loan, this is a very efficient way to do it. And there were some very sophisticated investors globally who understood that. Mostly banks, insurance companies. I can remember our PMs at that point going on two- week road shows to sell a CLO. And we had European investors. Didn't have risk retention then, so they were able to play in our deals. They were going to Asia, predominantly Japan, to sell top of the stack as well. So there were investors. I'd say the bottom of the stack was a little bit more bespoke, but generally speaking, same investors, just not as many.

Greg Campion: Okay. And I imagine there must've been a decent amount of investor education going on in those meetings as well.

Adrienne Butler: The amount of deep dive, to go through a portfolio to explain the assets you owned, how you owned them, where you bought them, go through the credit metrics. I mean, today's world, the investors are so much more sophisticated. They can do their own analysis of our diversified portfolio, but we spent a lot of time really digging into the individual loans that were in the portfolio then.

Greg Campion: Okay, got it. That's really cool that you were involved in those kind of early days of the asset class and seeing it emerge like that. Let's kind of jump forward a decade or so and we'll put ourselves in the middle of the global financial crisis. Talk to me a little bit about what that was like, because I think that was kind of a seminal moment for the asset class. And obviously all securitized products were really under the microscope, to say the least. So tell me a little bit about what that was like. And I should have mentioned, I skipped over, but in 2002, Babson, which was already owned by Mass Mutual, acquired IDM. So you became an employee of essentially what would become this firm today.

Adrienne Butler: Correct.

Greg Campion: But talk to me about that 2008 experience for CLOs and for you.

Adrienne Butler: Right. Again, it was another one of those moments where you didn't really know. There's a shock to the system, a shock we'd never seen before, where we've seen banks basically frozen. Trading markets were frozen. And here we sat with a diversified pool of loans and a collateralized structure. That was a bad word, and we had to figure out how to manage through that. Didn't have the visibility of knowing the resiliency of the structure at that point. So we were tested in structure.

Greg Campion: It hadn't really been through a proper cycle yet, right?

Adrienne Butler: Right. We'd had a little bit'01-'02 with the telecom debacle. We had that, but that was one sector, one industry, and we managed through that in a fairly short time period. This was more extreme. Loan prices hit a low in the sixties. I mean, that's distressed by any definition. And we sat there looking at these portfolios. The structures kicked in. For the most part, CLOs are self- healing vehicles and they can recirculate what would be distributions to equity back into the structure in order to repair the structure and buy more assets. And we saw that happen across the board, and that's what we did. We spent a lot of time on the phone with investors, a lot of hard conversations explaining that we were trading out of some assets where we don't have visibility into the total return, and buying into other assets where we thought we did have visibility into the total return. And that you can only do by having deep credit work. We spent a lot of time doing that. That was our strategy. Turned out to work. Wasn't easy and we didn't know what we were doing. We knew we were relying on our credit fundamentals, but we didn't know how the structure was going to work out. What we probably didn't fully appreciate until we got a little bit further into the cycle was that we were managing a closed- end vehicle where the all- in cost of capital was less than 1%. Now think about what borrowing costs were during the GFC. We had probably the cheapest form of financing out there, and we were making credit calls or we were buying loans below par. So not only are you financing them cheaply, but then you're buying them at a discount. So if you flash forward to post- GFC, some of those CLOs that were created, the 1.0 CLOs, turned out to be some of the best performing CLOs ever. The structure worked, making good credit calls helped, and the cheap cost of financing was a combination that brought incredible returns to a lot of investors. We didn't know it at the time. It was scary. You were doing the best you could to make credit calls, but it turned out to be a pretty positive story.

Greg Campion: So if you were an investor going in and you held on, you ended up doing quite well.

Adrienne Butler: And that's true, right? There were a lot of investors who bailed. And there were a lot of folks who came in and filled the void and understood what was happening.

Greg Campion: Sure. Everybody had their own liquidity issues and everything else to deal with, redemptions and the whole nine.

Adrienne Butler: Right. And we as CLO managers, we had a lot more flexibility in terms of managing those structures than we do today. I mean, we did things. We bought CLO tranches and put them into the CLO, but we bought those tranches at 5 cents and they recovered at par. Huge gains to the portfolio. So in retrospect, it truly tested your credit chops, but the structure was resilient. I think that's what buyers found out post.

Greg Campion: Well, you mentioned that the term collateralized kind of became a bad word during that period, and you referenced CLO 1.0. So my understanding is that the GFC ushered in a new era for CLOs and a new, basically the CLO 2.0 era. So can you just kind of make that distinction for us? What is 1.0, 2.0 and how they differ?

Adrienne Butler: Yeah, I don't think there's actual formal definition somewhere that says 1.0, 2.0, but the GFC is kind of that line in the sand that says, okay, everything before GFC was a 1.0 CLO and everything after was a 2.0. And as you might suspect coming out of the GFC, the market became more regulated. As you mentioned, anything that had a collateralized word associated with it was kind of a bad thing. And despite the fact that CLOs were super resilient and didn't face the same issues that the mortgage debacle had, we didn't escape the regulations.

Greg Campion: Right. We need to regulate something. We need to do something here.

Adrienne Butler: We need to punish all these people who are doing anything with collateralized anything. So they did, and you can argue whether it was a good thing or a bad thing, but I think for an investor in a CLO, it did provide additional security. And a couple of ways that we saw that kind of transpire was in terms of par subordination, which is basically the cushion beneath the tranches you might invest in. So it's the cushion beneath your piece of the debt, increased significantly. So say for a AAA investor where then they were getting a 28% subordination. In today's market, they're getting 38%, so huge amount of increase in the collateral value beneath them. So that brings comfort to the investor., In terms of what we can invest in almost all senior secured loans now. I referenced that we could buy CLO tranches. You could buy bonds. You could buy a lot of things. Not so much anymore. They restricted us.

Greg Campion: We're not talking about CLO squared or CDO squared.

Adrienne Butler: No. No. They really made it a very vanilla product in terms of what you can invest in. And so we are very much a senior secured loan product today. And then the last piece, I'd say that... There were a lot of things that changed, but the other one was much more investor- friendly documents in terms of the debt. So what I can do as a manager to enhance the structure for equity was restricted to some degree. It doesn't mean that the manager still doesn't have a lot of discretion and I still can't freely trade a portfolio to make the right credit decisions, but they did stop some of the more nefarious things that a manager could do within the structure.

Greg Campion: Okay. Okay. I actually want to just double- click on the concept of managing a CLO versus kind of investing in third- party CLO tranches really quick, because I just want to make sure that distinction is clear. So can you just explain those two activities really quick? Because Barings is active in both of those, and I think maybe from an outside perspective that could be confusing. So I thought maybe we should just hit that.

Adrienne Butler: Yeah. No, you're right. I mean, we manage an over$ 50 billion global CLO portfolio. About$ 30 billion of that is in tranche investing. And to your point, that is investing in other third- party manager CLO tranches. That would be AAA through BB, and in some cases equity. And that is managing a portfolio of investments in CLO debt for a third- party investor. The other part of our business, say the other roughly$ 20 billion, is in the origination of CLOs. So that is creating a CLO, building a diversified pool of loans, selling those tranches to investors, and then managing returns for equity. And so that is a manager actively managing a portfolio of loans for credit quality to deliver a return to both debt and equity investors. Whereas the tranche investing is really making relative value decisions amongst the tranches and giving that return to an investor.

Greg Campion: Got it. Thank you for explaining that. And I think both of them obviously require real deep credit expertise and knowledge. And I know that the teams rely significantly on the research effort that we've got on our global high yield team.

Adrienne Butler: Well, it's a great symbiotic relationship, right? Because we do have that deep credit research team that helps us build the portfolios for the originating CLOs, but it also helps us to identify credit risk, maybe tail risk in the... Say you're investing in BBs, understanding that tail risk in the BB investments you're making in third party CLOs. So there really is a symbiotic relationship.

Greg Campion: Okay. Okay. All right. I'm going to fast- forward again. And when I was preparing my outline for this conversation, I was like, then we'll just fast- forward another decade to present day. But I'm like, nope, that's actually 17 years since 2008, which is kind of-

Adrienne Butler: It's like time travel here.

Greg Campion: Slightly mind- blowing. Let's talk in two minutes or less about it. What happened in 17 years? No, I'm just kidding. So let's talk about some of the big things that happened in the asset class from the GFC to the present day. Maybe let's start with geographically things expanded, right?

Adrienne Butler: Oh yeah. I said earlier that I think we had European investors, North American investors and then some Japanese investors. That base has increased. The European base has increased, the US base has increased, the Asian base has increased. We've not just seen Japanese investors, we've seen a broad Asian investor base that has gotten into the asset class. We've seen a deeper penetration of certain of those markets. Whereas we saw large Japanese investors, we now see regional investors in the product. So it's become much more mainstream there. On the North American side, I think Canadian investors have really jumped into the market in a big way and in the last five to 10 years, Middle Eastern investors have made a big push into this. We've seen a lot of sovereign wealth invest in CLO business as well.

Greg Campion: Yeah, yeah. All right. So the investor base we talked through, just tell me a little bit more in terms of the development of that investor base though, because in terms of where different investors maybe are buying at different points in the stack, it'd be interesting to hear that, kind of the different risk return attachment points for different types of investors.

Adrienne Butler: Absolutely. Absolutely. If you look at the top of the stack, and when I say top of the stack, I mean investment grade type of investing. And again, that investor base has stayed steady, although it has increased in number of investors. And a lot of those are insurance companies and banks looking for good RBC treatment. That's a great risk return strategy for them. And we have seen that base really increase. But again, it's going to be insurance companies and banks and some asset managers who are looking for that. The interesting feature in the last couple of years, has been the growth in the ETF market there. This has become a big enough asset class now that we've seen retail investors jump into the investment grade part of the stack. And a few years ago that was zero and now it's a$ 30 billion market. I would call them the marginal bid on the AAA side of the market now. So that's probably been the most interesting growth sector of the investment grade piece is that growth in ETFs. If we go further down the stack and further down the stack, I'm talking Mez and then equity. On the Mez side, we spoke earlier that they're more bespoke investors. Hedge funds are in there. We have some insurance companies in there, some pensions in there. What's become interesting, I think on the Mez side is the multi- asset credit aspect to that. It used to be a very focused investment into some of those tranches and now it's kind of the pixie dust that gets added to a multi- asset credit mandate that creates that additional return profile for investors. And we're getting requests from investors to consider CLO tranche investing within the mandate of a broader multi- asset credit mandate. So it has become more mainstream, and we're seeing that. The last thing I'd add is on the equity side. If you're looking for kind of a mid- teen return today, not a lot of places to go. The equity markets are a little choppy right now. So CLOs are an interesting place for investors to look, and people with a long- term focus for return, who aren't as sensitive to volatility, have found CLO equity to be a great place to invest. And those are people, they may be hedge funds, they may be BDCs, they may be pensions, they may be endowments. A lot of what we're seeing may be partnerships that managers have created with some of these institutions to provide enhanced returns and have ready access to the market. So this market has really involved... We've seen wealth involved in equity. We've seen sovereign wealth involved in equity. It's a very interesting place to traffic in today's world.

Greg Campion: Okay. Great overview. I will remind our listeners on your equity comments there though, that past performance is not indicative of future results. Investments have risks, et cetera, et cetera.

Adrienne Butler: Thank you.

Greg Campion: But it is interesting that those kind of higher risk, higher potential reward tranches are seeing fairly diverse interest based on what you just described. Let me just ask you about the competitive environment and how that's kind of developed over time. I imagine in'98 when people were getting on planes and going on these road shows, there weren't a whole heck of a lot of CLO managers out there. So tell me what you've seen there from a competitive standpoint.

Adrienne Butler: It was like single digit, the number of managers that were around in the late nineties. Today there's about 130 managers in the US and about 60 in Europe. So very established marketplace, and it's growing and consolidating at the same time. There've been a handful of high profile acquisitions or mergers of CLO managers. And when you look at an acquisition of a CLO manager, you're either looking at buying a platform or buying the contracts. I'd say for the most part it's a buying of the platform that we've seen in the marketplace. And that's usually an investor who wants access to this growing CLO market, and they've made that investment in buying a platform. At the same time, as much as we've seen some of this consolidation, there have been new managers who've come to the market. There's a lot of people who want to access this market. It's been growing. It's a great place to grow AUM in a fairly large manner. So I think we've seen growth in the asset base at the same time, or asset managers in the same time. What is probably the number one growth aspect in CLO managers has been the private credit side of the business. As we've seen private credit take off over the last decade, it kind of makes sense that you'd see the CLO market trail that play. We've been issuing middle market CLO since 2017, but I'd say in the last five years it's really taken off. And that's where we've seen a lot of growth in CLO managers is really leaning into that private credit CLO growth trend.

Greg Campion: Okay, cool. So we've come from'98 to 2008 to, I think we're up to present day now and the growth and proliferation of private credit. I think as we start to think about where things go next, I'd be interested in hearing your views there. I mean on the private credit side... So you and the broader team here at Barings were able to put together a European middle market private credit CLO, which was first of its kind, which is very exciting, kind of landmark transaction. It's gotten a lot of media attention. Tell me a little bit about that and what you see next I guess, in that space.

Adrienne Butler: Yeah. No, that's super exciting. I think that was a huge achievement last year and we were all pretty proud of the team that came together to launch that. It was the very first of its kind. There's never been a European private credit CLO. So to kind of open that door to the market was something Barings has been thinking about for a long time and really working on. And it just felt like the time was right and we could get it done. We did a 380 billion inaudible CLO, well diversified between countries and industries, and we had large demand from very established investors in the market. So very well received. We're super excited about it. I hope it opens the doors for other managers to get into the sector. I've heard rumor there could be, and I know it's something that we're committed to issuing in again as well. So yeah, that was kind of a crowning achievement last year.

Greg Campion: Yeah, that's awesome. Congratulations. And to you and the whole team, I think it's... Not to toot our own horn too much, but I think it's cool to see the CLO expertise pairing up with the direct lending, private credit expertise and it all kind of coming together and moving the market forward really, which is exciting to see. So what's next? We can't rest on our laurels. What's next? Are there other areas for innovation? Curious where you see that kind of market going next.

Adrienne Butler: Yeah, I guess I'm a CLO geek and so I like the technology. I think it's the most efficient way to either buy or leverage an asset class in my mind. And while there have been other managers who've broken into these sectors, I think the growth in say like an infra- CLO is something that could be super exciting, to take infrastructure loans and securitize those and give investors a means to access that asset class is super interesting. Real estate CLOs, inaudible CLOs, I think that's another area for growth that we will see. It's been out there. It's been done before, but it just feels like the acceptance of the CLO strategy, the technology, is something that will lend itself to a variety of asset classes. As long as you can create an arbitrage, it works.

Greg Campion: Okay, cool. Well we will look forward to doing that, maybe future episodes on infrastructure debt CLOs and commercial real estate CLOs. And we've got great teams in both of those places. So exciting to see that potentially develop. I guess maybe a couple of things just to finish up, as you look at the asset class today... So we've talked about its development. We've talked about the kind of initial opportunity that you saw, but I'm curious as you look at it today, is that attraction and the potential opportunity for investors, is that still as exciting today for you when you look at CLOs broadly?

Adrienne Butler: Yeah. It's been fun to have this conversation and think back 25 years. And I don't know that we knew the growth of that industry when we started, but my answer to your question now would be yes. It is probably more attractive now than it was then. And my answer is just that I think it is probably the most efficient way to buy or leverage an asset class. To be able to provide risk adjusted returns to a number of different investors so they can get access to an underlying asset class that they may not have had another means to access, is very exciting. The fact that the structure works and has been proven resilient over multiple shocks in the system. I mean, we didn't even talk about COVID and that shock, but it proved itself through that period as well. I think has distinguished it as an asset class that is more than commercial. So it's a real asset class today. And I think the growth of it and how we use that technology is... I look forward to hearing this podcast in 25 years with the next Adrienne, and I want to hear what they did with it because I think it will be interesting.

Greg Campion: I think it'll be two AI robots talking to each other about how it all went. All right. Well, last question for you. I'm sure there's been many things that you've learned, but are there any lessons that jump out to you as you look back over 25 plus years? Could be in CLOs or more broadly just kind of interested in what comes to mind.

Adrienne Butler: Yeah, I saw you were going to ask me this question and I was afraid we're going to get into little therapy here, because I could go deep.

Greg Campion: Okay, well who's the therapy for, because I could probably use some too.

Adrienne Butler: But, we won't. We won't though. I kind of kept it to two very high level themes that I think are important for anybody who's investing in credit and particularly CLOs. And my number one is doing fundamental credit research is important. It's everything. You'd want to make sure that you're doing a deep dive into every credit you buy and you're building a diversified portfolio. You wouldn't go out on the golf course with a bag full of drivers. You want to go out with a diversified pool of clubs. You want to be contemplative on each stroke you take. You don't want to go too far off the fairway. And if you do, you want to be able to chip back on. So you want to manage a diversified credit portfolio to stay in the fairway. And I think that's a lesson learned for anybody who's managed credit is to manage risk and don't stretch for that extra one or two basis points. The par loss you can take is always more impactful than the little bit of return you can make there. So that'd be my number one. Fundamental credit research is everything. And then my number two is having a deep well- resourced team approach to doing this type of work. You can't do it on your own. We've talked about the GFC. We've talked about other shocks to the system. If you don't have a deep team that can come together and work together to make those right decisions and you're not well- resourced, you can make those mistakes that you can't recover from. So I think it is very important and we at Barings focus on being collaborative and working together and making sure that every voice is heard and respected when we make a credit decision. And so I think that's my other big takeaway. So I kept it simple. Fundamental credit research, team approach.

Greg Campion: I love it. I love it. Great lessons. Thank you for sharing that and thank you for sharing all of this with us today. I think you're a great leader in this firm and in this industry, and I think it's an honor to get a chance to take a little walk back in history with you and hear how all of this has developed over time. So thank you. I really appreciate it.

Adrienne Butler: Well, you're more than kind. I've enjoyed the conversation. Thank you.

Greg Campion: Thanks for listening to or watching this episode of Streaming Income. If you'd like to stay up to date on our latest thoughts on asset classes ranging from high yield and private credit to real estate debt and equity, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. And if you have specific feedback, you can email us at podcas @ barings. com. That's podcast @ barings. com. Thanks again for listening and see you next time.