Hungry For Yield, Sovereign Wealth Funds Enter The CLO Market

For years, the rapidly growing $450 billion U.S. market for collateralized loan obligations, or CLOs, has been mostly limited to a clubby group of asset managers, hedge funds, and banks familiar with the relatively arcane private syndicated loan market.

But that club has since opened up to insurance companies and pension funds across the U.S., China, Korea, Japan, and Australia. Investors have grown more comfortable around the CLO asset class after it perhaps unfairly received negative attention following the 2007-2008 financial crisis, thanks in part to a phonetic similarity to collateralized debt obligations, or CDOs. With higher quality underlying collateral — leveraged loans instead of poorly underwritten residential mortgage loans — CLO default rates held up well even at the worst times.

In recent years, however, the CLO investor base has expanded even further 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, Singapore's $359 billion GIC Pvt. Ltd., and the $900 billion China Investment Corp., according to market sources. Representatives for those firms declined to comment on their investment plans.

CLOs are special purpose vehicles established to hold and manage pools of leveraged loans. These loans are for the most part secured and experience relatively high recoveries in cases of default.
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 the Dodd-Frank Act 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 toward 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. A few sovereign wealth funds participated.

Two sovereign wealth funds were also involved when a private equity firm raised 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, or ADIA, stated in its most recent annual review that it would seek direct investments in private equity and alternative assets after its returns have fallen 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 an Alternative Investments Department 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.

Singapore's Temasek Holdings (Pte.) Ltd., which is owned by the Government of Singapore and 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.

Managers who opt to hold the equity to comply with the risk-retention rules will usually end up owning anywhere between 55% to the entire tranche in order to meet the 5% requirement, leaving only minority, non-control pieces of equity available to third parties. Many experienced CLO equity holders, though, prefer owning control pieces because they have enough of the voting rights to refinance the debt coupons lower when the opportunity arises, or collapse the deal when returns fall too low.

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Nuanced issues such as those are often why sovereign wealth fund and pension fund investors instead opt to invest through risk-retention funds, which receive a similar income stream to the underlying assets and handle those sort of issues — the trade-off being their funds getting locked up for anywhere between five to nine years when initially investing in the fund.

"Sovereign wealth funds coming to the CLO market have been a decade in the making and, given the return profile and duration of the assets, they are certainly a logical source of capital," another CLO manager said.

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Dec 07, 2017