Looking for Investors for Your CLO? Ask a BDC
August 4, 2011
CLOs are finding new fans from among the ranks of another kind of vehicle that invests in leveraged loans—business development companies.
BDCs are increasingly buying the junior-most securities issued by collateralized loan obligations, equity that CLO managers might otherwise get stuck holding. This is contributing to the revival in CLO issuance by freeing up managers' balance sheets, enabling them to work on more deals.
While both CLOs and BDCs lend to speculative-grade companies, they are very different animals. BDCs are a kind of closed-end fund and are heavily regulated by the Securities and Exchange Commission. They can issue publicly traded stock, meaning they are not limited to accredited investors and are also attractive to certain kinds of institutional investors, such as pension funds, that are also heavily regulated.
Since BDCs never have to return money to shareholders (investors sell their stock on an exchange, rather than redeem it from the manager), they have a permanent source of capital. This makes it practical to hold illiquid securities, such as the debt of very small companies or the equity of CLOs.
Like other highly regulated investment vehicles, however, BDCs are limited in the amount of leverage they can employ to boost returns. As a result, they tend to invest in securities that are low in an issuer’s capital structure.
CLOs, by comparison, are private, lightly regulated investment vehicles that are typically domiciled outside the U.S. Like other kinds of securitizations, they issue securities backed by a pool of assets, in this case loans. The cash flow from the underlying assets is used to make payments on the securities.
So why would BDCs buy securities issued by another investment vehicle that holds commerical loans, rather than lend directly to companies? The short answer is that CLOs offer exposure to loans that are more broadly syndicated, and more senior in a borrower’s capital structure. These investments have been performing well but might otherwise be unattractive to BDCs.
“(CLO) equity returns are in the 12% to 15% range, which, on a pure yield basis, is in the strike zone for many BDCs,” said Christian Oberbeck, chairman and chief executive of Saratoga Investment Corp., a business development company with a portfolio of $93.7 million.
“The underlying asset class is first-lien loans. A BDC has a hard time making first-lein loans directly, because, without leverage, on an absolute basis, broadly syndicated senior loans yield Libor plus 500 (bps) or so, below where BDCs want to lend,” Oberbeck said. “But if the loans are aggregated into a highly diversified CLO, in different tiers, you can generate a 12% to 15% return, with a good quality underlying asset class.”
Saratoga owns the subordinated notes of a single CLO, Saratoga Investment Corp. CLO 2007 Ltd, which represented about 27% of the fair value of the BDC’s investment portfolio as of May 31.
This illustrates another, more complicated explanation of BDC appetite for CLO equity: many BDCs are managed by affiliates of the managers of the CLOs. A year ago, Saratoga Investment Corp., which was then called GSC Investment Corp., was in default on its own debt and was rescued by a $55 million recapitalization, including an equity investment by Saratoga Investment Advisors. Saratoga Investment Advisors is an affiliate of Saratoga Partners, a private equity firm spun out of Dillon Read in 1998.
The BDC was renamed, its senior management replaced by executives from Saratoga Investment Advisors, including Oberbeck, and its asset base expanded, in part through the acquisition of subordinated notes of the Saratoga CLO.
“The CLO equity we have is somewhat strategic to us, we own all of the equity and manage the CLO,” Oberbeck said. “It gives us a strong presence in the leveraged loan market, access to the broadly syndicated and middle market. A good information flow comes out of that capability and it’s a very attractive investment for us.”
For these same reasons, Oberbeck said, Saratoga has considered making other, non-strategic investments in the equity of CLOs the firm does not manage. CLOs “have done pretty well over time, even through the last downturn. However, if you had to mark them to market or sell them during the downturn, you might not have done so well.”
While most BDC holdings are illiquid, CLO equity is particularly vulnerable to downgrades because of diversification requirements, including triple-C baskets. “If you get downgrades because triple-C baskets get filled and management fees and dividends to equity can get cut off. The cash gets diverted to amortize the debt ahead of payments to the equity,” Oberbeck said.