Orchard Global Asset Management’s CloverTree Opportunities Fund received The Hedge Fund Journal’s Alternative & Private Credit 2021 award for Best Structured Credit Launch. The awards were powered by data from Preqin.
The timing of the fund’s launch in the Covid crisis was clearly fortunate, as CLO spreads in March and April 2020 blew out nearly as far as in 2008, partly due to forced selling from leveraged investors and funds which offered weekly/quarterly liquidity. But the fortunate timing does not take anything away from Orchard’s strong performance in the CLO space through multiple cycles since 2008.
Junior and mid-level CLO tranches can generate double digit returns (even after some default related losses) year after year but can also have shorter bouts of double digit price volatility in times of stress. Both variables present opportunities for active managers. “The return attribution split between buy and hold coupon clipping, and active trading, is very much market dependent. It could sometimes be 80% carry and sometimes 80% trading,” says Shawn Cooper, Orchard’s Head of ABS and CLOs, who joined in 2016 from Brevan Howard, where he ran a CLO portfolio for the global macro fund. Prior to that, Cooper was the head of secondary structured credit trading at Deutsche Bank. He has a strong network of connections in the CLO world, and is regularly sounded out on new capital structures.
The strategy trades relative value opportunities and market conditions dictate whether the relative value is geographic or in the capital structure.
Shawn Cooper, Head of ABS and CLOs, Orchard Global Asset Management
Orchard views CLOs as an attractive asset class and aims to outperform the market in several ways: actively trading CLOs according to relative value; selecting CLO managers (and to some extent underlying loans); modifying CLOs; opportunistic hedging; and various fee rebates or reductions including those associated with risk retention.
Though some mortgage-related structured credit with sub-prime exposure blew up in 2008, CLOs comprised of corporate credit were remarkably resilient and weathered the global financial crisis, posting mid to high teens returns and repaying long term investors in full. Even in years such as 2008, 2013, 2016 and 2018, when CLOs saw varying degrees of mark to market price pressure, this was outweighed or offset by coupon income, meaning that overall returns were flat or positive, based on Orchard’s experience.
The CLO yield pickup over alternative fixed income instruments for a given credit rating ranges from about one hundred to several hundred basis points. Furthermore, within the CLO market, there is a sub-segment of CLOs that invest in middle market companies, which offer an additional yield pickup. One explanation for these return profiles is market segmentation: “There is a smaller buying base for middle market CLOs compared with BSLs (broadly syndicated loans), and in turn fewer buyers for BSLs than standard bonds and loans outside a CLO structure,” says Cooper.
CLO equity also has a fundings and ratings arbitrage. Since equity tranches are unrated, they cannot be bought by credit rating-constrained investors. The funding arbitrage arises from CLO liabilities paying less than asset yields, and again there are different groups of investors on each side of the balance sheet.
CLOs can offer some degree of illiquidity premium that may be greatest for middle market CLOs, which are also harder to access: “Their default rates are similar or better, but managers usually do not place the equity tranches so there can be a lack of liquidity,” says Cooper.
“The strategy trades relative value opportunities and market conditions dictate whether the relative value is geographic or in the capital structure. The CLO arbitrage bounces around quite a bit and this is a key factor determining long term returns. It is also very important for our active trading. Fundamentals ultimately determine the long-term payoffs, but technicals are very important for trading,” says Cooper.
The CLO arbitrage fluctuates with liquidity and technical factors: “Funds offering daily and weekly dealing, or those with leverage, may sometimes become forced sellers to meet redemptions or margin calls,” says Cooper.
Issuance of leveraged loans and CLOs in the first half of 2021 has been buoyant in the US and Europe, with over $200 billion in the US and over $50 billion in Europe, four times the volumes seen in the same period of 2020
Since 2008, there have been opportunities to buy deeply discounted CLOs every few years. The 2011 European sovereign debt crisis provided a brief window mid-year though prices had recovered by year end. In 2015 there was also some pullback in pricing partly due to energy exposures in the US, which Orchard had been reducing since late 2012.
Changes in regulations such as risk retention can also influence the relative scarcity and value between different types of CLOs. For instance, the US court ruling in 2018 relieved US BSL CLOs from the need for skin in the game, while conversely European rules became stricter in 2019.
Being able to exploit often fleeting opportunities depends on some element of luck in terms of the timing of cashflows from fund subscriptions or coupon income or both. Orchard was serendipitous in raising fresh capital in March and April 2020. Using this fresh capital, Orchard was able to invest when liquidity constrained investors were forced to sell. There was also scope to switch from more senior to more junior paper: “If we view a selloff as being technically rather than fundamentally driven, we can move down the capital structure into more convex, lower cash price positions,” says Cooper.
Issuance of leveraged loans and CLOs in the first half of 2021 has been buoyant in the US and Europe, with over $200 billion in the US and over $50 billion in Europe, four times the volumes seen in the same period of 2020. With more than $1 trillion of CLOs outstanding globally – nearly all in the US and Europe – it is a big market. Orchard review all CLO issues and is quite selective about which to invest in. Orchard take a multi-manager approach to diversify by manager, geography, industry and trading style. For primary issues, Orchard can also sometimes secure fee discounts from underwriters.
One allocation decision is the split between European and US CLOs, though some of them are effectively transatlantic in that they may be financing US assets with lower cost European liabilities, which is a structuring feature that Orchard has sometimes helped to orchestrate.
Orchard aims, via its selection of managers, to play an active role in selecting industries and companies but cannot have complete control because CLOs are diversified, and managers trade loans. “Recently there has been a lot of yield compression and we have been conservative on the most Covid-sensitive and lower-rated industries,” says Cooper. For instance, Orchard’s overweight stance in Europe also means it has had less exposure to energy, retail and other cyclicals.
Covenant-lite has become such a standard in the market that we might now be more concerned to research why a loan has covenants.
Shawn Cooper, Head of ABS and CLOs, Orchard Global Asset Management
For primary CLOs, Orchard has varying degrees of visibility of underlying CLO loan portfolios, at the warehouse or creation stage. “We may be given a preliminary portfolio to review and can make recommendations on individual loans before the full ramp is done. In between the warehouse and CLO stages we may roll into the CLO or choose to exit our investment at that stage,” explains Cooper.
The balance between private equity sponsored and non-sponsored loans will vary. The number of covenants on loans has declined in recent years and perhaps paradoxically the existence rather than the absence of covenants could now be a red flag. “Covenant-lite has become such a standard in the market that we might now be more concerned to research why a loan has covenants,” says Cooper.
Orchard has historically invested in managers with default rates well below market averages. “We choose managers based on their ability to avoid or work through defaulted loans. CLO managers may sell loans upon default or might go through a workout process,” says Cooper.
ESG is a nascent but growing influence: “We are increasingly emphasizing managers who do have ESG criteria for selecting loans and are starting to see ESG mentioned in offering documents, more so in Europe than in the US,” says Cooper.
CLOs are to some extent dynamic both in terms of managers’ bottom-up trading of loans, and top-level changes in the assets and liabilities. They can be modified via repricing, resetting or call and reissue. Repricing can take advantage of lower credit spreads to reduce liability costs and expand the CLO arbitrage.
Investors can play a role in reshaping CLOs. “When we are a majority holder of the CLO equity, we have complete discretion. Elsewhere, we work with other minority investors, managers and banks to effect re-financings and restructurings,” says Cooper. There have historically been very few differences of opinion amongst the stakeholders. “Everyone wants a lower cost of debt, but there can be potential for disagreements over some finer details, such as small print text clauses missed out the first time and spotted later. Some investors might have had bad experiences of earlier restructurings,” recalls Cooper. “The documents will prescribe refinancing, but Orchard can still get involved in deciding whether or not to do it based on market conditions, which bank to work with, and can negotiate fees. For resets or calls and reissues it is effectively a brand new deal so we are heavily involved in originating and structuring the deal, in addition to normal refinancing. We have even more influence where risk retention capital is involved,” he adds.
Orchard does not manage its own branded CLOs but does co-manage CLOs where it provides risk retention. This can either be equity or a vertical slice taking a percentage of all tranches. The proportion of primary CLO investments involving risk retention will move around depending on the attractiveness of CLO equity and managers’ need for risk retention. The fee split with managers can include management, arrangement or performance fees or a mix of these, and it might help to boost return targets, depending on market conditions. Orchard can do one-off risk retention deals or invest in a series of them from the same manager. “A lot of risk retention vehicles are captive to a single manager, which can give rise to conflicts of interest if they are forced to invest into multiple issues. We can be more opportunistic. We are diversified between managers and not locked into a single platform,” says Cooper.
Orchard occasionally leverages individual positions but not the overall fund. Conversely hedging is opportunistically pursued at the fund level. “We want exposure to CLOs as an asset class and like the fundamental proposition. Therefore, we are only using shorts as a hedging tool when we see it as necessary, depending on the position in the cycle. The challenge of hedging is that no perfect hedges exist, and therefore there is limited value to implementing complex hedges which are imperfect anyway. We hedge on a case-by-case basis. We use mainly macro based hedges and use them partly to exit risk quickly when it is challenging to sell cash instruments,” says Cooper. Orchard might use credit indices or tranches, such as iTRAXX or CDS, which are also traded elsewhere in the firm. Correlation is also traded in other parts of Orchard, but is not typically used for hedging CLOs, though it is very important for credit selection.
The expertise in hedging and correlation is one example of synergies within the firm, which spans public credit such as liquid credit indices and tranches, leveraged loans, CLOs and structured credit, out to private credit such as bank capital and specialty lending. The same team of credit analysts at Orchard cover CLOs, bank capital and specialty lending, and there is some overlap of names across these spaces. The main advantage of having teams in Asia, Europe and the US – with offices in Toronto, NYC, Houston, Singapore and London – is the ability to move faster on analysis. Junior bankers may work through the night, but firms such as Orchard use staff in different time zones to work on time sensitive analysis. “Asia can start work before Europe wakes up and the US can work at night before Europe opens the next day,” says Cooper. Orchard’s team have spent most of their careers in banks, and they use long standing relationships to access deal-flow. Being familiar with banks’ loan books and trading records, they provide solutions to asset managers and banks, and get paid for it.
In September 2021, Orchard is cautiously and selectively optimistic. Refinancing has pushed the maturity wall on leveraged loans (which typically have seven-year tenors) out by several years, which reduces the chances of default, while fiscal and monetary policy combined with fewer and looser covenants make defaults prior to maturity much less likely. Some parts of the market might be overly sanguine however: “Pricing implies that the recovery will continue in a linear fashion. We do expect some defaults going forward but view systemic default risk as low. We are more optimistic on some individual companies and sectors and more bearish on others. Under a benign default scenario we would expect to beat our return targets,” says Cooper.