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Finding Relative Value in CLOs
Tuesday, April 19 2011 | 10:07 AM
Robert S. Sainato CFA, CFP, CIC, CAIA
Managing Director, Structured Credit & Mortgage Group,
ADVISORS ASSET MANAGEMENT
|Generally speaking, we remain bullish on AAA to BBB CLOs and negative on Equity, as mentioned in the last blog. However, not all CLOs are created equal. For this piece, we would like to explore some nuances that are involved in CLO investing.
As seen below, the general CLO market trend over the last 6-8 months has been positive.
Even after this positive trend, from an asset-liability arbitrage perspective, CLOs still remain cheap (overall) as loan prices are around $96 while the weighted average price of all of the liabilities and equity in the CLO structure are ~$90.5. We believe most of this value is locked into the AAA to A tranches with the best risk/reward in the AAA's and AA's. During the CLO rally in February to early March, the asset-liability arbitrage (see below) closed its gap to around 3.2 pts at its lowest, but has since widened back out to 5.5 pts post-Japan/Middle East.
CCC's Overvalued? Defaults Understated?
Recently Deutsche Bank released its annual default study, which analyzes CCCs on a historical default/risk adjusted basis. The study concludes that current CCC loan prices do not adequately compensate investors for risk. The risk we are referring to is associated with the next economic downturn. We believe, as does DB, that cycles are going to become significantly shorter (we are in the 3rd year of the current bull move) because the government no longer has the necessary ammunition, i.e. rates at 0% cannot go lower and budget deficits are bloated and unlikely to go higher. In the past the US government, specifically the Fed and Congress, and foreign cooperation (via no inflation) was able to prolong economic cycles and give us a “Goldilocks” economy. In our opinion, this Pollyanna situation is long gone and reality (risks) will set in with substantially lower growth and shorter economic cycles. Additionally, defaults have been understated due to many extensions and prepays. Although the default wall has been pushed back as companies have prepaid, defaults are still likely to rise. Remember the long-term high-yield default rate averages over 4%, NOT 1-2% as most are modeling.
Arbitrage in PiK Risk
Currently, we see the average Junior OC cushion around 2.5% in the US CLO universe, which has increased considerably over the last two years due partly to managers being able to build par but also increasing CCC prices. If CCCs are overvalued and understated, as we explored above, a price correction and ratings migration in this part of the curve would have a negative effect on CLOs’ OC tests, causing some deals to PiK. However, down the cap stack (where PiK risk matters), in our opinion the market has forgotten deal language and is not pricing accordingly. PiK risk is important and deals with lower PiK risk should trade better.
For those that are taking these binary risks, thorough reading and understanding of CLOs’ indentures is essential. While most CLOs take CCC haircuts for OC tests across all parts of the capital structure, there are some deals where these haircuts vary from the senior OC tests down to the junior and interest diversion tests. We have seen some deals in the universe where CCC haircuts are only used for the junior OC and interest diversion tests. These deals can offer extra cushion to the notes above these tests as they will more easily divert excess interest from the equity to delever the structure, while not PiKing the single As, BBBs, and BBs in some cases.
Prepays and WAL: Smart Investors Can Outperform but Document Work is Essential
Relative outperformance can be gained by taking advantage of the different non-modeled WALs (where the manager can/cannot extend the WAL of the deal) via reinvesting beyond the reinvestment period/OC trigger avoidance/extension language etc. A lot of research has recently come out from the bulges regarding prepays in CLOs as the headline numbers, on an annualized basis, have been in the mid-20s for the index and mid-30s for CLOs. Many of these analysts suggest that these high rates are generally good for AAA/AA post-reinvestment and equity pre-reinvestment, and bad for AAA/AA pre-reinvestment and equity post-reinvestment.
In general, we believe these statements to be true but want to caution investors on many of the nuances to this. We strongly believe that investors must read the indentures closely to determine the effect as many deals allow for prepays to be reinvested post-reinvestment date, as long as certain criteria are met, with some even allowing unrestricted reinvestment of prepays.
The following restrictions typically apply to the reinvestment of prepays: Sr. Notes must not be downgraded from their original ratings and Mezz./Jr. Notes must not be downgraded more than 1 notch from their original ratings. Some deal language use both Moody's & SP ratings, while others only use Moody's. Below, we explore the possible effects of the Moody's upgrades in relation to prepays and WAL.
The recently proposed Moody's methodology changes could also an effect on which deals are able to reinvest prepays post-reinvestment date. Its new proposal, if accepted, would upgrade Sr. Notes 0-2 notches and Mezz./Jr. Notes 0-5 notches. Performing a quick back-of-the-envelope analysis, we see 76% of the Sr. AAA universe currently within 2 notches of their original ratings and 30% of AA's within 2 notches. In the Mezz./Jr. area, we see 85% of A's within 5 notches of the one-notch downgrade limitation, followed by 63% of BBB's and 43% of BB's. Although many deals can be upgraded, as seen above, deal quality and indenture language should be monitored closely to determine the extent to which prepays can be reinvested post-reinvestment date. This is an ironic case where, if upgrades do occur, some of the AAAs from cleaner deals could actually underperform some of the dirtier AAAs as the cleaner deals will be able to continue to reinvest and extend the deal, negating the higher prepays and driving AAA WALs up and DMs down.
See below for Moody's rating transition table, showing the percentage of each part of the cap structure across the US CLO universe and how many notches are currently downgraded from their original ratings. For example in Sr. AAA's, 36.91% are currently rated Aaa (their original ratings), while 19.66% are rated Aa1 (1 notch downgraded), 19.66% are rated Aa2 (2 notches downgraded), and 12.2% Aa3 and below (3+ notches downgraded).
If all of these restrictions are passed, then typically after the reinvestment date the proceeds from the prepaid loan must still be reinvested in a loan that is inside the maturity and has the same or better rating of the prepaid loan. This could effectively cause deals to run at a 0% prepay post-reinvestment (all prepays would be required to be reinvested in similar loans, maturity-, spread-, and rating-wise, simulating a similar asset to that which prepaid as noted above), extending the deal and lowering DMs at the top of the cap structure, while increasing yields on the equity for these deals. Investors should pay careful attention to the language in deals in which they are buying AAA/AA and equity.
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Irrational Exuberance 2.0 - CLO Equity Edition
Wednesday, April 13 2011 | 08:44 AM
Robert S. Sainato CFA, CFP, CIC, CAIA
Managing Director, Structured Credit & Mortgage Group,
ADVISORS ASSET MANAGEMENT
|CLO Equity Overvalued? Can Investors Earn 20's and 30's Cash on Cash Returns and Sell Before the Next Credit Cycle?
Credit Opp/Hedge Funds have been clamoring for CLO equity, attracted to the very high cash on cash returns seen so far. We are seeing cash on cash returns on many deals producing 20's%/30's% returns. This cash flow is enticing investors similarly to how the Sirens lured Odysseus (for those familiar with The Odyssey). Equity/BB's and some BBB's in our opinion have run their course and caution should be warranted (especially for long-term hold investors).
We believe that the I/O & P/O parts of equity/BB's are overvalued in general. In our opinion, the I/O part is overvalued due to the likeliness of excess spread to drop because of a combination of high prepays (empirical loan prepays 25-35% CPR vs. valuation 15% CPR in models); all resulting in lower leverage and lower WAS of future Libor floor loans which will be invested in. Real IRR on the I/O is likely to be substantially lower than the cash on cash returns received thus far.
In addition P/O valuations are extremely levered (at the bottom of the cap stack) to loan prices, defaults and CCC's loan prices and percentages. Small negative changes in these can have profound effects on sub tranche and equity prices by making a cash flow positive investment stop paying. The significant OC improvement throughout the past 1.5 years will begin to wane as this improvement was the product of discount purchases, CCC price appreciation, and low defaults. As mentioned previously in section II, we firmly believe that defaults have been artificially held at bay due to prepays and overly optimistic CCC loan prices. We believe that this is not a normal cycle (as we have seen in recent years) and can see a downturn sooner than most are assuming in their valuations.
Incentive Mgr. Fees (IRR Hurdles) Hurting CLO Equity Cash Flows?
In many deals, we've seen that future equity cash flows can be affected by incentive mgr fees beginning to kick in over the next few years. This is a common feature in CLO's that causes the manager to be paid an additional fee out of the excess interest once the IRR, since inception, has reached anywhere from 10-15%. Most only begin accruing once the hurdle is hit, while some deals have accrued this incentive fee since deal closing, accumulating fees between as much as $6-8mm that will be released once the hurdle is hit. With most deals now cash-flowing to equity and excess spread having increased, this issue is beginning to arise in cash flow and pricing analysis.
The higher quality deals that continued to pay throughout the cycle will be first to hit these targets, as expected. There are a few deals that are close to hitting their 1st IRR hurdles within the next 2 years. Babson 2006-2 and Stone Tower V are two deals we see kicking in as early as this year, with 7% of the universe observed by us with hurdles (20 deals) having hit their hurdles by 2013. We project many more will hit their hurdles over the next 3-4 years, 30% by 2014 and 50% by 2015, as cash flows begin to tail off because of the reinvestment period ending, exacerbating the drop in cash flow to equity.
Investors should run the prospective cash flows to determine if hurdles are being hit, how the fees are paid/accrued, and how that affects equity return. Deals that are currently cash-flowing robustly could drop off suddenly upon the passing of this IRR hurdle, especially on those deals that accrue since closing – which can divert 50-60% from equity to pay off this accrual. A simple back-of-the-envelope analysis of collateral, reinvestment, and current cash flow is no longer sufficient, and we suggest investors have a very strong grasp of the deal's indenture and all of its intricacies before purchasing.
US CLO Equity Analysis from BWICs dated 2/15-4/8
BWIC volume for CLO equity spiked in February and March (as seen below), giving the market more clarity on where different types of deals’ equity tranches are trading.
Using these prints, we compiled a datasheet below including a few relevant datapoints for each deal’s equity tranche that traded. Included below is the Bloomberg ticker for the equity that traded, color for where it traded (if at all), the reinvestment date, Junior OC cushion, underlying weighted average asset prices, and then yields at six different scenarios using generic reinvestment assumptions. This data should help investors find out where comparables have been trading when looking at CLO equity offers, BWICs, or current holdings.
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The Biggest Headache For Groupon And Facebook Investors
Friday, March 04 2011 | 10:02 AM
TAVAKOLI STRUCTURED FINANCE
|Groupon makes its money by selling coupons for goods and services. It partners with local merchants. When you buy a coupon for a merchant's discount on Groupon, it reportedly takes a 50% cut in the U.S.
Groupon has had a few embarrassments. On Valentine's Day, FTD's flowers were priced lower than Groupon's "deals" and the online discounter had to apologize to customers. Moreover, merchants often put conditions and restrictions on Groupon discounts that dilute the value of the deal, similar to restrictions on redeeming air miles. Even so Groupon's valuations have ranged from $1.2 billion to $6 billion to $15 billion all in the space of a year. What's it really worth? More on that later.
Facebook is free and "always will be." It makes its money from ads and revenues from games (if users don't block them), albeit phone apps so far do not display ads. Michael Arrington at Techcrunch reported that Facebook is secretly building its own phone to control its own operating system. He noted that Li Ka-Shing is a Facebook investor, and he is an investor in the rumored INQ and Spotify phone project. While Facebook may remain free, it would have to figure out a way to get users to pay their phone bills.
Facebook has tremendous potential to exploit its 500 million users. In fact, one of Facebook's fundraisers is a genius at exploitation. Goldman Sachs, the Great and Powerful Oz of Finance (just don't look behind the curtain), has already opined on Facebook's value. In January 2011, it valued Facebook at $50 billion when it sought to raise $1.5 billion in Facebook financing.
Rich Teitelbaum of Bloomberg News reminded the financial world that Goldman Sachs Asset Management's anemic track record suggests that Goldman may not be the best go-to source for putting a value on an asset. Despite Goldman's public relations hype that it employs the "best and brightest," it trailed the average return of its peer group in every category. Goldman has an incentive to dangle a high valuation on Facebook in front of clients:
Jim Clark of Netscape and Silicon Graphics fame was irritated that Goldman wanted to fee stuff its Facebook offering with a 4 percent placement fee, a half percent expense fee, and a snatch-back of 5 percent of investors' potential profits.
A few months earlier, Clark had invested in Facebook through another financial firm at a lower price, and the other firm wouldn't potentially gouge him with Goldman's 5 percent pleasure-of-your-company tax. "I don't think it's reasonable," Clark told Bloomberg. "It's just another way for [Goldman] to make money from their clients." The question remains whether Clark bought his stake at a reasonable price.
"Blankfein Flunks Asset Management as Clark Vows No More Goldman," by Richard Teitelbaum, Bloomberg News, January 24, 2011
In January 2011, SharesPost Inc. valued Facebook at $82.9 billion on the secondary exchange. Whatever price the market will pay today, one has to be concerned about what it will pay tomorrow. Even if the future value of Facebook is say, $4 billion, Goldman will rake in fees.
Both Facebook and Groupon became successes because they are web based networks that required few management skills, minimum capital to start, and there were no barriers to entry. That is also their biggest problem. The ugly truth is that no one can tell you what they are worth as businesses.
Groupon's successful-so-far revenue model is its curse. It's both trying to hold its position in "established" markets, and it's trying to expand. The problem is that web users in other countries have noticed Groupon's success and the fact that Groupon has been paying high premiums for local established discounting web sites just to get at the client distribution lists.
Groupon's competitors are both buying sites for the same reason as Groupon, and local entrepreneurs can easily copy Groupon's business model. It seems all it takes is a good web developer, a two-page merchant agreement, and an accounting firm that can handle the taxes as a site expands internationally. Groupon may have a head start, but it has no long-term competitive advantage. That puts its margins, its market share, and it's ability to expand and hold its position in new markets at risk.
Smart investors look for highly skilled managers in industries with a long-term competitive advantage in a stable industry run by decision makers with a "here-today, here-forever" mentality. Between Groupon and Facebook, it seems Facebook has the better chance of making a case, but it hasn't made one so far.
Facebook seems to be thinking of ways to create a loyal user base by penetrating deep within its user base. It certainly has a shot, but it is unclear whether it can maintain a competitive advantage.
Users are fickle, and young users will gravitate to the next exciting new thing. The rapid success of Catherine Cook's myyearbook.com has to give investors pause. She started the site 6 years ago as a 16-year old high school student with a $250,000 investment from her brother, and the site is valued at $20 million. While it's no threat to Facebook, it has a fresh look, is responsive to users, and offers new spins such as allowing users to buy each other gifts and "lunch money."
Investors may wonder when the next bright young kid will eat Facebook's lunch and make it look like a site for old fogies. Facebook may adapt, but it would do itself favors by disclosing its revenues, and how it plans to face up to potential competitors.
Note: This post originally appeared in the Huffington Post.
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