CLOs in the Heartland. April 26, 2016

Transcription

1 CLOs in the Heartland April 26, 2016

2 Opening Remarks Jill Zelter, Managing Director, Fitch Ratings

3 State of the Capital Markets: First Quarter 2016 Review and Second Quarter 2016 Outlook Randy Schwimmer Senior Managing Director Head of Origination & Capital Markets Churchill Asset Management T (212) M (646) randy.schwimmer@churchillam.com April 26, 2016

4 Capital Markets Review First Quarter 2016 Volatility eases as market conditions stabilize US public markets recovered from 4Q lows; dovish Fed eases investor worries about inflation; China, commodities, and energy take back seat HY issuance has modest comeback as fund flows reverse; bond volume at $35.5B, flat to last quarter, but off sharply from $91.6B for 1Q 2015 $41B of US leveraged loans was 18.6% off previous quarter ($50.4B) worst quarterly performance since 2011; retail loan funds broke a 32-week streak of outflows in March; YTD still negative at $4.9B Middle market sponsored volume of $6B (est.) is lowest in six years Risk retention worries and below-hurdle equity returns grind new CLO formation to near-standstill of $7.1B (vs $25.3 for 1Q 2015) Sources: S&P Capital IQ, Thomson Reuters LPC CLOs in the Heartland 4

5 Capital Markets Review First Quarter 2016 What s the setting for debt and equity INVESTORS? Low-rate, low-growth environment remains challenging for PE returns; purchase price multiples close to record highs 1Q saw advantage swing to the buy-side as spreads remained wide Private credit funds continue to fundraise and invest; regulated banks retreat from highly leveraged transactions Chase for yield winning out over liquidity or credit concerns; institutional investors have swung back to higher risk alternatives With BDCs cash-constrained, second lien has been disintermediated by mezzanine; unitranche and senior stretch taking larger structure shares CLOs in the Heartland 5

6 Capital Markets Review First Quarter 2016 How about debt and equity ISSUERS? Known large cap borrowers getting good terms in broadly syndicated market; story credits still struggling amid constrained market liquidity Larger middle market arrangers with higher holds offering club execution alternative to syndication for increasingly bigger deals ( cargo pants strategy ) Sponsors getting one-stop shop solutions from private credit providers; unitranche financings providing certainty of execution Borrowers and sponsors seeking flexibility at a price; covenants, debt baskets, and structures all continue to be issuer-friendly CLOs in the Heartland 6

7 Capital Markets Behind the Scenes CLOs remain a significant share of the institutional market Institutional investor market share 2.3% 6.8% 11.0% 21.1% 58.8% Finance Co. Insurance Co. Hedge, Distressed & High-Yield Funds Loan Mutual Funds CLO Institutional investor market share Source: S&P LCD, Capital IQ CLOs in the Heartland 7

8 Capital Markets Behind the Scenes With deal flow down, banks share of loans has rebounded 100% 90% 80% 70% Primary market for highly leveraged loans (banks vs. non-banks) 60% 50% 40% Institutional investors and finance companies Banks & securities firms 30% 20% 10% 0% Q16 Institutional investor market share Source: Wells Fargo, S&P LCD Capital IQ CLOs in the Heartland 8

9 Capital Markets Behind the Scenes Correlation between asset classes has grown since the credit crisis 100% Correlation between asset classes 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Loans vs High Yield Loans vs Equity Shows cumulative correlation between indicated asset classes Source: LSTA, S&P LCD CLOs in the Heartland 9

10 Capital Markets Behind the Scenes PE fundraising remains healthy, as expected $ $80 $70 $60 $50 $40 $ $20 $10 $0 $36 $34 $25 $20 $35 $36 $27 $36 $37 $82 $35 $77 $54 $60 $41 $59 $46 $36 $45 $65 $57 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q Capital Raised ($B) # of Funds Closed Source: PitchBook; data for North America CLOs in the Heartland 10

11 Capital Markets Behind the Scenes while deal flow declines for third consecutive quarter $250 $200 $ , , ,0671,060 1,028 1,030 1, ,200 1, $ $ $0 $108 $113 $101 $126 $93 $99 $104 $194 $106 $125 $149 $183 $159 $162 $172 $174 $160 $155 $198 $147 $141 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q Capital Invested ($B) # of Deals 0 Source: PitchBook; data for North America CLOs in the Heartland 11

12 Capital Markets Behind the Scenes Sense of market stability causes investors to reverse out-flows $2B Prime-fund flows (weekly reports only) $1B $0B $1B -$2B -$3B $4B $5B Mar 2015 Apr 2015 May 2015 Jun 2015 Jul 2015 Aug 2015 Sep 2015 Oct 2015 Nov Dec 2015 Jan 2016 Feb 2016 Mar 2016 Source: S&P/LCD CLOs in the Heartland 12

13 Capital Markets Behind the Scenes New CLO formation building slowly; lowest volume in four years $18B Monthly CLO Volume $16B $14B $12B $10B $8B $6B $4B $2B $0B Jul 2014 Sep 2014 Nov 2014 Jan 2015 Mar 2015 May 2015 Jul 2015 Sep 2015 Nov 2015 Jan 2016 Mar 2016 Source: S&P/LCD CLOs in the Heartland 13

14 Capital Markets Behind the Scenes Financing activity with sponsors slumps amid uncertainty Sponsored Sponsored Middle Market Volume Issuance ($B B.) Q00 4Q00 3Q01 2Q02 1Q03 4Q03 3Q04 2Q05 1Q06 4Q06 3Q07 2Q08 1Q09 4Q09 3Q10 2Q11 1Q12 4Q12 3Q13 2Q14 1Q15 4Q15 Source: Thomson Reuters LPC CLOs in the Heartland 14

15 Capital Markets Behind the Scenes LBO leverage is down, thanks to Leveraged Lending Guidance 7.5x 7.0x Institutional MM Large Corp. 55% 50% Institutional MM Large Corp. LBO Debt to EBITDA (x) 6.5x 6.0x 5.5x 5.0x 4.5x 4.0x Equity Contribu utions 45% 40% 35% 30% 3.5x 25% 3.0x 20% Q Q16 Source: Thomson Reuters LPC CLOs in the Heartland 15

16 Capital Markets Behind the Scenes Supply/demand dynamics continue favoring investors % % % s ($B) Loan fund flow % 6.0% 5.0% 4.0% 3.0% Single B-yields (3 years) -6.0 Loan fund flows Single- B loan yields 2.0% % Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar % Source: Thomson Reuters LPC CLOs in the Heartland 16

17 Capital Markets Behind the Scenes Better credits get better pricing; liquidity challenged regardless 7.0% New-issue yield to maturity for leveraged loans 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% BB B 2.0% 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 Source: S&P LCD CLOs in the Heartland 17

18 Capital Markets Behind the Scenes Middle market illiquidity premium remains around 75 bps L+700 L+600 L+500 L+400 L+300 L+200 L+100 Large Cap Middle Market L+0 Source: S&P LCD; institutional spreads, sponsored transactions; LC = >$50mm ebitda, MM = <$50mm ebitda CLOs in the Heartland 18

19 Capital Markets Behind the Scenes Middle market leveraged loan yields up fourth straight quarter 12% 11% LIB/LIB Floor LIB Spread Spread due to OID 10% 9% All-in-yield (3 3-year) 8% 7% 6% 5% 4% 3% 2% 1% 0% 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q Q-3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 Source: Thomson Reuters LPC; all-in middle market institutional yields (3 year) CLOs in the Heartland 19

20 Capital Markets Behind the Scenes Structural terms remain seller-friendly, despite lower volume US Covenant-Lite Loans US Covenant-Lite Loans (by purpose) $275B 100% 70.0 $250B $225B $200B $175B $150B $125B $100B $75B Volume Percent 90% 80% 70% 60% 50% 40% 30% Cov-lite volume ($B Bils.) M&A/LBO Div. Recap. Refi & All Other $50B 20% 10.0 $25B 10% 0.0 $0B Q151Q16 0% Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 Source: S&P LCD & Thomson Reuters LPC CLOs in the Heartland 20

21 Capital Markets Behind the Scenes Energy and commodities push default rate to five-year high Lagging 12-mo leveraged loan default rate by number Composition of defaults (LTM thru March 2016) 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Oil & Gas Metals & Mining Healthcare Forest Products Services & Leasing Electronics/Electric Retailers (exc Food & Drug) 0% 10% 20% 30% 40% 50% Source: S&P LCD CLOs in the Heartland 21

22 Capital Markets Second Quarter 2016 Outlook Supply/demand balance creating Goldilocks effect Deal flow will pick up modestly as sponsors work to put dry powder to work Technicals in broadly syndicated market will continue to favor investors, though needle likely to swing further sell-side later in second quarter Middle market conditions will be constructive for both issuers and investors; increased direct lender demand balanced by weak CLO and bank appetite Unitranche remains hot product; more direct lending capacity coming from new firms; smaller managers merging or bulking up with JV s and partnerships All-in first-lien loan yields ease to <6% for BSL s; mid caps remain in 6-7% range Senior leverage of 3.5-4x; total of 5-5.5x for traditional middle market; x senior/ x total for larger mid caps; >4.5x senior/6.0x total for BSL CLOs in the Heartland 22

23 QUESTIONS CLOs in the Heartland 23

24 State of Middle Market Lending and BDCs

25 State of Middle Market Lending and BDCs Moderator: Mike Simonton, Managing Director, Fitch Ratings Panelists: Tom Bax, Treasurer, NXT Capital Frederick C. Fisher, Partner, Mayer Brown Brad Hamner, Senior Vice President, Antares Capital Meghan Neenan, Senior Director, Fitch Ratings Michael Paladino, Managing Director, Fitch Ratings Jerry Stahlecker, Executive President, Franklin Square CLOs in the Heartland 25

26 Regulatory and Accounting Update J. Paul Forrester Partner Sagi Tamir Partner April 26, 2016

27 Volcker Rule Legacy CLOs The Volcker rule prohibits banking entities from making or maintaining investments in covered funds CLOs are generally covered funds since they rely on Section 3(c)(7) for an exemption from the Investment Company Act Since the adoption of the Volcker rule, the CLO market generally has been using the loan securitization exclusion under the Volcker rule and has been Volckerizing many legacy CLOs to become eligible therefor CLOs in the Heartland 27

28 Volcker Rule Legacy CLOs (Con t) However, some legacy CLOs have not yet been Volckerized and prior expectations that they would have been refinanced are being challenged by current market conditions Acknowledging that banks have been important investors in CLOs, the Federal Reserve Board (FRB) has extended the conformance period for banks that invest in CLOs until July 2016 and stated that the FRB intended, if banks were making good faith efforts for conformance, to grant one additional extension until July 2017 and that they would do so in So far, the FRB has not extended such conformance period CLOs in the Heartland 28

29 Quick Risk Retention Primer Compliance already required for all new RMBS deals; compliance for all other deals beginning December 24, 2016 Sponsor of a securitization transaction generally must retain at least 5% of fair value as of the closing date of all ABS Interests in the transaction Forms of Risk Retention: Eligible vertical interest Can be either: A single vertical security or An interest in each class of ABS Interests issued as part of the securitization transaction Eligible horizontal residual interest (or reserve account) or Any combination of the above Special rules for specific types of deals CLOs in the Heartland 29

30 Credit Risk Retention for CLOs For CLOs Collateral Manager is sponsor and required to retain Lead Arranger exemption is not practical Issue is therefore how to optimally capitalize retention 4 possible basic approaches: Direct Capitalization Capitalized Manager Vehicle (CMV) Majority-Owned Affiliate (MOA) Capitalized-MOA (C-MOA) CLOs in the Heartland 30

31 CLO Industry Reactions Why us? Not originate-to-distribute CLO manager acts as agent for CLO Collateral acquired in secondary transactions Regulators confused and over-reached LSTA sued in November 2014 in DC Court of Appeals claiming that: CLO managers are not securitizers and cannot be subjected to risk retention The federal agencies misconstrued the meaning of credit risk by requiring a horizontal equity slice equal to 5% of the fair value The federal agencies acted arbitrarily by failing to consider less costly alternatives proposed by commenters Hearing on February 5 (audio: CLOs in the Heartland 31

32 CLO Legislative and Lobbying Efforts Qualified CLO bill Builds on LSTA comment letter to CRR re-proposal Passed (as H.R.4166) with bipartisan support out of HFSC in February 2016 Requires: Asset quality Asset portfolio diversification Alignment of manager and investor interests Manager must be a registered investment adviser Transparency and reporting for investors CLOs in the Heartland 32

33 Risk Retention Solutions in the CLO Market Direct capitalization CLO Manager obtains capital from a related entity (e.g., its parent) to finance its purchase of risk retention securities and continues to provide management services to CLO Capitalized manager vehicle (CMV) CLO Manager raises capital from 3rd party investors through CLO Manager-created CMV to finance its purchase of risk retention securities. Instead of CLO Manager being the asset manager, CMV is the primary asset manager. CMV then hires CLO Manager as sub-advisor. Key accounting consideration is making sure CMV is NOT consolidated by CLO Manager Majority-owned affiliate (MOA) CLO Manager raises capital from 3rd party investors through CLO Manager-created MOA to finance the purchase of risk retention securities. Key accounting consideration is that MOA MUST BE consolidated by the CLO Manager CLOs in the Heartland 33

34 Example Capitalized Manager Vehicle CLO Manager 3 rd Party Investor(s) Economic interest Economic interest Sub-advisory agreement CMV (Sponsor) 3 rd Party Investor(s) Asset management agreement Risk retention interest Economic interest CLO CLOs in the Heartland 34

35 Example - Majority-Owned Affiliate CLO Manager 3 rd Party Investor(s) Controlling financial interest Economic interest MOA (Sponsor) 3 rd Party Investor(s) Risk retention interest Economic interest Asset management agreement CLO CLOs in the Heartland 35

36 Example Capitalized Majority-Owned Affiliate CLO Manager 3 rd Party Investor(s) Economic interest Economic interest Sub-advisory agreement MOA (Sponsor) 3 rd Party Investor(s) Asset management agreement Risk retention interest Economic interest CLO CLOs in the Heartland 36

37 Risk Retention: Fair Value Requirements Sponsor of a securitization transaction generally must retain at least 5% of fair value as of the closing date of all ABS Interests in the transaction Fair value determination is not required for vertical risk retention or the seller s interest option for revolving pool securitizations Fair value required to be determined using a fair value measurement framework under U.S. GAAP CLOs in the Heartland 37

38 Risk Retention: Pre-pricing Disclosure of Fair Value Sponsor must disclose to potential investors a reasonable period of time prior to sale: The fair value of the EHRI that the sponsor expects to retain at closing (expressed as a percentage of the fair value of all ABS interests issued in the securitization and dollar amount) If the specific prices, sizes or rates of interest of each tranche of ABS are not known, the sponsor may disclose a range of expected fair values based on a range of bona fide estimates or specified prices, sizes or rates of interest If disclosing a range of fair values, sponsor must disclose the method by which it determined any range of prices, tranche sizes or rates of interest CLOs in the Heartland 38

39 Risk Retention: Pre-pricing Disclosure of Fair Value Description of the valuation methodology and all key inputs and assumptions or a comprehensive description of such key inputs and assumptions, including (but not limited to): Discount rates and the basis of forward interest rates used Loss given default; default rates and lag time between loss and recovery Prepayment rates If description includes a curve(s), a description of the methodology used to derive the curve(s) Summary description of reference data set or other historical information used to develop key inputs and assumptions CLOs in the Heartland 39

40 Risk Retention: Post-Closing Disclosure of Fair Value A reasonable period of time after closing, sponsor must disclose fair value using actual sale prices and final tranche sizes To the extent the valuation methodology or any key inputs or assumptions that were used to calculate fair value prior to sale differ from the methodology or key inputs and assumptions used to determine fair value at closing, a description of those material differences CLOs in the Heartland 40

41 Fair Value Measurement Framework ASC Topic 820 defines fair value as: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. CLOs in the Heartland 41

42 Fair Value Measurement Framework Additional key concepts around fair value : Exit price Principal / most advantageous market Market participants Orderly / active market Measurement date Valuation techniques Fair value hierarchy CLOs in the Heartland 42

43 Fair Value Measurement Framework Market Approach A valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business. Cost Approach A valuation technique that reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost). Income Approach Valuation techniques that convert future amounts (for example, cash flows or income and expenses) to a single current (that is, discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts. CLOs in the Heartland 43

44 Fair Value Measurement Framework Fair Value Hierarchy Level 1 Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. Level 2 Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 Level 3 inputs are unobservable inputs for the asset or liability. CLOs in the Heartland 44

45 Accounting Advice Options Why engage accountants for advice on application of consolidation or fair value guidance? There are several sections of the risk retention rules that reference generally accepted accounting principles (GAAP). The two most significant references are: In section _.2 the term majority-owned affiliate (MOA) is defined as an entity (other than the issuing entity) that, directly or indirectly, majority controls, is majority controlled by or is under common majority control with, such person. For purposes of this definition, majority control means ownership of more than 50 percent of the equity of an entity, or ownership of any other controlling financial interest in the entity, as determined under GAAP. In section _.4(a)(2) the required 5% eligible horizontal residual interest is determined by reference to a fair value measurement framework under GAAP. CLOs in the Heartland 45

46 Accounting Advice Options Why engage accountants for advice on application of consolidation or fair value guidance? (cont d) To make a determination that a structure is compliant with the risk retention rules, a manager may wish to engage accountants to provide advice on GAAP. Lawyers may also be engaged to issue an opinion on whether the securitization structure complies with the risk retention rules. To issue such an opinion, they may need a certain level of comfort from accountants on those aspects of the rules that reference GAAP. CLOs in the Heartland 46

47 Accounting Advice Options What type of accounting advice may be obtained for ownership of a controlling financial interest in the MOA? (cont d) Engaging a third party accountant: If the manager has no auditor (or the audit is of the managed funds only), engaging a third party accountant is an option. In these cases, a third party accounting firm may be engaged to issue a report on the application of accounting principles, which analyzes whether a controlling financial interest is owned by the manager. Also note that some audit firms may not be willing to issue the separate letter by the engagement partner described above; this may also prompt engaging a third party accountant. CLOs in the Heartland 47

48 Risk Retention and Legal Assurance Third party legal opinions are problematic to deliver Difficult to make a determination as to how the highest court in a jurisdiction would interpret the rules No judicial decisions, very little regulatory guidance and many interpretive issues remain Lack of customary practice; no common understanding of language used in opinions or customary expectations regarding diligence Analysis relies on facts and, in some cases judgments on GAAP (fair value and controlling financial interests) Compliance burden is on sponsor; no obligation on counterparties to comply with risk retention rules CLOs in the Heartland 48

49 Risk Retention and Legal Assurance Emerging consensus of ABA Task Force no violation of law opinion not appropriate to give, even a reasoned opinion negative assurance re disclosures should be appropriate and feasible Nothing has come to the attention of counsel that caused them to believe the disclosures contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements, in light of the circumstances in which they were made, not misleading Does not rule out written advice, memos and perhaps opinions to clients CLOs in the Heartland 49

50 QUESTIONS CLOs in the Heartland 50

51 Managing CLOs Through the Cycle

52 Managing CLOs Through the Cycle Moderator: Kevin Kendra, Managing Director, Fitch Ratings Panelists: Matthew Andrews, Managing Director, Head of Structured Credit, CIFC Asset Management LLC Dan P. Baginski, Portfolio Manager and Director of Investments, Golub Capital Keith Oberkfell, Partner, Mayer Brown Alina Pak, Senior Director, Fitch Ratings Eddy Piedra, Vice President, Creek Source Capital/4086 Advisors CLOs in the Heartland 52

53 QUESTIONS CLOs in the Heartland 53

54 Closing Remarks Kevin Duignan, Managing Director, Fitch Ratings

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