CLOs: SEI's history and advantage

Hi, I am Jim Smigiel. SEI's Chief Investment Officer, and we're here today to discuss SEI's approach to managing Collateralized loan obligation, and helping me in that discussion is David Aniloff. David is our head of specialty credit here at SEI. And David, I wanted to start off by maybe asking you to give us a brief history lesson of SEI's involvement in CLOs. I think it'll be a bit of a surprise to our viewers just how long we've been in this space, Right? Yeah, so CLOs have been around for a very long time, over 20 years, and the market was fairly small when compared to the public fixed income markets such as high yield bonds and emerging market debt. And over the last 20 years has now grown to about a trillion dollars. It's actually on par with the high yield bond market, so it's come a long way. Our involvement was incepted in 2005 and we made a decision to expand the platform in 2007, and here we are in 2024 with over 2 billion in assets under management. So 2005, 19 years ago, being involved in the space, launching an institutional account in 2007, interesting time to be the launching a CLO focused portfolio for sure. I'm sure there's some war stories there.

So we talked a little bit about your philosophy, this kind of idea. If I can summarize, you win by not losing. Let's dig a little bit kind of into the process. So let's start putting a little bit of meat on the bones. Is that how actually you do go about managing these portfolios? Sure. I would say there's three steps. First is sourcing, second is the analysis part, and then third is the monitoring. And let's hit each of those separately. So the sourcing I think is a key differentiator for what we do at SEI. There's lots of new investors in the CLO space. They maybe don't have the scale that we do. They maybe don't have the relationships that they do that we do. So if they want to buy bonds, they have to participate in auctions that go off every day and compete with the rest of the world on try to source bonds. If they called a bank and said they wanted to do a deal, the bank would say, well get in line. I think our experience having done this consistently for 20 years, we're not in the market. Out of the market, I think gets appreciated by the banks. So I buy secondary when the opportunity presents itself. But generally speaking, our bread and butter and where we add a lot of value is creating deals. CLOs are not like public equities where you log on to Charles Schwab and you buy a hundred shares of Microsoft. New ones are created every single month, and the last few months have set records. That process is driven by investors like us who buy control stakes in the equity tranche. That drives everything because once that tranche is sold, the bank can then start structuring it and selling all the tranches above it. So I make that phone call, I work with the banks, telling them what exactly I'm trying to accomplish. This is the structure I want to see. And they do their magic by selling the debt, doing all the documents. We work with collateral managers that I've worked with for many years. I won't say I have a list of managers that I'll work with and a list that I won't work with. But having the relationship with the manager side and the bank side and us providing the control equity allows for us to create paper when other people are scrambling trying to buy things in the secondary market.

But you did mention the evolution of this market as an asset class, how much it's changed over time. You've been involved in all of that, and I think that will be a really interesting background to start the discussion around your approach to managing CLOs, your overall kind of overarching philosophy when you're designing these portfolios and managing these portfolios for institutional clients. Sure. So I've tried to be consistent over 20 years, but also recognize that the global economic environment changes technicals change. So we need to go through each of these episodes such as the global financial crisis, the European Sovereign Debt Crisis, and covid, and see what we can learn from those things so that we can continually enhance the process. And I would say that the key tenant of the philosophy from day one has always been to not necessarily try to shoot for the stars and have the highest returns of any CLO manager. I tried to identify relative value opportunities across the CLO capital structure. It could be aaas all the way down to equity. For example, during the global financial crisis, debt was trading in some cases at 5 cents on the dollar for double Bs and Triple Bs, and we thought that those were going to be fine, whereas equity given the uncomfortable nature of the economy at that time with Lehman and Bear Stearns going under commercial real estate and subprime CDOs blowing up all over equity was number one, hard to source. But two, it was a very binary outcome in our opinion. So that dynamic nature has played itself over and over again as we think about all the ups and downs in the market over 20 years. So we recognize that there's an inefficiency in the marketplace where there's generally an overreaction in good times and bad times, and we try to capitalize on that either through buying in the secondary or primary. But generally speaking, outside of those bouts of volatility, the strategy is start with a yield. And that yield is attractive when compared to public fixed income and other asset classes. And starting on day one is to protect as much yield as possible. It's all about margin of safety and downside protection. Good returns take care of themselves. You don't want to lose money in down markets. And that is the overriding philosophy that we've been using since day one. And when you get a bite at the apple to buy something cheap, you pounce on it, you act quickly, you do your analysis, and that's just an accumulated knowledge of going through these episodes and understanding what's exactly happening. So you can add true alpha when other people are running and selling, you're buying, but generally speaking, we're buy on hold investors doing a lot of upfront analysis. It's much easier to prevent a problem than it is to fix something after the fact. And that is how we look at everything. What can go wrong, what can go wrong? What can go wrong? Mistakes happen. These are below investment grade loans that back these pools. You're buying highly levered equity tranches. So every decision you make has a magnified effect. So you just want to be extra careful on not reaching for yield and not trying to be a hero and buying things you don't fully understand.

I am going to get wonky. I think it's really important when we're talking about your ability to control a deal, to get a deal launched into the market. I want you to introduce this concept of the CLO reset, so everybody stay with us. I think this is really, really important. This is something that's been driving performance over the last few years, and I think it's a real competitive advantage that we have on the SEI CLO platform, right? So the way A CLO is structured generally is it has a reinvestment period. And during that time, the collateral manager can continually buy loans. Nothing pays down. And if something does pay down, they replace it with another loan. After the reinvestment period ends, the deal starts to deleverage. It starts to pay down from the AAA tranche. Once that's completely paid off the aa, all the way down till the deal is completely paid off. That could be eight years from now. But prior to the end of the reinvestment period, there's called a no-call period. And that's two years meaning I can't touch the structure for the first two years. Once you hit the two year mark, you can reassess it. Our loan price is really high. Do you just want to redeem the deal and say that's been a great trade, or do you want to extend it? I have that option as the control equity investor, I may not want to extend it, but if financing costs have come in, if the loan market is cheap, I can do that as the control equity investor. Okay. The debt investors have no say in this, that has been happening at a record pace in 2024 as financing costs have come in. Right. So the reset, if you think about the cashflow stream with the front-ended nature of CLO equity, generally speaking, you get most of your money back in the first four or five years. And then the payments start to trickle down. These resets continue those high payments for another four, five, or even longer period of time. These things happen very quickly. So you need to analyze a deal, work with a bank, get to the front of the line, the rating agencies need to bless it, and it generally leads to a material price increase in CLO equity. So there's record amounts of these going on. In fact, half of the issuance this year is resets alone and the market's really strong and it's holding in well. But that's a true competitive advantage if you're a minority equity investor, and let's say you're in a deal with 10 other minority investors and they all own two to 3 million, it doesn't work. Everybody's trying to coordinate. They don't have Your capital cut up. Exactly. Exactly. So we like that strategy of being a control investor and resetting deals opportunistically. That was not even on my radar screen for the last two years. So I think everybody, when they think of CLO equity, they say what are defaults going to be? What are recoveries going to be? And those are certainly important things. But the beauty of CLO equity in my mind as an asset class is that you can time your optionality when there's a time to reset it. You do it right when loan prices go up, you call the deal. When loan prices go down, you can things at a discount. So those aren't things that are in the model. The model's just an Excel spreadsheet with a bunch of numbers, and I'll run different scenarios and probabilities, et cetera. But these options come into play in an unpredictable way. But you have to act quickly. And that is, I think, a key focus for us in the current market environment where the last two years people still had this idea, we're going into a recession, so spreads were just too wide on CLOs, so we just wanted the beta. I was buying a lot of debt, new issues, secondary yields were ridiculous. And that proved to be the right call. Now spreads have come in and it's about credit selection, it's about relationships, and it's about resets. And we're trying to do as many of these as we can in this Environment. Thanks for that. I think that is a immensely underappreciated aspect of the market, and that's something that SEO's approach to managing CLOs, I mean that option, that's what our investors get. We own the option, and I think that's something that was definitely worth highlighting.

Talk to us a little bit about that active return. What do you mean by that? How does that manifest itself in your process and how does that benefit our portfolios? Sure. So when I look at the CLO investor universe, I think it's very clear that there are certain investors that have preferred managers, preferred styles, preferred structures, and the delta between what we would call a top tier manager and a middle tier manager can shrink and grow depending on the market environment. So I think there's a natural gravitation to things that are simple, clean household names, and that's fine. It's not going to generate you the best returns. So having done this for as long as we have and knowing all the managers in the universe, I am okay investing in certain things. If it's priced appropriately, other investors won't look at it at all. They're not allowed. It's not in the mandate. It's Not necessarily a bad price for that. Exactly. Yeah. And depends where you are in the capital structure right now. Of course. Yeah. So those are the things is being willing to swim where others aren't willing to swim, and then doing the resets and then clipping the good yield. I wish CLO double B still yielded 15%. They don't, but it's still double digits. That's historically still a very high level. So unless you tell me the Fed is going to cut to 1% in the next 12 months, the carry is still super attractive. I think for investors, if they have a high single digit return objective CLOs have a place on the debt side as well as the equity side in that portfolio. And how has that manifested itself? So you touched on a little bit, the equity component of your portfolios has been as high as 70 some odd percent, maybe a little bit higher. It's been as low as something. Talk to us a little bit about how that has changed in the recent period. I think you mentioned a bit further back in our conversation that equity hasn't really been attractive until recently. So what are some of those allocations that Look like new issue equity has issue? The stuff that Was held? Yeah. The older vintage, yeah, sure did. Fine. If you can get a 7% return on a AAA CLO tranche, you're supposed to take that. So that allocation grew over the last two years. Spreads have come in, looks like the fed's going to start cutting. So now we're rotating out of a lot of that paper that was sold at a premium, by the way. So buying at par with the interest and then sell it above par and now rotating back into the CLO equity, particularly through the reset mechanism.

Do you believe that there's still a bit of a hangover, if you will, from the financial crisis as it relates to CLOs? I mean, I look at the market, I see the yields that you were able to get aaas at all the way down the stack, still getting a premium over like rated securities. Sure, there's a bit of a complexity premium in there, but is there still a financial crisis premium priced into these securities? I don't know if it's a financial crisis premium any longer, but I will say that there is a persistent structural and liquidity premium. And liquidity is a tricky word, and it's very hard to measure. I've seen people use things like trading volumes to measure liquidity, and my response back is, if I buy a CLO and I like it, I'm not going to sell it. So it's not going to be reflected in trading volatility. But even two years ago when the UK pensions were having some difficulty and needed to sell some assets, the first thing they sold was CLO aaas. So I think every time we go through one of these episodes of the financial crisis and covid and say, wait a minute, CLOs actually did what they were supposed to do, now it actually becomes the asset of choice to sell. There are still investors that I talked to that ask the question, how did this behave during the financial crisis? And I say, they actually performed well. The prices fell a lot because that was a contagion. So I think people are getting over that, especially now that we've been through another episode of Covid four years ago, and the CLOs were not impaired. Most equity continued to pay, so they'll get a trillion dollars. There's a lot more institutional investors. There's over 130 managers. There's lots of pensions, banks, hedge funds, they're all involved in the marketplace, but that premium still does exist. You could pull up a chart and say, where do CLO AAA spreads versus corporate aaas or sovereign bonds? Where to double B CLOs trade compared to high yield? And I wish I had an answer, but the truth is it's been persistent for 20 years now. The magnitude can change over time. So I think it's other things too. There's also an issue of scalability, I would say. So, even though the market's a trillion dollars, 65% of that is the triple eight tranche, and all the tranches below it are about five ish percent of a capital structure. So you can't put 20 billion to work in CO double Bs. You just can't. So the big household manager names that you read about, they just can't make a material enough allocation in their big core plus fund, for example. So I still think those inefficiencies exist. I just don't know that it's a global financial crisis. I think it's a whole host of things. Sure.

One of the key themes in the CLO market recently has been the advent of the ETFs. They're huge. Obviously they're higher quality. There's no doubt about that. Has that affected the market from a portfolio manager's perspective at all? I think that there is a nervousness that this is becoming correlated to interest rates higher for longer, put money in floating rate. So there's been some ETFs that have grown very rapidly and make up a very dominant share. The lower parts of the capital structure have not seen the robust growth. It's hard to scale. If you have a double B-CLO ETF and you get a massive inflow, you're scrambling to find something to put to work and CLO equity absolutely does not work in a daily vehicle like that. So I think it's great as a CLO equity investor that a lot of money's going into aaas because they're pushing spreads in, and that's good for CLO equity returns. But I don't think it's going to be that flighty, to be honest with you. I think at this point people are comfortable with how the asset class behaves. Will we see a little bit of outflows when the fed cuts? Probably a little bit, but this is not going away, and this is a welcome development. It took way too long, and I think we're up and away with the asset growth for CLO ETFs.

I can't have a meeting this year without private credit coming up. I'm so super interested in what I see as just a fever around private credit. Everybody's interested in it. I look at it relative to CLOs. I see less transparency. I see less liquidity. I see the drawdown structure that we don't have to worry about with SEI's approach to CLOs. Tell me a little bit about private credit, what it means to you, how you're actually accessing private credit within your approach to CLOs. I'm very careful to not slam private credit because I've loved the asset class. We've been investing in private credit through the CLO structure pretty much from the beginning. But I think people got way too excited about hire for longer. They got way too excited that the private credit funds were going to push out banks and other types of lenders and just take over the bank loan market. And there was a few quarters where that's happened, but the banks have come back a blazing and now there's been a huge shift. So a lot of money has now been raised for private credit, but they're not able to close on the deals. So you've made this commitment to something and it's not getting invested. I think that the private credit CLOs, which are generally fully ramped, and I can then pick and choose, so I want to buy a double B exposure to a private credit portfolio at SOFR plus 800. That's a higher yield than the direct lending fund itself. Exactly. So the SEI strategy is to have an allocation to private credit, CLO tranches as well as the equity component as well. But again, it's all focused on relative value. Sometimes that's a screaming buy and sometimes it isn't. And right now I'd say it's somewhere in the middle. Excellent. I'll leave it at that. Dave, thanks very much for your time. Thanks for walking us through your 20 year journey with this asset class here at SEI. And thanks to everyone for your patience and for watching us today.