ANALYSIS technical
Choosing a skilled CLO manager
Roberto Liebscher and Thomas Mählmann argue that some managers are more skilled
than others – and that skilled managers deliver higher returns from CLO equity tranches
I
s there heterogeneity in CLO management skill? And
if so, what is it that distinguishes the best from the
worst? In our study we tackle these questions using
proprietary data about the performance of equity
tranches during reinvestment periods from CLO-i and
Bloomberg. This data spans the period from 1998
through to the middle of 2012 and covers 817 deals.
Hence, our sample represents roughly 70% of the
market, according to figures from the Securities Industry
and Financial Markets Association (Sifma).
To find out if some managers are more skilled, we use
a well-known argument: if a manager is indeed more
skilled (or better informed) than its peer group, the
returns it delivers should be persistently higher, conditional on the risk taken. On the other hand, if a manager delivers an occasional great performance we would
presume it was just lucky.
Is performance a matter of luck?
To test this hypothesis we first calculate for each deal
a time series of half-year equity tranche cash-on-cash
returns by summing up all cash distributions to equity
tranche holders within each half-year and dividing this
sum by the nominal value of the tranche.
In a second step, we sort managers into quintiles
according to their deal-size weighted-average half-year
equity return in excess of the corresponding average
half-year equity return of all deals in our sample and
follow quintile performance in subsequent half-years.
We find striking results consistent with the notion that
some managers are skilled while others are not.
For instance, at the sorting date managers in the top
quintile generate a 25% higher annualised excess cashon-cash return than managers in the worst quintile.
More importantly, we find that differences in performance diminish only slowly. The best managers significantly outperform the worst for more than four years.
The chart (above right) shows this difference in manager
average excess cash-on-cash returns along with its 95%
confidence interval.
It is also interesting to know whether persistence in
skill is evident between various deals from a manager.
Such a finding would guard against a potential misinterpretation of return differences as differences in skill. For
instance, it might be the case that, by pure chance the
16
16-17 1502 analysis technical.indd 2
portfolio composition of one of a given managers’ deals
is of higher quality (higher spreads for the same risk) ex
ante. Then return differences would evolve mechanically
without any difference in skill.
However, our results on a deal-by-deal basis point in
the same direction as our previous analysis: if a manager
outperforms its peers with one deal, it is likely to repeat
this success with follow-on deals. As can be seen from
the table (see right), going with the best managers results
in a 19% higher annualised excess equity tranche return
for the first CLO of a manager but yields also a significantly higher performance for all subsequent deals.
You can judge a manager by its track record
Is this because some managers enjoy laxer trading
restrictions or covenants? Probably not. We analyse
the auto-correlation of deal performance controlling
for deal covenants. The results remain the same: equity
tranche performance is highly persistent. Previous performance is predictive of future performance, so investors may judge a manager by its track record.
The importance of this finding is not restricted to
equity tranche investors. Since high equity tranche
returns represent a big cushion against any debt tranche
losses, debt tranche investors can learn from a manager’s
equity tranche return record, too. Of course, this only
works out as long as the high equity tranche returns we
find are not the result of risk-shifting, that is, managers do not increase the volatility of returns in order to
increase expected returns at the cost of debt tranche
investors – a point we will address later.
A natural question is how do the best managers come
to be at the top of the league? We consider three potential answers. First, we analyse whether CLOs of superior
managers show lower primary market spreads on debt
tranches. In a hypothetical income statement of a CLO,
lower interest expenses raise profits, ceteris paribus,
implying higher equity tranche returns.
Second, we look at CLO portfolio summary statistics
and ask: conditional on a certain level of default risk, do
managers trade in higher yielding (potentially mispriced
or mis-rated) assets? Recycling our income statement
example this is equivalent to an analysis of the revenues
of a CLO. Finally, we consider the potential risk-shifting
explanation already mentioned.
February 2015 Creditflux
28/01/2015 19:09
ANALYSIS technical
Excess return over average cash-on-cash CLO equity return
30
%
25
20
15
10
5
0
-5
-12
Half-years after sorting
-9
-6
-3
Manager performance across deals
Manager
Deal 1
Deal 2
quintile
Q5
9.18%
6.90%
Q4
3.09%
4.05%
Q3
-0.18%
0.18%
Q2
-3.51%
-2.52%
Q1
-9.50%
-4.75%
Q5 minus Q1
18.68%
11.66%
p-value
(0.000)
(0.000)
0
3
6
9
12
Deal 3
Deal 4
Deal 5
5.98%
5.03%
0.42%
-2.60%
-4.15%
10.13%
(0.000)
5.74%
3.61%
0.52%
-2.08%
-2.53%
8.27%
(0.001)
3.14%
4.51%
0.81%
-1.92%
0.70%
2.44%
(0.037)
Looking at our income statement again we can rule
out that lower interest expenses drive the results. The
name of the manager does not play a role in determining debt tranche spreads. In fact, spreads can be almost
perfectly explained by overall market conditions and the
tranche’s rating. A simple regression of the logarithm
of spreads on rating notch and half-year fixed effects
explains 95% of the variation in log spreads.
Where do excess returns come from?
In order to understand the origin of excess returns we
look at the other side of the income statement. Controlling for several key variables like the weighted average
rating factor of the portfolio, the diversity test level
and the issuance year of the deal (among others), we
find that managers that generate higher equity tranche
returns purchase or hold loans with higher spreads. This
is in line with loan spreads not only capturing rating
information but also other characteristics that skilled (or
better informed) managers are able to exploit.
Another explanation might be that those at the top of
the league anticipate rating changes. For instance, they
might invest in loans rated at the edge in expectation of
an upgrade. Once the anticipated rating change becomes
effective, spreads tighten as prices rise and the weighted
average rating of the portfolio improves in favour of the
rating threshold.
Creditflux February 2015
16-17 1502 analysis technical.indd 3
Ratio CPU time
10,000
Interestingly, high equity
tranche returns do not come
at a cost to debt tranche investors.
In our analysis we
AAD
1,000
neither find higher collateral
default
rates nor higher
bumping
debt tranche rating downgrade probabilities for deals
100
managed by the most skilled.
Rather, we see that top
managers serve both investor types equally well. Debt
tranche investors benefi10t from lower downgrade probabilities and higher overcollateralisation ratios. Equity
Line label style
1
investorsAxis
benefi
t from higher
cash flows.
label style
This result is indicative of successful deal structures
Chart head style
in which deal covenants 0like overcollateralisation
and
10
interest coverage ratios as well as minimum spread and
diversity requirements are effective in mitigating problems of information asymmetries and risk-shifting. It is
in the interest of the manager to maximise the return on
the equity tranche even if it does not hold a stake of the
equity portion of the deal because it will benefit from
high equity tranche performance through incentive fees.
Good reasons for an investment in CLOs
Overall, our results make a case for CLO investments.
While performance might differ a lot from one deal to
another, defaults have been rare. Deal covenants seem to
be effective in aligning different noteholders’ interests.
This makes CLOs an interesting investment alternative
especially in times of low interest rates. Our analysis
shows that even the worst managers outperform the
S&P/LSTA Leveraged Loan Index, in line with a higher
risk compensation for CLO equity tranche investments.
In spite of these findings, and arguments from other
authors that a liquid secondary market for syndicated
loans reduces financing costs for companies, regulation has not been favourable for CLOs. But regulators
should consider the speciality of the CLO market rather
than lump all securitised products together.
Ideally, secondary market trading of loans through
CLOs should be encouraged in order to increase efficiency and liquidity in the market. This would reveal
whether top performers can stay ahead even under
increased competition. However, theory suggests that if
pricing becomes more efficient the chances of consistent
outperformance will decrease.
This article summarises results from the working paper “Are Professional
Investment Managers Skilled?” See ssrn.com/abstract=2417082. We thank
Michael Brehm and Raphael Ruess for research assistance and Steven Henny
for helpful comments on the data.
Roberto Liebscher
is a research
associate at the
Catholic University of
Eichstätt-Ingolstadt.
Thomas Mählmann
is Professor of
Finance and Banking
at the Catholic University of
Eichstätt-Ingolstadt.
17
28/01/2015 19:14