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CLO equity investor not losing sleep over exposure to asset class

Exposure to the equity tranches of collateralized loan obligations may be top of mind for some investors in Onex Corp., but officials with the Toronto-based private equity firm and asset manager continue to view the asset class for its potential rewards instead of its real or perceived risks.

With concerns about leveraged finance in general building amid rising recession fears, Onex CFO Christopher Govan said during the company's Oct. 10 investor day that the CLO strategy has generated a level of interest from investors disproportionate with its impact on Onex's overall financial results. CLO equity investments account for approximately 7% of Onex's capital and produce about 15% of the company's aggregate run-rate management fees, he said.

"The last seven-plus years have proven to be a good time to grow a CLO platform," Govan said, citing a longer-term trend of banks holding fewer leveraged loans on their balance sheets. "Armed with a competitive cost of capital, CLOs have captured a significant portion of the underlying growth and grown their share as banks continue to pull back."

Onex has raised 20 CLOs since launching its platform in 2012. Given its focus on holding equity investments, Govan said, Onex has been focused on the risk and return associated with that portion of the transactions.

It generally expects to generate returns of between 12% and 13% from CLO equity investments, Govan said. A hypothetical scenario that he presented during the investor day shows an expected equity return of 12.15% including the impact of leverage and taking into account annual credit losses and management fees and expenses. The consideration for annual credit losses of 50 basis points, Govan said, is typical in the industry and reflects the first-lien position for many of the loans in which a CLO tends to invest.

Several other publicly traded entities maintain a CLO equity investment strategy. Among them is Eaton Vance Corp., which reiterated an intent during an August conference call to allocate "prudent" amounts of capital to a business that accounts for a "pretty small [amount of] balance sheet exposure," according to Chairman, President and CEO Thomas Faust. Oxford Lane Capital Corp. executives, also during an August call, highlighted the company's success in acquiring CLO equity investments in the secondary market.

Others, such as business development company Portman Ridge Finance Corp. and insurer CNO Financial Group Inc., indicated during second-quarter earnings calls that they had been reducing their relative exposure to CLO equity.

Onex's Govan hypothesized that mark-to-market gains and losses recorded on his company's CLO investments may make the strategy appear to be more volatile than it actually is. Onex's mark-to-market gains on those investments totaled C$51 million during the first half of 2019 as compared with losses of C$11 million in the year-earlier period. He characterized the volatility as "misleading" and said "none of us at Onex spend time dwelling" on them.

Rather than mark-to-market accounting, Govan said, two primary risks to Onex's CLO strategy could emerge in the form of spread compression or actual credit losses within the underlying portfolios that exceed internal expectations. To the extent the latter scenario emerged, Govan suggested that it could be mitigated by widening spreads. But, he added, it remains "extremely unlikely" for credit losses to rise to 160 basis points, which the company presented as its modeled "inflection point." Conversely, if spreads compress in a material way, credit losses are likely to be very low.

Govan highlighted CLOs' lack of mark-to-market covenants as a reason that the asset class emerged as "one of the winners in the Great Recession" from a performance perspective relative to other structured finance products.

Onex's enthusiasm for CLO equity notwithstanding, Govan said the company does not plan to retain 100% of those investments in its transactions as it seeks to maintain flexibility to allocate capital in its credit platform to other opportunities that may emerge. In addition, its modeled net platform return would be higher in a scenario where Onex retains only 50% of a CLO's equity as opposed to 100% due to a higher expected benefit from fees.

Despite the attractiveness of those economics, one of the first questions Govan faced from the investor day audience following his presentation pertained to what the CLO acronym stands for. That suggests Onex's management might still face a tougher task in explaining its strategy to the market than actually executing it in a downturn.