CHAPTER III

Evaluating CLO Managers

Most CLOs have an active manager, and that sets them apart from almost all other securitizations and moves them closer to other actively managed businesses that issue debt. Most securitizations start with a trust that buys a fixed pool of assets and issues debt and equity to fund the purchase. Principal and interest, defaults and losses from the fixed pool then service the debt. But a CLO instead starts by hiring a manager. The manager builds the portfolio, trades and rebalances it, reinvests maturing or repaid principal, manages cash and does everything else needed to meet the investment risk and return goals of CLO equity investors. The manager handles the pricing, refinancing and restructuring of debt used to fund the portfolio. And the manager handles operations and administration. Managers can have a big impact on portfolio performance, liability cost and return on CLO equity. It is a powerful role.

Because of active management, many traditional tools for evaluating securitizations do not work well for CLOs. Modeling repayment and default risk in a pool of leveraged loans can easily get grounded by the lack of good, public information on the borrower and the loan. Most leveraged loans are private transactions with limited disclosure of borrower financials and loan terms. And even if the issuer has made public financial disclosures, the loan may not be in portfolio long enough for the modeling work to pay off.

Many CLO investors consequently view themselves not as narrow investors in CLO debt or equity but as investors in a CLO management platform. Investors weigh the manager’s infrastructure and institutional support. They consider the alignment of manager incentives with CLO equity and debt. They evaluate the impact of the manager on likely loan portfolio performance and cost of funds.

Any investor in CLO equity or debt needs to understand what the manager does and how well the manager does it, the alignment of manager interests and the investment performance the manager might deliver. The number of managers issuing CLO equity and debt has grown quickly, with an average of 47 unique managers quarterly bringing deals between early 2011 and early 2022 (Exhibit 3.1). As of mid-2022, Amherst Pierpont tracked more than 200 managers that had issued in the trailing decade, and more than 120 managers with active deals outstanding. Understanding the differences between these managers is essential to good CLO investing.

Exhibit 3.1: A steady stream of unique managers bring CLO deals to market

Source: LCD as of August 2022, Santander US Capital Markets

A CLO manager’s responsibilities

A CLO manager runs both CLO operations and investment management. Operations affect the stability and cost of running the CLO. Investment management determines the performance of assets, the cost of debt and returns on CLO debt and equity.

CLO operations include legal, accounting, compliance, books and records, technology, staffing and similar functions. The CLO pays for these services, so the ability of the manager to provide them reliably and at a reasonable cost is important. Some CLO managers have dedicated internal operating teams, others share services with other parts of a larger fund to lower costs, others outsource parts of operations. Both CLO debt and equity count on reliable operations. And because CLO equity gets paid only after all other expenses, it is sensitive to operating costs.

The manager also markets CLO debt and, where needed, equity. Some managers have a dedicated investor relations team, which becomes part of CLO operating costs. Marketing debt and equity often puts the manager in the middle of negotiations between different investors over important aspects of the rules governing the CLO. Relationships with brokers and with potential investors can have a significant impact on debt and equity cost. Managers that have helped issue a large number of CLOs often have the broadest investor and broker networks and can issue at the most aggressive levels.

Investment management is a manager’s most visible and specialized responsibility. It entails designing a portfolio within CLO guidelines, sourcing and evaluating loans, weighing relative value, trading and risk management. For equity investors, investment management also includes structuring, issuing, refinancing and restructuring debt to lower the cost of funds, lower CLO funding risk or both. A manager with good investment performance should be able to cover the cost of CLO debt and distribute attractive excess value to equity. Good equity returns make it easier to attract more equity capital, issue more CLOs, improve liquidity in the CLO debt and get a lower cost of funds. It can be a virtuous cycle.

Alignment of manager interests

Like any business, manager incentives matter. CLOs typically pay the manager fixed fees to cover operating responsibilities and an incentive fee to reward investment performance. A fixed fee often running from 10 bp to 25 bp on loan portfolio par value gets paid before distributing interest to debt or equity. This fee covers basic operations, and it is often called the senior collateral management fee. A second fee, ranging between 25 bp and 40 bp, gets paid after expenses and distributions to debt but before equity. This fee, the junior collateral management fee, could get suspended if deal credit deteriorates. It serves as incentive to maintain good credit. An incentive fee, often set at 20% of remaining portfolio value, gets paid if final loan portfolio internal rate of return exceeds a threshold, commonly set at 12%.

Although manager fees have limited effect on CLO debt, they have a surprisingly big impact on equity. One of the first comprehensive studies of CLO equity returns, from a team of researchers led by Larry Cordell at the Federal Reserve Bank of Philadelphia, found that measuring returns before fees pushed up the internal rate of return by 50%. That implies managers capture a big piece of portfolio residual value.

CLO managers also often hold equity, aligning them with other equity investors but potentially putting themselves in conflict with debt. Perhaps the clearest example comes in distressed markets when the value of the loan portfolio falls toward the par balance of debt. In a CLO with a $500 million portfolio funded with $50 million in equity and $450 million in debt, for example, a drop in market value of $50 million would wipe out the market value of equity and leave the deal with just enough to cover the par value of debt. A CLO, of course, is not subject to margin calls and would not have to sell assets. But CLO investors watch market value closely as a sign of the potential default risk in a portfolio. Debt investors might prefer the manager to trade into the safest loans capable of covering interest payments and returning principal. But that would likely lock in losses for equity. Equity may prefer to do nothing or even add risk to recover losses. Debt and equity under stress have conflicting incentives.

There are also incentives unique to managers apart from the interests of debt or equity. Managers likely have interest in managing future CLOs and will still need to attract debt and equity. That future stream of senior, junior and incentive fees just may balance manager incentives to act in the interests of debt or equity alone.

CLO investors also often look at whether the manager is a standalone CLO manager, part of a broader investment management platform or even part of an insurance company. This can have implications for operating stability and efficiency and for investment expertise and performance, but it also has implications for manager incentives. A standalone CLO manager may have strong incentives to perform well but limited resources to deal with rapidly changing markets. A manager on a broader investment platform may be more focused on gathering assets than generating excess return. A manager affiliated with an insurance company may reflect the risk preference of the insurer. Managers on broader platforms also may need to protect a reputation important to other markets and may respond to stress in their CLO platform by allocating more resources or absorbing costs to stabilize their CLO effort. Large platforms housing a CLO manager can have significant franchise value at risk.

Investment performance

Many CLO investors start by qualifying a manager’s operating strength, looking at manager incentives and ensuring the platform meets some set of standards. Then comes an evaluation of manager investment performance.

The view of a CLO manager’s investment performance depends on whether the CLO investor holds equity or debt. Equity shareholders need to focus on the quality of net interest income—the gap between interest revenue from loans and the interest cost of debt—and on the value of portfolio loans once all debt is paid off. Holders of CLO debt need to focus on the ability of the CLO to pay principal and interest.

For equity investors, net interest income, principal distributions and residual portfolio value matter the most. The manager influences these through income on loans, the cost of debt and the credit quality of the portfolio. All of these are linked. A manager could invest in weaker credits, for instance, to throw off more income. But weaker credits usually prompt debt investors to demand a higher rate of interest to compensate for default risk, offsetting some of the higher income. And weaker credits may default and cut into residual portfolio value. Equity investors routinely monitor portfolio risk, portfolio value and net interest income to gauge the quality of likely future returns to equity.

Equity investors also monitor the net asset value of their position as a market sign of residual portfolio value. This is simply the amount of equity leftover assuming liquidation of all assets and all debt. A $500 million CLO funded with $50 million in market value equity and $450 million in market value debt would have an initial NAV, ignoring fees, of $50 million. The percentage ratio of equity to NAV would equal 100. If portfolio value drops by $5 million, NAV would drop to $45 million and the percentage ratio of equity to NAV to 90. The more risk the manager takes in the loan portfolio, the more volatile the NAV. NAV signals the likelihood the investor can recover residual value from portfolio loans, and the more volatile it is, the greater the chance of loss. Most investors want more income to compensate for NAV risk.

Equity investors also monitor a manager’s ability to stay within the rules or covenants of the CLO. CLOs have to abide by collateral concentration limits, quality tests, interest rate coverage and diversion tests and overcollateralization tests. Violating any of these tests limits the manager’s ability to invest freely. Violating an interest diversion, overcollateralization or interest coverage test can even force equity and other classes to divert cash flow to other purposes, reducing or even eliminating cash flow to equity and other affected classes and cutting into returns.

For debt investors, ability to cover interest and principal matters the most. The manager influences these outcomes through the loan portfolio. Debt investors also need to track portfolio income, value and credit quality.

Just as equity investors track NAV, debt investors track market value overcollateralization, or MVOC. MVOC for any class measures net loan portfolio value as a percentage of class par amount. The investor looks at loan portfolio value as a percentage of par for the debt class and all debt senior to it. For a $500.25 million CLO with all loans trading at par and a $316.25 million ‘AAA’ class, for example, the initial MVOC would be the ratio of $500.25 million to $316.25 million, or 158 (Exhibit 3.2). The MVOC would match the OC ratio. The value of the CLO loan portfolio would need to decline by more than 58% before market value would fail to cover ‘AAA’ principal. For a typical ‘BB’ class in the same CLO, where the ‘BB’ class and all debt senior to it amount to $444.25 million, the MVOC would start at the ratio of $500.25 million to $444.25 million, or 113. The value of the portfolio would need to decline by only 13% before it might fail to cover ‘BB’ principal. As MVOC approaches 100, the implied risk to the debt class rises. An MVOC below 100 suggests a class of debt might not fully recover par. The more volatile the MVOC, the more income the debtholder needs to compensate for the risk.

Exhibit 3.2: An example of MVOC in a deal where portfolio market value falls below par value

Source: Santander US Capital Markets

Debt investors also have to monitor a manager’s performance against CLO tests. Interest coverage tests protect most debt from interest shortfalls, diverting cash flow from junior classes to pay down more senior classes until the coverage test is met. Overcollateralization tests buffer debt from principal shortfalls, also diverting cash flow to pay down senior debt. Ultimately, debt relies on the value of the loan portfolio to cover principal. The CLO manager influences the ability of the loan portfolio to meet these tests and ultimately repay debt principal. Failing any of these tests influences the cash flows and market pricing of the debt.

CLO managers typically devote lots of time to developing an investment process that may offer some proprietary advantage. Managers commonly highlight core elements:

• The expertise available on the platform
• The experience of the investment management team
• The number of credit analysts and number of companies followed by each
• The process for evaluating issuers, their market segment and the loan
• Strategies for buying and selling loans
• Tools for monitoring portfolio performance
• Approaches to risk management

Managers also tend to emphasize their portfolio credit record and investment track record as an indication of possible future performance. Here is where analysis of a manager gets more complex. A CLO investor has to take a view on the likely future performance of leveraged loans in general including their expected return, the volatility of that return and any diversification the exposure might offer to a broader portfolio. Then the investor has to take a view on whether a particular manager will offer a materially different performance.

Managers also have important influence over the form and cost of equity and debt used to fund the loan portfolio. Many managers hold equity in their own CLOs, especially newer managers without a ready audience among other equity investors. Managers may choose to continue holding majority equity and retaining control over portfolio and debt management or may choose to broaden their equity investor base in hopes of reducing the cost of equity and seeding more deals to manage. Managers also market new CLO debt and influence decisions about refinancing or resetting deals. Decisions about debt directly affect the cash flows to equity and the duration and convexity of the debt. Equity wants a manager that issues debt at the lowest possible cost and refinances or resets the debt to maximize equity returns. Debt wants a manager that issues at something above the lowest possible cost and exercises its call options with at least some inefficiency.

Combining manager performance on both the asset or loan side of the CLO balance sheet and on the liability or debt side of the balance sheet leads to a simple approach to relative value (Exhibit 3.3). Where a CLO manager delivers efficient returns on the loan portfolio—high returns for risks taken—and engineers a low cost of debt, then both sides of the balance sheet work in the best interests of equity. Where asset returns look efficient but debt trades at relatively wide spreads, the debt should look attractive. Where asset returns look inefficient, both CLO debt and equity look like poor value relative to competing managers with better asset returns and similar debt spreads. If the debt of a poor asset manager trades at tight spreads, the debt could be a good sell candidate. And if the debt of a poor manager trades at wide spreads, the equity could be a good sell candidate.

Exhibit 3.3: A simple framework for CLO relative value

Source: Santander US Capital Markets

Although the implications of CLO loan and debt management might seem clear for relative value investing, it requires measuring the quality of loan portfolio and debt performance.

Investment style based on holdings

CLO investors often try to identify a manager’s investment style and likely future performance based on current portfolio holdings. The implicit assumption in this approach is that the manager will maintain consistent style in the future and that style will align with a distinct investment performance.

Investors typically characterize CLO style based on a set of portfolio attributes (Exhibit 3.4). For example:

• Annual dividend to equity
• Bid depth or lending facility size
• Diversity score
• Leverage
• MVOC of the lowest rated class
• Net asset value of equity
• Overcollateralization test cushion
• Share of portfolio in ‘CCC’ loans
• Share of portfolio in deeply discounted loans
• Share of portfolio in second liens
• Weighted average price of loans
• Weighted average rating factor
• Weighted average spread

Exhibit 3.4: Investors often filter managers based on style of holdings

Source: Santander US Capital Markets

Comparing one CLO to another or one manager to another along more than a few dimensions is complicated. Each measure says something slightly different about portfolio risk, and the investor has to decide which measures are more important than others in shaping portfolio performance. The complexity is magnified by changes in portfolio composition over time.

Although every CLO investor may characterize style differently or use different measures, CLO portfolios embed only a few broad dimensions of risk:

• Credit risk as reflected in weighted average spread, rating factor, price and the share of portfolio in riskier loans
• Liquidity as reflected in bid depth and lending facility size, and
• Diversification as reflected in diversity score, number of loans and issuer or industry concentrations

Some managers concentrate in higher risk, higher spread, higher WARF loans with limited liquidity and modest diversification. This approach requires deep underwriting expertise since limited liquidity makes it expensive to trade out of mistakes. These portfolios try to maximize current income from assets in hopes of paying high dividends to equity. Other managers concentrate in lower risk, lower spread, lower WARF loans with strong liquidity and high diversification. This approach requires trading expertise to capture mispriced loans. These portfolios may pay lower dividends to equity but hope to eventually deliver higher residual portfolio values. Most managers fall somewhere between these extremes. And managers may vary over time in where they fall.

Although style based on holdings offers a rich description of a CLO manager, most CLO investors reduce style to a qualitative judgement of whether one manager tends to run riskier or safer portfolios than another manager. The simplification of style into a judgement about risk reduces the complexity of comparing one CLO to another—or one manager to another—across multiple measures. Investors ultimately care less about style itself than about the risk and return in a CLO portfolio. Performance rather than style drives returns on equity, the volatility of return and the fair value of debt.

Style also does not address the manager’s impact on CLO cost of funds, something critical to equity. Spreads on CLO debt should reflect loan portfolio risk, with debt backed by riskier portfolios trading at wider spreads than debt backed by safer portfolios. Managers can structure and market debt and encourage secondary trading to lower the cost of funds even after accounting for portfolio risk. Style does not capture this contribution.

Investment style based on performance

Investors in a wide set of assets have evaluated investment managers based on performance since the capital asset pricing model (CAPM) debuted in the 1960s. Investors have applied this approach to individual stocks, equity funds, fixed income, hedge funds, private equity and other markets. Rather than evaluate managers based on potential contributors to performance—credit risk, liquidity, diversification, trading strategies, operational support and so on—CAPM focuses on performance itself (Exhibit 3.5).

Exhibit 3.5: Investors can evaluate managers on performance directly rather than on contributors to performance

Source: Santander US Capital Markets

Evaluating an asset manager through the lens of CAPM involves comparing investment returns over time to a broad market benchmark or index. The idea is that any series of returns breaks down into performance due to broad market exposure and performance due to unique manager contribution. Broad market exposure is usually easy for a manager to offer and reflects portfolio risk relative to the full set of investments available to the manager. Unique manager contribution reflects proprietary value added by the manager.

Applied to CLOs, benchmarking involves calculating periodic total returns on a CLO loan portfolio and comparing them to a benchmark such as the Morningstar/LSTA Total Return Index. This is straightforward for CLOs backed by broadly syndicated loans that regularly get marked to market. For CLO backed by middle market loans without regular marks, this approach is hard to apply. Although a CLO has limits on portfolio investments, the broad index captures the full set of potential investments. A simple regression of portfolio returns on index returns produces valuable information:

• Beta, or the average amount of risk the manager has taken in an investment portfolio over time relative to the index
• Alpha, or the average amount of excess return the manager has delivered over time, and
• Information ratio, the stability of alpha or excess return

Interpreting beta

Portfolio beta comes out as a multiple of index risk. A portfolio with beta of 1.0 will show periodic returns that rise and fall in parallel with the broad market index. If the index goes up by 1%, so will the portfolio. If the index goes down by 1%, so will the portfolio. The portfolio effectively shows 1.0x the risk of the index. A portfolio with beta less than 1.0 takes less risk than the index. A portfolio with a beta of 0.80, for example, takes 0.8x or only 80% of average market risk and will show returns that rise and fall less than the broad market. If the index rises or falls by 1%, a portfolio with a beta of 0.8 will rise or fall on average by 0.8%. A portfolio with beta of 1.20 takes 120% of average market risk and will show returns that rise and fall more than the broad market. Low beta is relatively stable, high beta is relatively volatile. A beta of 1.0 represents risk identical to the index over time, a beta of less than 1.0 represents less risk and a beta of more than 1.0 represents more risk.

Portfolio beta summarizes the risk of individual loans in the CLO portfolio. A pure portfolio of ‘BB’ loans, for example, has a beta to the index of 0.80 (Exhibit 3.6). A pure portfolio of ‘B’ loans has a beta of 1.09. And a pure portfolio of ‘CCC’ loans has a beta of 1.69. Portfolio beta then represents the beta of each underlying loan weighted by market value.

Exhibit 3.6: As loan credit risk rises, beta to the broad index rises, too

Note: Based on monthly total returns in respective loan portfolios from January 2011 to July 2021. Source: LCD, Santander US Capital Markets.

Beta has direct implications for the fair value of CLO equity and debt. In particular, the higher the beta, the more volatile the loan portfolio. And the more volatile the loan portfolio, the more volatile the equity NAV. Modern portfolio theory argues that any asset with more volatility needs to compensate investors with a higher return or, alternatively, trade at a higher yield than a more stable asset. The same argument applies to debt. All else equal, debt backed by a more volatile portfolio should trade at a wider spread than debt backed by a more stable portfolio. The market, in fact, seems to trade this way. Looking at CLO debt issued on new deals from a wide set of managers, the higher the manager’s historic beta, the wider the average spread on the new CLO debt (Exhibit 3.7).

Exhibit 3.7: The higher the manager beta, the higher the new issue cost of funds

Note: Based on manager life-to-date performance calculations through October 20, 2020, reported by November 3, 2021. Liability Z-Score represents the margin on newly issued debt relative to peers issuing around the same time. Managers scoring below zero price with margins below their peers while managers scoring above zero price with margins above their peers. Source: Intex, Markit, Santander US Capital Markets.

CLO loan portfolios show a wide range of beta, but the median beta is close to 1.0. Amherst Pierpont analysis shows a median beta of 1.01 on CLO loan portfolios since the start of 2011 but with a 25-percentile beta of 0.88 and a 75-percentile beta of 1.06 (Exhibit 3.8). The median of nearly 1.0 argues the average CLO effectively holds an index-weighted portfolio of loans despite efforts to pick relative value. Rating agency portfolio diversification requirements limit managers’ ability to take concentrated risk, which limits managers’ ability to capitalize on mispriced assets. Nevertheless, the wide range of portfolio beta gives CLO equity and debt investors choice about the amount of broad market exposure to leveraged loans.

Exhibit 3.8: Deal beta spans from high to low with a median of 1.01

Note: Based on calculations for individual CLOs reporting through June 21, 2021. Source: Intex, Markit, Santander US Capital Markets.

These is room to expand the concept of beta to cover other systematic risks embedded in a leveraged loan portfolio. The idea of alternative beta has led to factor investing in other assets. In equities, a wide range of work has led to benchmarking funds based on measures of price-to-book value, market capitalization and price momentum. Similar work in leveraged loans promises to identify other systematic ways managers create returns.

Interpreting alpha

Benchmarking also measures the average amount a manager either adds or subtracts to portfolio performance after accounting for broad market exposure. This alpha or excess return flows mostly from income or price appreciation in excess of the broad market index. Cash flow reinvestment also could add to excess return, but that typically has minor effect. Alpha is the unique and most valuable contribution of the manager.

Alpha benefits CLO equity directly and CLO debt indirectly. A deal pays excess income to equity in the form of excess interest through the life of a CLO. It pays excess price appreciation to equity typically at the end of a deal after paying off all debt and other expenses. For debt, excess income has limited or no value since it flows directly to equity. Excess price appreciation, however, helps debt by raising the market value of the portfolio and the MVOC of each debt class. All else equal, a higher MVOC means tighter fair value spreads on the debt.

Amherst Pierpont’s work on CLO alpha shows a wide range but a median monthly value before manager fees of less than 2 bp or slightly more than 20 bp a year (Exhibit 3.9). Based on deals issued since the start of 2011, the 25-percentile alpha is -3 bp and the 75-percentile is 7 bp. The low excess return before fees suggests the median manager adds little to portfolio returns. But the wide range of alpha suggests significant differences in managers’ approach to investing.

Exhibit 3.9: Deal alpha spans from high to low with a median of 1.7 bp

Note: Based on calculations for individual CLOs reporting through June 21, 2021. Source: Intex, Markit, Santander US Capital Markets.

Interpreting information ratio

Not all alpha is created equally, and the stability of alpha matters. Some managers produce excess return consistently. Others may be entirely opportunistic and produce only occasionally. It can be hard to tell these cases apart. Over the course of a year, one manager that produced 10 bp of excess return every month and a second that produced 120 bp once and nothing otherwise would have the same average monthly alpha. But the reliable alpha is more valuable and more likely to persist.

Information ratio helps distinguish the good from the lucky—or, perhaps, the consistent from the erratic. Dividing alpha by the standard error of the regression of portfolio performance on index performance produces the information ratio. Investors can think of the information ratio as analogous to a Sharpe ratio after subtracting the market or systematic risk of the benchmark—it is excess return for each unit of residual or idiosyncratic risk. Investors can also think of information ratio as converting absolute alpha into standard deviations of excess return. An information ratio of 0.50, for example, would mean the alpha was half a standard deviation above zero. Based on a standard normal distribution, a manager would show an information ratio of 0.50 or higher by chance only 31% of the time.

Amherst Pierpont’s work suggests the median CLO deal shows an information ratio of 0.06 with a 25-percentile of -0.07 and a 75-percentile of 0.20 (Exhibit 3.10).

Exhibit 3.10: Deal information ratio has a median of 0.6

Note: Based on calculations for individual CLOs reporting through June 21, 2021. Source: Intex, Markit, Santander US Capital Markets.

In sum, benchmarking CLO portfolio performance captures the historic risk a manager takes, the average absolute return in excess of market risk and the stability of the excess return. An investor could try to recast these measures into a manager’s style, but the numbers themselves have direct relevance to returns on equity and debt.

One big implicit assumption of performance benchmarking is that past alpha, beta and information ratio say something about future performance. Most managers tend to take a consistent level of risk across deals, meaning some consistency in levels of alpha, beta and information ratio. Of course, that does not prevent a change in approach. But investors can track recent deal performance against the returns expected from past beta, alpha and information ratio. If performance deviates significantly from expectations, it is a simple, measurable signal that the CLO investor can investigate and determine if the change is temporary or permanent and, if permanent, the better assumptions to make about the future.

Manager impact on CLO debt

CLO managers also influence the cost of funds, but benchmarking the debt side of the balance sheet is less straightforward than the asset side. There are broad market indices for CLO debt performance, such as those published by Palmer Square, but regular market prices or total returns on individual tranches of CLO debt are rare. Still, measuring manager performance against peers while controlling for market conditions can identify the manager’s contribution to debt management.

One way to benchmark debt performance is to break down past debt issuance into time periods small enough for market conditions to vary only within a narrow range. In some periods, spreads will be wide. In others, spreads will be tight. But within each period, spreads should be relatively stable. This controls for market conditions.

Within each period, an investor can compare managers to their peers. A varying number of deals will come to market in each period with debt at different rating levels and different structure. Ratings will typically vary from ‘AAA’ down to ‘B’. And structure will typically vary from 5-year reinvestment and 2-year non-call period to 3-year reinvestment and 1-year non-call and beyond. Within a comparable set of debt, such as ‘AAA’ 5-year non-call 2-year, for example, realized debt spreads will form a distribution (Exhibit 3.11). Each piece of debt falls somewhere in the distribution, measurable by a standard Z-score—the distance of the nominal margin on the debt from the average margin divided by the standard deviation of the distribution. The investor can calculate a Z-score at each rating and add the separate scores, weighted by the par amount issued at each rating, to get a Z-score for the deal. And the investor can further weight deal Z-scores to get one for the manager. Negative Z-scores signal managers that price at a cost below average, and positive Z-scores signal debt priced above average.

Exhibit 3.11: An approach to scoring manager impact on the cost of CLO debt

Source: Santander US Capital Markets

Using Z-scores helps in a couple of ways. Managers do not always issue a full set of debt from ‘AAA’ down to ‘BB’ or lower. If an investor only compares managers on nominal cost of funds, then managers that issue at low ratings—where debt comes at a high cost—would get penalized for issuing the low debt. The distribution of spreads also usually gets bigger at lower ratings, so combining nominal spreads would allow the lower debt to have an outsized impact. The standard scores avoid these problems.

Combining manager asset and liability performance

With sufficient measures of asset and liability performance, relative value across managers becomes clearer. Investors can compare managers on information ratio and Liability Z-Score, and see the average level of risk or beta the manager takes (Exhibit 3.12). Managers with a high information ratio and a low liability Z-score are most likely to provide the strongest returns to equity. And managers that do both with a low beta, or relatively low risk, are likely to provide those returns with the lowest volatility. Managers with a high information ratio and a high liability Z-score are likely to provide attractive debt returns. The wide spreads on the debt compound to the advantage of the investor, and the reliable excess return, to the extent it comes from loan price appreciation, raises the value of the loan portfolio and raises the MVOC of the debt. Managers with low information ratios are generally poor relative value compared to peers and need to find some way to improve performance.

Exhibit 3.12: Manager asset and liability performance points to relative value

Note: Size of each circle reflects portfolio beta. Data from deal performance through October 20, 2021, reported by November 3, 2021. Source: Intex, Markit, Santander US Capital Markets.

Choosing a manager

Every investor ultimately develops a distinct approach to choosing acceptable CLO managers. Some simple guidelines can help get every investor started:

• Step 1: Choose the platforms. Identify manager platforms that meet the investor’s requirements for infrastructure, expertise, efficiency, stability and alignment of interests
• Step 2: Select on information ratio. Among managers still on the list, choose ones with information ratios above average since excess return ultimately helps both equity and debt
• Step 3: Select on debt spreads. For equity investors, choose the ones with debt that trades at tighter spreads since good asset and liability performance raise the odds for good return on equity; for debt investors, while choose the ones with debt at the widest spreads
• Step 4: Select on beta. Among the set left, choose the ones with the lowest beta since those platforms have a record of delivering performance with the lowest risk
• Step 5: Select on liquidity. Finally, select the managers with acceptable liquidity. Some investors might put this step higher in the order. But liquidity in CLOs is hard to pin down, and limiting the field on this attribute could eliminate otherwise good investments.

These guidelines can help sort through newly issued deals where collateral, structure and pricing are often similar. Par pricing along with similar subordination levels, MVOC, coupons, non-call and reinvestment periods and other attributes can make comparing new deals straightforward. But once a deal is issued a lot of things start to change. CLO debt price, MVOC, collateral performance and non-call and reinvestment periods start to shift. It takes a more subtle analysis to filter out relative value in the secondary market. That takes us to the next chapter.

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