HOOPP's New CLO Risk Retention Vehicle?
Healthcare of Ontario Pension Plan (HOOPP) has formed a strategic partnership with CIFC LLC, a U.S. private debt manager specializing in U.S. corporate and structured credit strategies. HOOPP has committed a “substantial” undisclosed amount to a new risk retention vehicle, CIFC CLO Strategic Partners II (CMOA II), which will purchase the majority equity positions of CIFC’s new issue collateralized loan obligations. CIFC has committed US$75 million. CMOA II is expected to support about US$7.5 billion of the firm’s incremental new issuance over the next several years. Toronto-based HOOPP oversees more than $70 billion in assets.Last week, I contacted HOOPP's President and CEO, Jim Keohane, to ask him about this deal. Jim told me to talk to David Long, HOOPP's Senior Vice President & Chief Investment Officer, ALM, Derivatives & Fixed Income.
(Correction: It was previously reported that HOOPP committed US$75 million to CMOA II. The commitment was actually undisclosed.)
PRESS RELEASE
CIFC Partners with Healthcare of Ontario Pension Plan to Form New Risk Retention Vehicle
Healthcare of Ontario Pension Plan Commits to CIFC CLO Strategic Partners II
September 14, 2017
NEW YORK–(BUSINESS WIRE)–CIFC LLC (“CIFC” or the “Firm”), a U.S. private debt investment manager specializing in U.S. corporate and structured credit strategies, today announced that it has entered into a strategic partnership with the Healthcare of Ontario Pension Plan (“HOOPP”) to form CIFC CLO Strategic Partners II, a new capitalized manager-owned affiliate of CIFC (“CMOA II”). CMOA II intends to purchase the majority equity positions of CIFC’s future, new issue Collateralized Loan Obligations (CLOs) to comply with U.S. and E.U. risk retention rules.
Under the terms of the partnership, HOOPP has made a substantial, single external investor commitment to CMOA II, with CIFC committing up to $75 million. CIFC has issued a total of $2.9 billion in new CLOs, making the Firm the largest issuer by assets this year. CMOA II is expected to support approximately $7.5 billion of CIFC’s incremental new issuance over the next several years.
Oliver Wriedt, Co-CEO of CIFC, said, “We are thrilled to partner with HOOPP, a well-recognized thought leader within the Canadian pension fund community and a long-standing, active participant in the CLO market. We are pleased that HOOPP has chosen CIFC to help it gain access to the new issue CLO opportunities that lie ahead and look forward to a mutually beneficial strategic relationship for years to come.”
David Long, Senior Vice President and CIO of HOOPP, added, “CIFC has a strong and consistent track record, making the Firm our choice with whom to partner to access new issue CLO opportunities. As we embark on this partnership, we look forward to leveraging CIFC’s deep expertise as one of the top CLO managers in the world.”
About CIFC
Founded in 2005, CIFC is a private debt manager specializing in U.S. corporate and structured credit strategies. Headquartered in New York and serving institutional investors globally, CIFC is an SEC registered investment manager and one of the largest managers of senior secured corporate credit in the United States. As of August 31, 2017, CIFC has $15.7 billion in assets under management. For more information, please visit CIFC’s website at www.cifc.com.
About HOOPP
With more than $70 billion in assets, HOOPP is one of the largest DB pension plans in Ontario, and in Canada. Our proven strategy and track record of investment returns drive our plan performance, making HOOPP a leader among its global peers. HOOPP is fully funded which means it has more than enough assets to pay pension benefits owed to members today, and in the future. HOOPP is a defined benefit pension plan that is dedicated to providing a secure retirement income to more than 321,000 workers in Ontario’s healthcare sector. More than 500 employers across the province offer HOOPP to their employees. For more information, please visit HOOPP’s website at www.hoopp.com.
David and I spoke on Monday and went over this deal. First, let me thank him for taking the time to talk to me. David handles most of the investment decisions in Public Markets and his colleague, Jeff Wendling, Senior Vice President & Chief Investment Officer, Equity Investment, oversees HOOPP's Public and Private Equities and Real Estate investments (you can read all about HOOPP's executive team here).
Let me begin by referring you to a Guggenheim paper David sent me as a background, Understanding Collateralized Loan Obligations (CLOs). You can downliad the PDF version here.
The two critical points are the following:
- Collateralized loan obligations have many investor-friendly structural features, a history of strong credit performance, and characteristics that seek to provide protection in a rising interest-rate environment
- Historically, CLOs have experienced fewer defaults than corporate bonds of the same rating, a testament to the strength and diversity of the underlying bank loan collateral
Let me also begin with a definition of a CDO and CLO from Pluris:
Collateralized Debt Obligations (CDO) were first issued in 1987 to allow investors the opportunity to invest in the underlying collateral indirectly. The underlying collateral assets and securities are typically comprised of various loans or debt instruments and financed by issuing multiple classes of debt and equity. CDOs either have a static structure or an active structure that is managed by a portfolio manager. With a static deal, investors can assess the various tranches within the CDO. With an active deal, a portfolio manager will actively manage the CDO by reinvesting the cash flow by buying and selling the assets. Portfolio managers perform coverage tests for the protection to the note holders and an event of default may be triggered if collateral values fall too low.Anyway, David is super sharp and he explained to me that HOOPP committed a substantial amount (think he said $300 million or he used it as an example) to invest in the first loss tranche of CIFC's future CLO deals.
CLO, also known as Collateralized Loan Obligation, is a special purpose vehicle (SPV) with securitization payments in the form of different tranches. Financial institutions back this security with receivables from loan portfolios. CLOs allow banks to reduce regulatory capital requirements by selling large portions of their commercial loan portfolios to international markets, reducing the risks associated with lending.
CDOs and CLOs are similar in structure to a Collateralized Mortgage Obligation (CMO) or Collateralized Bond Obligation (CBO).
Now, I'm going to refer you to this Nomura paper, Tranching Credit Risk, which examines the different tranches in a collateralized debt obligation (CDO). Keep in mind, CDOs are sometimes classified by their underlying debt. Collateralized loan obligations (CLOs) are CDOs based on bank loans, which is what we are discussing here.
Different tranches within a deal's capital structure present different degrees of risk and have differing performance characteristics. What is important to remember is the first loss equity tranche has the most risk and the most reward. More senior tranches are less sensitive to changing the level of assumed recovery rate.
Some pension funds are not able to invest in the first tranche because their investment policy doesn't allow them to invest in low-rated tranches, which is why they typically invest in higher, more secure tranches with high credit ratings (and less yield).
This isn't the case for HOOPP. David explained they actually like the first loss equity tranche and are comfortable with this investment citing three reasons:
- Senior secured loans are very attractive relative to other assets in the current market environment where credit spreads are at historic lows. Since these loans are the basis of this investment, they offer a better risk-reward option.
- Opportunity for HOOPP to engage in a strategic partnership with CIFC in a 'risk retention vehicle' where HOOPP is the sole partner (segregated account). This allows us to achieve an attractive price and scale of investment with a top-notch CLO manager.
- CLO equity tranche has a unique set of attributes different from the underlying portfolio of loans: Most importantly, the tranche allows an investor to access much of the income from a large loan portfolio but limits the downside risk to the amount invested.
In this case, HOOPP gains access to a strategy that cannot be replicated in-house and CIFC gains a strategic long-term partner with extensive knowledge and experience. It is a segregated account which effectively means fees are negotiable and in the best interest of both parties.
Most importantly, David explained to me how this is a very effective way to allocate credit risk, giving me the following example:
"Let's say you have a $500 million loan portfolio managed by a CLO manager and you decide to invest $50 million in the first-loss equity tranche, you will receive the highest coupon and your downside risk is limited to the $50 million you put in. However, in order to gain the same return investing in corporate bonds or emerging market bonds, you need to allocate significantly more to generate the same return at a time when spreads are down at historic lows."He added this:
"At HOOPP, we always worry about the risk of not generating enough return to meet out liabilities over the long run as well as the risk of negative returns in the short run. Our day-to-day operations consist of finding the best allocation of risk without necessarily increasing overall risk. Hypothetically, we can and likely will reduce our risk in other credit markets because of this deal."Last week, I discussed how Canada's pension funds are levering up, stating the following on HOOPP:
Like Ontario Teachers', the Healthcare of Ontario Pension Plan (HOOPP) is no stranger to leverage. For quite some time, it has been using extensive repo operations to intelligently lever up its massive bond portfolio. Ontario Teachers' has been doing the exact same thing.Basically, HOOPP leverages its extensive bond portfolio to do risk parity strategies in-house and it engages in a lot of arbitrage opportunities in-house (much like a multi-strategy hedge fund) to add value in the absolute return space.
Jim told me once: "People think we are increasing risk by leveraging up but they don't understand there is more risk in a traditional 60/40 stock bond portfolio."
[Note: Watch this BNN clip where KPA Advisory Services founder Keith Ambachtsheer discusses how the Healthcare of Ontario Pension Plan has a history of unconventional investment styles and risk management.]
David explained to me HOOPP does not invest in hedge funds for the simple reason that it cannot control risk and it can replicate a lot of the arbitrage strategies internally.
In this case, it has a strategic partnership with CIFC which will be actively managing a portfolio of bank loans and it has a big stake in the segregated fund. HOOPP is willing to pay for this service because it cannot replicate this attractive credit strategy in-house.
David told me he doesn't see CLOs as a separate asset class but part of an overall credit allocation. As I stated above, allocating to CLOs will mean reducing risk elsewhere in credit markets.
In terms of liquidity, he told me CLOs are a long maturity product (7-8 years) which made me ask him if part of the reason to invest was to gain a better match to HOOPP's long-dated liabilities. He told me he didn't think of it that way but to be sure, traditional credit markets have a much shorter duration.
On risks, take the time to read this Ares paper on investing in CLOs to understand key considerations and the risks of investing in these structured credit vehicles.
Lastly, I want to bring to your attention that HOOPP is launching a series of articles to deepen the conversation around retirement security and to bring awareness around the benefits of defined benefit (DB) pension plans. Please read the comment on why senior women are most at risk for pension poverty.
Let me end by thanking David Long for taking the time to explain this deal to me. If there is anything to change, I will edit this comment during the day (always refresh by clicking the big piggy bank image at the top of my blog).
Also worth reminding those of you who regularly read my comments to kindly donate/ subscribe as you simply wouldn't gain the insights you do without reading this blog. I thank those of you who take the time to subscribe and/ or donate using PayPal on the right-hand side (view web version on your cell).
Below, Oliver Wriedt, CIFC Asset Management's co-chief executive officer, discusses the success story of the collateralized loan obligation (CLO) market with Bloomberg's Vonnie Quinn on "Bloomberg Markets" (May, 2017). This is an excellent discussion, listen to his insights.
Update: In a subsequent email, I asked David Long why CLOs provide protection in a rising-interest-rate environment, and whether they would under-perform traditional credit if deflation strikes America, and he responded:
They say that because the underlying loan portfolio is typically based on floating rates, e.g. a loan made at LIBOR + 4%.I thank David for sharing his wise insights with my readers.
Typically, CLO liabilities (the AAA, AA, etc. tranches) also bear a coupon of LIBOR +.
Because there is a smaller amount of CLO debt liabilities than loan portfolio value (at the beginning), a higher LIBOR will lead to a higher "residual" cash flow to the equity tranche.
At some point however, if the loan portfolio cash flow falls too far due to loan defaults, a higher LIBOR will lead to lower residual cash flow, hurting the equity tranche.
At a more macro level, a rising LIBOR (in the absence of offsetting effects like higher growth) will reduce borrowers' ability to make payments on their floating rate loans - thus tending to increase defaults and hurting every tranche potentially. The same effect would be felt in a floating rate (standard) loan portfolio.
Thus we can't be *overly* reliant on floating rate investments being "immune" to higher rates.
CLOs and floating rate loans will react differently from fixed rate bonds (or loans). In a falling rate scenario, the latter will generally perform better as the coupons will not fall as they will for floating rate products (floating rate loans and CLO tranches).
Since corporate loans frequently have “LIBOR floors”, typically at 1 or 1.5%, their coupons stop falling once LIBOR hits the floor. CLO debt liabilities typically do not have a LIBOR floor, so once LIBOR drops below about 1.5%, the residual cash flow to the CLO equity tranche increases as the payments made to the debt tranches decrease.
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