Is Investing in an Equity Tranche of a CLO Too Risky?

From November’s Axiom on Value:

By: Dr. Stanley Jay Feldman, Chairman, Axiom Valuation Solutions

John Roberts, Managing Director, Axiom Valuation Solutions

One of the more complicated investments to value is the lower end tranches of CLOs, collateralized loan obligations.  Axiom’s CLO model provides investors with accurate pricing of all CLO tranches including the equity tranche, which, as it turns out, is highly valuable in a low interest rate slow growth economic environment as we show below.

CLOs are an important part of the fixed income landscape primarily because they offer benefits that other structures do not.   CLOs offer investors an opportunity to invest in slices or tranches of the CLO that meet their particular risk appetites and yield objectives.  At the same time, CLOs contribute to a more liquid loan market since CLOs use the funds raised through issuance of securities (tranches) to fund the purchase of loans.  The basic CLO structure is shown below.

Basic CLO Structure

A CLO operates like any other business: It owns assets, in this case bank loans, and funds the purchase of these assets with debt and equity. The debt stack is made up of a series of securities (X thru C) that have priority claims on the cash flows generated by the assets.  Securities with the highest priority claims (X-A) are paid interest and principal first, and hence are rated highly, while those securities that are at the lower end of the debt stack (B-C) have a lower priority claim on the cash flows and as a result face the possibility that interest and principal will not be paid as expected.   The subordinated notes are equivalent to equity since it receives cash flow only after X thru C is paid. In cases where issuing firms default on their loans, promised cash flows  to all but the least risky tranches are at risk of not being fully paid.   Since the equity tranche only receives residual cash flow, its value in large measure is a function of the probabilities associated with loans in the CLO portfolio defaulting, dollar size of the defaults, size of the recovery value associated with defaults and the timing of these recovery payments.   

Using Axiom’s CLO model, the chart below shows the payment to equity under the base case and three default scenarios.   Keep in mind that even though there is a default, in most cases, a large percentage of the principal is subsequently recovered.  The analysis assumes a 70% recovery rate, which is the average recovery of principal for bank loans.  The recovery occurs subsequent to the default date.

Equity Payout at Different Default Rates

In this example, the par value for the equity tranche is $35,000,000.  In the base case scenario, the equity holder would receive over $60,000,000 for a six year investment period.  If, however, the default rate for the collateral loans was 1% per year (cumulative 6%), the equity holder would only receive $54,000,000.  At a 2% per year default rate, the equity holder would receive $47,000,000, and at a 5% per year default rate, the equity holder would receive less than par or about $28,000,000.

Based on the weighted average credit rating of the CLO loan portfolio, the cumulative six year default rate for six years is about 12% based on a recent S&P study on loan defaults.   Our analysis indicates that the equity tranche is reasonably well protected since even at a 2% annual default rate (12% cumulative), cumulative payments to the equity tranche exceed par value.

Mr. Vladimir Hulpach, CVA, Named Managing Director of Axiom Valuation Solutions Arizona

Axiom Valuation Solutions Arizona is an affiliate of Axiom Valuation Solutions, a leading business and financial security valuation firm serving clients across North America, Europe, Latin America, and Asia. As Managing Director, Mr. Hulpach will be responsible for engagements that run the gamut from valuing private firms for various purposes, including estate planning and acquisitions, to valuing various types of intangible assets including patents and trade names.

Mr. Hulpach received master degrees in Economics and International Trade from the University of Economics in Prague, and he has recently been awarded the prestigious Certified Valuation Analyst (CVA) designation from the National Association of Certified Valuators and Analysts.

Vlad Hulpach, CVA

Vlad Hulpach, CVA

“We are very fortunate to have a person of Vladimir’s talents and capabilities joining the Axiom family,” states Dr. Stanley Jay Feldman, Chairman of Axiom Valuation Solutions. “Axiom has been a leader in providing fixed price, cost-effective, high quality valuation services nationwide. Vladimir will be able to provide Axiom’s valuation services and financing connections to business owners in the Valley, while also contributing his local knowledge, contacts, and expertise to these engagements. This combination of local and national knowledge, connections, cost-effectiveness, and expertise will deliver solutions to Arizona companies that have simply not been available in this market.”
Since 2001, Axiom has provided a comprehensive range of valuation services to thousands of business owners of private companies, private equity and venture capital financed companies, and public companies. In 2013, two long-time Axiom clients, Chimerix and Oxford Immunotec, had successful IPOs. Axiom played a critical role for both companies in developing the valuation analyses used in the SEC filings.

“I am looking forward to working with Axiom that has an in-depth understanding of what it takes for private firms to expand, has access to capital sources needed to finance private firm growth, and is recognized by the BIG 4 and various regulatory agencies as a highly qualified valuation firm. Working together, we will deliver enormous value for our clients,” states Mr. Hulpach.

Fair Value of Loans: Solutions for Alternative Investment Managers and Banks – A Webinar

Axiom Valuation Solutions and Axiom Valuation Solutions Europe (AVSE) present a webinar exploring the global loan market, specifically looking at Axiom’s approach to determining fair value of a loan, default probabilities of loans and the recovery value of loans.

Objective:  This webinar will give the participants a greater understanding of approaches to valuing loans in light of the new AIFMD requirements.  It will also demonstrate straight forward methodologies for looking at default probabilities and recovery values of loans with implications for loss reserves for loans.  This should be of interest to Alternative Investment Managers holding loans as well as banks who are making loans.

July 22, 2013, is a date that every Alternative Investment Fund which does business in Europe should be aware of. This is the date that the Alternative Investment Fund Managers Directive (AIFMD) went into effect. The Directive establishes common requirements governing the authorization and supervision of any Alternative Investment Fund Manager who is located in the European Union or sells to clients in the Union.

The webinar will cover the following topics:

  • Fair Value of Loans:  A Case Study
    Dr. Stanley Feldman, CEO and Founder of Axiom Valuation Solutions
  • Default Probabilities and Recovery Values of Loans   Dr. Thomas Klepsch, Vice Chairman of the European Bond Commission and Senior Advisor to Axiom Valuation Solutions Europe (AVSE)

Click Here to Register

Letter to the Editor: Wall Street Journal: Auditors of Hedge and Private Funds are Not Validating NAVs

“Sophisticated institutional investors still insist on believing in the Tooth Fairy that can somehow miraculously provide market beating returns for everyone. May be that is the biggest crime of all” (Behind the High- Pressure Hedge Fund Culture” (WSJ, July 25, 2013)).   Chasing after returns is not greatest crime of all. Many hedge funds have the capacity to exploit inefficiencies in the market and do so. What is a shame is that endowments, pension funds and foundations in addition to their agents do virtually no due diligence as to whether the returns and NAVs are fraudulently reported.  Investors believe that when hedge funds provide audited financials to them that the NAVs shown have been vetted by the auditors. They have not. Hedge fund auditors “presume” the NAVs are correct and audit whether the investment process used by the manager to establish the NAVs is reasonable.  This is a very low standard.  We know this because Madoff feeder funds were blessed by reputable audit firms. The consultants offer performance evaluation services but the returns used in this analysis are self-reported and for all we know fraudulent.  The crime is that investors live under an illusion that they are covered while the auditors and consultants reinforce the fantasy since it is not in their interest to do otherwise.  The fact remains that there are analytics in place that investors can use to test whether a manager is a Madoff clone.  The fact that the SEC is currently using its data mining ABI (Aberrational Performance Initiative) to ferret out fraudulent managers should be enough of anW incentive for investors to finally wake-up.