Babson Capital Perspectives January 2014 Why CLO Managers Matter The tepid economic recovery in the post-2008 credit-crisis era provides investors with unique opportunities in the CLO market. Evaluating a CLO manager’s historical performance provides key insight into their investment-style, upfront portfolio construction and ongoing ability to manage credit risk during turbulent markets. During the 2008 credit crisis, the disparity between strong and underperforming CLO managers widened dramatically. OVERVIEW Developing a sound investment strategy begins with comprehensive research, and the intricacies of investing in structured credit underscores the need for rigorous upfront analysis. When evaluating a potential CLO investment, there are three primary areas that should be examined, as each factor influences the CLOs overall performance and risk profile. These areas include: the creditworthiness of the CLOs underlying collateral, the components of the CLO structure, and the behavioral characteristics of the CLO manager. Each factor is important and merits close evaluation but, surprisingly, the manager -analysis phase tends to get short shrift from many CLO investors in comparison to the other two. At Babson Capital Management, we believe this can be a costly mistake, as manager behavior can have a dramatic impact on performance during volatile markets. This was abundantly clear during the 2008 credit crisis, when the investment decisions by the CLO manager had a greater impact on the performance of CLOs than structure or credit quality. Evaluating a CLO manager’s historical performance provides key insight into their investment-style, upfront portfolio construction and ongoing ability to manage credit risk during turbulent markets. It also highlights their success (or failure) to mitigate losses within the restrictions of a CLO while considering the interests of debt and equity investors. Further, by closely monitoring a manager’s actions during volatile markets, investors may uncover the manager’s investment-style weaknesses and possible biases towards equity-friendly or debt-friendly management. CLO MANAGER PERFORMANCE IN VOLATILE MARKETS—SEPARATING THE WHEAT FROM THE CHAFF It has long been understood that a CLO manager’s investment style and decision-making process has an impact on performance, but prior to 2008 there was little empirical data to evaluate a manager’s performance during times of severe market dislocations. The credit crisis eliminated that data gap, however, and provided a unique window to evaluate performance in times of extreme market stress. What the data showed put manager performance directly in the spotlight. During the crisis, the disparity between strong and underperforming managers widened dramatically, from both a default-rate perspective and a cash-on-cash (COC) perspective. This historic period of volatility brought a new level of transparency to CLO manager performance, because until then, the default rate had remained at such a depressed level that a CLO manager could not distinguish their performance versus their peer group by highlighting their ability to minimize collateral losses within the CLO structure. This reinforced the need for proper due diligence during the manager evaluation phase of CLO investment analysis. The chart on the following page highlights the sizable dispersion between top-tier and bottom-tier managers during the 2008 credit crisis. Bottomtier managers witnessed credit default rates soar as the market tanked. This led to an increased dispersion in losses, which in turn widened the gap on COC returns among managers. PCLO6346_ 12/1710_ 2012/132 For Investment Professionals Only 1 DEFAULT RATE OF CLOS MANAGED BY TOP & BOTTOM TIER MANAGERS1 EQUITY CASH-ON-CASH RETURNS OF TOP & BOTTOM TIER MANAGERS1 12% 40% 30% 6% 4% 2% 25% 20% 15% 10% 5% 0% Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 0% All CLO Managers Top Tier CLO Managers Bottom Tier CLO Managers Performance dispersions increased significantly as the credit crisis unfolded 2004Q4 2005Q2 2005Q4 2006Q2 2006Q4 2007Q2 2007Q4 2008Q2 2008Q4 2009Q2 2009Q4 2010Q2 2010Q4 2011Q2 2011Q4 2012Q2 2012Q4 2013Q2 8% Avg. COC Return Avg. Default Rate 35% Performance dispersions increased significantly as the credit crisis unfolded 10% Top Tier CLO Managers Bottom Tier CLO Managers Source: Credit Suisse as of September 30, 2013. 1. Market data taken from 480 CLOs from 134 managers. Past performance is not indicative of future results. A TALE OF TWO DEALS The table below highlights how a CLO manager’s actions can lead to a significant performance variance. These two deals were issued in July 2006, roughly eight days apart. Each deal was structured with a similar initial credit profile, average spread and Moody’s Diversity Score. Despite a slightly more conservative portfolio, Deal 1’s collateral pool incurred 3% greater losses and paid investors 43% less of their equity investment—due to the divergence in collateral performance, and the manager’s decision to take considerable trading losses. DEAL 1 DEAL 2 Manager Manager A Manager B Close Date 7/18/2006 7/26/2006 Average Spread of Collateral at Closing Average Collateral Rating at Closing Moody's Diversity Score Collateral Gain / (Loss) % of Equity Investment Repaid Projected Equity IRR 227 247 B1/B2 B1/B2 38 53 (5.3)% (1.1)% 137.1% 180.5% 12.1% 20.0% Source: Babson Capital as of October 4, 2013. For illustrative purposes only. Projected Internal Rates of Return (IRR) were calculated by combining historical and projected future cash flows for each portfolio’s investments and subtracting estimates of projected management fees, technology reimbursements, expenses, incentive fees and other expenses. There can be no assurances that the projected IRR will be met. What drove the performance disparity? Deal 1’s manager decided to liquidate many of the portfolio’s distressed credits and reinvested the proceeds in higher-quality loans trading closer to par—which locked in losses within the CLO structure, hurting equity shareholders by reducing excess spread and COC returns. Deal 2’s manager, however, took a different route. The manager decided to either hold the CLO’s lowerpriced loans, or sell and replace them with similarly priced issues. In doing so, the portfolio reaped the benefits when the market rebounded, as greater excess spread remained and COC payments were higher. 2 For Investment Professionals Only Babson Capital Perspectives January 2014 BABSON CAPITAL’S DEEP EXPERIENCE WITH CLOs OFFERS UNIQUE INSIGHT INTO MANAGER ANALYSIS As an active investor in the structured credit market since the early 1990s, Babson Capital understands the critical importance of strong management from both a risk and return perspective. Our structured credit team manages over $13 billion in structured-credit investments, including $10.7 billion of cash flow CLOs as of September 30, 2013, for a variety of institutional clients, including insurance companies, endowments, pensions and banks. The chart below shows the average COC return for 63 managers and 206 unique deals from 2004-2007 vintages, as of July 15, 2013. From deal issuance through July 15, 2013, the average COC return was 20%, with an average loss rate of 3%. The chart highlights how certain managers did a much better job of delivering higher returns to equity investors, as they minimized losses through the 2008 credit crisis. Thus, manager selection is paramount in generating strong returns—especially during volatile markets. MANAGER LEVEL CLO PERFORMANCE -2.5% Sample Avg Average Annualized Cumulative Equity Distribution 30% 28% 26% 24% 22% 19.9% Sample Avg 20% 18% 16% 14% 12% 10% 8% -11% -10% -9% -8% -7% -6% -5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% 6% Average Par Change Since Inception (net of Interest Diversions) Source: Babson Capital as of July 15, 2013. Simple average for each of the 63 managers from 2004-2007 vintages, where Babson Capital owns any manager with two or more deals. Past performance does not guarantee future results. The tepid economic recovery in the post-2008 credit-crisis era provides investors with unique opportunities in the CLO market, and CLO equity can be a particularly attractive option. CLO equity survived the crisis better than many structured products, since they are term financed and generally well managed by experienced loan managers. CLO equity is also considered less risky than other leveraged investments in challenging economic environments, due to structural features like front-end loaded cash flows, a lack of mark-to-market volatility and CLO liabilities that are match funded with the underlying assets. For these reasons, and the fact that a large portion of the underlying loan collateral has LIBOR floors while the CLO liabilities (tranches) do not, CLO equity returns have roared back as well after a sharp downturn in late 2008, demonstrating the segment’s resilience in the face of economic headwinds. MANAGERS DO MATTER Investing in CLOs can provide the potential for strong risk-adjusted returns through exposure to a wide array of asset classes and risk levels, and the current ultra-low-interest-rate environment continues to fuel interest in these investment vehicles. CLO investing is, however, an area that requires proper due diligence, with particular emphasis on manager analysis. Since the manager’s behavior will have a significant impact on the portfolio, it’s critical to evaluate his or her historical performance through different market cycles— and heed the painful lessons learned in the 2008 credit crisis. Ignoring those lessons can have unintended consequences, and with the continued overhang of market uncertainty, it’s vital to have experienced, proven managers at the helm. Babson Capital Management LLC For Investment Professionals Only 3 IMPORTANT INFORMATION Babson Capital Management LLC, Babson Capital Securities LLC, Babson Capital Europe Ltd, Babson Capital Australia Pty Ltd, Wood Creek Capital Management, LLC, Babson Capital Cornerstone Asia Ltd. and Cornerstone Real Estate Advisers LLC, each are affiliated financial service companies (each, individually, an “Affiliate”), together known as “Babson Capital” and members of the MassMutual Financial Group*. Each Affiliate may act as introducer or distributor of the products and services of the others and may be paid a fee for doing so. ADDRESSEE ONLY: This document is issued to investment professionals and institutional investors only. It is intended for the addressee’s confidential use only and should not be passed to or relied upon by any other person, including private or retail investors. This document may not be reproduced or circulated without prior permission. NO OFFER: The document is for informational purposes only and is not an offer or solicitation for the purchase or sale of any financial instrument in any jurisdiction. The material herein was prepared without any consideration of the investment objectives, financial situation or particular needs of anyone who may receive it. This document is not, and must not be treated as, investment advice, investment recommendations, or investment research. Unless otherwise mentioned, the views contained in this document are those of the Affiliate producing it. These views are made in good faith in relation to the facts known at the time of preparation and are subject to change without notice. Parts of this presentation may be based on information received from sources we believe to be reliable. Although every effort is taken to ensure that the information contained in this document is accurate, Babson Capital makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information. Any forecasts in this publication are based upon the Affiliate’s opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Past performance is not a guarantee of future results or a reliable indication of future performance. The investment results, portfolio compositions and examples set forth in this document are provided for illustrative purposes only and may not be indicative of the future investment results, future portfolio composition or investments. The composition, size of, and risks associated with an investment may differ substantially from the examples set forth in this document. No representation is made that an investment will be profitable or will not incur losses. Where appropriate, changes in the currency exchange rates may affect the value of your investment. In making an investment decision, prospective investors must rely on their own examination of the merits and risks involved and before making any investment decision, it is recommended that prospective investors seek independent investment, legal, tax, accounting or other professional advice as appropriate. OTHER RESTRICTIONS: The distribution of this document is restricted by law. No action has been or will be taken by Babson Capital to permit the possession or distribution of the document in any jurisdiction, where action for that purpose may be required. Accordingly, the document may not be used in any jurisdiction except under circumstances that will result in compliance with all applicable laws and regulations. Any service, security, investment, fund or product outlined in this document may not be generally available or be suitable for a prospective investor or available in their jurisdiction. It is the responsibility of the prospective investor to ensure that any service, security, investment, fund or product outlined in this document is accordant with any jurisdiction specific guidelines/regulations before any approach is made regarding that service, security, investment, fund or product. INFORMATION: Babson Capital Management LLC is a registered investment adviser with the Securities and Exchange Commission under the Investment Advisers Act 1940, as amended. Babson Capital Management LLC is registered as a Commodity Trading Advisor (CTA) and Commodity Pool Operator (CPO) with the Commodity Futures Trading Commission under the Commodity Exchange Act, as amended. Babson Capital Securities LLC is a registered limited purpose broker-dealer with the Financial Industry Regulatory Authority, Inc. Babson Capital Europe Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom (Ref No. 194662) and is a Company registered in England and Wales (No. 03005774) whose registered address is 61 Aldwych, London, WC2B 4AE. Babson Capital Australia Pty Ltd (ACN 140 045 656), is authorized to offer financial services in Australia under its Australian Financial Services License (No: 342787) issued by the Australian Securities and Investments Commission. Babson Capital Cornerstone Asia Limited is licensed with the Securities and Futures Commission of Hong Kong to carry on regulated activities Type 1 (dealing in securities), Type 4 (advising on securities) and Type 9 (asset management) in Hong Kong in accordance with the requirements set out in the Securities and Futures Ordinance (Cap 571). Wood Creek Capital Management, LLC is a registered investment adviser with the SEC specializing in investments in real assets. Cornerstone Real Estate Advisers LLC is a registered investment adviser with the SEC specializing in real estate related investments. COPYRIGHT: Copyright in this document is owned by Babson Capital. Information in this document may be used for your own personal use, but may not be altered, reproduced or distributed without Babson Capital’s consent CONTACT SALES U.S. Jeff Stammen Managing Director +1.917.542.8308 [email protected] Europe Andrew Godson Managing Director Head of Distribution +44 (0)20 3206 4574 [email protected] Australia Duncan Robertson Managing Director +61.2.8272.5044 [email protected] Asia Giselle Lee Managing Director +85.2.3515.8025 [email protected] CONSULTANTS U.S. David Acampora Managing Director +1.917.542.8375 [email protected] Glenn Weiner Managing Director +1.704.805.7350 [email protected] Europe Neil Godfrey Managing Director +44 (0)20 3206 4576 [email protected] Asia / Australia Duncan Robertson Managing Director +61.2.8272.5044 [email protected] *MassMutual Financial Group is a marketing name for Massachusetts Mutual Life Insurance Company (MassMutual) and its affiliated companies and sales representatives. For Investment Professionals Only PCLO6346_ 12/1710_ 2012/132