Hedge Funds Lure Pensions to $1.3T Risky Credit, Raise $3.1B

Key Takeaway

• Pension plans and insurers are increasingly investing in high-risk CLO equity tranches, raising $3.1 billion for such strategies despite concerns over potential pitfalls.
• The appeal of CLO equity's high returns is attracting traditionally risk-averse investors, amid warnings that low default rates may mask recovery and loss issues.
• Sales of new US CLOs surged 64% this year, with funds like GoldenTree successfully raising significant amounts targeting first-loss equity tranches.

CLO Equity Attracts Conservative Capital

In a surprising shift within the $1.3 trillion credit market, pension plans and insurers, traditionally conservative investors, are increasingly drawn to the high-yield potential of equity tranches in collateralized loan obligations (CLOs). Asset managers, including notable names like GoldenTree Asset Management and Carlyle Group Inc., have successfully raised over $3.1 billion for strategies focused on these risky investments. CLO equity, known for its position at the bottom of the repayment hierarchy, offers enticing returns in the mid- to high-teens, despite its inherent risks.

The Lure of High Returns

The recent surge in demand from pension funds introduces a significant new buyer into the CLO equity market, previously dominated by hedge funds, family offices, and sovereign wealth funds. This shift is driven by the chase for higher yields, despite the high risk associated with these investments. Dan Zwirn of Arena Investors LP highlights a common oversight in the market's enthusiasm: low default rates in leveraged loans mask the potential for lower recoveries and actual losses. With recoveries for high-yield bonds and loans declining, the risk-reward ratio for CLO equity investments becomes increasingly questionable.

Market Resurgence and Regulatory Scrutiny

The CLO market is experiencing a resurgence, with sales of new US CLOs up 64% from the previous year. This revival is partly fueled by pension inflows into CLO equity, despite the opaque nature of these investments. However, the growing interest from traditionally risk-averse investors raises concerns about their exposure to potential losses. In Europe, regulatory constraints limit insurers and pension funds' ability to allocate heavily into these high-risk strategies, emphasizing the need for cautious investment into CLO equity.

Street Views

• Dan Zwirn, Arena Investors LP (Bearish on CLO equity):

  "There’s this 'pretend notion that because default rates are low, everything’s fine,'... But it’s not about defaults, it’s about recoveries and actual losses and that’s what people miss." "There’s a lot of extending and pretending, as well as ‘liability management exercises,’ which means that pain is being pushed out, and recovery levels are going to be much lower than expected. For returns in the low-teens, CLO equity actually has a terrible risk-reward."

• Loic Prevot, Polus Capital Management (Neutral on pension inflows into CLO equity):

  "Recently, however, there's been a growing interest from others as well."

• Mahesh Bhimalingam, Bloomberg Intelligence (Bullish on CLO equity strategy):

  "The so-called total arbitrage...has shown a premium of more than 200 basis points over the last six months. If that stays, more funds will continue to chase the strategy."

• Dan Robinson, DWS Group (Cautiously Optimistic on insurers and pension funds' participation in high-risk strategies):

  "They can’t be casual about investing into CLO equity...For example there can be deep draw-downs and market liquidity has been volatile for first-loss pieces."

• Craig Bergstrom Corbin Capital Partners (Bearish on industry-wide returns from high-risk credit strategies):> "A lot of big owners are going to wake up one day and ask 'Wait! We’ve taken 10 times levered first-loss risk in an OK credit environment and we’ve made 6% or 8% returns?'"

Management Quotes

• Kathy Sutherland CEO GoldenTree Asset Management:> "The strategy optimizes returns in both volatile and benign environments."