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Over the past few days I’ve gone down a rather deep rabbit hole within the topic of Collateralized Loan Obligations (CLOs). This came from pulling on the thread from Athene’s Retirement Services Day. It was outlined that CLOs are an under-appreciated asset class for myriad reasons, and is a source of outperformance for the insurer balance sheet. I understood the basics of the reasoning, but didn’t understand some of the foundational elements of CLOs. Furthermore CLOs sound similar to its bugaboo cousin, CDOs, the star of the ’08 financial crisis.

Over the past few months I’ve been periodically digging, but finally got serious about really understanding CLOs recently. If interested, see the below thread (below is the last post in the thread) for all of the resources I’ve pulled and posted for others to join in:

https://t.co/ndAyA4Gb3e

— The Red Deer (@the_red_deer) August 22, 2022

As I mentioned in my prior post, I’ve been pulled towards investing with fewer variables that have to be “predicted” or understood, a nod to how difficult it can be to get an edge as a retail investor in any part of the market. In many ways, CLOs offer a very structured investment vehicle with clear inputs and outputs.

The way I understand CLOs is as a simple bank with a secure long term funding base (versus deposits that can flee any given day), and a rules based approach to how the loans are managed versus management making human based decisions. It doesn’t need to grow like a business does, it doesn’t have to deal with overhead like a business, it doesn’t have to worry about competitors explicitly, and it can potentially benefit from market upheaval.

To be clear, there are always downsides to everything. CLOs struggled with getting primed during Covid when companies went into bankruptcy and the covenant light nature of the loans paired with the CLO’s lack of access to incremental capital put them at a disadvantage to distressed funds. But the interesting thing about CLOs is that while they have been around for ~25 years now, every negative event results in improved documentation that helps govern against such an event in the future.

But what does that mean for a retail investor? CLOs can be interesting because they tend to sell off in tandem as markets recoil. Why – as CLO owners aren’t necessarily forced sellers? Nobody can perfectly explain why prices move the way they do, but one reason is liquid funds that invest in bank loans (they key ingredient in a CLO’s asset base) see outflows during market dislocations, which push bank loan pricing down, and thus reduce the liquidation value of CLOs. This may offer a way to get discounted access to investment grade, non-investment grade, and equity layers, individually, of the CLO market. Access is now available via ETFs and interval funds for each broad CLO ratings layer – but buyer beware, the manager matters.

I recommend Flat Rock Global’s CLO primer to learn more, as it goes through all the basics, the acronyms, and mechanics of the CDO lifecycle in detail. And I recommend the podcast The Last Tranche to understand how CLO managers were reacting during and after Covid.

The spark of something amazing, in this blog post, specifically refers to the idea of doing something truly legendary that creates great wealth and admiration. To do something like that, one has to be built a bit different. Morgan Housel wrote:

Reversion to the mean is one of the most common stories in history. It’s the main character in economies, markets, countries, companies, careers – everything.

Part of the reason it happens is because the same personality traits that push people to the top also increase the odds of pushing them over the edge.

He goes on to describe how it may apply to investors:

The kind of personality willing to take enough risks to earn outsized returns is generally not compatible with the kind of personality willing to shift everything into muni bonds once they’ve made enough money. They’ll keep taking risks until those risks backfire. It’s why the Forbes list of billionaires has 60% turnover per decade.

And last, he talks about how acquiring “the spark of something amazing” and keeping it are two different skills often at odds:

Long-term success in any endeavor requires two tasks: Getting something, and keeping it. Getting rich and staying rich. Getting market share and keeping market share.

These things are not only separate tasks, but often require contradictory skills. Getting something often requires risk-taking and confidence. Keeping it often requires room for error and paranoia. Sometimes a person masters both skills – Warren Buffett is a good example. But it’s rare. Far more common is big success occurring because a person had a set of traits that also come at the direct cost of keeping their success. Which is why downside reversion to the mean is such a repeating theme in history.

For me, investing has never really involved “getting rich” as much as I hoped it would in the earlier years. I would dream about finding a 100x investment, or perhaps even a 5x investment, and realizing that big score with fists pounding the table thinking I did it. But frankly, it isn’t how I’m wired. I’m not someone who is willing to swing the bat so hard that I become the outlier statistic of the one who earned the outsized returns. But I am the person who is willing to invest in muni bonds ;).

As such, investing to just make a reasonable return via current income to enable a relatively freedom-full life is in fact up my alley. It foregoes the idea that I have “asymmetric” investments that can produce life-changing returns. It narrows the investment universe to things with more certain outcomes versus uncertain. It removes me from fooling myself that I have differentially good insight on the future of various businesses across different industries.

It’s why credit has been so intellectually interesting to me lately. One credit investor outlined with respect to CLOs:

So you’re not exposed to management, you’re not exposed to R&D, you’re not exposed to weak documentation or leaking of proceeds. You’ll have a very tight closed loop system defined by rules where you’re taking asset level risk from predictable cash flows from a diverse set of borrowers or a diverse set of consumers.

It’s less the CLO product level insight that I find interesting, more the idea that there are ways to invest that expunge with having to predict the future. Predicting the future is an exceedingly interesting intellectual pursuit but one that few master.

To that end, I continue to think I’m positively evolving by virtue of letting go of the idea that I’m somebody special. That it is okay to target modest returns that achieve a specific psychological goal and sleep well at night. And with that mindset, my investing continues to get better each day.

KKR is out with a new credit focused letter. The summer lull seems to be real among the authorship. KKR’s note is a wandering comparison of credit markets to Hemingway’s A Sun Also Rises. And they do a fairly decent job of that far reaching parallel. Kudos.

I didn’t find the entire note to be particularly full of insight, more a check in of where we are in credit markets, but it’s useful for me. Let’s get to the interesting parts:

The late July rally in high yield and increased appetite for risk assets is a great example of why we are paying close attention to the total return opportunity in the credits we like as spreads compress quickly when the market decides to move. Bids for liquid credit re-emerged in late July, sending spreads tighter by ~100bps off their wides and high yield is now up +6.02%34for the month of July — its best month in 11 years. Notably, BB’s closed out the month up 6.23%,35 outperforming CCC risk by 134bps. It is of note that this rally is heading into the depths of corporate earnings. Similarly, the loan market was up +2.1% as of July 31st, which has been its largest move since November 2020. July’s resilient CLO demand of $9 billion coupled with a decade low for new issue supply of $2.2 billion36 has been supporting technicals for positive price action. The recent activity has helped us get more comfortable that there may be a floor to additional dramatic downside risk as we are now starting to see pools of capital stepping into risk providing stability, albeit feeling leadership-less.

The question going forward, obviously, is will there be another leg down?

Interestingly, KKR discussed how liquidity constraints can make a market opportunity frustratingly unavailable for large players:

Ultimately, the invisible strain to this market’s volatility has been the lack of liquidity. We have discussed many times how critical liquidity is during market drawdowns. Thin liquidity not only affects the pricing of assets but also the ability to execute. While the market has had a number of sharp moves this part quarter, we saw muted volumes. This was not a scenario of a contained bull fight in a ring, but rather bulls running the streets wild and as a result, required true patience. There are long-term opportunities swimming in the market but there has been a lack of the market-depth needed to take full advantage of them. The street has been remiss to provide new capital given underwriting and risk limitations are already at a constraint for the year, which has in turn re-directed deal activity and also echoed caution across all market participants.

I have seen echos of this elsewhere, with Ladder Capital being one:

And as far as security, I would love to add a lot of securities where they’d be pricing in the last months, but I don’t think we’re going to be able to, I get $100 million to $200 million, but I don’t think we’re going to be able to buy a large amount of AAA bonds that are yielding 21% [levered return].

LADR Q2-2021 Earnings Transcript

Alas, here is where we are in US credit as of today:

As somebody who is generally interested in the annuity space by virtue of an investment in Apollo / Athene (disclosure: author owns), I realized I don’t know the KKR analogue to Athene well, if at all. To that end, I looked up some high level figures try to understand the basics of Global Atlantic (GA), the annuity player majority owned by KKR.

As a starting point, Marc Rowan commented on KKR / GA on two occasions:

It’s not to say we’re always going to have this fixed income replacement market to ourselves versus our alternatives peers. Some are making good progress. I would say KKR is probably making the best progress because they have the greatest understanding of what is needed to feed a retirement services balance sheet.

APO 2021 Investor Day

Most of the marketplace today in the alternatives area has originated higher octane, higher risk reward, if you will, credit, which is generally not where insurance company balance sheets invest. Some, I believe, will be successful in getting this over time. I think KKR bought a very nice franchise with an excellent management team. And I think if they embrace what I’ve just said and understand what their management needs, I think, over time, they will be very successful. Others will be effective server — providers of assets to the insurance company marketplace. 

Credit Suisse Financials Conference, Feb 2021

First, just to understand the scale of the two businesses:

Athene’s business is substantially larger than GA’s, especially considering the Q1-22 number of $181B excludes $37B of assets attributable to Apollo / Athene’s sidecar investment vehicle (ADIP / ACRA). KKR / GA has a similar sidecar vehicle (perhaps multiple), but I’m unfamiliar as to how much of its liability base is attributable to the sidecar (it seems like $14B via the “trading fixed maturity securities” line item).

Athene’s business is more profitable on an absolute basis as is to be expected by its larger asset base:

However, it appears that Athene is more profitable per unit of assets. Here are the ROAs net of tax for each:

While it would be great to drill into the investment yield of each book and associated expenses – Athene notes in its docs that its investment yield is messed up due to purchase accounting from the Apollo merger (yield goes down during period of rising rates without any acquisition and increased retail flows). Thus for now I think ROA, or nominal operating earnings vs its asset base is the best way to compare the two for now.

As for new business, both have nice organic flows vs their asset bases:

Athene has been super quiet on the inorganic front within the US – as other alt players have crowded the market and its retail channel took off. GA got off a deal with Ameriprise in July of ’21. I’m not sure what is happening with GA’s low organic print as 2022 started. Below are the annuity rankings for 2021, in which Athene is at the top (the below includes VAs):

Last, considering the debt profile of both, Athene appears to use less leverage than GA to drive profits to the equity:

Perhaps this is why GA pulled back on organic flows in Q1-22? I’m not sure. Surely Athene put its foot on the gas post-Covid while others pulled back and the result was its jump to the top in annuity rankings for now.

In conclusion, the above helps outline some notable differences between the two, namely profitability, asset base size, organic funnel size, and debt profile. It isn’t a judgement of what the future may hold for each, just a high level overview of some differences measured by past results.

I’m looking forward to following GA more closely to the extent that public disclosures allow in the future.

Disclosure: This isn’t investment advice, do your own work.

While evaluating companies on a yearly basis is still too short a timeline to evaluate wholesale strategy change, it’s worth at least giving it a shot.

2022 has been a potential year of divergence. While too early to see if select alternative asset managers will definitively falter or shine, it’s worth trying to start parse stylistic differences in the performance numbers. At least year to date, the more “thematic” oriented private equity sub-businesses (Blackstone, KKR) are down on the year versus the more value oriented managers (Apollo, Ares, Carlyle).

Firm	1Q-2022	2Q-2022	YTD
Apollo (Flagship PE)	+7.7%	-4.9%	+2.4%
Ares (Corp. PE)	-1.0%	+1.5%	+0.4%
Blackstone (Corp. PE)	+2.8%	-6.7%	-4.1%
Carlyle (Corp. PE)	+3.0%	+0.0%	+3.0%
KKR (Trad. PE)	-5.0%	-7.0%	-11.6%

To be fair, managers down YTD have had a golden age of returns over the past 5 years. For example, KKR’s America’s Fund XII that started investing in 2017 is tracking at roughly a 2x MOIC in ~5 years, a strong performance. Furthermore, the S&P500 at the halfway point was down more than all of the above, though an argument is to be made that the asset managers don’t mark their holdings down appropriately.

On the credit front, cousins Apollo and Ares appear to be having a standout year on a relative and absolute basis.

Firm	1Q-2022	2Q-2022	YTD
Apollo (Direct Orig.)	+3.4%	+3.3%	+6.8%
Ares (Sr. Direct)	+2.3%	+3.8%	+6.2%
Blackstone (Priv. Credit)	+1.7%	-0.1%	+1.5%
Carlyle (Global Credit)	+0.0%	+2.0%	+2.0%
KKR (Alt. Credit)	-1.0%	-1.0%	-2.0%

As mentioned before, it’s too early in this new monetary regime to conclude anything about dispersion within the pack. Furthermore, corporate private equity and direct lending are a subset of the full product suites of these players. But if I were sitting in an institutional allocator’s seat (disclaimer: I’m not, and I never have been), I presume I’d be watching these numbers closer than usual to determine if certain managers are better positioned for a new regime than the prior.

Disclosure: We own shares of BX, APO. This isn’t investment advice, do your own work.

Last night, at 10pm EST, Carlyle announced that its CEO is out.

Prior, Kewsong Lee, the now ousted CEO, was Co-CEOs with Glenn Youngkin. The two didn’t work as partners and Youngkin departed. Only now it seems perhaps Youngkin is having the last laugh, as he is now the elected Governor of Virginia.

Surely something bad went down. Perhaps some form of an affair? Perhaps violations of the divide between personal and corporate investments? Gotta be something fairly bad to eject a CEO who on the surface has appeared to be doing a great job.

Accordingly, the market does not like uncertainty:

The lesson here in my mind is when investing in single companies, things like this can happen that are well outside the realm of what one contemplates. While I don’t think, based on the press release, the business is impaired – that scenario is entirely possible in any single business. And that’s why prudent diversification is key to mitigating some of these tail risk events.

Disclosure: We do not own shares of CG, this is not investment advice. Do your own work.

Back in 2000, David Swenson, the former head of the Yale endowment, wrote his seminal book Pioneering Portfolio Management. Yale really shook up endowment investing. In the 80s / 90s, it allocated a very large portion of its funds to Alternative assets. Namely corporate private equity, real estate private equity, and venture capital. Its results have stomped the competition, and the market at large.

In that, Swenson “dared to be different.” His portfolio wouldn’t likely have been approved elsewhere, and most wouldn’t be willing to risk looking like a fool if his strategy did not work.

In that vein, one can’t expect to have good investment performance versus a benchmark if the portfolio for the most part resembles or is highly correlated to the benchmark. Today, Alternatives are permeating insurers, endowments, and even retail investors. Thus, the Swenson strategy has finally arrived and with it, one can presume its advantage is diminishing.

So the question is, what is the next level of portfolio strategy that will shine over the next 20-30 years? TBD.

So the jobs report came out late this week, and kinda defied all expectations. Ren-Mac outlined:

A significant beat in payrolls with an even more surprising downtick in the unemployment rate. Recession talk is premature along with talk of a policy pivot. This report is consistent with an inflationary boom. 75 in September and on the table in Nov and Dec.

— RenMac: Renaissance Macro Research (@RenMacLLC) August 5, 2022

Fed Funds Futures are sitting at the following (with benchmark at 2.5%):

Sep: 97.44 (2.56%, Fed meeting is end of Sept)

Dec: 96.52 (3.48%)

Mar: 96.37 (3.63%)

Point is while there was a lot of talk on Friday about how this jobs report forces the Fed to keep the aggressive rate hikes alive, it doesn’t seem like the market is aligning to that (looks like 100bps by December). Market expectations / futures are often wrong and we may see this change quickly.

While I am now biasing towards potentially more aggressive rate hikes (contrary to futures implications) and thus a bit more more mayhem in financial markets, no change to how I’m thinking about our investments. Keeping calm and carrying on.

A good portion of our equity portfolio has reported earnings thus far. Frankly, if I didn’t know there was so much negative sentiment out there, I’m not sure I would know there was a weakening economic environment based on our those that have reported so far.

I generally try to keep us, at least in the equity sleeve, invested in companies / funds that tend to be opportunistic, overcapitalized, and diversified (perhaps I should start using the acronym ODD?). Our alternative investment managers we are invested in are doing M&A to bolster their platforms (both Vinci and Patria), buying stressed assets (Apollo), and pushing forward monetizations (Brookfield Business Partners).

Our energy investments are hitting on all cylinders, with bond-like energy infrastructure companies showing high single digit growth versus last year with pricing increases pending regulatory approvals as the year goes on (highly influenced by backwards looking inflation). Dividends are increasing materially. Our coal investment is spewing cash, increasing its dividend 10-15% per quarter, and locking up forward sales ~3 years in the future at peak pricing, of which contracting that far in the future was unheard of in the recent past. Our infrastructure fund reported cash flow growth in the 20%+ range versus last year by acquiring energy infrastructure on the cheap and inflation indexed rates pushing profits higher while fixed rate debt keeps interest costs low.

Our convention center hotel / country music venue investment reported all time high profits with no equity issuance through Covid, an incredible feat. It is just beginning to push rates materially.

Despite the softness in retail, our mall stock reported occupancy climbing, an increase in the dividend, and a full capital return of all capital invested in distressed retailers during Covid.

Frankly, it’s not like there aren’t some bumps in the road of certain equity holdings (namely M&A sensitive and direct retail), but for the most part, things don’t seem as bad as headlines indicate these days.

Perhaps that changes in the future…

One of our equity holdings, Atlas Corporation, received a take-private bid at $14.45 / share today after the bell. It traded at $11.57 / share at the close. It can essentially be described as a publicly traded infrastructure fund, that is primarily focused on containership leasing and mobile power generation. Given it is led by the legendary David Sokol of Berkshire fame (and fall), it has potential to be something amazing in the future, and has already transformed dramatically under his oversight since 2017. The great thing about Atlas is it trades at ~7x ’23 earnings, so you’re not paying for that potential growth.

To cut to the chase, Sokol has bemoaned the share price multiple times on conference calls and Q&As. Here’s their March investor day long term guidance:

So the take-private group (which includes Sokol) wants to pay ~10x ’23 earnings. I think with a business model that has transformed the company to have contracted revenue with 8 years of term dialed in, a proven management team, and Sokol at the helm to bolster its energy arm – this thing will grow nicely over the next 10 years and get a re-rate as the track record is built.

I sent a quick note to David Sokol right after the deal was announced voicing my displeasure and offered to organize an SPV to roll equity. I’m not expecting anything back, but one has to do something (most people just throw their hands up and don’t take even the first step):

What likely will transpire *if* the deal goes through is there is a modest bump to the initial offer and it gets done. Ugh. The goal of making investments like this is the reinvestment risk is near eliminated as the business self funds its own growth and the capital invested can stay invested indefinitely. While this has been a multi-year investment to date, it would cut that hold period short and force a re-investment on our part. Not the end of the world but not part of the plan.

We will see what shakes out.

Disclosure: We own shares of Atlas Corp. This is not investment advice, do your own work.