Are CLOs a good alternative investment for Asian Family Offices?

In recent years, we have seen an influx of Asian money into countries like Singapore and Hong Kong. According to the recent World’s Billionaire’s list published by Forbes, Asia is home to 719 billionaires, approximately 32.65% of the world’s billionaires. The ultra-rich are starting to take a more hands on approach in the investment of their wealth and Family Offices are on the rise. At the end of 2018, Asia has nearly 500 Family Offices in Asia and this number is set to rise in 2019. Family Offices not only provide investment strategies, they also assist with diversification of the family’s business portfolio, dispute resolution, and succession planning.

As Family Offices look to diversify their investments and increase yield, will investments in collateralised loan obligations (CLOs) serve as a good form of alternative investment for Asian Family Offices?

To answer that, we first have to understand what a CLO is. A CLO is a repackaged instrument consisting of a single security backed by a pool of non-investment grade debts. These debts are usually senior secured corporate loans to corporates with a lower credit rating or leveraged loans. With a CLO, the investor receives scheduled debt payments from the underlying loans and takes the risk of those borrowers defaulting on their loans. The upside for the investor is that it receives higher returns and has a more diversified portfolio and for the financial institution, these low-rated/leveraged loans are off its balance sheet.

There are two kinds of tranches in a CLO: the debt tranche and the equity tranche. Debt tranches have credit ratings and coupon payments. The debt tranches get repaid first but within the debt tranches, there are different pecking orders for repayments - those who get repaid first will take on less risk and those who get repaid last will take on the most risk as there could be very little/nothing left. Equity tranches do not have credit ratings and are paid out after all debt tranches have been paid if there is any excess cashflow and equity tranches do offer ownership in the CLO itself which means equity tranche holders will receive proceeds of any sale.

So how would a Family Office benefit from investing in CLOs?

1. Higher returns
In an economy where the interest rates are rising, the prospects of investing in fixed income instruments like bonds become less attractive. CLOs can provide investors with a nice alternative as the underlying loans in a CLO are floating rate loans (ie such loans are priced at a spread to a benchmark rate like LIBOR or EURIBOR). As such, the higher the interest rates, the higher the returns for the investors of the CLO. For Family Offices, investments in CLOs, in particular equity tranches, has proven rewarding with yields as high as 20%. 

2. Diversity
CLOs can provide Family Offices with the diversity they need. Firstly, the loans are from corporates (usually 100-300 corporate loans) across different sectors in the economy (assuming one is not investing in a sector specific CLO). As such, even if one borrower defaults because of a downturn in a particular sector, it is not a total loss scenario for the investors as there will be other corporates who will not be affected by such a downturn. Secondly, Family Offices can invest in different tranches, including equity tranches, to cater for different risk appetites and investment objectives.

3. Ability to hold for longer term
Family Offices, unlike other public companies, funds and insurance companies, have the ability to commit their capital for a longer period of time and ride through volatility in prices, thereby getting higher returns on their investments. That being said, if the Family Office chooses to liquidate its investments in the short term, CLOs generally have a good trading liquidity in a healthy economy.

Notwithstanding the diversity and high yields, CLOs, being a complicated structured instrument, are not without risks. Below are some risks Family Offices should consider before investing in CLOs:

1. Covenant lite loans to low rated corporates
The high demand for CLOs has led to loosening of borrowing conditions since banks are essentially transferring the risks of the low rated borrowers to the CLO investors - borrowers with weak credit ratings will still be able to borrow on the back of ‘covenant lite’ loan documentation ie there are now less protections in the loan documents which serve as early alarm bells for when a borrower may be in financial difficulties. By the time the borrower defaults on payment, there will be little protection left for the investors. According to the S&P Global Market Intelligence Leveraged Commentary & Data, in 2018, about 80% of all new leveraged loans are based off ‘covenant lite’ documents.

2. Illiquidity due to macroeconomic conditions
Trading liquidity is good to the extent that the economy is performing. To the extent that economies are facing a downturn or if there are any political uncertainties in the world from Brexit to the US-China trade war, this could impact on the liquidity of the CLOs. If a sizeable number of corporates in a CLO gets downgraded, this could lead to a frenzy to sell and prices to fall.

Despite the above concerns, we believe that, amongst others, the rise of Family Offices in Asia will continue to fuel the growth of the CLO markets in Asia. CLOs do offer good opportunities for Family Offices (whether they are new Asian Family Offices setting up and taking advantage of the tax and other incentives given by governments in countries like Singapore and Hong Kong or satellite offices of the US/Europe Family Offices wanting to gain access to Asian funds) notwithstanding the risks. The right investment strategy coupled with the patient capital that Family Offices can offer will allow Family Offices to withstand turbulence in the CLO markets and reap the benefits in the long term.