Q&A: Sancus Capital And The Disruption Of The CLO Market

Editor’s note: Traditional collateralized loan obligation (CLO) funds in the U.S. market can offer investors attractive returns and strong credit performance, but refinancing costs and liquidity concerns are often questioned, says Sancus Capital Management founder and CIO Olga Chernova. In response, the company has designed an automatic refinancing feature named AMR that can simplify the process and bring greater transparency to the market. FINalternatives recently discussed her firm’s innovation and the improvements it may bring to the traditional CLO market.

FINalternatives: Tell us about Sancus Capital. What is your approach?

Chernova: I launched Sancus in 2009 after a long career in credit, primarily at Goldman Sachs, JP Morgan, and Dillon Reade. Sancus is a multi-strategy credit hedge fund with a focus on exploiting arbitrage and inefficiencies across credit markets. Our approach at Sancus essentially mirrors my career in credit. I began my career on the fundamental side trading high yield, and over time moved into trading indices, tranches, and options. As derivative products developed, I evolved with the markets building new strategies and products along the way. 

Derivatives and structured products including CLO’s are our focus at Sancus. These products often do not get the credit they deserve. But we view them as a great source of alpha. For example, they allow us to isolate interest rate exposure and focus on producing returns from credit premia. Structural subordination available in mezzanine CLO’s and synthetic tranches can be a useful source of protection during a high default environment. Lastly, we feel the complexity premia often embedded in such products is very valuable and are often overlooked by fundamental investors. 

You mentioned CLO’s. What are the shortcomings of traditional CLOs, and how did they push you to develop AMR?

CLO’s are a large part of the credit market. With a current market size of roughly $600 billion, CLO’s are a critical investor in the U.S. leveraged loan market, accounting for whooping 65% of the asset class. Investing in CLO funds have been our focus for the past few years as they have some interesting technical benefits and features associated with increased regulation. 

CLO debt is a floating-rate asset class and a good alternative in the current environment of rising interest rates. We also believe that mezzanine tranches issued at a discount to par are an interesting way to get positive convexity in a negatively convex asset class. Loans are assets that are issued close to par and can be prepaid by the issuers at any time.  In a rallying market, loan investors would easily be refinanced tighter without much upside, while mezzanine CLO’s would be taken out earlier with a substantial price appreciation. 

Now with that said, there are indeed several shortcomings in the traditional CLO structure especially in regard to refinancing and the new risk retention rules. The traditional refi process is similar to a new issue of securities. Whenever equity investors would want to refinance the liabilities of the CLO, they would have to undergo the new issue process with an underwriting bank. New securities would be structured and rated (again) by rating agencies – The whole process is very onerous and costly. And with the new risk retention rules instituted last year, the uncertainty around managing the risk in a traditional CLO was increased. That is why we sought a better solution for this process and came up with AMR.

What exactly is AMR, and how does it work?

AMR is short for “Applicable Margin Reset”. It’s a mechanism that allows for CLO debt to be refinanced one tranche at a time, without using a bank to underwrite the transaction. Instead, the coupon for tranches to be refinanced is determined through an auction mechanism, and the results of the auction are made publicly available.

After thoroughly researching and designing the parameters around AMR, we requested clarification from the SEC. In the fall of 2016, Sancus received a no-action letter confirming that the mechanism we invented would not constitute an “offer and sale” of new securities. 

Simply put, AMR avoids the necessity for new issue of securities. Therefore, it also avoids additional expenses like rating agency fees, legal fees and bank underwriting fees. And because the CLO is not re-rated or re-valued, the original fair value calculation for risk retention stays intact, which reduces uncertainty. 

When did you come up with the idea for AMR? 

We began working on the idea in 2015 and engaged Dechert as legal counsel for a potential CLO transaction. Our original focus was to find a way to manage the risk retention requirement that was still pending at the time. But through the process, we realized we could also achieve other benefits through AMR, so reducing refinancing costs gradually became our main focus. 

We were confident in our idea and, with Dechert as counsel, petitioned the SEC for agreement. Two years later from when we originally conceived the idea, we launched the first-ever CLO utilizing AMR in our Atlas Senior Secured Loan Fund VIII, which closed in July. 

How did the Atlas VIII launch go? Did the AMR feature need a lot of explanation? 

The process was surprisingly smooth. Atlas VIII was a $413.7 million CLO, and we partnered with Crescent Capital as the CLO manager and MUFG Securities as the leading underwriter, who did a phenomenal job educating the market on the new features and benefits. The market welcomed the new feature – it was extremely well received by all investors, and we enjoyed a quick placement. 

How does AMR improve upon the traditional way CLOs are refinanced? Why would a manager utilize it over the traditional method? 

There are big advantages for various participants. Equity investors can utilize this new structure to significantly better control the timing of their refinancing. In addition, investors can refinance one tranche at a time, which means they can segment the different investment grades to time technicals in the market and achieve better cost of funding. Also, the refinancing process becomes cheaper, so it can be executed more often. More frequent financings can help align assets and liabilities, potentially reduce risk for equity investors. 

From the managers’ point of view, the fact that there will be no “offer and sale” of new securities provides a lot more certainty around risk retention. Since no securities are being considered, it is not required to conduct a new fair value analysis on the 5% retention piece and potentially buy more equity to cover the value. This is a big advantage for CLO managers. 

Debt investors can benefit through debt-friendly features offered by equity investors in return, such as longer non-call, may-call premium, and reserve margin rate that would provide call protection. 

It sounds compelling. Are there any limitations? 

Not really. Even if the auction mechanism failed, CLO equity investors would always have access to the traditional refinancing process as a backup. We believe AMR is a win-win situation for everyone concerned - managers, debt investors and equity investors.

Is AMR proprietary to Sancus? How can other managers utilize it, and do they need their own SEC “no-action” letter? 

Not at all. Other managers can utilize AMR in their products easily, and they don’t need their own no-action letter, as ours is in the public domain and thus applies to the overall market, not just Sancus. Managers would only need to build in the AMR mechanism in the initial transaction or to add the feature onto an existing CLO at the reset. In the future, they would not need a broker again for the refinancing process once AMR is in place.

What are the implications for the CLO market if AMR takes off?

We think the AMR structure could be a game changer. Ultimately, it could result in greater transparency and accessibility to the CLO market, which usually leads to greater liquidity. We think this can bring new participants to the market and result in overall growth.