Given my line of work, I think this topic is interesting and clearly very dangerous. Have you ever heard of ESG investing? Know anything about it? Seen any marketing blurbs about it when opening your brokerage account? It came up on an investor call today so it got me going.
ESG stands for Environmental/Social/Governance investing. It's quickly becoming all the rage on Wall Street and is every bit as big a threat to corporations and whole industries as government regulation. I work for a large buy side firm that manages a huge platform of CLOs. CLOs have been immune from ESG stupidity for a while, but it's creeping into our newest issue funds and is being pushed hard by investors. Our investors are institutional investors (banks, insurance companies, other funds, etc). These investors are usually some sort of pass thru to further investors and stakeholders. As our society continues to get more "woke", end investors are demanding that their fund managers be "woke" too. To that end, ESG is showing up EVERYWHERE.
ESG analysts rate various industries and companies based not solely on credit worthiness and yield prospects, but layer in the "wokeness" of the business. Gone are the days when a portfolio manager could fulfill his fiduciary responsibility to his investors by seeking max yield/return for a given risk profile. Now, because of investor demand or an assumption of the existence of such a demand, PMs are having to tweak portfolios to consider this utter f***ing nonsense. As such, some investors who could care less about woke faggotry, lose yield so that other "woke" investors in the shareholder pool can feel special about themselves.
So this is how companies and industries can be destroyed without even needing government stupidity. ESG is the wholesale divestiture of unsavory business from portfolios. Simply put, ESG chokes off capital to businesses, or assesses a non-ESG premium to lending rates such that access to liquidity and cap-ex funding becomes prohibitively and punitively expensive. We've seen this here, with banks/credit card processors not processing gun purchases. But ESG investing takes this to a whole new level where entire industries are excluded from a vast sea of readily available capital.
CLOs as you may or may not know, issue bonds in a structured finance transaction against a pool of "leveraged loans". In simple terms, a leverage loan is a speculative grade (i.e. non-investment grade) syndicated loan made by a pool of lenders to provide capital to these non investment grade companies. These are companies rated BB+/Ba1 and lower by rating agencies such as Moody's and S&P or Fitch. The lender pool is made up mostly of CLOs and other leveraged loan funds. A typical $500M CLO will issue about $300M AAA notes, $50-60M AA rated notes, $30ish M single A rated notes, $30M BBB notes, and 15-17M BB Notes. At the bottom of the capital stack is about 50M equity notes. This $500M is used to purchase about $500M in leveraged loans.
The 50M in equity is considered "first loss" as there is no credit protection. To juice the equity returns, the fund leverages about 10x over, so that is why we issue about $450M in rated notes. For each turn of leverage, the equity return doubles less the cost of capital in the structure above and expenses. The large $300M AAA class of notes is often issued such that is pays LIBOR plus ~1.3% spread. The most junior class of BB rated or sometimes B rated notes pays LIBOR plus 6.5-8.5%. The structure is set up such that the largest chunk of leverage is very cheap, getting more expensive as you go down the stack and the class size decreases. The aim is to get the weighted average cost of capital (or weighted average spread of the debt notes) to be somewhere around 2%. The $500M worth of leveraged loans that are purchased with the sales proceeds of the notes carry a weighted average spread over LIBOR of about 4%. The CLO then will use incoming loan interest payments per year to pay the interest on the Notes and keep the 2% excess spread to pass on to the equity class, after management fees and admin fees are paid.
It's really a brilliant structure when you stop and think about it. Say an equity investor wanted to give an asset manager $50M to invest in a pool of leveraged loans that paid an average all-in coupon rate of 5%. Absent any fees, the equity holder would be able to rely on a 5% annual return by investing in mostly BB and B rated loans. 5% in BB and B loans is MUCH higher than what they could get buy investing in a high yield bond fund. Moreover, the default rates in the leveraged loan asset class are significantly lower than the default rates in corporate bond paper. Recovery rates post default for a leveraged loan are around 70% vs 40-45% for corporate bonds. Clearly it's an attractive asset class due to both being "yieldier" and lower default rates/higher recoveries. But what if the equity investor could spend that $50M investing in the leveraged loan asset class but rather than get a 5% annual return, get a 23% annual return? The way this is achieved is by creating a highly (typically 10x) leveraged structure. This is why another $450M in debt is issued above the equity class. For every turn of leverage the equity investor can double his return minus the cost of the leverage. When you leverage 10x at 2% cost, the equity investor nets an additional 3% per turn of leverage: 9x3=18% plus his initial 5% = a 23% return based on the same $50M investment. Not only this, he gets a shit ton of protection via diversification because his $50M exposed him to $500M of credits, typically 200 companies across 30+ industries. Now his actual return will be a bit lower because the asset manager is charging about 4-6 million per year per CLO to manage, there are admin and legal expenses etc. But still a solid return and value prop typically around 17-18%.
Now, without all these CLOs (nearly $700 Billion currently outstanding CLOs) there aren't a lot of buyers for leverage loans. The leveraged loan market is about $1.2T so CLOs account for nearly 60% of the market. Speculative grade companies who need access to capital for things like dividend recaps and LBOs find attractive borrowing terms in the leveraged loan market vs issuing bonds. Lenders like them because leveraged loans require a senior secured first lien status backed by tangible collateral. Bonds are unsecured and lower in a companies capital stack and thus subject to significantly more risk to the investor/lender. In a leveraged loan scenario, a large investment back arranges the loan, but individual investment funds (CLOs and others) basically form a lending syndicate to fund the loan. These funds are de facto lenders and now have first lien claim status to the companies assets in a default situation, higher than any of the company's bondholders or other creditors. Leveraged loan lenders are only junior to taxes.
Until recently, a CLO manager's fiduciary responsibility was to buy an appropriately "yieldy" pool of levaged loans within the covenants of a CLO indenture. A number of simple statistical tests ensures the credit enhancements of the senior rated note classes is kept intact, and the structure is set up such that each subsequent class of notes has sufficient subordination beneath it to absorb losses in case of portfolio credit deterioration or major market disruptions like Covid. Each class is effectively "overcollateralized" such that a class will not become affected by losses unless the losses reach a certain threshold (the class "attachment point"). Typically the AAA class attaches at around 40% meaning that the 40% of the portfolio would have to default at 0% recovery before the AAA class lost a penny! Each lower class assumes the extra risk by getting a higher spread and everyone is happen. No AAA clo note has EVER defaulted (and actually this goes down to AAs), and there have only been a few losses all the way down at the Single B level CLO notes in history. Long before a default happens on a CLO note, a failure in an overcollateralization tests will force an accelerated maturity of the highest rated outstanding class. This usually cures the OC test failure and leaves behind a healthy but somewhat de-leveraged structure.
Now CLO managers are being pressured to incorporate ESG into the portfolios. These ESG rules get covenanted in the CLO indentures and become unbreakable rules. Entire industries and companies get excluded. Now remember, if it wasn't for CLOs (which make up about 60% of the leveraged loan market) there would be no lenders to fund these loans and the companies relying on this capital would lose access to that capital. You can see where this is going. Weapons manufacturers are often tops on the ESG black list. Regardless of how you feel about say "cluster bombs", esg says no way Jose. Nevermind that the last US manufacturer of these munitions stopped producing them in 2016. Regardless of how you feel about palm oil, it's a huge commodity and a legal business. But envrio nazis hate palm oil and almost all ESG blacklists include Palm Oil manufacturers. Add tobacco - even non tobacco companies who derive 50% of their revenues from tobacco sales/transport/packaging, semi auto civilian gun manufacturers, fossil fuels especially evil coal, the list goes on and on. If a liberal doesn't like it, you can bet it's going to show up on ESG black lists.
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ESG stands for Environmental/Social/Governance investing. It's quickly becoming all the rage on Wall Street and is every bit as big a threat to corporations and whole industries as government regulation. I work for a large buy side firm that manages a huge platform of CLOs. CLOs have been immune from ESG stupidity for a while, but it's creeping into our newest issue funds and is being pushed hard by investors. Our investors are institutional investors (banks, insurance companies, other funds, etc). These investors are usually some sort of pass thru to further investors and stakeholders. As our society continues to get more "woke", end investors are demanding that their fund managers be "woke" too. To that end, ESG is showing up EVERYWHERE.
ESG analysts rate various industries and companies based not solely on credit worthiness and yield prospects, but layer in the "wokeness" of the business. Gone are the days when a portfolio manager could fulfill his fiduciary responsibility to his investors by seeking max yield/return for a given risk profile. Now, because of investor demand or an assumption of the existence of such a demand, PMs are having to tweak portfolios to consider this utter f***ing nonsense. As such, some investors who could care less about woke faggotry, lose yield so that other "woke" investors in the shareholder pool can feel special about themselves.
So this is how companies and industries can be destroyed without even needing government stupidity. ESG is the wholesale divestiture of unsavory business from portfolios. Simply put, ESG chokes off capital to businesses, or assesses a non-ESG premium to lending rates such that access to liquidity and cap-ex funding becomes prohibitively and punitively expensive. We've seen this here, with banks/credit card processors not processing gun purchases. But ESG investing takes this to a whole new level where entire industries are excluded from a vast sea of readily available capital.
CLOs as you may or may not know, issue bonds in a structured finance transaction against a pool of "leveraged loans". In simple terms, a leverage loan is a speculative grade (i.e. non-investment grade) syndicated loan made by a pool of lenders to provide capital to these non investment grade companies. These are companies rated BB+/Ba1 and lower by rating agencies such as Moody's and S&P or Fitch. The lender pool is made up mostly of CLOs and other leveraged loan funds. A typical $500M CLO will issue about $300M AAA notes, $50-60M AA rated notes, $30ish M single A rated notes, $30M BBB notes, and 15-17M BB Notes. At the bottom of the capital stack is about 50M equity notes. This $500M is used to purchase about $500M in leveraged loans.
The 50M in equity is considered "first loss" as there is no credit protection. To juice the equity returns, the fund leverages about 10x over, so that is why we issue about $450M in rated notes. For each turn of leverage, the equity return doubles less the cost of capital in the structure above and expenses. The large $300M AAA class of notes is often issued such that is pays LIBOR plus ~1.3% spread. The most junior class of BB rated or sometimes B rated notes pays LIBOR plus 6.5-8.5%. The structure is set up such that the largest chunk of leverage is very cheap, getting more expensive as you go down the stack and the class size decreases. The aim is to get the weighted average cost of capital (or weighted average spread of the debt notes) to be somewhere around 2%. The $500M worth of leveraged loans that are purchased with the sales proceeds of the notes carry a weighted average spread over LIBOR of about 4%. The CLO then will use incoming loan interest payments per year to pay the interest on the Notes and keep the 2% excess spread to pass on to the equity class, after management fees and admin fees are paid.
It's really a brilliant structure when you stop and think about it. Say an equity investor wanted to give an asset manager $50M to invest in a pool of leveraged loans that paid an average all-in coupon rate of 5%. Absent any fees, the equity holder would be able to rely on a 5% annual return by investing in mostly BB and B rated loans. 5% in BB and B loans is MUCH higher than what they could get buy investing in a high yield bond fund. Moreover, the default rates in the leveraged loan asset class are significantly lower than the default rates in corporate bond paper. Recovery rates post default for a leveraged loan are around 70% vs 40-45% for corporate bonds. Clearly it's an attractive asset class due to both being "yieldier" and lower default rates/higher recoveries. But what if the equity investor could spend that $50M investing in the leveraged loan asset class but rather than get a 5% annual return, get a 23% annual return? The way this is achieved is by creating a highly (typically 10x) leveraged structure. This is why another $450M in debt is issued above the equity class. For every turn of leverage the equity investor can double his return minus the cost of the leverage. When you leverage 10x at 2% cost, the equity investor nets an additional 3% per turn of leverage: 9x3=18% plus his initial 5% = a 23% return based on the same $50M investment. Not only this, he gets a shit ton of protection via diversification because his $50M exposed him to $500M of credits, typically 200 companies across 30+ industries. Now his actual return will be a bit lower because the asset manager is charging about 4-6 million per year per CLO to manage, there are admin and legal expenses etc. But still a solid return and value prop typically around 17-18%.
Now, without all these CLOs (nearly $700 Billion currently outstanding CLOs) there aren't a lot of buyers for leverage loans. The leveraged loan market is about $1.2T so CLOs account for nearly 60% of the market. Speculative grade companies who need access to capital for things like dividend recaps and LBOs find attractive borrowing terms in the leveraged loan market vs issuing bonds. Lenders like them because leveraged loans require a senior secured first lien status backed by tangible collateral. Bonds are unsecured and lower in a companies capital stack and thus subject to significantly more risk to the investor/lender. In a leveraged loan scenario, a large investment back arranges the loan, but individual investment funds (CLOs and others) basically form a lending syndicate to fund the loan. These funds are de facto lenders and now have first lien claim status to the companies assets in a default situation, higher than any of the company's bondholders or other creditors. Leveraged loan lenders are only junior to taxes.
Until recently, a CLO manager's fiduciary responsibility was to buy an appropriately "yieldy" pool of levaged loans within the covenants of a CLO indenture. A number of simple statistical tests ensures the credit enhancements of the senior rated note classes is kept intact, and the structure is set up such that each subsequent class of notes has sufficient subordination beneath it to absorb losses in case of portfolio credit deterioration or major market disruptions like Covid. Each class is effectively "overcollateralized" such that a class will not become affected by losses unless the losses reach a certain threshold (the class "attachment point"). Typically the AAA class attaches at around 40% meaning that the 40% of the portfolio would have to default at 0% recovery before the AAA class lost a penny! Each lower class assumes the extra risk by getting a higher spread and everyone is happen. No AAA clo note has EVER defaulted (and actually this goes down to AAs), and there have only been a few losses all the way down at the Single B level CLO notes in history. Long before a default happens on a CLO note, a failure in an overcollateralization tests will force an accelerated maturity of the highest rated outstanding class. This usually cures the OC test failure and leaves behind a healthy but somewhat de-leveraged structure.
Now CLO managers are being pressured to incorporate ESG into the portfolios. These ESG rules get covenanted in the CLO indentures and become unbreakable rules. Entire industries and companies get excluded. Now remember, if it wasn't for CLOs (which make up about 60% of the leveraged loan market) there would be no lenders to fund these loans and the companies relying on this capital would lose access to that capital. You can see where this is going. Weapons manufacturers are often tops on the ESG black list. Regardless of how you feel about say "cluster bombs", esg says no way Jose. Nevermind that the last US manufacturer of these munitions stopped producing them in 2016. Regardless of how you feel about palm oil, it's a huge commodity and a legal business. But envrio nazis hate palm oil and almost all ESG blacklists include Palm Oil manufacturers. Add tobacco - even non tobacco companies who derive 50% of their revenues from tobacco sales/transport/packaging, semi auto civilian gun manufacturers, fossil fuels especially evil coal, the list goes on and on. If a liberal doesn't like it, you can bet it's going to show up on ESG black lists.
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