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- [00:00]
Michael Batnik
Today's Animal Spirits Talk. Your book is brought to you by Flat Rock Global. Go to flatrockglobal.com to learn about their suite of credit funds, clos private credit flatrockglobal.com to learn more. Welcome to Animal Spirits, a show about.
- [00:16]
Ben Carlson
Markets, life and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholz Wealth Management. This podcast is for informational purposes only.
- [00:32]
Michael Batnik
And should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain.
- [00:37]
Ben Carlson
Positions in the securities discussed in this podcast.
- [00:43]
Michael Batnik
Welcome to Animal Spirits with Michael and Ben. On today's show, we talk to Shiloh Bates, who is a partner CIO at Flatrock Global. I have to admit, a brand new one to me, this is, I think you would say, a boutique firm. Is that correct?
- [00:55]
Shiloh Bates
Yes.
- [00:56]
Michael Batnik
Right. I don't know who came up with that as a name, but it just. If you say I work for a boutique asset management firm, I don't know, you get like a premium in my eyes.
- [01:05]
Shiloh Bates
You know what's interesting? You say boutique, I say boutique.
- [01:08]
Michael Batnik
But Kobe, like finance and finance.
- [01:11]
Shiloh Bates
In kindergarten, he went to a boutique, he held a boutique, and we thought it was the cutest thing in the world. I don't even know what boutique means. Let's see, a small store selling fashionable clothes.
- [01:21]
Michael Batnik
Yeah, it's a smaller. It's not one of the big, huge brand names. It's a smaller.
- [01:26]
Shiloh Bates
Anyway, we spoke a lot about Clos today and at the end I finally got it. I got it. I get it, I get it. And I got it. So Flatrock is essentially the bank that is making loans to these alternative asset managers as their debt financing to do these private equity deals.
- [01:45]
Michael Batnik
Yes. Right. Banks can't do it anymore because all the regulations from 2008, it is kind of weird you could do that. The meme of the guy knocking the dominoes over. Right. Great. Financial crisis, 10% yields for advisors and private credit funds.
- [01:59]
Shiloh Bates
10%?
- [02:01]
Michael Batnik
Oh, yeah. Higher in some cases. Right. So anyway, we've had a handful of discussions about private credit and Clos recently, but I think bringing this together, it is kind of slowly but surely becoming clear to us because this stuff is you. And I track this stuff pretty closely and it's still not always easy to understand. So I think if you're going to invest in this stuff, you have to make sure the firm you're working with Is really good on the education piece.
- [02:24]
Shiloh Bates
Yes.
- [02:25]
Michael Batnik
And so Shiloh, actually, he wrote a book on this. He hosts a podcast. So he's like, he's all in on the content piece, which obviously you and I are very familiar with.
- [02:33]
Shiloh Bates
I think an educated makes for a good. An educated investor. Excuse me, makes for a good investor. And we covered a lot of it today. Like you asked a good question, which actually I was gonna ask, but great minds think alike. You got to it before I could. What are some of, like the unknown risk? What are some of the risks that advisors might not be at thinking about? So this was an instructive conversation with Shiloh Bates from Flat Rock. Shiloh, welcome to the show.
- [02:58]
Ben Carlson
Great to be with you guys.
- [03:00]
Shiloh Bates
We are recording this. It is Monday, April 21, and once again, there is a lot of volatility in the stock market and in the bond market for that matter. Anything that is liquid, anything with a ticker, it's going up and down violently. One of the appeals to private markets and CLOs, which we're going to talk about today, are two things. Number one, high income people love that. Number two, I'm looking at a chart of your. Of your total return, and it is basically up and to the right with very minimal blips in between. I mean, the drawdowns like are. Are not existent. Anytime I see something like that, my antennas go up. So why is this? How does that happen? Like, where's the free launch? How do we get big income distributions and very little price volatility?
- [03:51]
Ben Carlson
Sure. So we manage three different funds. And if you're talking about the CLO Equity Fund, basically it's been around for about seven years and it's lagged the S&P 500 by about 150 basis points since inception. But it's had a third of the volatility of the S and P. And the reason that I think, you know, we can offer attractive risk adjusted returns versus the S& P are a few things. So one is, you know, really across all three of our funds, we provide exposure to private credit loans. And so these loans, they start their lives with like a 50% loan to value. They're senior, they're secured, but they pay floating rates of interest. So SOFR is the rate in my market. And if you go back to 2021, SOFR was basically zero. Now SOFR is at four and a quarter. So that's meant more income into our funds, more income into the clos. So that's one dynamic that we benefit from.
- [04:55]
Shiloh Bates
When did SOFR take over from Libor.
- [04:58]
Ben Carlson
So that was about a year and a half ago. So Libor was fixed. There was a big kind of scandal about that. And sofr, LIBOR was basically like a theoretical rate where they polled banks and said, hey, if you needed to borrow overnight, what would the rate be?
- [05:16]
Shiloh Bates
And there was like a shenanigans scandal, right?
- [05:19]
Ben Carlson
Yes. Out of the uk. And so now we use sofr, which is a real rate where banks lend to each other on a secured overnight basis.
- [05:30]
Shiloh Bates
All right, so that was a terrible, terrible first question on my part. Forgive me, I should have started here. Who is Flatrock Global?
- [05:35]
Ben Carlson
Sure. So we started in business about seven years ago. We manage billion five of AUM and our three strategies are in interval funds. So that's one thing that's unique about us. And across three of our funds, we provide exposure to private credit loans. So really the only question is, do you want to own the loans directly on your balance sheet or do you want exposure to them through the Clos structure? And then within Clos, we have private credit loans owned in clobbs, double B notes and also CLO equities. So those are our three strategies. And I think what's one thing that's different about our firm is again being in business for about seven years, growing to a billion five of aum. It's been like nice, steady growth. And along the way we've been hyper focused on our track record. So I've seen months and quarters where other firms have raised almost the totality of our business. And that might be good for the asset management firm they work for, but we're really just more focused on our track record. That's kind of our DNA at Firerock.
- [06:47]
Michael Batnik
Mike and I have talked about this before, but I think it's good for a refresher, explain to the audience what an interval fund is and how it works.
- [06:55]
Ben Carlson
Sure. So it's very similar to a mutual fund. You can buy a share any day using a public, like a share price or nav. But the difference, the key difference is that because what we own, the underlying assets are illiquid, we're not in a position to do redemptions daily. So how we set it up is that people buy shares using the nav, and if people want out of the fund, we agree to buy back 5% of shares each quarter. So those are, those are the tenders, and that's a fundamental policy of our funds. So that's not something that's at our discretion or at board discretion. So that's basically how an interval fund is different from a US mutual fund.
- [07:43]
Michael Batnik
Where can you buy an interval fund? Any brokerage firm. Where can you buy them?
- [07:47]
Ben Carlson
Yeah, so our funds are on all the custodial platforms. So if you're an ria, it's just point and click. And then if you're not an riaa, you can send in mail in a subscription document.
- [08:00]
Shiloh Bates
All right, dumb question. Where does the NAV come from? Because the point that I opened with like it just seems literally up and to the right is that who's making that? Is that the market? Is that you? Is that an auditor? Like where, where does the price actually come from on a day to day basis?
- [08:14]
Ben Carlson
So if we're talking about CLO equity, it's not always, you know, up and to the right. So during COVID for example, our peak to trough drawdown was 22%. So we captured about two thirds of the drawdown of the S and P. And how we do the daily nav is that our clos are marked by a third party daily. So they send us an Excel file with all the marks for our securities and then that flows into Ultimas is our fund accountant and they calc the nav using those third party prices. That's how it's done.
- [08:51]
Michael Batnik
Okay, so the big question right now for everyone is okay, the economy's slowing, recession is perhaps at our doorstep. Who knows, but it's possible, what does that do to this type of strategy? So you mentioned in the COVID period, and that was interesting because yes, that was a recession, but you also had this credit event where spreads were blowing out and people were selling Treasuries too, like everything was getting sold there for a little bit until the Fed stepped in. So it's hard to know if we get a recession, if that would be some sort of credit event like this where this happens. But you know, what sort of baselines do you and expectations do you set for investors if we do go into a slowdown period?
- [09:29]
Ben Carlson
So when we invest in CLO Equity, we provide exposure or we get exposure to 200 different private credit loans. And the loans are rated single B on average by Moody's and S and P. And we know that not all of the loans are going to be money good at the end of the day. So looking back over the last decade, we see roughly a 2% default rate on the loans and a 70 cent recovery. And so we bake that into all of our financial projections and you could think of that as a loan loss reserve. So one thing to keep in mind is we already have a Loan loss reserve. And that's very different from other asset classes where if you're in a loan fund like a BDC or a separately managed account and a loan defaults, you just kind of, there's no loan loss reserve and you just kind of take the hit on your nap. So then what we've seen in clos is that when you hit pockets of instability or higher recessionary risk, that the overall loan market tends to trade down. And loans in the CLOs are constantly prepaying at par. And with those par proceeds, the CLO manager goes out into the market and they buy new loans, often at discounts to parent. And so when you hit a recessionary period, on the one hand, you expect to take more losses on loans which is negative for your returns. But at the same time, lots of loans are still prepaying at par. And the expectation is that you can buy discounted loans that can offset the higher loan losses that you might experience.
- [11:07]
Shiloh Bates
What is CLO equity?
- [11:09]
Ben Carlson
So think of it like this. So basically the CLO has 500 million of assets in it. So let's call it a loan pool of 200 different senior secured loans, floating rate. The loans are created in leverage buyouts. So imagine Aries, Apollo, kkr, they buy a company, they put up about half the purchase price in equity and they finance the remainder with a term loan. And that term loan today might end up in literally dozens of different closing. So that's the vehicle that owns these, these loans. And then so that's the close assets. And then we finance this, we finance this CLO by issuing debt that's rated triple A down to double B. And that's long term non mark to market financing. And then CLO equity, you could think of that as like the owners of this pool of loans. So it's kind of imagine if you bought a stock in a bank today, except the bank is only a pure play lender. That's the way to think about CLO equity. And so in this investment strategy, kind of how it works is the CLO is very profitable and so it distributes to the equity very large payments each quarter. But then the risk is that you're on the hook when loans default. That's the risk that you're running there.
- [12:39]
Michael Batnik
So I'm curious, who are your investors in a fund like this? Is it retail? Is it mostly advisors? Like who's coming to your door and asking for help with this?
- [12:46]
Ben Carlson
Yeah, so it's large RIAs who, their clients go to them and might say, hey listen, I'm not sophisticated in how I should allocate my portfolio. And a lot of RIAs would have funds like ours in a model where say we're 5% or something of their assets. And as those clients kind of increase their exposure to the markets or decrease, that's funds that might make their way into the Flatrock funds.
- [13:17]
Shiloh Bates
Hey, I apologize for the mischaracterization of the line. Go up earlier, twice earlier I was talking about the Enhanced Income fund as well as the diversified private credit fund. So those are legitimately up to the right. But this is a different animal. So apologies there.
- [13:35]
Ben Carlson
Happy to describe the enhanced Income fund if you'd like. That's the other CLO strategy, I guess.
- [13:41]
Shiloh Bates
Before, before we get there on the. Just sticking with the CLO equity. So you're investing like you're loaning money to the areas of the world who are then loaning money to the deal sponsors. Is that, am I misdescribing it?
- [13:58]
Ben Carlson
So think about it like this. So at Flatrock, we're not a CLO manager. So we're not picking the underlying loans that go into clos. So we hire a CLO manager to do that. And at Flatrock, our biggest CLO managers are people like BlackRock, like New Mountain, like Jefferies Barings. A lot of the big alternative asset managers are our CLO managers.
- [14:21]
Shiloh Bates
So how does that process work? Like, what are you looking for to determine? All right, we're giving BlackRock 8% of the portfolio. This company's getting that. What are you looking, what are some of the characteristics that you're looking for?
- [14:31]
Ben Carlson
So in CLOS, there's roughly 130 different closures. And my job, one of my jobs is to kind of distill, you know, that list of 100, 130 to about 20 or 25 that we want to work with. And then within that list of who we think are the top performers. My job is to buy the CLOs that offer the best risk adjusted returns. And part of that is trying to buy Clos securities as cheaply as possible.
- [15:02]
Michael Batnik
So there's a ton of money going into private credit these days and working in the wealth management space. Michael and I are inundated with emails all the time. How do you try to stand out in this space and get people to trust you? Because it seems like there's an endless opportunity to find managers in this space.
- [15:19]
Ben Carlson
Sure. So in our CLO funds, I think the opportunity is that I go to a lot of private credit conferences and the conclusion of all the panelists. And I think People in the audience is that they think private credit's pretty attractive. And if you come to that conclusion, CLOs are one way to implement that strategy. So for example, we have a clob fund. And how that works is that if people want exposure to today 2000 different private credit loans, they can do that through the clob BB note. And the attraction of doing that is that in the CLO structure there's a third party equity investor who signed up to take the risk on the underlying loans. And so again, if you invest in a GPLP fund or a BDC and loans default, that's the risk that you're taking. Right. But if you do clobbs, it's again exposure to this diversified pool of loans. But there is a CLO equity investor who signed on to take the primary risk of loan defaults. And so if you look back over 30 years, CLOs have basically a de minimis default rate. It's about 25 bips. And so like what we found from our RIA clients is that for people who are either concerned about the economy in general or they think maybe too much money is flown into private credit, the CLO double B space is a way to invest in that in a more, more conservative way.
- [16:57]
Shiloh Bates
So you mentioned that the Cielo Equity, the ticker is FRO PX FR O P X. Yes, it did have a of a 20ish percent drawdown during COVID but it's, I don't know, it's given you like you could fact check me here. 85% of the upside of the S and P with much, much, much smoother, a much smoother ride. I mean, I guess if you're investing in equity then an equity benchmark is appropriate.
- [17:23]
Ben Carlson
That's right. There's also no other like great benchmarks for. I mean we benchmark against the S&P 500. We could also benchmark, I guess against the Russell. If we did that, we'd handily outperform the Russell.
- [17:36]
Michael Batnik
Sorry to cut in. How often do you get distributions in this? Is it monthly? Quarterly.
- [17:40]
Ben Carlson
So this pays monthly distributions that are covered by the fund's net investment income.
- [17:45]
Michael Batnik
You know what would be a good benchmark for this? I'm an ideas guy, so I got to lay it out there. I feel like a covered call strategy is a pretty good benchmark for something like this because it's probably lower volatility, you're getting the higher income, but you also have equity like characteristics.
- [17:57]
Ben Carlson
Thoughts, you know that's an interesting idea, but I don't, I'm not an options guy. So something to consider.
- [18:04]
Michael Batnik
All right. Just the kind of stuff that we hear a lot.
- [18:06]
Ben Carlson
Yeah.
- [18:07]
Michael Batnik
I'm curious how. How often do you have advisors coming to you and they're just focused on the yield piece of this, like, they're picking the fund based on the yield versus how much do advisors actually understand the different fund structures of the. In the different variations among the funds that you're giving? I guess what I'm trying to get at here is, like, how much education is necessary when you're helping people figure out what fund is right for them.
- [18:31]
Ben Carlson
Yeah. So it's a very big educational process. So I don't think our end clients are buying for yields. In fact, because we have three different strategies. They rank from like, a distribution yield of 9% at the low end to CLO equity at 15 and a half. And we're not just seeing people buy the higher one. That's not what they're doing. In my strategy, I like to and have to do a lot of education for folks. So I wrote a book on CLO investing, and I wrote it really with kind of the target reader is like an ria, somebody with financial knowledge, but, you know, not in the CLO space. And I think that it's very comprehensible. And then also, you know, like, you guys, I have a podcast where, you know, once every couple of weeks, I have somebody on from the CLO market to talk about the performance of the underlying loans or anything that's really kind of topical in the space. I. I like to do that kind of education.
- [19:39]
Michael Batnik
Hey, we're all about plugs here. What's the name of the book and the podcast? Give it to us.
- [19:43]
Ben Carlson
So the podcast is the CLO Investor by Shiloh Bates me. And the book is CLO Investing with a Focus on CLO Equity and Double B Notes, and the books on Amazon. And the podcast is on Spotify and everywhere else.
- [20:02]
Shiloh Bates
So what's the pitch for investors? If somebody's like, hey, why do I need this? Why can't I just buy anything else? What's. What's the pitch?
- [20:10]
Ben Carlson
Yeah, so the pitch is that our funds have pretty low correlation to other asset classes, like the S&P 500 and high yield or the AG. And they also offer, like, pretty favorable returns. So by including our funds in an investor's portfolio, you can, if you think about it in kind of the parlance of economics, whatever, it's like, basically, you're pushing out your expected return and lowering the overall risk of your client's portfolio. That's what our funds are designed to do.
- [20:44]
Michael Batnik
When you have conversations with advisors, do you get the feeling that they're using these strategies and taking from fixed income and having that be just a diversified portion of that. Are they taking a little from stocks and bonds? What is the asset allocation decision here?
- [20:56]
Ben Carlson
Sure. So for CLO Equity, we see it kind of as a one to one into our fund out of the S&P 500. We see it as a way to get equity like returns, but with again, a fraction of the volatility of the S and P. One thing, one piece of research we've looked at is over the last 20 years or so, CLO Equity, there's only like 5% of deals that have had negative returns. So it's a great way to try to get that equity return you want, but with limited or reduced downside exposure. And then for our clob BB fund, I think people allocate to that fund in lieu of private credit funds where they own the loans directly, where they're taking the first loss risk on the loans, and also high yield. That's another asset class where we think our funds can really kind of shine in comparison.
- [21:51]
Shiloh Bates
What do investors need to believe for this to make sense? Do they need to believe a story about interest rates, a story about the economy, the growth in private markets? What's the thesis that Dr. This investment making sense?
- [22:05]
Ben Carlson
Sure. I don't think you need to believe a lot because the loans, again that we provide exposure to, they start their lives with a 50% loan value. These are companies that a sophisticated private equity firm wanted to own the equity, thought the business would be able to grow revenue and profits over time. And because the loan is senior and secured, if the business has problems, if there's a restructuring, if there's a bankruptcy, we're first in line in that senior secured position. And so the underlying loans that we provide exposure to, we see them as much more conservative than other investments like the S&P 500 or like high yield bonds which are unsecured. And so our asset classes can definitely underperform at times in like an absolute sense. But in periods of heightened economic risk or potential recession, we think people want to be first lien, senior secured and not unsecured or not owning equity. We think in a recession, our underlying loans will certainly outperform other sort of corporate securities.
- [23:18]
Michael Batnik
When you have your conversations with advisors, do you get the sense that they are using multiple private credit strategies to. Because you keep talking about and comparing and contrasting your strategy with other private equity or private Credit strategies. Do you get the sense that they're doing that or are they pretty much picking one and sticking with it?
- [23:34]
Ben Carlson
So I think they're taking a portfolio approach. I mean there's like one or two very large funds in interval funds that are private credit. And when I talk to RIAs, they usually have exposure. A lot of times they have exposure there. And then there's like probably five other private credit focused interval funds that are also very popular. So we're often compared versus them and kind of pitching against their products. But I don't think there's anybody where we get 100% wallet share and I don't think our competitors do either.
- [24:12]
Shiloh Bates
If an investor were to look under the hood into the pool of loans themselves, and I know it's like a diversified pool of a diversified pool of loans, what are we investing in in terms of are these US based only? What sort of sectors, industries are we talking about? What size of the companies?
- [24:28]
Ben Carlson
Sure. So each CLO might have 200 different borrowers in there and it's going to be diversified also by industry. So there's going to be a cap on how much the largest industry in there in clos, generally the biggest industries are going to be technology, health care and business services. And then these are going to be companies, US based companies where they're doing kind of call it 20 million of EBITDA or cash flow per year, up to 100 or 150 million of EBITDA. So they're not going to be companies that are on page one of the Wall Street Journal, but they're going to be companies that provide a material product and service in the economy.
- [25:14]
Michael Batnik
The recession risk is the obvious one to everyone. Like what could be a problem for some of these types of strategies? What are the other risks you think that advisors aren't really considering when investing in private credit? Is there anything that people are overlooking?
- [25:28]
Ben Carlson
Sure. So I think a challenge now is not just the performance of the loans, but also just staying fully invested. So if you're an interval fund and you've raised a lot of money for a private credit strategy, it turns out that these loans, the underlying collateral is created in leveraged buyouts. And since 2022, interest rates went up and LBO activity has gone way down. And so I think it's very hard for private equity firms to find companies that they believe in that they can acquire at a price where they can pencil out the 20% plus returns they're going for, especially given the higher SOFR base rate. So they're Paying their lenders, again, the loans are floating rate, they're paying their lenders much higher interest expense. And so there's a risk that you fund into, say an interval fund and sit in cash for longer as it takes time to deploy. And I think kind of one of the benefits of our slow growth, hyper selective approach is that we just don't, we don't see those kind of inflows that would give us concern on just kind of the negative cash drag there.
- [26:46]
Shiloh Bates
What if you were to triple overnight in terms of the assets that you manage, like you mentioned that you're very focused on, on performance and not overextending yourself. Would you not be able to deploy that or what would be the risk of you getting too big?
- [27:04]
Ben Carlson
Well, I mean, basically we raise in all of our funds in the interval fund structure, we might raise 1 or 2 million a day in each of our funds. It's something like that. And if more money came in than we could accretively deploy, we just put the brakes on it. That's how we think about it. So I'm a big investor in our funds and other members of management as well. And so we're aligned alongside our investors. And if more money came in than we could handle, we just put the, put the brakes on it.
- [27:40]
Shiloh Bates
Meaning, like, you could actually prevent money from, you could like gate it on the way. Oh, interesting. Ignore that.
- [27:44]
Ben Carlson
Yeah, we could.
- [27:45]
Shiloh Bates
One of the things that caught my eye as looking through the material was there's a big gap between like and I want to get your compliance in trouble here, but the gross expense ratio versus the management fee.
- [27:55]
Ben Carlson
Sure.
- [27:56]
Shiloh Bates
Could you, could you talk about that?
- [27:58]
Ben Carlson
Yeah. So basically the way the SEC requires you to disclose your, your expense ratio in that they would include, for example, like if you do, if you borrow or if you have preferred shares, the interest expense for both of those would be in the expense ratio. And so like we borrowed. Let me give you an example of our CLO Equity fund. So we have preferred shares that were put in place during the zero interest rate period that have their fixed rate in the 6% area. And we're going to enjoy that cheap cost of capital for years in that fund. And it's a huge benefit to fund returns and to our return on equity. Well, in our expense ratio, all the distributions from preferred are captured in the expense ratio there. So it looks skewed. I mean, what investors should care about is what's the amount of profits that are leaving the fund in a way that doesn't kind of benefit them. Right. So across all three of our funds, we have a 1 and 3, 8 management fee and we have an incentive fee of 15% over a hurdle that, that vary, that varies by strategy. So that's when people are asking about the expense ratio. I mean, I would kind of explain the debt. And then also management fees are what I think investors should focus on. And then for all three strategies, what we do is we think these are inefficient strategies. So it's not something that you can kind of like index. If you want to invest at 50bps or something like that, you're not going to find anybody who's kind of doing our, our strategies.
- [29:51]
Michael Batnik
You don't need to name any names. But are you seeing deals go down these days where investors are simply because they have so much money to put to work over levering up because they want to keep the yield high? Is that something that's happening in the private credit space a lot these days?
- [30:06]
Ben Carlson
So I don't think so. So in, in my clos funds, the CLOs, all their securities are rated, you know, again by Moody's and S and P. The top part of CLOs is rated AAA. The most junior CLO debt security is double B. And to get those ratings, to have the CLO rated, all the underlying loans that go into the CLO also have to be rated. And so it's, you know, a lot of money has flown into private credit. People ask me, you know, hey, is it, is it a bubble or not? Well, the rating agencies have not changed their rating criteria for the underlying loans that go in, nor have they changed their rating criteria for the CLO securities that are, that are sold. And so I don't think lenders are stretching on leverage. One and two, kind of. One of the benefits of having this higher SOFR base rate is that company's interest expense is higher, which benefits us. And that means that the initial leverage of the deal has to be a little lower than it would have been. For example, during 2021 Shiloh back in.
- [31:18]
Shiloh Bates
The GFC, a lot of these three letter acronyms were at the epicenter of the decline in our financial system. What's different or improved about the current crop of products versus the derivatives that almost took the system down in 08.
- [31:36]
Ben Carlson
Sure. And I think my answer to this question maybe ties into like one of your previous questions about why we earn excess returns in our space. And one of the reasons, I think, is that we're kind of painted with the same brush of the securitizations that failed during the financial crisis. So the CDOs that, that failed and that almost brought the economy to a halt. If you look through to the underlying loans, what you would see is subprime mortgages, maybe no docs, the end mortgage holder had no job, no income. This is very different from the kinds of assets that are in clos. Right? So again the CLOS has corporate borrowers with call it 20 million of cash flow and higher. And so one of the things that surprises people is that if you bought CLO equity right before the financial crisis and you held it through its 12 year life or so, the IRRs there would have been in the 30% area. And so the CLO equity, that's who takes the most risk in the CLO. So that performance is in sharp contrast to CDOs where there were defaults all the way up until the AAAs. And so no and CLOS, no AAA is defaulted. And in fact even the CLOBB, which is the most junior debt that's sold by the clo, that has a de minimis default rate as well. So today CLOs are $1 trillion in AUM. It's like a very big asset class. And the growth has been partially driven by performance since the gfc.
- [33:22]
Shiloh Bates
Last question for me. I don't think we spoke a lot about the borrowers themselves. Why are they tapping this form of a loan instead of a more traditional financing?
- [33:32]
Ben Carlson
So banks are no longer making the kinds of loans that end up in clos. So if you're Apollo and you're buying software as a service technology company, maybe you want to leverage it five and a half times or thereabouts. Banks are not making those loans. So that's going to be made in the traded loan market or the private credit market. And the financing rate today on average for private credit it's about 5% over SOFR. So that's basically a little bit over a 9% yield. And that's kind of, I mean that's really kind of the story for private credit. That's like why it's interesting. 9% yields on the underlying assets and first in line for repayment if the business gets into trouble.
- [34:22]
Michael Batnik
This is why Jamie Dimon hates private credit. Because he's feels like he's missing out, correct?
- [34:26]
Ben Carlson
That's correct.
- [34:28]
Shiloh Bates
All right, so Shiloh, I know we've already been on the line for 34 minutes, but just in wrapping up, this is not an easy space to wrap your head around. So for somebody that's like, wait, what is this? These are the I'm investing in Flat Rock Global, which is an interval fund that invests in different cielo pools, whether it's BlackRock, Aries, KKR, whoever, and then they're investing or they're loaning money to these middle market companies for operations and then it's all flowing back.
- [35:08]
Ben Carlson
That's correct.
- [35:10]
Shiloh Bates
Okay.
- [35:11]
Michael Batnik
Nailed it. Michael.
- [35:14]
Ben Carlson
Yeah, I mean, I could, I could try to do it, do it myself. So again, so in my example, Apollo is buying, making a private equity investment. They only put up half the purchase price and equity. The remainder is a first lien term loan. That term loan ends up in literally dozens of CLOs. It pays its interest into the CLO, and then in the CLO, the equity is, that's the junior security, that's who gets paid last. And then those distributions go into, are received by our fund, and then they're paid out by the fund in monthly distributions.
- [35:50]
Shiloh Bates
Wait, hang on. So I actually think I misunderstood a part. I think I mis explained this or maybe I'm misunderstanding now. So you're loaning money or buying a piece of. So blackrock is putting. I'm sorry, blackrock. Blackstone is putting up half the money in a deal. The other half is coming from the clo. So it's not like you're, it's not like Blackstone is making loans to. Well, all right, okay.
- [36:16]
Ben Carlson
In that example, Blackstone needs a loan because they're only going to put up 50% of the purchase price. They're going to borrow the rest, and those borrowings are the fuel for the CLO market.
- [36:26]
Shiloh Bates
All right, so ultimately you're making the loan to the alternative asset manager who is then making the loan to or not making the loan, who is using this loan to purchase these companies.
- [36:34]
Ben Carlson
Yeah, that's right.
- [36:35]
Michael Batnik
So I guess the one follow up question would be what happens if the private equity deals come under fire for some reason or they run into trouble? Is it just because you're a senior? Note that you're not that worried in that situation.
- [36:48]
Ben Carlson
Yeah. So again, these loans do occasionally default. So looking back over 10 years or so, it's about a 2% default rate. Fortunately, when you're senior and secured, the recoveries are going to be better than if you would have owned a high yield bond, for example. But basically, the income from the clo, if we're talking about CLO equity, enough profitability is kind of produced by the CLO that even in times where default rates are above your loan loss reserve, it can still be a good year.
- [37:20]
Shiloh Bates
So, shiloh, for people that listen to us and are still not quite sure what CLOs are. How do they reach you?
- [37:27]
Ben Carlson
Yeah. So I would start with a book. So again, CLO Investing on Amazon and then they can reach out to us just through our website. It's very easy. We're happy to do a lot of CLO education and I think we're pretty good at it.
- [37:43]
Shiloh Bates
Cool. Thanks for coming on today.
- [37:45]
Ben Carlson
Thanks. Enjoyed it.
- [37:49]
Michael Batnik
All right. Thanks, Shiloh. Remember, check out flatrockglobal.com check out his book. We'll have links to that in the show notes. Email us animalspiritscompoundnews.com.