He has the familiar trappings of the ultra-wealthy: a Beverly Hills estate, a superyacht, art by Rothko and Pollock.
But Eric Smidt is a new kind of super-rich. He made his fortune by transforming an old-fashioned business into a giant ATM, an overhaul aided by one of the hottest plays on Wall Street: collateralised loan obligations. Meet the new aristocrats of debt—the people and companies cashing in on a record boom in these once-marginal investments whose relatively high returns have attracted yield-hungry investors. They’ve fueled a rapid buildup in corporate debt that some think could become the epicentre of the next credit crisis but has been minting money for many.
From low-profile executives like Smidt to prominent banks like Credit Suisse Group, a host of players are getting rich off CLOs. Fees linked to the industry topped $10 billion this year alone, according to calculations by Bloomberg. That’s in addition to billions in payouts that private equity and other owners have extracted from businesses. Some, like Credit Suisse, get paid for underwriting loans to companies such as Smidt’s Harbor Freight Tools USA. Because CLOs are really a package of risky loans from various businesses like Harbor Freight, a bank like Morgan Stanley also scores a fee for structuring the parcel and then selling it to investors.
That bundle of debt also needs an overseer. Enter CLO managers such as private equity firm Ares Management, co-founded by billionaire Tony Ressler, and GSO, part of Blackstone Group. They get a cut, too.
Regulators globally are sounding alarms. For the Bank of England’s Mark Carney, the surge is reminiscent of the boom in subprime lending just before the financial crisis in 2008. Some members of the Federal Reserve are concerned that high debt levels are making the economy vulnerable.
“The risk is that if a bunch of these get downgraded, many CLOs will scramble to sell,” said Gene Tannuzzo, a fund manager and deputy global head of fixed income at Columbia Threadneedle Investments.
In recent weeks there have been increasing signs the machine is sputtering as volatility swirls through markets. Loan prices have fallen to the lowest in more than two years. Here are the key players and what’s at stake.
The debtors: $1.3 trillion
Harbor Freight—which sells discount tools such as $7.99 wrenches and $8.99 pliers sets—has tapped the debt market five times since 2010, raising $6.8 billion, including refinancings and has paid about $2 billion of dividends, according to Bloomberg calculations.
That’s just a fraction of the market. Corporate owners loaded a combined $1.3 trillion in loans onto their books this year, enabling them to raise greater amounts of capital at lower rates over the past decade. About $40 billion worth of leveraged loan deals this year had dividends as one of the stated uses of the proceeds. The market has helped bolster the wealth of business owners like Smidt, who’s worth about $3 billion.
Lender fees: $6 billion
When Harbor Freight went to the market to refinance in January, investors were drooling. The company got $2.16 billion—fully funded just eight days after it was announced.
As lead lender in the deal, Credit Suisse would have scored the bulk of any fees for underwriting the loan. The fees collected would have been even higher for a brand new loan issued. Lenders can charge about 2 per cent of the issuance, generating at least $6 billion for them in 2018, according to calculations by Bloomberg.
Management fees: $2 billion
The Harbor Freight loan has made its way into hundreds of separate CLOs with the biggest holder being funds managed by Ares, the Los Angeles-based firm with a history of generating wealth through private credit. As with the banks who underwrite the loans, fees paid to CLO managers like Ares can mount. Larger CLO managers generally charge between 30-to-50 basis points on the assets they manage. Ares declined to comment.
The investors: 20% yield
Yield-hungry investors have been eager to invest in CLOs, helping to fuel the market. Returns on the riskiest equity piece can stretch to 20 per cent. While those gains suffered this year, they still stand out in credit markets where corporate bonds have delivered little or negative returns.