Jeff Herlyn, Michael Rosenberg and David Wishnow, principals of Tetragon Financial Management, discuss their firm and their expectations for the CLO market

Q: How did Tetragon come about?
JH: The idea for Tetragon came about because we are all big believers in the senior secured bank loan space, which has proved itself by weathering many different financial cycles, but saw that it was very difficult for institutional investors to access it. Even more importantly, it was even more difficult for equity investors to get exposure to the asset class as most of the banks they could invest in that used to hold senior bank loans as their primary asset - the Manny Hannys, the Chemicals and the Chases of the world - had all morphed into investment or global banks.

So the original concept was to bring back the old form of commercial bank and reintroduce the asset class to the public equity investor. That was the case even when we began raising money privately in 2005 before ultimately taking the company public in 2007.

With that concept in mind, we asked ourselves: 'What is the best and most efficient way to invest in the senior bank loan asset class?' So far, we continue to answer that question by saying that it is by utilising cashflow CLO equity.

Q: How did you implement that?
JH: The idea is not just to replicate the old commercial bank model, but also to improve on it. By setting up our company and investing in the CLO markets, we weren't running the risk of mismatching liabilities and assets - cashflow CLOs match our funding and our asset class.

A traditional commercial bank model uses customer deposits, which are typically short term in nature, to fund longer-term loans. While we may have seven-year loans inside a CLO, we also may have 14-year locked-in non-recourse non mark-to-market financing - which is one of the major typical features of CLOs that we felt was an improvement upon the commercial bank environment.

We also generally don't have the same expenses that commercial banks have. For example, we don't have the bricks and mortar costs associated with a full bank network; we mainly outsource to what we believe are best-in-class third-party loan managers; and we also have an in-house CLO and loan management team called LCM , which we purchased in early 2010 from Calyon, that manages some of our CLOs for us. At the same time, we also seek to structure the company in a tax efficient manner.

In addition, we may offer more diversification than a typical single commercial bank did back in the day when it really was just one chief credit officer's view of the world and the rest of the lending officers essentially followed suit and added exposures to his views. Right now, we have exposure to 68 different CLOs among 32 different managers; each one has a slightly different style of management.

We have European deals; we have US deals. In the US, we have middle market and broadly syndicated deals, all with slightly different risk profiles and styles of investing.

In our view it all makes sense now, but when we were going public in 2007 we had to ask potential investors to, among other things, trust our experience and belief that the underlying market and the structures involved were robust. Since then, we have been through a very severe cycle and we think that the asset class has proven itself once more. Equally, both our method of investing in the senior bank loan space through structured deals with our input and the diversity that comes from that have in our view proven themselves as well.

Q: Why is the senior bank loan market so resilient?
JH: We believe it comes back to in a large degree the original premise that banks had in taking principal risk in this space by using customer deposits, which they thought of as very safe assets. All of their senior loan investments were underwritten to a very high level of probability of return of principal and that was because, among other things, they typically took security in the companies they were lending to, were senior in the companies' capital structure and also generally held 100% of their assets as collateral.

Consequently, the historical recovery rate on the asset class is in the high 70s close to 80%. Obviously things do go in cycles and that average was pulled down when the underwriting got a little exuberant back in 2007, but on average in our view the market has generally remained fairly disciplined - that can be seen from its relatively quick revival and its return characteristics. Going forward there may be even more scrutiny of deals as regulatory changes may require the banks to be even more disciplined in this asset class.

MR: We think that the relative resiliency of CLOs compared with other assets that were securitised within CDOs has in part to do with the leverage and the structure itself. When the old style commercial banks held loans on their balance sheets, they typically were leveraged 12 to 1 - tier 1 capital was traditionally 8% - and when you look at CLOs you see that not coincidentally they are typically leveraged at the same ratio.

So, there was a good amount of long-term empirical data that you could look at with respect to expected losses in helping to understand the risks you were taking in utilising the same amount of leverage. When you take other asset classes - subprime mortgages or ABS for example - that were put into CDOs, those were often levered upward of 50-plus times and banks holding those assets on their balance sheets were never levered 50 times. That meant from our perspective there was an unfortunate combination of mainly untested assets - subprime mortgages had never before been through a real downturn - and generally untested structures.

Q: Where do you see the opportunities and challenges in 2011 and beyond?
JH: Going forward, we see the senior secured bank loan asset class as a key part of the capital markets in the US and Europe, especially here in the US. Indeed, the market has improved and increased in size significantly since the downturn over the last 18 months. We continue to see it as a relatively resilient and more disciplined market compared to others and see it as potentially continuing to be lucrative for us going forward in creating what in some sense carry trades - where we own the assets inside of our CLOs for the interest income just like a bank, as opposed to looking to trade in and out of those assets in search of price appreciation.

DW: Also, there may be opportunities with LCM. In November 2010, we put together through LCM the US$300m LCM VIII CLO, which we believe was one of the first new issue fully distributed CLOs post-crisis. For 2011, we expect that market to continue to come back from where it was a few years ago and we would seek to do further new CLOs with LCM where we may own the majority of the equity.

We would also expect to continue to invest in third-party managed deals. We are believers in cashflow CLOs and we are believers in the senior bank loan market. With appropriate leverage applied to it, we think it's a potentially solid investment opportunity.

MR: As David says, we have already seen the opening up of the new issue CLO market in 2010 and we think that's going to continue through 2011 and going forward. In our view, it probably won't reach the volumes we saw in the heyday of 2006/7, but we would expect to see volumes more reminiscent of the early 2000s.

That's because in our view there's a need for these instruments. As we said earlier, senior secured loans are a proven part of a company's capital structure and there are going to be companies with funding needs and CLOs will be one of the market participants for those loans - along with banks, hedge funds, investment managers and retail funds.

So, we do think our core business model is strong and we'll continue to see opportunities going forward to invest in attractive new issue CLOs. What is likely to change compared to prior years is something we saw in 2010, which is low levered transactions.

Instead of 12 times, we may only see six, seven or eight times levered transactions. But, as we've seen, there is a market for such structures.

DW: As the market continues to expand in 2011, fewer managers will be able to do deals. In the past, many different loan managers - regardless of their experience and size - were able to get deals done, but now that has changed.

Track record is key; performance history is key; even size and scale and access to capital is key for CLO managers to grow. I think that puts us in a very good position, given the size and scale of what we've done to date. We're arguably the largest CLO equity investor in the market and we've got significant resources and capital to expand on that still further.