Lynn Tilton
Courtesy of Patriarch Partners
By Stephen Gandel
March 31, 2015

Lynn Tilton seemed like the right kind of person to manage one of Wall Street’s hottest and most opaque investments, so-called collateralized loan obligations, or CLOs. She had a reputation for letting it all hang out, literally.

Early on in her career, Tilton sent out “Dominatrix Santa” holiday cards, that featured pictures of Tilton in lingerie, a Santa’s hat and a whip. She talked a lot about her wealth, routinely defending her claim that she was one of the world’s few women billionaires. She nearly had a reality show, tentatively titled the ‘Diva of Distress,’ that never aired. And she would drop in references to oral sex in speeches about her business philosophy.

Tilton does not try to hide the fact that many of the companies she invests in, often old-line American-based manufactures, face a difficult future. Tilton is all about disclosure.

That, though, doesn’t seem to have kept her from trouble. On Monday, the Securities and Exchange Commission accused Tilton of defrauding investors with her CLOs, and improperly collecting $200 million in fees.

CLOs are essentially publicly traded funds that invest in loans. And they are hot. CLOs typically invest in highly leveraged companies, and therefore pay higher yields than typical corporate debt. To fund those investments, CLOs issue bonds. CLO issuance soared nearly 40% to $115 billion in 2015 alone. The total market for CLOs in now close to $400 billion. Tilton helped pioneer the market in the mid-2000s, even getting a patent for a particular type.

But CLOs are also complex. And people have been raising red flags about them for some time. They are essentially bonds that buy illiquid debts, of often private companies, which are themselves illiquid and hard to price. That makes it an opaque market and one the SEC has recently been increasingly concerned is open for abuse.

Earlier this month, Matthew Katke, a former broker at the Royal Bank of Scotland, pleaded guilty to lying to investors about the value of CLOs, tricking them into paying more than they should have and cashing them out at less than they deserved. Mark Zandi, the prominent economist, recently warned at a client event that he thought CLOs might be inflating a bubble in risky corporate debt.

The SEC’s case against Tilton seems to rest on the claim that she was hiding key facts about her financial empire and the health of the companies she was investing in from her investors. Tilton denies the allegations, and says the SEC’s charges are “ill-founded” and that she will fight them.

Tilson oversees the Zohar CLOs funds, which have raised $2.5 billion dollars. But she also runs a separate private equity firm, Patriarch Partners, which owns dozens of companies. And here’s where Tilton’s financial empire gets murky.

Tilton uses the money she raises from investors and manages in her CLO funds to finance the buyouts done by her private equity firm. In fact, according to the SEC suit, all of the loans in the Zohar funds have been to companies that are now controlled by Tilton. This creates a conflict of interest, but not an illegal one. Other private equity firms have funds that invest in the debt of their own deals. Still, it’s unusual for all of the money in one fund to be invested in deals controlled by the same person. At larger firms, debt funds are typically managed by different people than those who manage the private equity portfolio.

Tilton, who has a small firm, manages both.

According to the SEC, Tilton’s CLOs charge investors a 1% fee management fee. But in order to collect that fee, the CLOs have to hit certain performance targets. That includes the health of its loans and their value of their collateral – namely the companies that the CLOs have lent to.

But Tilton and her team are the ones who determined which loans had gone bad, and the value of the underlying companies. Out of self-interest, they only rarely did they find problems, according to the complaint. The SEC says that Tilton was supposed to regularly rank all of the companies the CLOs have lent to in four categories with four being the best.

The result is a Lake Wobegon portfolio. Nearly all of the companies in Tilton’s CLO portfolios end up with the highest ranking, even though some of the companies have missed 90% of their interest payments. The SEC says not until Tilton has pulled the plug on her investment, and stopped backing a company, does she immediately drop the company down to a 1 ranking, the lowest.

But this kind of makes sense. Tilton owns the companies and is backing them. So as long as she keeps funding them, they will make good on their loans, even if they have missed a payment. Similarly, the SEC says Tilton almost never marked down the value of her companies. But Tilton’s response is that she never marks up the value of her companies either. They just stay the same price, which she says is the fairest way to do it. You could imagine the SEC going after her for inflating the value of her holdings.

On top of that, the SEC says Tilton regularly is the one who directs how much interest companies pay on the loans to the CLOs. And often the amounts don’t match what the executives running the day-to-day operations of the companies wish to pay or what they owe on their loans. But again that might not be as nefarious as it sounds. Tilton controls the companies, and she runs the CLOs. So you might expect her to manage the payments in a way that keeps all of her companies alive but also makes sure the CLO makes its interest payments to its investors. And with a portfolio of troubled companies, as Tilton has, that juggling might be tough. So you could see why some companies would pay more than they have to at times, and others less. That all may seem like Tilton is bending the rules, but if no one losses money it’s difficult to say Tilton is defrauding investors.

Unfortunately, the system didn’t appear to work. And Tilton recently told the investors in her first CLO that they may have to take some losses. But this again doesn’t mean Tilton defrauded anyone. Tilton’s investors put their money into a fund that lends to troubled companies. It’s not that surprising that they would lose money.

On top of that, the SEC also claims that Tilton’s investors didn’t understand the obvious conflicts of interest in her business model. This is going to be really hard to prove. Back in 2011, New York magazine wrote a profile of Tilton that basically laid out the potential for all the charges that the SEC brought against Tilton and her companies today.

However, the Patriarch-managed CLOs own dozens of Patriarch loans issued to ­Patriarch-owned companies that are severely underperforming. These companies, like the fire-truck-maker American LaFrance, are more like zombies than functioning businesses—they can make their monthly interest payments, but they appear more likely to default than ever pay back their principle. This leaves the CLOs dependent on profitable companies like Dura to pay their principal-plus-interest at a premium rate so that the CLOs remain healthy enough to function—and Patriarch can collect its fees.

And the article was written by Jessica Pressler, who defended an inaccuracy in another one of her articles by saying she doesn’t work for a financial publication. But Pressler was able to figure this out, four years ago. So I’ve got to imagine most people familiar with the CLO market would have sussed out the conflicts as well.

The real problem here is not with Tilton but with the CLOs. They are structured investments made up of illiquid loans often to illiquid private companies, packaged into a product that trades and is supposed to be liquid. You don’t need to be a finance professor to know that’s a recipe for problems. University of Michigan business professor Erik Gordon recently told Bloomberg that true problem of the CLO market is no one knows what any of the structured investments are really worth.

And, of course, in a market where no one knows where things should be priced, proving manipulation is really hard to do.



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