CLOs Are Packed With New Loopholes, Triggering Investor Backlash
CLOs Are Packed With New Loopholes, Triggering Investor Backlash
(Bloomberg) -- Allison Salas was taken aback.
As she scanned the latest collateralized loan obligations to cross her desk last spring, tucked into the deal documentation were changes that let the managers of the CLOs swap one distressed loan for another without booking a loss. In other words, they could unload an asset trading at a mere 70 cents on the dollar, buy another troubled loan, and value it at 100.
In recent months, similar loopholes have become more common, according to market watchers. Managers that assemble and oversee the securities are increasingly worried that a slowing global economy could spark a selloff in risky corporate debt, they say, and have been looking to give themselves more flexibility should things go south.
But now, some of the industry’s biggest buyers are pushing back, the latest sign of tumult in a market that has ballooned over the past decade to more than $600 billion. They’re rebuffing changes, limiting new provisions and demanding the return of prior protections.
That’s because when it comes to CLOs, which package and sell leveraged loans into chunks of varying risk and return, what’s best for Salas and other holders of safer debt tranches isn’t necessarily the same as what’s good for the firms that put the CLOs together. In fact, their interests are more closely aligned with buyers of the riskier equity portions, the piece of the pie that gets paid off last if the underlying loans struggle.
The changes affect the basic rules that determine if and when CLOs have to stop making distributions to the lowest-priority investors, the safety valve at the very heart of the structure. For collateral managers who often retain stakes in the equity and whose reputations are built on how much the slices pay out, the new rules could allow them to keep the cash flowing for longer should credit conditions sour.
The flip side, of course, is that if things get really bad, the money that otherwise would’ve been set aside for those higher up the chain won’t be there, exposing them to unexpected losses.
“We’ve seen more documents incorporating looser requirements, and we’re not happy with several of them,” said Salas, a CLO specialist at DWS, the asset management unit of Deutsche Bank AG. “This goes against the nature of the structure.”
Read more: Bond buyers hunt for cheap CLOs, mortgages after credit windfall
Whether these new provisions are designed to protect investors against temporary downturns or whether they’re simply an effort to protect manager bonuses is a matter of debate.
Yet the clash highlights the somewhat warped incentive system underpinning the CLO market, which buys more than half of all leveraged loans.
Collateral managers pledge to safeguard the debt investments of pension funds and endowments by beefing up the structures with cash from equity stakeholders. Yet the fees they earn are largely determined by how little of the buffer actually gets used, and how much residual cash flow they can dish out to hedge funds and others that buy the riskier chunks.
While most agree that some degree of flexibility is beneficial for CLO managers should they need to ride out a slowdown, over the past year more and more have been pushing the envelope. They’ve sought broad discretion to swap troubled loans, circumvent credit-quality limitations, and double down on risky wagers, largely in an effort to ensure they can pass crucial compliance tests, even if a large swath of a CLO’s underlying loans lose value.
‘Abuse of Documentation’
It’s these compliance tests that determine when interest from the CLO portfolio normally used to pay the equity and junior-debt holders gets diverted to reduce the principal balance of the more senior tranches and, moreover, if and when a manager’s fees get shut off.
The most important among them is known as the overcollateralization -- or OC -- test. It’s typically calculated for each tranche using the par value of loans that are bought above 80 cents on the dollar, and the purchase price of loans bought for anything less.
If the price of a loan marked at par plunges into distressed territory, collateral managers seeking to cut bait or swap into another asset would typically be forced to sell and take the hit to their OC ratio.
Yet recently, some CLOs have inserted language into deal documents that allows them to substitute a struggling loan for a similar distressed asset, but carry the new debt at par for the purposes of the overcollateralization test.
The rationale, CLO managers say, is that it gives them the leeway to swap into higher conviction loans without being punished.
“Of major concern is the manager being forced to push the sell button or be unable to hold an asset through stress to realize its best recovery outcome,” said Daniel Wohlberg, a director at CLO equity investor Eagle Point Credit Management who specializes in the negotiation and analysis of CLO structures.
But many debt buyers don’t view it that way, seeing it instead as a means to avoid widespread markdowns should a large swath of the leveraged loan market ultimately reprice lower.
“In my opinion, that is an abuse of documentation,” said Jason Merrill, a CLO specialist at Penn Mutual Asset Management. “That stipulation used to not exist.”
Some deal indentures also now include unprecedented latitude to swap in and out of defaulted loans. Still others allow managers to bypass normal trading limitations by exchanging defaulted assets for distressed -- yet still performing -- loans, which could also potentially be carried at par.
‘Hot-Button’ Issue
The addition of so-called swapped non-discount stipulations and defaulted-asset exchanges are hardly the only changes to deal documentation that CLO buyers are spotting with increased regularity.
CLOs typically limit the amount of CCC rated loans a structure can hold before values are discounted, with most capped at 7.5% of assets. Managers have tried to carve out a laundry list of loan types that don’t count toward the threshold, including debtor-in-possession financing, loans in technical default, deeply discounted obligations and loans of bankrupt companies that are still paying.
CLO managers are also seeking to take advantage of split credit grades on loans by mandating only one rating test and using the higher ranking to stay under the CCC limit.
This “is a hot button for us, especially at this part of the credit cycle,” Salas said.
Defenders of the changes argue that for many of them, there remain restrictions limiting just how much leeway collateral managers have. Yet the very rating companies that oversee the compliance tests note that the new provisions are getting increasingly aggressive.
“Some of these are worrisome,” said Algis Remeza, an associate managing director at Moody’s Investors Service. The credit grader is trying “to keep up with the fine print and account for the added risk as CLO managers push boundaries and lawyers get creative.”
Bankruptcy Battle
The latest wrinkle is an attempt by collateral managers to be able to participate in restructurings should a company they lend to go bankrupt. Historically, CLO rules have prevented them from doubling down on bets that have already gone bad, the thinking being that such risky wagers could jeopardize the entire capital stack while disproportionately benefiting equity investors if they pan out.
The change could help managers who suffered through the worst year for CLO equity returns since 2013 last year rebound in 2020.
Yet amid fears of mounting loan downgrades, declining recovery rates, and even fake earnings projections, many are predicting that the push back from debt buyers over documentation language will only increase.
“You don’t want to handcuff the manager completely,” said Wohlberg. “The question is, what option builds value for all investors?”
To contact the reporter on this story: Adam Tempkin in New York at atempkin2@bloomberg.net
To contact the editors responsible for this story: Nikolaj Gammeltoft at ngammeltoft@bloomberg.net, Boris Korby, Dan Wilchins
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