European CLO managers now have an unprecedented range of tools to deal with stressed and distressed assets, most of them barely used. The widely expected restructuring of Altice France’s debt may soon force CLO managers to reclassify some obligations they hold; some could move to the restructured obligations or bankruptcy exchange buckets, or even to the uptier priming debt basket. But in the meantime, and probably even after Altice France’s restructuring, CLO documentations contain several provisions that could be seen as superfluous.
CLO professionals, unsurprisingly, see the value in such provisions. In a more challenging market, with increasingly sophisticated sponsors, they are seen as indispensable because they act as a deterrent.
“We don’t know what the future holds in terms of restructuring, but restructurings in the US have shown that it is important for CLO managers to have access to all these tools because they allow them to be at the table and have the flexibility to participate,” said Blake Jones, a partner at Clifford Chance. “If something is not likely to happen, it doesn’t mean it won’t happen.”
He pointed out that, without an appropriate set of tools, CLOs may not be able to participate effectively in a restructuring or a restructuring could be designed to keep CLOs out of the deal (like through an aggressive liability management exercise, for instance).
The CLO partners at Milbank liken the phenomenon to the détente at the end of an arms race, which began when maintenance covenants all but disappeared from the leveraged loan market. Initially this gave sponsors more opportunities to benefit from creditor-on-creditor violence.
“Transaction documents were then adapted to put CLOs on a level playing field. With these upgrades broadly adopted, ‘divide and conquer’ strategies targeting CLOs became less effective and so the need to use these provisions waned,” Milbank CLO partners said.
CLOs as such have not fundamentally changed, remaining investment vehicles offering exposure to performing credits rated below investment grade. When some credits are no longer performing, the CLO manager’s work is all about protecting the value of this specific asset and mitigating the deterioration in overall portfolio quality.
“CLOs are designed to work through the cycle, and the market develops incrementally,” said Chris McGarry, partner at White & Case. “After the Covid pandemic, CLOs, as par investors, found that they were at a disadvantage relative to non-par investors in certain restructurings. The CLO market took it in its stride and adapted.”
But even if investors’ stipulations can sometimes be very long, CLOs remain a simple product, he added, pointing out that “there is some structuring at the margins, but at its core, a CLO is simple — a CLO portfolio comprises 85-90% of senior secured loans, with a blended rating of B+ and a tranched capital structure from triple-A down to a single B which has worked through all the economic cycles and global events for a quarter of a century now.”
Balancing act
Loss mitigation obligations (LMOs), which allow a CLO to advance new money to a borrower in default or undergoing restructuring in order to mitigate losses, emerged in Europe during summer 2020, in response to a few high-profile restructurings in the US (Deluxe Entertainment, Acosta Inc, JC Penney). Anti-priming provisions, which allow CLO managers to invest in new money tranches in the context of a restructuring and deemed as a “defensive” tool, appeared in European CLOs in summer 2022.
The restructurings of Schur Flexibles and Vue Cinemas in 2022 saw some European CLO participation, with managers getting involved in the new money financing by way of LMOs. Others just relied on the Corporate Rescue Loan bucket; with these rescue loans, a CLO manager can invest principal funds into the most senior debt of an issuer in distress. “There were some differences in the way CLOs participated and they ended up using different buckets because of the way the tools were written in the existing documentation,” a source commented. CLO practitioners also cited two other cases: Swissport and Cineworld.
The market has been debating ever since over what the right balance should be between what CLO managers are allowed to do and what the appropriate safeguards should be. “Managers like the flexibility to be able to add loss mitigation obligations and uptier priming debt to the portfolios but it is quite common to receive pushback from debt investors on this flexibility,” said Martin Sharkey, partner at Schulte Roth & Zabel — the rule of thumb among investors being that some higher up the stack will always want to reduce flexibility for managers in the more edgy tools, those that require more expertise in the field of debt restructuring, he explained.
For other investors lower down the stack, those tools may be seen as advantageous and an important defense mechanism for CLOs, while for a third group they are viewed as fine in the right hands, but inexperienced and more thinly staffed managers tend to be given less leeway.
Some tools such as restructured obligations baskets and collateral enhancement obligations have been present in CLO documentation for years. Some concepts are overlapping and the definition is not always clear-cut, but the key idea in the case of uptier priming debt and LMOs is to allow CLO managers to participate in a restructuring involving new money financing — this is why they are the most talked about, as the downside risk can look more obvious (at least to senior CLO debt holders) than the upside potential.
Empty shelves
The fact remains that all these buckets are not being used much, looking more like empty shelves in the handful of investor reports posted in the past few months on the Irish stock exchange ahead of refinancings or resets. LMOs and uptier priming debt are uniformly at 0%. But what is clear is that CLO managers have already had to deal with some restructured assets, which have remerged as HoldCo PIK debt or as equity.
In June, AlbaCore Euro CLO IV had some assets classified as “Collateral Enhancement Obligation & Exchanged Equity Security” (Covis Finco, Ideal Standard International and Keter), but no LMOs or corporate rescue loans. The deal was refinanced in July.
In CVC Cordatus Loan Fund XXIII’s July 2024 investor report, there is very little use of the buckets dedicated to stressed assets, but the portfolio contained some “exchanged equity securities” (Flint Group Topco Ltd’s ordinary A shares and Silk Topco AS). CVC in July received a repayment from Flint Group Midco Ltd’s super senior facility euro notes. The defaulted obligations bucket comprised Hurtigruten, OQ and Oxea. Some 0.42% of the aggregate collateral balance consisted of PIK obligations or partial PIK obligations, below the 5% limit. Cordatus XXIII was partially refinanced in August.
Jubilee CLO 2019-XXII held in July some equity (AS Adventure BV’s preference shares equity and Haya Holdco 1 Ltd - B shares equity). Before its reset this summer, the deal was in breach of a few collateral quality tests: weighted average life test, weighted average fixed coupon test, weighted average spread test and Moody’s maximum weighted average rating factor test.
Invesco Euro CLO VIII, in the June report, had no defaulted obligations, no distressed exchange obligations, no corporate rescue loans, no discount obligations and no LMOs. Invesco VIII’s portfolio contained one current pay obligation: Keter Group BV’s Super Senior Term Facility.
Analysing CLO investor reports and reviewing deal documentation is not only about checking the caps for different types of securities or credit situations, but also when these obligations must be included in specific buckets (and make sure they don’t slip out of these buckets through extra provisions).
In an Aug. 12 report, BofA’s European strategists point out that investors also need to pay attention to provisions that prevent obligations by distressed borrowers to be classified as defaulted obligations, and thus avoid the haircuts in the overcollateralization (OC) calculation that otherwise would come with holding such securities.
BofA Global Research also found some divergence in language for the conditions allowing CLO managers to make LMO purchases — in some cases the requirement is for the junior OC test to just pass, in others the junior OC ratio must be higher than what is required for a regular test pass. “Consequently, some deals are more equity-friendly (e.g., lower hurdles for LMO purchases, less strict conditions for classifying an obligation as Current Pay Obligation) than others,” BofA said in the report.
However, the bank notes that “very aggressive language” where only an OC test on the Class D or above needs to pass rather than the Class E or F OC test is rare, with just 17 such deals out of almost 200 (including resets) over the past two years.
Active trading
One reason why all these buckets look underused may simply be because CLOs are actively managed and managers have until now been quite successful at picking the right credits and disposing of the weaker ones.
“Credit managers use different strategies but they have the ability to trade out or transfer some stressed names to other funds. CLOs within their reinvestment period can sell these assets, and even CLOs out of their reinvestment period have the ability to trade out of impaired and credit risk obligations,” Chris McGarry noted.
Ultimately, a swift sale may indeed be the best option, as BofA strategists pointed out when commenting on anti-priming provisions. While the “super senior creditors will experience a better recovery than the formerly senior secured (and now subordinated) creditors, this does not necessarily mean that CLO managers that can participate in an uptier priming will fare better than those who decide to sell early,” BofA strategists noted in the Aug. 12 report.
They point to a key risk: “the ability to participate in a priming transaction may encourage an investor to stay invested rather than cut losses and sell.” Back in March, the same strategists pointed out that “in some cases it is — with the benefit of hindsight — better to sell a defaulted obligation rather than stay invested and participate in the uptier priming, as was the case with Genesis Specialist Care.”
But another consideration is whether CLOs can sell the asset they wish to offload, as white lists sometimes restrict the transferability of loans. CLO managers can also find that some names are tradeable, but turn out to be quite illiquid. They also know that credit risk cannot be fully eliminated. As the market share of CLOs in the leveraged loan market reaches record highs, CLO managers are likely to want to keep their options open and an adequate restructuring toolkit.
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