Global credit funds & CLO's

October 2023 | Issue 258

Published in London & New York.

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October 2023 | Issue 258

Analysis

CLO documentation

Coping with stress

Tom Davidson

Managing editor

New tools in CLO documentation are giving managers new ways to deal with distressed assets

After a long period of relatively stable European CLO documentation, 2023 has seen a number of innovations. Tom Davidson, Creditflux’s managing editor, sat down with S&P Global Ratings’ Sandeep Chana and Kos Vavelidis, a partner at DLA Piper, to discuss the trends.

Tom Davidson:

What are the structural trends you’ve noticed recently?

Sandeep Chana:

I think structure-wise things are, at least in Europe, quite homogeneous. What we’re seeing now, we’ve seen before: unfunded tranches; more loan notes versus bonds; and more split-rated tranches. The interesting part comes when we turn to CLO documentation. In Europe, we’re seeing existing innovations become commonplace.

TD:

What’s a good example of that?

SC:

The easy one is bankruptcy exchange language. Without having to consider the CLO’s reinvestment criteria, a manager may exchange a defaulted asset that they already hold for another defaulted asset. Several conditions need to be met, and one of those is that the overall recovery likelihood of the new asset is the same, if not better, than the existing asset they hold. Generally speaking, that’s a good thing because you’re trying to improve your loss-given default.

Recently, we’ve seen more deals expand that language to include the exchange of credit-impaired or credit-risk assets. These are assets which a CLO manager believes have a risk of declining in credit quality or price. So they utilise that definition and fix it on to bankruptcy exchanges.

The definition works in various ways. You can exchange credit risk assets, or you can exchange defaulted assets. The expanded definition isn’t in every deal, but it’s certainly growing in popularity.

“Every new deal has some form of LMO language — but there isn’t a single wording”

Sandeep Chana, Director | S&P Global Ratings

TD:

Is this language a way to combat the lender-on-lender violence that has become a feature of the US market and a growing concern in Europe?

SC:

I would say it’s certainly an expansion of the existing toolkit that managers have to help navigate situations when assets are in distress. In terms of defending against the kind of distressed asset players out there who are looking to impair the recoveries of loans that CLOs hold, there are other tools which CLOs have, like LMO workout language and up-tier priming definitions.

TD:

Can you explain what an LMO is?

SC:

It’s a loss mitigation obligation, which is synonymous for a workout obligation. Workout language varies across CLOs, but one expansion to the existing toolkit is what we refer to as a market value transfer mechanism. Keeping this as simple as possible, CLOs may purchase LMOs using interest proceeds that otherwise would have been used to pay the equity holders.

If the LMO works out and the asset itself turns into a performing credit again, the CLO is then able to transfer from the principal account to the interest account an amount equal to the market value of that asset at that point in time. It’s essentially a way of compensating equity investors for providing CLOs with money at the time that led to a successful restructuring. For our analysis, the transfer is typically subject to certain requirements being satisfied, such as that the CLO remains above target par. Again, we’ve seen the concept before; we’ve just noticed that more and more CLOs are finding it attractive.

Kos Vavelidis: Exactly. The language initially appeared in the European CLO documentation in 2020 in response to fears of defaults and restructurings during the pandemic, and in anticipation of future workout situations, but, as is often the case, it’s only after some real-life case studies of debt restructurings of loans that European CLOs own that people have had the chance to properly look at the language in the documents, test its application and see where improvements might be needed. This year there were a few such examples, including the proposals on the French supermarket operator Casino Guichard-Perrachon’s restructuring this summer.

Even slight differences in the drafting of the workout provisions can make a huge difference in what deals are allowed to do or not, with some pre-2020 deals having no ability to participate in certain restructuring proposals. Post-2020 deals — including new issue and reset/refis — vary greatly. There are different restrictions in terms of what you can buy with principal and/or interest proceeds, and when and how you can use principal or interest proceeds to participate in workouts.

Since the inception of the language, the market has come to appreciate that the ability of CLO managers to participate in some of these workouts is actually to the benefit of investors across the stack.

TD:

How do you view this as a rating agency, Sandeep?

SC:

We generally are not concerned if the purchase of workout obligations derive from excess proceeds, provided certain conditions are satisfied in accordance with our framework. If, however, you are using principal proceeds that are within the target par of the transaction (which essentially is the credit enhancement that CLO investors have put in to get the deal done), then our framework typically looks for additional considerations to be satisfied.

Almost always if you are buying principal-funded LMOs while within target par, it would have to be a debt obligation. It would be challenging to purchase equity because you just don’t get any value for equity in a CLO.

TD:

So even with the right LMO workout language, if the deal isn’t performing well enough, you won’t be able to participate?

SC:

Yes, depending on which proceeds the CLO is looking to utilise. So, for example, if you are looking to use principal proceeds within target par to buy an LMO, typically one of the requirements is that the OC tests are passing. If they’re not, then you’re unlikely to be able to buy an LMO using these proceeds. As a result, CLOs may use other sources of proceeds instead — such as interest proceeds, manager advances and/or collateral enhancement proceeds — if that option is provided for in the documentation.

Arguably, that’s exactly the optionality managers may be looking for. If a CLO is failing its OC tests, the manager may want to ensure there are other avenues open to buy that LMO to help improve those losses. As always, investors have to be cautious about how the mechanics work.

KV: It’s also interesting to discuss what’s happening in pre-2020 deals. Some managers and investors have recently sounded the alarm that the number of restructurings taking place are expected to increase, and they need to be prepared for those scenarios, including situations where distressed debt funds might potentially be looking to exploit the language in older CLO documents.

Brigade recently amended two older deals, after receiving no objections from their investors, to allow the equity to inject fresh capital and participate in certain restructurings that they would previously have not been allowed to participate in. I think that’s something that the market will now take a closer look at and we might see more of these amendments.

“Brigade amended two older deals to allow the equity to inject fresh capital”

Kos Vavelidis, Partner | DLA Piper

TD:

Have you heard about any other managers going down this route?

KV:

I think people generally were waiting to see if these amendments would go through — it seems to have grabbed the attention of more market participants now. Investors are seeing the value in having different tools that the CLO can use to tackle the specifics of the workout in question.

TD:

What language are you seeing in new deals in the market?

SC:

Every deal we’re seeing has some form of LMO language. But the market isn’t unifying into a single wording. Deals have variations. It can be just principal, just interest, it can be both, it can be principal but as long as you’re above target par and so on. We’ve also seen some examples where a manager may use both the senior and the junior management fee to buy an LMO.

KV: This one likely has to do with various considerations around timing, position in the waterfall, and requirements and/or limits that need to be satisfied. If you look at the provisions of some older deals, you can only participate in a workout at certain times, buying certain assets and subject to various caps. So unless you have money already sitting in your supplemental reserve or collateral enhancement account, you might have to put the money into the account on one payment date and then wait until another payment date to buy the LMO.

SC: Arguably it may also signal incentive. If you’re using your sub-management fees, you’re aligning yourself with the equity and saying you have faith that in the long run the CLO may be better off purchasing this asset.

KV: Correct. Managers and investors alike realise the value in having equity money to participate in restructurings as well as being able to buy debt workout obligations with principal proceeds. This is another example of including optionality and is likely supplementary to the usual collateral manager advance and equity contribution tools.

TD:

The other documentation issue gripping the market is snooze-lose provisions, where some managers have been accused of deliberately allowing amend-and-extends to go ahead despite them breaching CLO tests.

SC:

I think the market is trying to digest what’s been happening in the leveraged loan world where borrowers are successfully extending the maturity of existing obligations. The typical maturity amendment language in CLOs has always been that, first of all, a manager may not vote in favour of a maturity amendment unless the WAL test is satisfied, which is obviously more challenging for seasoned CLOs that are up against their WAL test covenant (or failing the test).

The second condition, and probably the most important for S&P’s methodology, is that accepting the maturity amendment does not lead to the asset becoming long-dated. The concern from our viewpoint is the potential market-value risk that arises if CLO managers become forced sellers of these assets before the CLO’s final maturity.

CLO docs address long-dated risk by stressing OC tests via a haircut to the carrying value of these assets. What we’ve typically seen is that long-dated assets resulting from maturity amendments are captured by the haircut, as the amendment falls under the restructured obligation criteria.

KV: For the first condition, as Sandeep mentioned, the majority of deals require the WAL test to be passing but, since CLO 2.0 arrived, there have been deals that allow exemptions to such rules in certain situations, for example, by including buckets allowing maturity amendments that can avoid the WAL test up to certain limits.

SC: Investors appear to be raising concerns in situations where CLOs are dragged along with maturity amendments when there is a clause in underlying loan documents which says that, if a lender says nothing within a period of time, it will be assumed that they’ve accepted the maturity amendment. What we’re seeing in the market in response to this is a new set of variations of what used to be very consistent language.

There are examples where a maturity amendment can be accepted even if it leads to a failure of these tests; for example, provided that you can demonstrate that you can sell the asset by a certain period. Another example we’ve seen is where you can accept the amendment if it represents a credit amendment, where the manager demonstrates that, had they not accepted the maturity amendment, it would have had an adverse impact on note holders.

There are also proactive examples coming through that explicitly require managers to vote against a maturity amendment if it’s going to result in a breach of a WAL test and the bucket that Kos mentions is reached.

As Kos said with LMOs, the language will eventually converge at one point and we’ll see more consistency, but the market is in exploratory mode at the moment.

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