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September 2023 | Issue 257

Do resets help CLOs perform better?

Poh-Heng Tan
As the market for CLO resets opens, we look at the performance of deals that were previously reset, and find they soon deliver higher distributions than those deals that were not reset
As senior spreads tighten, CLO managers are turning their attention to resetting older deals. The reset market was effectively closed for the first half of the year, but began to stir in July (in the US at least). August has seen six resets by the time of press, so now seems a good time to explore how previously reset CLOs performed for equity investors.
The option to reset did not exist in 1.0 CLOs. Unlike a standard refinancing, resetting a CLO involves extending its reinvestment period. While there are costs associated with a reset, equity investors (or first loss retention managers) believe the benefits of a reset outweigh these costs. Is that the correct decision?
Annual equity distributions of reset CLOs by vintage
annual equity.svg
Downsides of CLO resets
In essence, resetting a CLO extends the total reinvestment period, which is positive from an equity standpoint. If a CLO deal can generate an annual equity distribution of 13–14 points over a period of 8–11 years, its equity is likely to perform reasonably well, even if the final equity NAV is poor.
Seasoned deals were active during a substantial period of very low interest rates. When the reset window opens, many will reset to lengthen their reinvestment period and gain additional WAL test cushions, putting them in a better position to take advantage of long-dated new issues as well as amend-and-extend deals.
However, in a strong loan market, loans will be repriced, and spreads will be compressed again. This may lead to mediocre median cash-on-cash annual distributions for more seasoned US CLOs. Additionally, annual distributions may decline if a reset deal includes a class X tranche or it pays down its liabilities. A low cash-on-cash annual distribution will cap the eventual equity IRR of a deal unless the final CLO equity NAV is above the primary issue price — and CLO equity tranches typically yield a low final equity NAV compared to par, given their first-loss nature.
However, it is worth mentioning that most of the redeemed CLO equity deals issued in 2020 saw a solid final equity NAV with above-par value. These trades were primarily driven by principals rather than long-term regular income trades. As for the outstanding 2020 vintage deals, many have undergone resets, effectively transforming them into regular arbitrage income deals.
Resetting a CLO may be challenging if the deal has experienced a significant decline in collateral market value. Under such circumstances, pricing the long-dated liabilities can become prohibitively expensive, especially at the mezzanine levels, regardless of otherwise favourable market conditions. The correlation between deal performance and market conditions is shown by the fact that 93.5% of reset deals were priced when the bid price of the Morningstar U.S. B/BB Ratings Loan Index was at 98 or higher.
Resets boost cumulative distributions
Table 1 (see above) presents the cumulative equity distributions for 570 equity tranches of reset CLO deals across various vintages. We also looked at the same metrics for non-reset deals as a counterpoint.
Slightly over three-quarters of the seasoned CLO equity tranches from the years 2012 to 2015 have already fully recovered at least 100% of their tranche notional. This means that many of these equity tranches will not be dependent on their final NAV to achieve a decent IRR.
Essentially, non-reset seasoned deals from 2012 to 2016 exhibited considerably poorer performance compared to their reset counterparts. Non-reset equity tranches from 2019 and 2020 also exhibited weaker performance. On the other hand, while the non-reset equity tranches from 2018 have demonstrated better cumulative and annual distributions than their reset counterparts, their success will greatly hinge on consistent, satisfactory annual distributions for an additional 1-2 years, as well as a favourable final net asset value (NAV).
Importance of equity distributions
The chart (above) shows annualised distributions of reset equity tranches by vintage.
For older deals, the median annual distributions were largely in the 12-13% range. However, the median 2015 vintage deals stood out with an impressive 14.1% distribution. The reasons for this outperformance include, first, that the 2015 deals utilised fewer class X tranches, and secondly, that the 2015 deals saw a large first distribution.
One example from that vintage is York CLO-1, which was called recently. Given its outstanding annual distribution of 16.3%, which places it among the top quartile for 2015 vintage reset deals, it’s final equity NAV (which is likely to be in the low-30s), did not prevent it scoring a final IRR of at least 12.0%.
*As of 31 July 2023
Interestingly, 2020 vintage CLO equity tranches have reported the highest annual distributions. In general, par distribution, including par release upon reset, has significantly boosted them. And the current high interest-rate environment is expected to bode well for future distributions.
In the 2018 vintage, CLO equity tranches witnessed a broader variance in annual distributions. This was primarily due to a smaller sample count, and the results were influenced by several deals featuring class X tranches — which operate in a manner akin to reverse par distribution.
More than 75% of reset 2012-2015 CLO equity tranches have recovered at least 100% of tranche notional
Runways and recent figures
Tables 2 and 3 present the last distributions and the remaining reinvestment periods/WAL cushions/AAA factors of our set of reset deals’ equity tranches by vintage.
As deals come out of their reinvestment period, they tend to be regarded more as principal value trades rather than income trades. Looking back, post-2012 deals were typically called when their last distributions averaged around 2%. However, the range of their last distributions varied significantly, spanning from 0% to over 4%. On average, the loan index bid price when deals were called was around the $99 level. Only about 10% of deals were called with the loan index below the $96 level. Some investors opted not to wait for their deals to pay down further, as this would lead to a decrease in their distributions to a low level. This decision is particularly relevant given that new issue BB tranches yield 12-13% on an annual basis in today’s market.
A good percentage of 2015 and 2016 vintage deals may still have a bit of runway ahead. But the median 2017–2020 vintage deals definitely have a good amount of reinvestment period remaining — an advantage in today’s higher interest rate environment, provided that any increase in distributions can effectively offset any increased losses resulting from trading or defaults.
In conclusion, the outlook for many reset deals is positive, provided they can sustain good annual equity distributions over an extended period. This highlights the crucial role of the long reinvestment period resulting from the reset, which can effectively offset a potentially lower annual distribution profile. In essence, achieving success in these deals can be likened to running a marathon, where consistent performance over time becomes the key to favourable outcomes.
  • All data is sourced from CLO Research, Intex, Refinitiv LPC and Pitchbook LCD.
  • In our distribution tables and chart, the figures show the range of distributions for each vintage, looking at the 75th percentile, the median (50% percentile) , and at the 25th percentile levels.
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Global credit funds & CLO's
September 2023 | Issue 257
Published in London & New York.
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