Those distressed buyers, often acting in a small group, eventually accumulate control of a loan and push through a restructuring that is decidedly unfriendly to CLOs. Names like Acosta, Deluxe Entertainment and 4L Holdings are recent examples. In situations like these, value is transferred from the CLO community to the distressed community.

This topic was previewed in these pages back in March, in a column written in late February. The issues it covered seemed academic at the time, but today they are unambiguously real.

With CLOs controlling roughly 60% of the loan market, CLO collateral managers as a class clearly have the raw financial wherewithal to be able to have a major influence on the outcome of a restructuring. Yet with so many loan market participants, the law of large numbers seems to be in play. It takes just one or two CLO collateral managers (a small percentage of the total) selling into the distressed community for cracks to start forming. Then word gets around that people are selling. Momentum builds. Before we know it, distressed funds control the majority of a loan and restructurings are done in a manner unfriendly to CLOs. The CLO community would be well served to stop this trend.

In addition to changes in CLO collateral manager behaviour, the CLO community needs to better equip CLO collateral managers to navigate these situations. This is not a ‘debt issue’ or an ‘equity issue’ — it is a CLO issue. The behaviour of others in the loan market has changed, and CLOs need to evolve and adapt.

Some features that we believe would be helpful for CLO collateral managers include the following:

Some debtor-in-possession financings do not have final ratings when commitments are due. CLOs should be able to buy these, carrying them at par if they are already a lender. If a rating isn’t published within 60 days, then the DIP would be carried with a triple C rating until such time as a rating is issued, since most DIP loans receive ratings above the triple C category.

CLOs should be able to swap on a risk-neutral basis between different distressed situations, allowing CLO collateral managers to move into credits with the best recovery outlook.

CLOs should be able to use interest proceeds, or even some amount of principal proceeds, to participate in workout packages of existing obligors, even if the loan did not otherwise meet eligibility criteria.

Some of these suggestions may require changes in the Volcker rule before they can be implemented. Hopefully that relief will be adopted in the near term. As it stands, the Volcker regulations are adversely impacting many CLO investors, including banks and insurance companies. Ostensibly, these are the investors the regulations were seeking to protect.