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Analysis CLOs
Reset or refinancing?
by Poh-Heng Tan
The CLO market is expecting another strong half year for both resets and refinancings. But what factors are leading equity investors to prefer resetting deals over refinancing them?
Based on the number of transactions priced year-to-date, CLO resets remain the preferred option over refinancings. According to our data, 242 resets have been priced YTD as of 30 August, compared to 139 refinancings.
Refinancing involves refinancing existing rated tranches at tighter spreads, while keeping the reinvestment end date unchanged. The presence of an upward-sloping term structure at the triple A tranche level favours refinancing. Recent pricing data shows that top-tier names with zero, one, two or three years of remaining reinvestment period had their triple A tranches priced at approximately 107 basis points, 115bps, 125bps and 128bps, respectively.
If a deal is out of its non-call period and any tranches are ‘in-the-money’, these tranches could be prepaid at par whenever equity holders decide it is worthwhile to refinance the deal.
Market value overcollateralisation tests for BB CLO refis by reinvestment end date*
* Based on asset prices as at 28 Aug 2024
Strong loan market hurts refinancings
A high prepayment rate can offset the benefits of refinancing due to the increased cost of funding from paydowns on the triple A tranche and reduced structural leverage. Additionally, refinanced deals with limited reinvestment flexibility, or those that are out of their reinvestment period, must contend with the repricing of underlying asset spreads in today’s strong loan market, making it challenging for managers to redeploy prepaid proceeds. In contrast, during a reset, managers might offset some of the underlying loan spread tightening due to repricing by redeploying prepaid proceeds into longer-dated assets. Long-dated or primary loans are typically more attractive for CLOs.
Refinancings do not require class X notes or additional equity capital
Equity distributions drop over time due to the underlying asset spread repricing, reduced structural leverage and significant paydowns on the triple A tranche. If a deal’s equity distribution drops to around 2-2.5% or lower, equity holders may need to fully redeem the deal, especially if projected distributions are expected to decline further. Fully redeeming a deal shortly after completing a refinancing could mean missing out on the net economic benefits of a refinancing.
CLO tranches that are out of the money are not refinanced. However, unlike refinancings, resets can potentially add value to debt holders, particularly those tranches quoted at a discount before the reset.
Since 1 July 2024, 36 US BSL CLO deals have been refinanced. In over 83% of these deals the floating-rate triple A to triple B tranches were refinanced, while fixed-rate tranches (if any) and lower mezzanine tranches were left untouched. In fact, 15 deals did not refinance their double B tranches. Unsurprisingly, most of these deals have a low market value overcollateralisation test (MVOC) at the double B tranche.
A reset extends a deal’s reinvestment period by several years, making it prohibitively expensive to price long-dated lower mezzanine tranches with a low MVOC, even in today’s favourable market. For instance, reset double B tranches over the same period were priced from as low as 540bps to over 800bps for managers with large platforms.
CLO triple-A term curve*
*0-3Y tier-1 manager BSL CLO refinancings, 5Y new issue
Improving OC ratios
Deals that refinance their triple A to double B tranches tend to have a better MVOC (double B) metric or a pre-refinancing wide double B tranche spread. Six of these deals still have a decent reinvestment period of two years or more remaining. Equity investors may have determined that pursuing a refinancing first is more accretive. They can explore a reset later once the deal’s reinvestment period has ended — or they can opt for a full redemption if the deal has been substantially prepaid.
Refinancing is straightforward since no class X or additional equity capital is required, but investors must take a significant hit on one payment date distribution to cover refinancing expenses. Some equity investors are also wary of including a class X note in a reset. These can negatively impact cash-on-cash distributions, depending on the note’s size and payment schedule.
In a sample of 138 redeemed deals, reset deals outperformed those that were only refinanced
Managers which proactively restructure their deals whenever opportunities arise are generally viewed favourably. Certain managers have access to internal or external equity capital, enabling them to execute a reset or even upsize a deal. To implement a reset, some seasoned deals may require additional equity capital to support a new, long-dated structure, while other betterperforming deals may do so without any equity injection or even the class X tranche. In a sample of 138 deals from 2014 that were fully redeemed, those that were reset outperformed those that were only refinanced by approximately 6 percentage points in terms of median equity IRRs.
Managers which have conducted at least three resets of BSL CLO deals issued between 2013 and 2021, since mid-2023.
Source: CLO Research
Benefits for mezz investors
All things being equal, lower mezzanine tranche investors typically prefer to own deals with a higher probability of being reset. If deals are not performing as expected, some lower mezzanine tranches with low MVOC are likely be quoted at a discount, even in a strong loan market. Upon reset, these tranches then pull to par.
In some cases, a reset benefits all or most of the debt tranches as well as the equity holders. For instance, deals that were reset late last year or during the first half of this year saw their weighted average cost of capital increase, but equity investors still found it worthwhile to reset them due to the added reinvestment period and flexibility. If deals are performing well, executing a reset is likely to be straightforward, as no additional equity injection is needed.
CSAM, CIFC, Oak Hill, Elmwood, Octagon, Neuberger Berman, PGIM, Onex and Generate Advisors have all reset seasoned deals from 2013 to 2021.
