There is ample time and flexibility on the pathway from warehouse to securitisation

Thomas Majewski

Founder & managing partner Eagle Point Credit Management

A big loan sell-off does not mean CLO warehouses will be forced to liquidate

By our estimations, there are currently around 200 CLO warehouses open (that probably have exposure to over $40 billion of broadly syndicated loans). This suggests equity investors are hoping to create $100 billion of new CLOs.

Alas, at the moment, despite the attractiveness of floating rate CLO debt, many regular CLO debt investors have pulled in the reigns. As a result, the equity arbitrage for new primary CLO creation is a challenging and fast-moving target. With such a vast amount of potential issuance to digest, some have started speculating that CLO warehouse liquidations could commence en masse in short order. We find that highly improbable.

First, recall that the lion’s share of CLO warehouses have at least two-year, non-mark-to-market facilities. That two-year term is most often separated evenly into an aggregation period (where collateral managers can accumulate assets for the anticipated CLO), and an amortisation period (where if no CLO materialises, the collateral manager is given a year to selectively sell assets or seek different financing).

Often, the amortisation period doesn’t even require scheduled periodic principal payments, so the collateral manager likely has the full one-year period before any action must be taken. This leaves collateral managers with time to unwind structures without the fear of an early maturity or margin call. The warehouses opened at the end of last year that we see most often noted by those worried about forced sales still have more than a year to work for best outcomes for their investors.

Warehouse costs may increase

Next, even as these warehouses run longer than investors planned, bank arrangers have incentives to show flexibility with the hope of earning a structuring fee upon the eventual securitisation. This aligns arrangers with managers as they consider requests for extensions to facility aggregation periods or even maturity dates, and enables banks to move financing terms in their favour. As part of an extension, the cost of warehouse financing may increase to meet current market levels, but this typically comes along with an ability to add assets at today’s discounted prices.

Similarly, investors can seek to split one warehouse into many to lessen any one warehouse’s collateral balance. Issuance can then be staggered, providing the arranging bank with two fee opportunities, while the collateral manager ends up with double the CLO AUM.

Collateral manager sacrifices

In some of the most difficult situations, investors may even ask the current collateral manager to resign in favour of a more tenured CLO collateral manager which is able to obtain more reasonable CLO debt liability levels. While certainly not the desired outcome for erstwhile collateral managers, its one that has occurred and will again to clear warehouse balances.

Finally, collateral managers can use market rallies to effect trading plans whereby they pair riskier asset sales with assets added at lower prices that have appreciated. In this most basic sense, collateral managers naturally cut down the amount of assets held on a return neutral or better basis. This allows for some degree of portfolio repositioning as the collateral manager can then wait or add newer assets to the pool until an attractive CLO liability path emerges.

This optionality, which is innate in the CLO warehousing process, is vital to the health of the CLO market. Since there is no catalyst for forced sales, there is little pressure for third-party equity investors to issue CLOs with uneconomic profiles.

This keeps our primary market from becoming distorted in times of volatility. So long as equity investors are well-partnered in their banking and collateral manager relationships, there is ample time and flexibility on the pathway to securitisation. Any report calling for massive warehouse liquidations misses how the entanglement of relationships, incentives and contractual terms in CLO warehouses provides optionality and staying power to the equity investors backing them.

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Global credit funds & CLO's

October 2022 | Issue 249

Published in London & New York.