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Global credit funds & CLO's
April 2024 | Issue 263
Published in London & New York.
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April 2024 | Issue 263
Analysis CLOs
What do reset deals have in common?
Poh-Heng Tan
Is it possible to predict which deals are likely to be reset next? With reset mania continuing to grip the US CLO market, we search for common factors among 2014-2021 deals that were reset
Resetting a deal incurs costs — but given that since June 2023 no less than 81 BSL CLO deals have undergone resets, equity investors (or first-loss retention managers) seem to have concluded that the long-term benefits outweigh these additional costs.
In the current market, this makes sense. Resetting a deal is generally more feasible when the deal is performing well and is bolstered by favourable conditions.
Average change to WACC by vintage for recently reset US CLOs (bps)
Source for chart and all tables: Pitchbook LCD, Intex, S&P Global Market Intelligence, CLO Research
Pattern recognition
Beyond the ‘obvious’ US CLOs from 2022-2023, which were launched at an opportune moment for a future reset, it is clear that seasoned deals from the 2014-2021 vintages that sit in the top quartile for market value over-collateralisation (MVOC) and equity net asset value (NAV) are in a notably stronger position to explore a reset.
Among the 81 US resets we analysed, 39 deals from the 2022–2023 vintages reduced their cost of funding by an average of 44bps, while also extending their reinvestment periods by about 2.5 years on average (see table 1). These transactions are the most straightforward cases, because their resets significantly boosted the value of equity investments through substantial reductions in funding costs and extended reinvestment periods.
13bps
Average increase in cost of funding for reset 2014–2021 deals gaining an extra 3.8 years of reinvestment period
It is the other 42 deals, from vintages between 2014 and 2021, that require further study. They experienced an average increase in their cost of funding by 13bps in return for an extra 3.8 years of reinvestment period, or around 3.7bps for an extra year of reinvestment.
Evaluating the benefits of resets to equity investments typically involves comparing the valuations of investments before and after the reset. If a deal requires additional capital, then it is perhaps less clear cut if it benefits the original equity investors. Nevertheless, some CLO equity investors may prioritise different goals, such as prolonging the period of income distributions from their investments, or capitalising on a longer reinvestment period.
*CLO resets between 1 June 2023 and 29 March 2024
Declines in market value
Resets become challenging if the deal experiences a significant decline in the market value of its collateral due to poor collateral performance, defaults and trading losses (which can sometimes be more problematic than losses due to defaults).
Pricing the reset for long-dated liabilities of underperforming deals, especially at mezzanine levels, would become prohibitively expensive, even under favourable market conditions. Besides paying more for the reset CLO liabilities, additional capital in the form of unrated debt or equity would be needed. Typically, most equity investors would not want to add new money after ‘bad’ money.
Table 2 shows that the median reset deal has an equity NAV of 70 points based on asset prices as of 29 March 2024. To reset, a deal needs to do well: 75% of reset deals have an equity NAV of over 57 points.
Reset timing is everything
Seasoned deals from vintages between 2014 and 2021 have priced their resets when their remaining reinvestment periods averaged between zero and one years.
For a seasoned deal that is performing well and has a shorter duration profile, its liabilities typically are priced close to par before a reset. Therefore, it is not easy to buy discounted triple A to double B tranches prior to a reset. These deals comfortably have their average MVOC metrics, by vintage, placed in the top-quartile performance range, with the exception of the 2020 vintage deals.
However, if a deal includes a single-B tranche, a reset could lead to additional costs for equity holders. They would be required to refinance the discounted single-B tranche at par to facilitate a reset.
Of course, investors holding the single-B tranche would be delighted to receive par, highlighting some of the single-B tranche opportunities still available for lower mezzanine investors.
Five deals from 2014-2021 vintages — Palmer Square CLO 2020-3, Palmer Square CLO 2018-2, Madison Park Funding XIX, GoldenTree Loan Management US CLO 9 and OHA Credit Partners XII CLO — had a single-B tranche with notional amounts ranging from $6m to $12.1m before the reset. This resulted in holders of these single-B tranches benefiting from a pull-to-par effect after a reset.
Success breeds success
CLO managers which have recently completed a significant number of resets are likely to be viewed favourably by investors. Elmwood has established itself as the most prolific manager, having completed six resets. Unquestionably, investors in single-B tranches would be satisfied to hold Elmwood’s single-B tranches prior to resets.
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