thesis master v3 - vernimmen · thesis submitted to hec paris in partial fulfillment for the award...
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REGULATORY&STRUCTURALEVOLUTIONOF
COLLATERALIZEDLOANOBLIGATIONS
Thesissubmittedto
HECParis
Inpartialfulfillmentfortheawardofthedegree
of
MasterinManagement
MajorinFinance
by
PahunJAIN
Undertheesteemedguidanceof
Prof.RichardBRUYERE
June2016
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Declaration
Icertifythat:
i. Theworkcontainedinthisthesisisoriginalandhasbeendonebymeundertheguidanceofmysupervisor.
ii. Theworkhasnotbeensubmittedtoanyotherinstituteforanydegreeordiploma.
iii. IhavefollowedtheguidelinesprovidedbyHECParisinpreparingthethesis.
iv. IhaveconformedtothenormsandguidelinesgivenintheEthicalCodeofConductoftheschool.
v. WheneverIhaveusedmaterials(data,theoreticalanalysisfigures,text)fromothersources,Ihavegivenduecredittothembycitingtheminthetextofthethesisandgivingtheirdetailsinthereferences.
vi. WheneverIhavequotedwrittenmaterialsfromothersources,Ihaveputthemunderquotationmarksandgivenduecredittothesourcesbycitingthemandgivingrequireddetailsinthereferences.
PahunJAIN
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Acknowledgement
ItakethisopportunitytoexpressmysinceregratitudetoProf.RichardBruyereforhissupport,guidanceandencouragementthroughouttheresearchandthesis-writingprocess.Hiscalmdemeanorandprofoundunderstandingofthesubjecthelpeddefinetheresearchgoalsclearlyrightfromthebeginningandsupportedmeateverystageoftheprocess.
IamalsogratefultoProf.JeanEdouardColliardforhelpingmeunderstandandappreciatethecomplexregulationsassociatedwithvariousfinancialsecuritiesthroughourinteractionsduringthecourse‘FinancialRegulation’atHECParis–MajorFinance.
PahunJAIN
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Abstract
ThispapertalksabouttheregulatorychangesthathaveaffectedthestructureoftheCollateralizedLoanObligations(CLOs).CLOsareimportantfinancialinstrumentsthathelpdistributetherisksofbanksandotherloanissuinginstitutionstooutsideinvestors.Theseinstrumentsareextremelyusefultoprovideliquiditytotheotherwiseilliquidmarketofleveragedloans.Thefinancialcrisisof2008exposedthestructuraldeficienciesandloopholesinthepre-crisisvintageCLOstructures,popularlycalledasCLO1.0.
Thisledtoaseriesofregulationspassedbyvariousregulatoryauthoritiesaroundtheworld.Thischangingregulationsenvironmentandlackofinvestorinterestduetohugewrite-offsinthethenexistingCLOsledtoadramaticfallintheCLOissuancesafterthecrisisperiod.TheregulationshelpedcreateasaferandmoretransparentstructureforinvestorstherebyboostingtheirconfidenceandtheCLOissuancesatalaterstage.TheseCLOsof2011and2012vintagesaretherebypopularlycalledasCLO2.0.
TheCLO2.0hadabetterperformancerecordovertheCLO1.0transactions.TheymandatedissuerstoretainthecreditriskswhenplacingtheCLONotesandabolishedtheloantodistributestrategywhichhadbecomecommoninthepre-crisisperiod.TheCLOissuancelevelsandtheassetsundermanagementreboundtopre-crisislevelespeciallyintheUnitedStatesbutthentheVolcker’sRulewaspassed.
Volcker’sRulemandatedthatallCLOsof2.0structurearetobeclassifiedascoveredfundsandthatinvestmentsbybankingentitiesintosuchstructuresneededtobesupportedbycorrespondingTier1Capital.ThisclassificationhurttheCLOindustrydramaticallywiththeCLOissuancesfallingsharply.TheCLOmanagersrespondedbyfindingwaystogettheCLOstobeexemptfromthisclassificationandthisledtothedevelopmentofanewVolcker’sRulecompliantCLOstructureorpopularlyknownasCLO3.0.
TheCLOhavehadaturbulenthistorywithseveralregulationsandmacroeventsaffectingitsstructure.Therehasbeenachangeinitsinvestorcompositionaswell.ThepaperfollowssuchchangesandcommentsontheseeventsandtheimpactofitontheCLOindustryanditsvariedparticipants.
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TableofContents
Declaration
Acknowledgements
Abstract
I. IntroductionII. CLOOverview
A. HistoryoftheCLOMarketB. ConceptandimportanceofCLOsC. MarketparticipantsandrolesD. KeytermsofaCLOE. LifecycleofaCLOF. DifferenttypesofCLOs
i. StaticversusManagedCLOsii. BalancesheetversusArbitrageCLOsiii. CashFlowversusMarketValueCLOsiv. CashversusSyntheticCLOs
G. KeyRiskFactorsofaCLOIII. CLO1.0vsCLO2.0
A. OverviewB. MajorDifferences
i. Over-CollateralizationandCreditEnhancementofSeniorTranchesii. CollateralRestrictionsiii. ReinvestmentPeriodsiv. Non-CallPeriodsv. NoteCancellationstoimproveO/Cvi. TranceRefinancingvii. PricingandExcessSpreads
C. RePricingsD. Cov-LiteLoansE. RiskRetentionF. ExampleofapreandpostcrisisCLOTransactionG. PerformanceofCLO2.0ascomparedtoCLO1.0
IV. CLO3.0A. VolckerExemptCLOStructuresB. TheImpactofVolcker’sRule
Conclusions
Bibliography
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I. Introduction
Financialinstitutions,andbanksinparticular,havetraditionallycollecteddepositsfromthosewhohavemoneyinexcessoftheirconsumptionorinvestmentneedsandredistributeittothosethathaveafinancingneed;theyactasintermediariesbetweenborrowersandlenders.These‘lenders’thuslendtothefinancialinstitutionsasdepositorsofmoney.Thefinancialinstitutionsthentakeuponitselfandmanagestherisksassociatedwithlendingtosuchindividuals,publicbodiesand/orcorporationsthatborrowfundsbytransformingshort-termdepositsintolong-termloans.
Financialinstitutionshavelongstruggledtomanagetheaforementionedrisks.Theinherentrisksinmanagingthedifferenceindurationsoftheseinstitutions’assetsandliabilitiesandthemanagementofthecredit/counterpartyriskshavebecomeamajorconcernforthebanks,moresointhecurrentageofincreasedregulatoryrequirementswhichinturnaffectsprofitabilitybyrequiringadditionalequity.Theseinstitutionshavelongexploreddifferentmechanismstomanagetheserisksonandoffbooks.Thisledtotheuseofanassetsecuritizationstructureknownasa“CollateralizedLoanObligation”,or“CLO”,tomeettheirfinancialobjectives.CLOsenablebankstosellportionsoflargeportfoliosofcommercialloans(orinsomecases,theassociatedcreditrisks)directlyintointernationalfinancialmarkets,andofferbanksameansofachievingavarietyofgoalssuchasbutnotlimitedto–
• Transferofcreditrisktothirdparties• Offbalancesheetaccountingtreatment• Increasedliquidityofbilateraland/orsyndicatedloans• Accesstoefficientfundingsourceforlendingorotheractivities,generallywithalonger
durationthandeposits• Overallreductioninregulatorycapitalrequirementsandincreasedprofitability
ThefirstmajorCLO-$5billionR.O.S.E.FundingNo.1Ltd.TransactionwasplacedsuccessfullyinNovember1996byNationalWestministerBankPlcandthetrendsoonexplodedintheworldfinancialmarkets.MorethansixteenbankCLOtransactions,accountingfor$34.1billionofratedsecurities,wereclosedin1997.Anincreasinginvestorappetitebuoyedbyalucrativereturnonthesefixedincomesecurities,andtheincreaseduseoftheseinstrumentstomanagebanks’risksduetothefavorableaccountingtreatmentpostCLOstructuringledtoanincreasednumberofsuchtransactionsinthemarket.SinceanincreaseddiversityoftheunderlyingincreasedthecreditratingofCLOs,larger,diverseandmorecomplexCLOstructuresstartedappearinginearly2000swhichwerefavorablyratedbytheratingagencies.AsecondlevelandsometimesathirdlevelofstructuringtodevelopsecuritieswithotherCLOsasunderlyingstartedtoappearinthemarketandwereconsideredsaferduetoagreateramountofdiversityoftheunderlyingpoolofassets.
TheincreasedproliferationofCLOswasaccompaniedbyanincreaseinthenumberofCLOmanagersandCLOfunds,whichhadwarehousingfacilitiestobuyloansandthensecuritizedthesaidloansthroughanSPVtootherinvestors.Mostofthetimes,theCLOissuerretainedaneconomicandcreditriskinthetransactionbysubscribingtoapartofthesecuritybutbetween2005and2007,severalsecuritieshadaloan-to-sellstructurewhereintherewasnoriskretentionbythepartymakingtheoriginalloantotheborrower.AnotherimportantpartyinvolvedduringthisperiodofincreasedCLOactivityweretheratingagencies.Theywereresponsibleforassigningratingstosyndicatedloanscomprisingthecollateralof
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CLOsandalsoratedthedifferenttranchesofthesecuritiespost-structuring.Theinstitutionalinvestors,suchaspensionfunds,whowereprincipalinvestorsinthesefixedincomesecuritiesduetotheirhighpayoutbasedtheirriskassessmentsontheratingagencies’recommendationsanddidlimitedduediligenceofthesameduetoincreaseddifficultiesoriginatingfromthecomplexstructuresofthesesecurities.
Inthefinancialmarketcrashof2007-08,securitiessuchasABSandCLOstookahugehit.ThesystemicfailurecausedduethefinancialcrisisprovedthesupposedlydiverseunderlyingassetsofCLOstobeveryhighlycorrelatedandsawthefailureofanumberofsuchsecurities.TheEuropeanCLOmarket,comparatively,didmuchbetterbutsufferedfromtheincreasedapprehensivenessofinvestorstoinvestinthesesecuritiesresultinginwidenedspreadsowingtoincreasedassumedrisks.TheannualCLOissuancefellfrom$88.9bnin2007to$0.8bnin2009.TheCLOmarkethassincerecoveredbuttheissuanceamountdroppedrecentlyinresponsetonewregulations.
CLOs,andsecuritizationingeneral,havesparkedaheateddebateamongtheinternationalfinancialmarketparticipants.RegulatorybodiesunderstandtheimportanceofsuchsecuritiesandhavebeentryingtocomeupwithnewerandbetterregulatoryandstructuralchangestotheCLOstobuildupinvestorconfidenceinthesesecurities,whichhadplummetedpostcrisis.ThisledtothedevelopmentofanewtypeofpostcrisisCLOstructurepopularlyknownasCLO2.0(pre-crisisCLOstructuresarenowpopularlycalledasCLO1.0).ThenewCLO2.0structuresaredeemedsaferbyregulatorsandinvestorsalikeandfeaturebettercreditprotectionfortheseniortrancheholdersandenforcetheissuerstoretainsomeamountofriskinthesecuritiesbeforesellingthemintothemarket.ThenewCLOsconformingwiththeprescribedCLO2.0structureshaveperformedbetterthantheirCLO1.0counterparts.ThishasenabledtheCLOmarkettobouncebacktoitspre-crisislevels.
In2014,Volcker’sRulewasputintoplaceintheUnitedStateswhichclassifiedthethenpopularCLO2.0structuresascoveredfundsandmakingitdifficultforbankingentitiestoinvestinthesame.Thebanksneededtoposttier1capitaltoholdeventheseniortranchesofthesesecuritiesresultinginlowerreturnsonequityforthem.CLOsseniortrancheshavehadbankingentitiesastheirmostprominentinvestors,therefore,Volcker’sRulewasahugesetbackfortheCLOindustryespeciallyintheUS.MassivelobbyingeffortshavebeenlaunchedbytheparticipantsoftheCLOindustrytopursuetheregulatorstoreevaluatetheclassificationofCLOsintocoveredfunds.Meanwhile,severalCLOmanagershavelaunchedVolcker’sRuleconformingCLOs,popularlyknownasCLO3.0,thatareexemptfrombeingclassifiedascoveredfundsmakingiteasierforbankingentitiestoinvest.Thatsaid,thesenewerstructuresprovidealowerreturnandtheinflexibilityoftheunderlyingportfoliohasmadethemriskiertherebyprovingtheregulationtobecounter-productive.
Therefore,theCLOmarketisever-changingandextremelydependentonnewregulations.TheCLOmanagershavebeenabletokeepupwiththeconstantregulatorychangessincethegreatfinancialcrisisof2008andhavelaunchednewerstructuresintheformofCLO2.0andCLO3.0.ThesenewCLOtypeshavehelpedrevivetheCLOmarketandattractbacktheinvestorstothisveryimportantassetclass.Thatsaid,acloseeyeneedstobekeptontheissuersandtheregulatorsasthenewerstructuresarearesultofthelobbyingtusslebetweenthesetwoprimarymarketparticipants.AbrieftimelineoftheCLOMarketisshowninExhibit1onnextpage.
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Exhibit1:CLOMarket:Timeline
FirstCDOstructurecreated
backedbyapoolofhighyielding,
speculativegradebonds
(CBOs)
CDOmana-gersstarted
issuingsecuritiesbackedbyapoolofonlyleveragedloanport-folio(CLOs)
CreditDownturn
HighyieldCBOmarketpracticallyended
CLOmarketsflourishandbecometheprimarybuyerofnewissueleveragedloans
CLOmarketstemporarilyshut-offinwakeof
creditcrisis
ResurgenceofCLOmarkets(CLO2.0)
RiskRetentionRegulationsgointo
effectintheUS
CDOmanagersstartedincludingleveragedloaninthecollateralpool
CLOissuancegainsmomentum
Lowrecoveriesinspeculativegradebonds
CLOmarketcontinuedtogainmomentum
NewpeakissuanceintheUSduring2014
On-goingchangesfromUSandEuropeanregulatorybodieswithrespecttorisk-retentionandCLOcomposition
Leveragedloanasacollateralbecamemoreappealingdueto:− Higherrecoveries
− Floatingrateswhichreducedinterestriskandobviatedtheneedforainterestrateswap
Fixedtofloatingasset-liabilitymis-matchincreases
Atonepoint,nearly50-60%ofnewloanissuancesweresecuritized
RiskretentionregulationsgointoeffectinEurope
CBOsbackedbyhighyieldspeculativegradebondsfalloutoffavor
Loanscontinuedtotradecloseto90centsdespitemarketrecession
1998 1990s Early2000 2002 2004-2007 2008-2009 2010-2015 2016
Source:ING,WellsFargo
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II. CLOOverview
ACollateralizedLoanObligation,orCLO,isaspecialpurposevehicle(SPV)thatacquiresaportfolioofdiversifiedsyndicatedleveragedloansthroughprivateplacementofrateddebtandequitysecurities,providinginvestorswithdifferentiatingriskandrewardprofiles(Collateralizedloanobligations:Accounting,tax,regulatory–Deloitte).Thespecial-purposevehicleisfinancedwithseveraltranchesofdebt(typicallya‘AAA’ratedtranche,a‘AA’tranche,a‘BBB’tranche,andamezzaninetranche)thathaverightstothecollateralandpaymentstream,indescendingorder.Inaddition,thereisanequitytranche,buttheequitytrancheusuallyisnotrated.
Aleveragedloanisacommercialfinancingprovidedbyagroupofcreditors.Suchloansgenerallyconsistofrevolvingcreditand/ortermloanfacilitiesandaretradedintheopenmarket.
CLOstructuresaredesignedtoprovide–
• creditenhancementthroughportfolioovercollateralization• prioritiesofpaymentstoensurehigher-ratedsecuritiesreceiveavailable• fundspriortosubordinatedsecurities• areinvestmentperiodinwhichavailableprincipalproceedsareused• toacquireadditionalportfolioassets• mechanismstoprotectinvestorsfromportfoliodeterioration
Exhibit2:TypicalCLOStructure
PortfolioofSyndicated
Loans
PrivatelyPlacedRatedSecurities
Equity/PreferenceShares
PRIOITYOFPAYMENTS
CLOSPV
Trustee
AssetManager
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A. HistoryoftheCLOMarket
CLOsareatypeofCDOthatuseleveragedloansinthecollateralpool.CDOswerefirstissuedinthelate1980s,andthefirstCLOswereissuedaboutadecadelater.
AlthoughafewbigbankbalancesheetCLOswereissuedinthelate1990s,themarketremainedrelativelysmallforaboutadecade.Intheearly2000s,institutionalinvestorsstartedseekingouthigheryieldingalternativeinvestmentsbecauseoftheincreasedinterestrateriskcausedbythehistoricallylowinterestratesatthetime.Thecorporatedebtdefaultrateswerestartingtodecreaseafterspikingin2002tojustover8%.Thefloatingratenature,seniorityandsecurityinthecapitalstructuremadeexposuretoleveragedloansappealing.CLOsseveredasaneasyandgoodoptionfordomesticandforeigninvestorsaliketogainexposuretotheUSleveragedloanmarketwithouthavingheadministrativeburdenofsettlingleveragedloansdirectly.
Exhibit3:GrowthoftheCLOMarket
Source:“AcaseforCLOs”June2013–ShenkmanInvestorNote,CLOi,Creditflux.com
13.3 14.6 9.1 12.1 16.2 25.5
52.6
97 88.9
13.50.8 4.1 12.3
53.8
89.7
140.1
110.4
17.9
0
50
100
150
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
CLOnewissuancebyyear
4255
3931 35
63 69
11098
173
10
28
69
0
20
40
60
80
100
120
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
NumberofUniqueManagersIssuingCLOs
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CLOissuancereachedapeakin2006when$97billionofdealswereboughttothemarket.Thestrongtrendcontinuedinto2007,withanother$89billionsubscribedbyinvestors.By2008,however,theweaknessinsub-primecollateralledtoaglobalCreditCrisis,whichdramaticallyaffectedinvestorinterestinallstructuredproducts,includingCLOs.The2008CLOissuancewasonly$13.5billion,c.14%of2006levels.TheCreditCrisisalsocausedthedefaultofleveragedloanstoincrease,andthedefaultratesofsuchloansreachedalmost10%in2009.
Bythelate2010,theeffectsoftheCreditCrisisstartedtodiminishanddefaultratesbegantodeclineagain.Investors,althoughcautiousofre-enteringthestructuredproductmarketasmanyoftheirCDOportfoliossufferedhugelosses,carriedoutincreaseddue-diligenceofsuchproductsandanalyzedtheirhistoricalperformancepreandduringtheCreditCrisis.CLOinvestorsquicklyrealizedthatusingleveragedloansascollateralandthestructureofaCLOofaCLOdifferedsubstantiallyfromothertypesofCDOs.Fearsofdouble-digitdefaultratesandmajor“EventsofDefault”intheCLOstructurewereoverblown.Moreover,vastmajorityofactivelymanagedcashflowarbitrageCLOs,onceperceivedtheriskiestofCLOtypes,remainedintactastheywerebackedbyarealpoolofleveragedloans.
Atyear-end2012,S&Pestimatedover$280billionin670transactionsofCLOswereoutstandingnetoftransactionsthathavebeencalled(S&P’sUSCLOTransactionCount&AssetsundermanagementbyCollateralManagerasofDec2012–RobertJRadziul).AsofMay2013,thereareapproximately$310billionofCLOsundermanagement.Moreover,CLOsrepresentthesinglelargesttypeofinvestorininstitutionalleveragedloanstoday,accountingforoverhalfofallprimaryinstitutionalleveragedloansthatcometomarket(AcaseforCLOsJune2013–ShenkmanInvestorNote).
Exhibit4:CLOPrimaryMarket
Source:“AcaseforCLOs”June2013–ShenkmanInvestorNote
60%
0%10%20%30%40%50%60%70%80%
CLOShareofPrimaryInstitutionalLeveragedLoans
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B. ConceptandImportanceofCLOs
TounderstandtherationalebehindthecreationofCLOs,wehavetodiscusstheimpactoftheseinstrumentsonthreekeypartiesinvolved:
i. Businesses/Corporatestakingoutoriginalloansfrombanksii. Banksgivingoutaforementionedloansandsellingthemtoinvestorsiii. Businesslenders/Investorsbuyingsuchstructuredproducts
i. Business/Corporatestakingoutoriginalloansfrombanks
Corporatesborrowmoneyfrombankstoconducttheirbusinessandtoinvestinprojects.Theseloansaregenerallycollateralizedandaremonitoredbythebanks.Thecostofborrowingthesaidmoneyforthecorporates,theinterestrate,dependsonthecreditworthinessofthebusinessesandthecollateralposted.Anotherimportantaspectofthecostofborrowingistheavailabilityoffundsforborrowing.CLOscreateanincreasedsupplyofinvestormoneyforthecorporatestoborrow.Moreover,theyhelpmakethepreviouslyilliquidcorporateloansmuchmoreliquidastheybecometradableonseveralexchanges.Thisincreasedliquidityandsupplyofinvestormoneyforthecorporatesdirectlyimpactsthecostofborrowingforthem.
ii. Banksgivingoutaforementionedloansandsellingthemtoinvestors
Bankslendtocorporatestocreatelongtermassetsfromtheirshorttermliabilitiesofbankdepositsandotherinstruments.Thedifferenceindurationsoftheseinstitutions’assetsandliabilitiesandthemanagementofthecredit/counterpartyriskshavebecomeamajorconcernforthebanks,moresointhecurrentageofincreasedregulatoryrequirementswhichinturnaffectsprofitabilitybyrequiringadditionalequity.Theseinstitutionshavelongexploreddifferentmechanismstomanagetheserisksonandoffbooks.CLOsenablebankstosellportionsoflargeportfoliosofcommercialloans(orinsomecases,theassociatedcreditrisks)directlyintointernationalfinancialmarkets,andofferbanksameansofachievingavarietyofgoalssuchasbutnotlimitedto–
• Transferofcreditrisktothirdparties• Offbalancesheetaccountingtreatment• Increasedliquidityofbilateraland/orsyndicatedloans• Accesstoefficientfundingsourceforlendingorotheractivities,generallywithalonger
durationthandeposits• Overallreductioninregulatorycapitalrequirementsandincreasedprofitability
BanksuseCLOstoimmediatelysellloanstoexternalinvestors/lenderssoastofacilitatethelendingofmoneytobusinessclientsandearnfeeswithlittletonorisktothemselves.
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iii. Businesslenders/investorsbuyingsuchstructuredproducts
CLOsprovideanexposuretothe,otherwiseinaccessible,leveragedandcorporateloanmarketstoretailinvestors.Theseinstrumentsprotecttheinvestorsfrominterestrateriskswhileprovidingthemanincreasedreturnthanotherformoffixedincomeproducts.Historicallyspeakingtheperformanceoftheunderlyingassetsforthesesecuritieshasbeenexceptionalwithdoubledigitdefaultratesseenonlyoncesincetheirinception–intheCreditCrisisof2008,eventhenthesesecuritiesoutperformedothersbyahugemargin.ThisincreasedperformanceofthesesecuritiesisachievedbycombiningmultipleloansbutnottransmittingtheloanpaymentsequallytotheCLOowners.Instead,theownersaredividedintodifferentclasses,called"tranches",witheachclassentitledtomoreoftheinterestpaymentsthanthenext,butwiththembeingaheadinlineinabsorbinganylossesamongsttheloangroupduetothefailureofthebusinessestorepay.Normallyaleveragedloanwouldhaveafixedinterestrate,butpotentiallyonlyacertainlenderwouldfeelthattheriskoflossisworththeinterestthatischarged.Bypoolingmultipleloansanddividingthemintotranches,ineffectmultipleloansarecreated,withrelativelysafeonesbeingpaidlowerinterestrates(designedtoappealtoconservativeinvestors),andhigherriskonesappealingtohigherriskinvestors(byofferingahigherinterestrate).
Therefore,thewholepointofissuingCLOsistolowerthecostofmoneytobusinessesbyincreasingthesupplyoflenders(attractingbothconservativeandrisktakinglenders).Theyalsoservetominimizetheriskprofilesofbanksandmakingtheirassetsmoreliquidinnature.
CLOswerecreatedbecausethesame"tranching"structurewasinventedandproventoworkforhomemortgagesintheearly1980s.Veryearlyon,poolsofresidentialhomemortgageswereturnedintodifferenttranchesofbondstoappealtovariousformsofinvestors.Corporationswithgoodcreditratingswerealreadyabletoborrowcheaplywithbonds,butthosethatcouldn'thadtoborrowfrombanksathighercosts.TheCLOcreatedameansbywhichcompanieswithweakercreditratingscouldborrowfrominstitutionsotherthanbanks,loweringtheoverallcostofmoneytothem.
Thus,theCLOservedallthreemajorpartiesinvolvedinthetransactionandbyreducingthecostofborrowing,helpedboosttheeconomyaswell.Problemsarosewhentheincreaseddemandofsuchsecuritiesbyinvestorsinmid2000sandtheabilityofbankstotransfercounterpartyriskstothirdpartiesledthemtoconductdecreasedduediligenceonthecreditworthinessoftheborrowers.Moreover,structuralcomplicationsincertainsecuritiesandincreasedleveragingimplodedduringtheCreditCrisis.
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C. MarketParticipantsandRoles
CLOindustryconsistsofavarietyofmarketparticipantscollaboratingtogethertomakeitsuccessful.Someoftheseparticipantsandtheirrespectiverolesaredetailedbelow.
i. ThePlacementAgent
ItisacommercialorinvestmentbankthathasbeenmandatedbytheissuerortheCLOmanagertostructureandplacetheCLO’sunderlyingsecuritiesandotherassets.Theplacementagentactsasaliaisonbetweenotherimportantpartiesandleadsthemarketing,pricingandclosing-dateactivities.Itmayormaynotalsoprovidethewarehousefacilitiesdependingonthecapitalrequirementsofthebankingentity.
ii. TheCollateralManager
ThecollateralmanagerortheassetmanagerisresponsiblefortheacquisitionandmanagementoftheunderlyingassetsoftheCLO.TheassetmanagerhastooperatewithintheconstraintsspecifiedbytheCLO’scollateraleligibilitycriteria,theconcentrationlimitsandovercollateralizationandotherteststhroughoutthelifeoftheCLO.
iii. TheTrustee
TheTrusteeisarepresentativeoftheinvestorsandperformsthenecessaryfiduciarydutiesforthem.He/sheisthecustodianoftheCLO’sassetsandcashflowsandtransferstheavailablefundsintoinvestoraccountsonduedatesinaccordancetothecashwaterfall,ifany.Thetrusteealsomonitorsthecollateralmanagers’managementofthefundassetsandensuresthatalltheeligibilitycriteriaarefulfilledwhentransferofthesaidassetsissanctionedbythecollateralmanager.ThetrusteehascertainvotingrightsduringthelifecycleoftheCLO.
iv. TheCollateralAdministrator
TheCollateralAdministratoractsonbehalfofthetrusteetoperformthebookkeepingoftheunderlyingassetsoftheCLO.Thecollateraladministratorisrequiredtoproducemonthlyandquarterlyreportsfortheinvestorsandthetrusteedetailingtheperformanceoftheunderlyingpoolofassetsanditscompliancetothepre-determinedeligibilitycriteria.
v. TheInvestors
Investors,asthenamesuggests,investsinthedifferenttranchesofaCLO.Eachinvestormighthaveadifferentreasontosubscribetoaparticulartranchebasedontheirriskaversionandthespreadsthey
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mightseek.Typically,theseniortrancheortheinvestmentgradenotesareheldbybankingentitiesandinstitutionalinvestorssuchascommercialbanks,insurancecompanies,pensionfunds,mutualfundsetc.Investorsinthemezzaninenotesandintheequitytranchearegenerallyspreadseekingrisktakingfundssuchashedgefunds,privateequityfundsetc.
vi. TheCreditRatingAgencies
TheCreditRatingAgencies(StandardandPoor’s,Moody’sandFitch)assignratingstotheunderlyingassetsofaCLO.Theseratingsarebasedonthecreditratingoftheobligorandhisorherabilitytopaybacktheirdebts.ThecreditratingagenciesalsoprovideratingtothedifferenttranchesofaCLOtransaction.Theseratingsarebasedoncertaintestsperformedbytheseagenciesanddifferentagenciesmighthavedifferentprocesstoratethesetransactions.Theratingagenciesalsomonitorthehealthofthesenotesduringthelifeofthetransactionandpublishassociatedupgradingordowngrading,ifany.Theseagenciesmonitorthefund’sabilitytorepayitsinvestorsinatimelymannerandtypicallyanyimpactontheunderlyingassetpoolalsoimpactsthecreditratingoftheCLOtransactions.
vii. TheAttorneys
Aswithallotherfinancialtransactions,attorneysareimportantplayersintheCLOindustry.Duetothelargenumberofmarketparticipantsinvolvedandtheimportanceofthestructureanditscompliance,attorneyshavetheirworkcutoutinatransaction.Differentpartiesemploydifferentcounselstorepresentthemandguardtheirinterestssuchasthecollateralmanagerandthetrustee.TheCLOfundalsoemploysitsowncounseltohelpitdraftthearticlesofincorporation,bylawsandmotions/minutesofaCLOfunds’boardofdirectors’meeting.
viii. TheAccountants
TheaccountantprovidestheaccountingservicesandpassingonsuchinformationtotheassociatedpartiesduringthelifeoftheCLO.
(Collateralizedloanobligations:Accounting,tax,regulatory–Deloitte)
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Exhibit5:PartiesinvolvedinaTypicalCLOTransaction
SPV Investors
TrusteeRatingAgenciesCollateralPool
(LeveragedLoans)
PortfolioManager
InvestmentBank
(Underwriter)
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D. KeyTermsofaCLO
i. Warehouse
Theprocessbywhichtheportfoliomanagerbeginstoaccumulateassets(buyloans)foracashCLO.Thisgenerallybeginsoncethecontractbetweenthemanagerandunderwriterissignedandcanlastfromsomeweekstoafewmonths.Thisisaperiodofhighriskfortheportfoliomanagersastheriskisallappropriatedbythem.Duetosubstantialregulatorycapitalrequirementduringthewarehousingperiod,manydealstodayaredonewithoutawarehouse.
ii. Ramp-UpPeriod
Bythetimeofpricingofthetransaction,theportfoliomanagermighthaveonlyacquired50-75%oftheproposedportfolio.Theramp-upoccursafterclosingwhereintheportfoliomanageracquirestherestoftheportfolio.
iii. EffectiveDate
ThedatebywhichthePMmustacquire100%oftheportfolio;CLOcompliancetests&covenantsapply.
iv. DiversityScore
Ascore,originallydevelopedbyMoody’s,whichmeasurestheindustryandissuerdiversificationoftheportfolio.Thescorecapturesindustry-relatedcorrelationbygroupingobligorsinto33industriesandassigninganumericalvaluetoeachindustrythatreflectsthenumberandrelativesizesofobligorswithinthatindustry.ThehighertheDiversityScore,themorediversetheportfolio.
v. WeightedAverageRatingFactor(WARF)
AweightedmeasurementofeveryassetintheportfolioofaCLOwhichservestoprovideauniformmethodofcomparingtheratingsofdifferentportfolios.AhigherWARFscoreisindicativeoflowerqualityofunderlyingassetsandthereforeahigherriskprofile.TheWARFratingscaleispresentedbelow:
Rating Factor Rating Factor Rating FactorAaa 1 Baa1 260 B1 2220Aa1 10 Baa2 360 B2 2720Aa2 20 Baa3 610 B3 3490Aa3 40 Ba1 940 Caa1 4770A1 70 Ba2 1350 Caa2 6500A2 120 Ba3 1766 Caa3 8070A3 180 Ca&lower 10000
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vi. PD,EADandELModelling
PDistheProbabilityofDefault,EADistheExposureatDefaultandEListheExpectedLoss.Thesethreetermsareinter-relatedbytheformulabelow:
EL=PDxEAD
Thesetermsarecalculatedand/ordeterminedfordifferenttranchesofaCLOtransactionthroughvariousstresstestsandfedintoaMonteCarlosimulationtodeterminethecorrespondingratingsofthesame.ThisisapopularratingsapproachusedbyS&PandFitch.Eachhavetheirownmodelsandmethodsofdeterminationofthekeytermsbutmostofthetimestheratingsgivenarequitesimilarinnature.
vii. Over-Collateralization(O/C)Test
Over-Collateralizationistheprocessofpostingmorecollateralthanisneededtoobtainorsecurefinancing.Thus,thetestmeasurestheratioofunderlyingcollateralversustheclass(tranche)inquestion(andallclassesaboveit).TheOver-Collateralization,orparvalue,testrequiresthatthecollateralportfolioexceedtheratedbondsbytheminimumtriggerlevelassetoutintheOfferingMemorandum.
Forinstance, ClassCO/C = TotalParofPerformingCollateral
ParofClassA+ClassB+ClassC
viii. InterestCoverage(I/C)Test
TheInterestCoverageRatioisequivalenttoADSCR,i.e.theratiotodetermineifthecollateralpoolgeneratesenoughcashinteresttoservicetheoutstandingdebtontheparticularclassofthesecurity.InterestCoverageRatioforeachclassiscalculatedsimilartotheO/Ctest,bydividingthetotalinterestgeneratedbythecollateralbytheinterestrequiredtopaytheexpensesandserviceeachclassofdebtaboveit.
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E. LifecycleofaCLO
AlthoughtherearemanytypesofCLOswithvaryingtypesoflifecycles,thetypicallifecycleofanaverageCLOcanbesummarizedinthefollowingfourmainstages:
i. MarketingandAssetAccumulation(0-6months)
Thisisthebeginningphasewhereintheportfoliomanagerandtheunderwriteragreeupontheunderlyingstructuralelementsandassumptionsofthetransaction.Investorappetiteisassessedbytalkingtoafewinitialinvestors.ThePortfolioManageralsobeginstotalktobanksandotherfinancialinstitutionstoidentifyandevenbuypotentialleveragedloansfortheunderlyingportfolio.TheCLOisthenpriced(settingafinalpriceforalltranches)andclosedaboutamonthlater,duringwhichtimethePortfolioManagerpurchasesmajorityoftheunderlyingloanassetsoftheportfolio.
Theearlymonthsofthetransactiongenerallyfollowsthetimelinedescribedbelowduringthisphaseofthetransaction:
• Onemonth: Documentationofthedeal,warehouse(ifused),OfferingMemorandum,andInvestmentManagementAgreement
• One/twomonths: Marketingofthedebtandequitytranches• Pricingdate: Oncefundingforalltrancheshasbeenarranged,apricingdateisestablishedto
determinethespread.Thespreadisdeterminedonthebasisoftheinvestorinterestandoverorundersubscriptionbythesaidinvestors.Typically,50%oftheunderlyingportfoliohasbeenpurchasedbythepricingdate.
• Closingdate: Closinggenerallyoccurs2-3weeksafterthepricingdate.Attheclosingdatetheentiredealfundsandliabilitiesstarttoaccrue.Approximately75%oftheunderlyingportfoliohasbeensuccessfullyacquiredbythePM.
• Effectivedate: ThePMneedstohaveacquired100%oftheportfoliobytheclosingdate.RatingAgenciesalsogivefinalratingstoalltranchesbythisdate.Theeffectivedateisgenerallynotmorethan4monthsaftertheclosingdate.
ii. Non–CallPeriod
EquityinvestorscanchoosetocallandclosetheCLOcompletelyatalaterstage.However,mostCLOhaveapre-determinednon-callperiodwhereintheequityinvestorscannotexercisetheirright.Thisisessentialasitassuresnon-equityinvestorsthattheCLOwillbearoundforatleastafewyears.
iii. ReinvestmentPeriod
Duetorepaymentofprincipalofcertainunderlyingloans,theremightbeacashsurplus.Therearetwoalternativesforthesame.ThePortfolioManagercaneitherpassdownthesefundstothetrancheholdersofthesecurityorreinvestthesameintonewleveragedloansthatmightfulfillpre-determined
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covenantsandchecks.There-investmentperiodisstatedduringthestructuringofthetransactionandthePortfolioManagercannotreinvestfundsoutsideofthisperiod.Recentvintagetransactionshavehadafour-yearreinvestmentperiod.
iv. Wind–Down
Asdiscussedbefore,attheendofrepaymentperiodallprincipalrepaymentsfromtheunderlyingpoolofassetsmustbepassedontotheCLOtrancheholdersstartingfromAAAtrancheholders.However,astheAAAsgetpaiddown,theaveragecostoffinancingthepoolgoesup,therefore,thiswind-downperiodusuallylastsabout18monthsbeforetheentiredealiscalled.
Exhibit6:LifecycleofaCLO(source:FinancialTimesArticle:TheGreatCLODeleveraging,May23,2012)
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F. DifferenttypesofCLOs
i. StaticversusManagedCLOs
Asthewordsuggests,StaticCLOshaveastaticpoolofassetsthatarenotactivelymanagedbytheCLOmanager.OncetheunderlyingassetsintheStaticCLOsarepaidoff,theamountsarepassedontothepaperholdersoftheCLOandthepooloftheunderlyingassetssubsequentlydecreases.
ManagedCLOsontheotherhandhavetheirunderlyingassetsactivelymanagedbytheCLOmanagers.Uponthereimbursementoramortizationofafewunderlyingassetsothersimilarassetsthatadheretopredefinedrulesandconditionsareboughttoreplacethem.ThelevelofmanagementoftheunderlyingmayalsodifferfromoneCLOstructuretoanother.SomeCLOsonlypermitreplacementoftheunderlyingloansonlyiftheexistingassetsarefullyrepaidwhereasothersallowtheCLOmanagertoreplacenon-performingassetsintheunderlyingportfolio.
ThemanagedCLOshavethereforeadynamiccollateralpoolandthemakeupofthepoolmaydifferovertime.ThenewregulationshaverestrictedtheactivemanagementoftheunderlyingassetpoolsbytheCLOmanagertomakethemlessriskyandtoprovideinvestorsaconstantandpre-determinedassociatedriskswiththeportfolio.
ii. BalanceSheetversusArbitrageCLOs
BalanceSheetCLOsarethepurestformofCLOswhichwereinitiallycreatedtoreducethebank’sregulatorycapitalrisksbysecuritizingthecertainassetsandremovingthem,andtheassociatedrisks,fromthebank’sbalancesheet.InnewerCLOstructures,thisishardertoachieveastheissuerisrequiredtoretaincertainriskintheportfolio.Nevertheless,itisapopularwayforbankstomanagetheirregulatoryriskcapitalrequirements.
ArbitrageCLOsaremainlycreatedtotakeadvantageoftheadditionalincomesgeneratedbythepoolofassetsovertheinterestpaidonthedifferentnotesoftheCLO.ThisisquitepopularwhentheinvestorappetiteforCLOsoralternativeinvestmentsishighandthereforethecostoffinancingtheunderlyingpoolofloansisreduced.
iii. CashFlowversusMarketValueCLOs
CashFlowCLOsaresecuritieswheretheunderlyingpoolofassetsisassessedontheparvalue.Sincetheparvalueisnotdependentonmarketmovements,thevalueoftheunderlyingcollateralremainsfairlyconstantunlesstherearesomeredemptions.
MarketValueCLOsontheotherhandaresecuritieswhoseunderlyingpoolofcollaterizedloansareassessedatthemarketvalueofsuchassets.Thetransactionisthussubjectedtomark-to-marketandthepricevolatilitydependsonthemarketvolatility.
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AlthoughtheMarketValueCLOsareabletobetterassessthevalueofthesecuritiesifliquidationiscarriedout,thecorrectassessmentofthemarketvalueoftheunderlyingisoftendifficultasmostofthecollateralpostedisfairlyilliquidinnature.
iv. CashversusSyntheticCLOs
CashCLOsbuyrealassets(actualleveragedloansasunderlyingcollateral).TheaforementionedloansareremovedfromthebalancesheetofthesellerandaretransferredtothebalancesheetoftheSPVorthebuyer.
InaSyntheticCLOstructure,theoriginalowneroftheloansbuysthecreditprotectionfromtheSPVandpaysapredeterminedfeestotheparty.Incaseofdefault,theSPVneedstoreimbursetheowneroftheloansoftheamountowed.Inthistransaction,theloansarestillheldbytheoriginalownerandarenottransferred,onlythecreditriskistransferredtotheinvestorsofthetransaction.Thecounterpartyriskoftheinvestorsdefaultingincaseofdefaultoforiginalloansismitigatedthroughtheestablishmentofareserveorcashholdingaccountbythecustodianorthetrustee.
HistoricallymostCLOswerecashtransactionandnoorveryfewsyntheticCLOshavebeenprintedsincetheCreditCrisis.
v. AmericanversusEuropeanCLOs
LookingbackattheperformanceofCLOsduringthefinancialcrisisperiodof2008,theEuropeanCLOsperformedmuchbetterthantheirAmericancounterparts.Thisbetterperformancehasbeenattributedtotheperformanceoftheunderlyingcollateral.TheAmericanCLOshadagreaterpercentageofnonsecuredandsecondlienloansintheirportfolio.Theyalsohadahigherpercentageofcorporatebondsandothersecurities.EuropeanCLOsgenerallyhavebetterunderlyingcollateralastheiritisprimarilycomposedofseniorsecuredcorporateloanswithamuchhigherdiversityscorethanintheUS.Structurallytherewasn’tmuchdifferencebetweenthetwosecuritiesbutthedifferentperformancewasduetothedifferentialcollateralselectionandperformance.
NearlyalloutstandingCLOsandnewdealscomingtomarketcurrentlyaremanaged,cashflow,arbitragedeals.
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G. RiskFactorsassociatedwithCLOs
CLOshaveavarietyofassociatedriskfactorwhichcanbebroadlycategorizedinto:
i. StructuralRisksii. CollateralRisksiii. MacroeconomicandPoliticalRisks
ItisimportanttonotethateachtrancheofaCLOtransactionmaybesubjectedtodifferentriskfactorsinvaryingdegrees.
i. StructuralRisks
ThestructuralrisksarespecificallyapplicabletostructuredproductssuchasCLOs.Theyincluderisksassociatedtothestructuringofthesecurity,whichincludesleveragetests,non-callperiod,compliancetestsetc.Thereliabilityandeffectivenessofthethirdpartiesinvolvedinsuchatransaction,namelytrustee,custodian,lawyers,accountantsandratingagencies,alsoconstituteanimportantpartoftherisk.
TherelativeilliquidityofaCLOtransactionalsocontributestothisrisk.AsmanyCLOinvestorsconsidertheseinvestmentstobebuy-and-holdtypes,themarketsforthesesecuritiesisrelativelythinnerthanotherfinancialproducts.Inrecenttimes,asmallsecondarymarketforCLOtransactionshasappearedbutthemarketisstillinitsnascentstages.
AlthoughtheseStructuralRisksconstitutethemostimportantandprominentrisksofaCLO,theyarethemostpredictableandaccountableonesaswell.CLOstructuresaregovernedbypredeterminedrulesandthespecificdocumentsrelatedtothemaremadeavailabletotheinvestorspriortothepurchase.Inmanycases,earlyinvestorsareaskedtocontributetowardsdeterminingthestructureofaCLOtransaction.
ii. CollateralRisks
TheyarethecounterpartyrisksassociatedwithinvestingintheCLOtransactions.Thiscategoryofriskarisesfrominvestinginsecuritiesbackedbysub-investmentgradeand/orleveragedloans.Theyaredrivenbycreditspecificeventssuchasdefault,recovery,downgrade,speedofprepaymentsetc.CollateralriskscanalsoarisefromthecreditriskoftheCLOmanagerandhisabilitytoavoidormanagedefaultsandmaintainhighpaymentsfromtheunderlyingpooltosatisfythepaymentstotheinvestorsoftheCLOpaper.
CollateralrisksobviouslyvaryindifferentdegreesfordifferenttranchesoftheCLO.Forinstance,equitytranche,becauseitislocatedatthebottomofthecashwaterfall,isimmediatelyaffectedbyadefaultwhereastheAAAtrancheisbarelyaffected.LikeStructuralRisks,CollateralRiskscanbeanticipatedandareusuallymodelledinwhenpricingoftranchesoccurs.
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iii. MacroeconomicandPoliticalRisks
CLOtransactionsarefinancialinstrumentsandlikeotherfinancialinstrumentsareaffectedbythelargerMacroeconomicandPoliticaleventsthatcanimpactthepricingandliquidityofsuchinstruments.Theserisksgenerallyincludebroadriskssuchasfederalspendingcuts,theperformanceoftheeconomy,andmonetarypolicychanges.TheserisksarefairlyminisculeforCLOtransactionsespeciallyforCLOsmodelledaftercashflowswhereinthecollateralisnotmarkedtomarket.Butstilltheserisksareunpredictableandhardtomodelinthetransaction.
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III. CLO1.0vsCLO2.0
Duringthegreatfinancialcrisisof2008,theCollateralizedDebtObligationsincludingsecuritiessuchasMortgageBackedSecuritiesandCollateralizedLoanObligationsunderperformedandinvestors(mainlyinstitutionalinvestorssuchaspensionfundsandsovereignfundsetc.)whosubscribedtotoptranchesoftheseproductssufferedbiglosses.Thisledtothedevelopmentofanewstructurewhichwasdeemedsaferfortheinvestorsprovidingbetterriskassessmentandimprovedrisk-returnprofiles.Thereby,CLOsstructuredbeforethefinancialcrisishavebeentermedasCLO1.0andtheCLOsstructuredafter2008andcomplyingwiththesenewstructuresarelabelledCLO2.0.
Exhibit6belowshowstheUSCLOliabilitiesoutstandingforCLO1.0,CLO2.0&CLO3.0.ThegraphaptlyindicatestheincreasingproportionofnewCLOstructuredliabilitiesowingtoincreasedissuanceofCLO2.0andCLO3.0.
Exhibit7:USCLOliabilitiesoutstandingfrom2004through2014(source:WellsFargoSecurities)
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A. Overview
TheCLOmarkethadcompletelydriedupforacoupleofyearsafterthefinancialcrisis.Sincetheintroductionofthenewstructuralfeatureswhichgavebettercreditprotectiontotheseniortrancheholdersoftheaforementionedsecurities,therewasaresurgenceintheCLOmarketespeciallyintheUSCLOmarket.Exhibit7belowindicatesthenewCLOissuancesinUSDandEURinthepostcrisisperiod.Exhibit8showsthemostrecentpricedCLOsandtheirsizes.
Exhibit8:CLOnewissuancebyyear(source:CLO-i)
Exhibit9:RecentCLOissuanceasof11May2016(source:CLO-i)
ThisresurgenceoftheCLOmarketismainlyattributedtotheseveralchangesintheCLOstructurespostthefinancialcrisis.Someoftheseimportantstructuralchangesarediscussedinmoredetailbelow.
0 20 40 60 80 100 120 140
2010
2011
2012
2013
2014
2015
2016
EUR(bn) USD(bn)
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B. MajorDifferencesbetweenCLO1.0andCLO2.0
Asdiscussedbefore,theCLO2.0withtheirnewstructuresprovideabetterprotectiontotheinvestorsintheseniortranches.SomeoftheseimportantdistinguishingcharacteristicsinthenewvintageCLO2.0andCLO3.0structuresarelistedbelow.
i. OvercollateralizationandCreditEnhancementofSeniorTranches
Oneofthewaystoachievebetterprotectionforinvestorsisthroughenhancedsubordination,thatistheseniororAAAtranchesizesasapercentageofthecollateralaremuchsmallerthanbefore.ThisimpliesthattheCLOsecuritiescansustaingreaternumberofdefaultsoftheunderlyingcollateralbeforeaffectingtheseniortrancheswhencomparedtoequivalentpre-crisisCLOs.
Exhibit9showsthemediancapitalstructureofCLOsissuedin2006andinthe2012-2014period.TheAAAtrancheoftheCLO2.0sisnearly11%lessthanthatoftheirpre-crisiscounterpartsoralternatively,thepost-crisisCLOstructures’AAAtrancheshavec.11%moresubordinationthantheCLO1.0structures.Therehasbeenaneffectiveonetrancheshiftinthestructure–AATrancheofCLO2.0structurewouldhavebeentheAAAtrancheofCLO1.0structuresandsoon.Thisprovidesagreateramountofprotectiontonotjustthetoptranchesbuttoallsubsequenttranches.TheincreasedequitysliceandwidenedBBtranchecompensatesforthisshift.
Exhibit10:Pre-Crisisvs.Post-CrisisCapitalStructures
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Anotherwaytointerpretationofthistrancheshiftinthenewstructureisobtainedthroughstudyingtheenhancedcreditsupportfortheinvestorsofeachtrancheandbyanalyzingtheirrespectivecreditsupports.Exhibit10indicatesthecreditsupportsforeachtrancheandclearlyshowsthatalowertrancheinthenewpost-crisisstructureenjoysthesamecreditenhancementasahighertranchefromthepre-crisisstructureCLOs.
Exhibit11:AssetCreditSupportSubordination(%ofCreditSupportBasedonCLOAssets)
2006Vintage 2012-2014VintagesAAA 25.0% 36.1%AA 18.6% 24.8%A 12.8% 17.5%BBB 8.1% 12.5%BB 5.6% 8.1%
Source:S&P,Moody’s,Creditflux,Intex,WellsFargoSecurities
ii. RestrictionsonEligibleCollateral
Anothernoteworthychangeinthepost-crisisCLOproductsistheirchoiceofunderlyingcollateral.PostthefinancialcrisisalotofemphasishasbeenlaidonprovidingguidelinestotheCLOmanagerstodefinetheeligiblecollateralforCLOsecurities.Thepercentageofseniorsecuredleveragedloansintheunderlyingcollateralhasincreasedsincethefinancialcrisiswhereasinvestmentsinhighyieldbondsandseniortranchesofothersecuritieshasreducedsubstantially.ThemorerecentVolckerizedCLO3.0structuresdonotpermitanyinclusionofHYBondsorresecuritizationofsecurities.
Anotherimportantrestrictionthathasbeenputintoplacehasbeenregardingthegeography.AnincreasingnumberofCLOsecuritieshaveunderlyingcollateralspecifictotheplaceofissueofthesecurities,forinstance,theUSCLOshavealmostallofitsunderlyingleveragedloansascollateralwrittenintheUS.ThisisabigshiftfromtheCLOcollateralofprecrisisCLO1.0.
Restrictionoftheeligiblecollateralwasputinplacetohelpsafeguardtheinvestors’interestinthesesecuritiesbutonthecontrarythispracticehasledtotheCLOmanagersholdingontosomeriskiersyndicatedloanstoremainfullyinvestedduetotheunavailabilityofcollateralconformingtotheeligibilitycriteriaputinplace.TherehasbeengreaterneednowthanevertomonitortheunderlyingcollateralanditsriskinessonanongoingbasisandhascreatedanagentproblemwhereintheinvestorinterestandtheCLOmanagerinterestisnotaligned.ThisdiscrepancyhasbeenrecognizedandhasbeentriedtobemitigatedwhendiscussingtheCLO3.0structuresbutwithlimitedsuccess.
Exhibit11belowshowcasesthechangeintheunderlyingcollateralforpreandpostcrisisCLOtransactions.Asdiscussed,theshiftinunderlyingcollateralfrombondsandsecuritiestosyndicatedand/orleveragedloanscanbeclearlyseen.In2014and2015,thatisaftertheintroductionofCLO3.0structures,acompletedisappearanceofbondsandtheresecuritizationpracticeisglaringlyclear.
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Exhibit12:AverageCompositionofCLOCollateralbyVintage
iii. ReinvestmentPeriods
AsdiscussedbeforewhendescribingthelifecycleofaCLOtransaction,almostallCLOshaveaninitialramp-upperiodwhereapoolofunderlyingcollateralisdevelopedbyselectingandpurchasingofleveragedloans,bondsandsecuritiesbythecollateralmanager.DuringthesubsequentlifeoftheCLO,thereisamortizationofnotesoccurwhereinproceedsfromthematurityofunderlyingassetsispassedontothenote-holders.InstaticCLOs,ramp-upperiodandamortizationperiodsaretheonlytwoperiods.However,inmorecommonactivelymanagedCLOs,thereisalsoareinvestmentperiodduringwhichtheCLOmanagerisallowedtoselectandbuyothercollateraltoreplacematuredsecuritiesintheunderlyingportfolioofassets.Thisreinvestmentisusuallydefinedbeforehandandeligibilitycriteriaforthenewsecuritiesisputinplace.Howeveroncethenewsecuritiessatisfytheeligibilitycriteria,thereinvestmentsareuptotheCLOmanager’sdiscretion.TheCLOscouldbelightlymanagedwhereonlysomenonperformingassetsarereplacedorcouldbeactivelymanagedwhereCLOmanagerscanreplacecollateralwithmorefrequencytosearchforbetterriskrewardprofiles.
Longerreinvestmentperiodsareusuallyperceivedasriskierfortheinvestorsasitexposesthemtointerestrateriskduetotheunpredictabilityofdurationandweightedaverageinterestrateoftheunderlyingcollateral.InvestorsalsotakeonthepoorinvestmentdecisionriskoftheCLOmanagerforalongerperiod.Thatsaid,reinvestmentperiodshavebeendeemednecessarybytheinvestorsasitgivesanoptiontotheCLOmanagerstoweedoutnonperformingassetsandgivesthemflexibilityinchoosingtheassetsandincreasetheriskrewardprofileofthecollateralpool.
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AsExhibit12indicates,thereinvestmentperiodsinpre-crisisCLO1.0usedtobec.6-7yearsascomparedtoonly3-4yearsforpostcrisisCLO2.0.Therefore,investorsinCLO2.0andCLO3.0areexposedtolesserreinvestmentriskascomparedtoduringthepre-crisisperiod.
iv. Non-CallPeriods
AlmostallCLOshaveabuiltinprovisionthatallowstheequitytrancheinvestorstocallbacktheoutstandingnotesatalaterdatebeforetheactualmaturityoftheCLOnotes.Thisisdonemainlywhenmarketvolatilityandconditionsmakeitnon-worthwhilefortheequitytrancheholderstotakeonthegivenamountofriskfortheprojectedIRRs.Seniortrancheholdersarealsosatisfiedwiththisprovisionastheyareabletoclaimtheirnoteprincipalsatfacevalueorapre-agreedvaluetherebymitigatinganyrisk.TheCLOmanagerisusuallytheunhappiestpersonduetothisprovisionashelosesprecioustimeandresourceshehasspenttobuildupacollateralpooltoonlyseeitbeingusedtopaybacknotesthathavebeencalledearly.
Thenon-callperiodisthetimeperiodaftertheissuanceoftheCLOswhereintheequitytrancheholderscannotcallbackthenotesdistributedtothehighertrancheholdersirrespectiveofhowbadtheconditionsmightbecome.Usuallyalongernon-callperiodisdetrimentaltothenoteandequityholdersasitremovestheoptionalityandexposesthemtogreatermarketrisk.Theseniortrancheholdersmightgetexposedtogreatermarketrisktooasnon-liquidationoftheCLOduetothenon-callperiodmightwipeouttheequitytranchecompletelyandstartaffectingtheirtranchesaswell.
Exhibit12clearlyindicatesthattheCLO1.0hadalongernon-callperiodofc.5yearsatthetimeofissuancewhereastheCLO2.0haveamuchshorter2-3yearsofnon-callperiod.Infact,thenewerVolckerizedCLO3.0haveanoncallperiodofonly1.5years.Therefore,thenewerpostcrisisCLOstructureshaveashorternon-callperiodtherebyprovidingagreateramountofsecuritytothenote-holdersoftheCLOs.
v. RestrictionsonCLONoteCancellationstoImproveO/C
TheO/CtestsorOver-CollateralizationtestsareoneofthemostimportanttriggersindetermininganEventofDefaultoranEoD.Theseniortrancheholders’interestsarethoughttobesafeguardedaslongastheO/Ctestispassedthatistheparvalueofthecollateralpostedasunderlyingdividedbytheparvalueofthenotesoutstandingisaboveapredeterminednumber,often105%.Incaseofsevermarketconditionsand/orwrite-downssuchasthedepreciationofthefacevaluesofloansduringthefinancialcrisis,theO/CtestmayfailandmighttriggertheEoDresultingintheliquidationofunderlyingcollateralbytheTrusteeandpassingonthefundstothenote-holders.
TheO/Ctestwassupposedtohelpprotectthenote-holdersandtohelpmaintainaminimumamountofunderlyingcollateralaboveandbeyondtheoutstandingliabilitiesornotes.Butduringthewakeofthefinancialcrisis,someCLOmanagersboughtbacksomeofthejuniorand/ormezzaninetranchesoftheCLOsathugediscountstoreducetheiroutstandingliabilitiesandtherebypassingtheO/Ctests.Thejuniorandmezzaninetrancheholderswerehappytoselltheirnotesatadiscountbecausetheywerehappytoreceivesomethingasopposedtotheprospectivenothingduetotheadversemarket
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conditions.TheseniortrancheholdersnolongerexperiencetheEventofDefaultastheCLOspasstheO/Ctestsandtherebypreventingthetrusteefromliquidatingtheassetstopaydowntheliabilities.Buttheseniortrancheholdersareinfactinadirersituationafterthisasapartofthecollateralisusedtobuybackthemezzanineandjuniortranchesandtheybearthewholeriskofthedefaultofthecollateralandthereforethenotes.
Inthenewerstructurespostcrisis,thisuseofexistingcollateraltobuybacknotestosatisfytheO/Ctestshasbeenbanned.ThetrusteecansellsomecollateraltopaydowntheseniortrancheholderstosatisfytheO/Ctestsbutcannotpaythejuniorormezzaninenoteholdersbeforepayingtheseniortrancheholders.Effectively,thecashwaterfallismorestringentlyenforcedintheCLO2.0andCLO3.0.ThesamehasbeenindicatedclearlyintheExhibit12.
vi. Trancherefinancing
Duetodecreasedmarketappetiteandlowliquidity,theleveragedloansmarketcompletelydriedupafterthefinancialcrisis.Thisinturnledtoincreaseddifficultytorefinancetheleveragedloansthatwereduetoexpireimmediatelyafterthefinancialcrisisthatisfrom2009to2012.Manyborrowerstriedtorefinancetheirliabilitiesthroughthehighyieldbondmarketwithlittletonosuccess.ThisledtothedevelopmentofAmend&Extendtransaction.Amend&ExtendorA&Etransactionsenabledborrowerstorefinancepartoftheirexistingdebtthroughnegotiatingandgainingtheapprovalofatleast50%ofthelenderstoextendthepayoutdateoftheirliabilities.Theseliabilitiesarerestructuredtoprovideahigherinterestrateandafeetoretaintheexistingcreditarrangementswithalongermaturity.Thesearrangementsareextremelyhelpfultobothborrowersandlendersalikeastheysavebothcounterpartiesconsiderableamountofmoney,effortandtime.
ThesearrangementscreatedhugecomplicationsfortheCLO1.0structures.Theserenegotiatingofliabilitiestogetalongermaturityledtotheweightedaveragedurationoftheunderlyingcollateralpooltobemuchlongerthanitwaspreviouslyanticipated.Thisinturncreatedamismatchinthepaymenttermsofthenote-holdersandthepayoutofthecollateralpool.SincetheA&EtransactionscreatedalotofcontroversyaroundtheirtreatmentbytheCLOmanagers,thenewerCLOstructurespostcrisishaveexplicitrulestoeffectivelytacklethesetypeofextendedloanswhichwaslackinginthepre-crisisCLO1.0.
vii. PricingandExcessSpreads
WehavetalkedabouthowtheCLO2.0andCLO3.0structuredpostthefinancialcrisisissaferandcarrylesserrisks.Thisdoesn’ttranslatetothepricingofthesenotes.TheexcessspreadovertheLIBORforCLO2.0ismuchmorethanthecorrespondingexcessspreadsforCLO1.0.AsExhibit12indicates,theweightedaveragecostoffundsforCLO1.0was120to155basispointsbelowthatoftheCLO2.0.
Thisismainlyduetobuildbackinvestors’appetiteintheCLOsecuritiesandthehighcouponsaregiventonote-holderstopromotetheirtrustintheseinstruments.Therefore,goingforwardthenewerCLOstructureshavebeenmadesaferforinvestorsandareofferingthembetterreturnsthanthepre-crisisCLO1.0.Thatsaid,intherecentyears,particularlyinthelowinterestrateenvironments,theincreased
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availabilityofcheaperloanstoindividualsandinstitutionsalikehavemadethecollateralpoolofsuchCLOsecuritiesmuchcheaper.ThiscoupledwiththeincreaseddemandofCLOtranchesamonginvestors,mainlyinstitutionalinvestors,haveledtotighterspreadsofnewerCLOtransactions.
ThedemandforhighercouponsintheCLO2.0and3.0structurestoensureinvestorsagainstpossibledefaultsbyreducingthedurationofthesecuritieshasledtoalowerexcessspreadsinthesetransactionsdespiteahigherweightedaveragecostoffunds.ThesameisillustratedintheExhibit12below.
Exhibit13:StructuralFeaturesandInvestorProtectionsinPreandPostCrisisCLOTransactions
CLO1.0 CLO2.0 CLO3.0
a) CreditSupportforSeniorTranche(s) Low High Higher
b) CollateralRestrictionsa. CLOBucketb. HYBondBucket
5-10%5-10%
0%
5-10%
0%0%
c) ReinvestmentPeriod 5-7Years 3-4Years 3-4Years
d) Non-CallPeriod 3-5Years 2Years 1.5Years
e) NoteCancellationstoImproveO/C n/a No No
f) TrancheRefinancing No AfterNon-CallPeriod
AfterNon-CallPeriod
g) PricingandExcessSpreadsa. ExcessSpreadsb. Couponsc. Weightedaveragecostoffunds
HigherLower
50-70bps
LowerHigher
170-225bps
LowerHigher
170-225bpsSource:D.PrestonandJ.McNeilis,“TheInvestor'sGuidetoCLOSeniorNotes,”WellsFargoSecurities(April15,2015)
InadditiontothestructuraltweakslistedaboveintherecentCLOtransactions,whichensuredmorestabilityandsafetyofthesesecuritiesandbuildinginvestors’confidenceandappetiteforsuchsecurities,someotherimportantstructuralelementswereintroducedthatdistinguishedCLO2.0andCLO3.0fromtheirpre-crisiscounterparts.Suchdifferencesareenumeratedinmoredetailinthenextfewpages.
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C. RePricings
AnewfeaturethathasbeenintroducedinmanyrecentCLO2.0structuresistheRe-Pricingclause.AnumberofCLO2.0transactionsareapproachingtheendoftheirnon-callperiodsandinthelowinterestrateenvironmentoftoday,thereisanincreaseddemandbyequityholdersandCLOmanagerstorefinancetheCLOsecuritiesasthespreadsoftheunderlyingloancollateralhastightened.There-pricingtoolisamoreefficientwaytoachievethisrefinancingandismorecostandtimeeffective.
Re-Pricing,asthenameindicates,isthereadjustmentofthespreadsoftheCLOtranchesattheendofthenon-callperiodstocorrectlytranslatethetighterspreadsoftheunderlyingcollateral.There-pricingclauseisoftentriggeredbytheequitytrancheholdersortheCLOmanagersandisofferedasanalternativetotherefinancingoftheCLOsecurities.Inarefinancingdeal,oftennewtermsarediscussedandagreedwithbetweentheCLOManagerandthetrancheholdersortheinvestorsofaparticulartranchegettingrefinanced.Toprotecttheinterestoftheinvestorsoftranchesnotpartoftherefinancingdeal,thenewrefinancingcontracthastoabidebythefollowingfewrulesandconditions:
i. Thespreadontherefinancingdebtcannotexceedthatoftherefinancednotesii. Limitedrecourseandnon-petitionprovisionsshouldbeincludedintherefinancingagreementsiii. Thenewlyagreedpaymentstructureshouldabidebytheexistingwaterfallstructureofthe
transactioniv. Therefinancingholdersshouldn’tgetanypreferentialtreatmentwhendecidingtheirvoting
rights.Infact,thevotingrightsoftherefinancingholdersshouldbethesameasthatoftheexistingholders
v. Anapprovalfromtheratingagenciesisrequiredstatingthatnodowngradingoftheexistingtrancheswilloccurasaresultoftherefinancing
vi. Ataxoptionneedstobeprovidedforexistingandnewdebt
RefinancingonlyresultsinthereadjustmentofthespreadovertheLIBORorequivalentbenchmarkandcansaveconsiderableamountandmoneythatwouldhavebeenotherwisespentinfindingandmarketingthenewofferingtoprospectivenote-holders,gettingtaxcounselandgettingthevarioustranchesratedbytheratingagencies.Ifstructuredproperly,there-pricedtransactionsarenottermedasanewofferingtherebylimitingtherequirementofpreparationanddisseminationofnewofferingmaterials.
UnderrecentCLOstructures,there-pricingclauseistriggeredbythemajorityequityholders.OftentheAAAtrancheisexemptfromanyre-pricingsbutitispossibletore-pricethesetranchesaswellifagreedbeforehand.Anoticeforre-pricingisprovidedatleastamonthortwoinadvancesothatthenote-holderscantakeadecisiononwhethertheywouldprefertheirnotestobere-pricedortobecalledback.Suchnon-consentingnote-holderswouldbepaidbacktheirprincipalinfullalongwithanyaccruedinterestandthenoteswouldbesoldtoconsentingnote-holdersorintothemarketbyare-pricingmarketintermediary.Ratingagenciesdonotneedtoprovideconfirmationsinthesere-pricingscenariosbuttheyarestillnotifiedifandwhensuchaclauseistriggeredbytheequityholdersofthesecurities.
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Re-PricingclauseshaveobviousbenefitstotheequitytrancheholdersandCLOmanagersastheyprovideacheaperandfasterwaytorefinancetheCLOissuers’notes.Thedebt-holdersmightalsopreferthetransactionstore-pricedasitisafasterandcheaperalternativetoredeployingtheircapitalinnewtransactionswithincreasedduediligencerequirements.Moreover,intoday’slowinterestrateenvironmenttheredemptionofthenotesoncethenon-callperiodisoverisinevitable.Thatsaid,somedebtholdersareskepticalofincreasedrisksofre-pricingofsecuritiesupontheearliestsignsofdecreasedcollateralspreads.Therefore,anumberofguidelinesorconditionshavebeensetinplaceaccompanyingthere-pricingclauseinthelatestCLOindentures:
A. ProofneedstobeprovidedbytheCLOManagerthattheunderlyingcollateralspreadshavetightenedbymorethanacertainpredefinedthresholdbeforethetriggeringofthere-pricing
B. Apre-agreedone-timepaymentneedstobegiventonote-holdersofaparticulartrancheofsecurityifthere-pricingofthesaidtrancheoccurs.ThissumcanbecalculatedtobebelowthecostthatmighthavebeenotherwiseincurredbytheCLOManagertocallbackthenotesandrefinancethetransaction
C. Apre-definedminimumpercentageofcurrentnote-holdersneedtoagreetore-pricingbeforetheclausecanbeenforcedbytheequitytrancheholders
CLOmanagersandequityholdersarguethatsincethere-pricingsoccurafterthenon-callperiodhasended,theaboverestrictionsshouldn’tnecessarilyapply.
Anothernoteworthypointisthetaxsavingsthatcanbeincurredbydebt-holdersiftheyagreetore-pricingstherebyreinforcingtheargumenttore-priceinsteadofrefinancingtransactions.
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D. Cov-LiteLoans
Cov-Liteloans,orcovenantlightloans,areloansissuedwithlittleornomaintenancecovenants.Cov-Liteloansaregenerallydeemedtoberiskierthantheircounterparts–leveragedloanswithestablishedandstrongmaintenancecovenants.Thisestablishedfacthas,however,recentlybeendebateduponheavilywithbothpartieslistingargumentsintheirfavor.Peoplewhoagreewiththeestablishedpropositionthatcov-liteloansareindeedriskiersaythatsincethereisalackofmaintenancecovenantsintheissuedloan,thereislittlecontrolofthedebtorontheloanprovidedandheorshestandstolosemoreifnotallhisorherinitialloanamount.Peopleontheothersidecounterthatsincecov-liteloansareprovidedbybankstopeoplewithgoodcreditscoresandhistoryasopposedtoloanswithstrongmaintenancecovenants,theyarelesslikelytodefaultintimesofstress.Moreover,theysay,creditscoresandhistoryoftheborrowershouldbeusedtoassesstheriskofdefaultoftheloanthanthenumberofcovenantsassociatedwithit.Indeed,empiricaldataindicatesthatcov-liteloansinthepasthaveperformedbetterthantheircounterpartsandtheprincipalrecoveryrateofdefaultedloansisatparwiththemaswell.Procov-liteloansgroupalsomaketheargumentthattheincreasedflexibilityprovidedbythelackofcovenantsallowtheborrowertomaneuvererthemselvesintimesofdistresstherebymakingthemselvesabletopaybacktheirborrowingswithgreatereasethaninthecasewhenthemaintenancecovenantsforcetheborrowers’handsandhisorherbusinessstartsgettingdictatedbylender.
Duringthepre-crisisperiod,thepercentageofcov-liteleveragedloansinthetotalleveragedloanspoolwasc.15-20%.Thiswasmainlybecauseoftheincreaseddemandforsuchloansbycorporatesandinstitutionsallowingbankstodictatetheirtermswhenissuingsuchloans.In2010-2011period,therewasasurplusofcashthatcouldbelentoutasopposedtothenumberofborrowers.Theborrowerscould,therefore,startdictatetermswhenborrowingfrombanksandasurgeintheissuanceofcov-liteloansstarted.Todayc.50-60%ofthetotalleveragedloanmarketiscomposedofcov-liteloans.Thecov-liteloanissuancesinthepre-crisisperiodweremadeonlytoaselectfew,oneswithexceptionalcredit-worthinessandstellarcredithistory.Inthelowinterestrateenvironmentoftodayandincreaseofspreadseekingcapital,moreandmorecov-liteissuancesarebeingmadetolesscreditworthyclientele.Therefore,theargumentoftheprocov-liteloangroupasdiscussedinthepreviousparagraphwhereintheysaidthatitismorebeneficialtoissuecov-liteloanstoclientswithhighcreditworthinessthantoissueloanswithlargenumberofrestrictivemaintenancecovenantstoclientswithaweakerandunprovencredithistory,getsdefeated.Thatsaid,thereisstillanincreasedamountofduediligencecarriedoutbybankswhenissuingcov-liteloansthanwhenissuingloanswithrestrictivemaintenancecovenants.
ThismovementintheleveragedloanmarkethasbeenreflectedintheCLOStructuresaswell.Thepre-crisisCLOmanagershadalmostnoorlessthan15%ofcov-liteloansintheirunderlyingcollateralpool.15%wasalsothepercentageofcov-liteloansinthegeneralleveragedloanspool,thereforethisnumberwasagoodproxytobeusedfortheCLOcollateralpoolcompositionaswell.InthepostcrisisCLO2.0period,thedecreasedavailabilityofmaintenancecovenantsrichloanshasdiminishedandCLOmanagershavestartedtoincludemorecov-liteloansintheirunderlyingpoolcompositionwithsomeCLOcollateralpoolscontainingasmuchas70%cov-liteloans.ArecentCLOtransactionwasstructuredwith100%cov-liteloansascollateralpoolmakingitthefirstofitskindtransaction.TheCLOmanagershavestartedtolaymorefocusonthecreditqualityoftheborrowersoftheunderlyingloansthanonthepresenceor
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absenceofmaintenancecovenantsarguingthatsuchapracticeisshort-sightedaspointedoutbythefailureofsuchloansduringthefinancialcrisis.
Therecentincreaseintheissuanceofcov-liteloanshaveledtothetransformationoftheCLO2.0structuresandindentureswhereCLOmanagershaveadaptedtothemarketconditionsandloansavailabilitybymodifyingthedefinitionofcov-liteloans.SomerecentCLOindenturesindicatethattherestrictionsontheloanstobeincludedintheunderlyingcollateralpoolisnolongerbasedonthepresenceorabsenceofmaintenancecovenantsbutonthebasisofthehierarchyofthesaidloansinthedebtstructureofthecorporateortheborrowingentity.Theincludedloanshavetobeparipassuwiththeseniorloansoftheinstitutionandthereshouldbecrossdefaultclausesandtriggeringofmaintenancecovenantsofotherloansintheloanstructureoftheborrowingentityshouldtriggeradefaultoracallforthesaidloanaswell.ThesedefinitionsareusedtodefinethenewereligiblecollateralloansfortheCLO2.0transactionsasopposedtoCLO1.0transactionswherethecov-liteloanswithlittleornomaintenancecovenantswereexcludedfromthecollateralpool.Thestructureshaveincreasedthebasketofcov-liteloansintheCLO2.0andhaveintroducedaclausethatallowstheCLOManagertobuymorecov-liteloansifthemajorityofcontrollingclassofnote-holdersagreetoit.
Oftheratingagencies,onlyS&Phasexpresseditsconcernsovertheinclusionofcov-liteloansintherecentCLOtransactions.S&Pdoesaseverehaircutfortherecoveryrateofcov-liteloansandthereforemakesitunviableforanumberofCLOmanagerstogettheirtransactionsrichincov-liteloanstoberatedbyS&P.Therefore,thepercentageofrecentCLOtransactionstoberatedbyMoody’sorFitchhasincreasedalthoughS&Pstillmaintainsalion’sshareofratingintheCLOmarket.
Theperformanceofthesecov-literichCLOtransactionsisyettobeseenbutitdoesshowtheadaptabilityoftheCLOstructurestotheunderlyingleveragedloanmarket.Sincethissurgeintheissuanceofcov-liteloansisnotsustainableandthiscov-liteloanbubbleisboundtoburstatsomepoint,wemightbeabletoobserveanotherdramaticshiftinthetheCLOstructureswhichwouldresonatewiththischange.Butfornow,CLO2.0haveseeminglyadaptedwelltocoverthelowinterestrateenvironmentinducedcov-liteloansinthestructures.
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E. RiskRetention
AnumberofCLOsstructuredpre-crisiswerebelievedtofollowan‘OriginatetoDistribute’strategy(OtDStrategy)whereintheCLOmanagersorotherissuersissuedorcollectedloanswiththesolepurposeofstructuringtheminvarioustranchesanddistributingthemtoinvestors.Theyhopedtogainfromthedifferenceinthespreadsbetweenthoseoftheunderlyingloansandthatofthedifferentnotes.ThisdefeatedtheoriginalpurposeoftheCLOtransactions,thatis,structuringoftheilliquidloansintomoreliquidCLOSecuritiestoraisecapitalandallowinvestorstoinvesttheirmoneyinlucrativedealswithbetterspreadsthanothersecuritiesinthemarketwithsimilarrisks.Thefinancialcrisisof2008sawthewidespreadfailureofsuchsecuritiesandexposedtheweakloanunderwritingstandardsassociatedwiththewidespreadissuancesofsuchnotes.Amajorreasonfortheexistenceofsuchlooseunderwritingstandardswasidentifiedtobethelackofriskretentionbytheloanissuingorsponsorbody,thatis,theissuerortheoriginallenderretainednorisksassociatedwiththeunderlyingloansanddistributedallthetranchestothirdpartyinvestors.ThehighdemandforsuchsecuritiesmadeitpossiblefortheCLOmanagerstofindinvestorstoinvestintheriskiestequitytrancheorthetrancheofthefirstlossatrelativelytightspreads.PostthecrisisperiodandtheidentificationofthisOtDstrategyregulatorsandinvestorsalikeaskedtheissuersandlenderstokeeptheirown‘skininthegame’implyingthattheissuingorlendingpartiesshouldretainapredeterminedstakeandassociatedrisksinthetransactionforthelifeofthesecurity.Thisisalsoknownasriskretentionrequirements.
ThisisperhapsoneofthemostimportantstructuraldifferencesbetweentheCLO1.0andCLO2.0andforthatmatterCLO3.0.TherewerenosuchriskretentionrequirementsinCLOsofoldervintage(CLO1.0andearlyCLO2.0).Post2011,withfirstintroductionofsuchrules,CLOshavealwayshadariskretentionclauseintheirindenturesbutthepercentageriskretentiondiffersgreatly.TheriskretentionrulesintheUnitedStatesandinEuropehavebeenproposedandre-proposedmultipletimessincethefinancialcrisis.ThisconstantchangeintherulespertainingtoriskretentionresultsinconstantchangesinthestructuresofCLOtransactions.SomeearlyCLO2.0transactionshavebecomenon-compliantwiththeEURiskRetentionRegimesincetheEUreviseditsearlierproposedriskretentionrulesinMay2013forimplementationfromJanuary2014.UnitedStates,ontheotherhand,startedtotakeacloserlookatitsownriskretentionlawsinlate2012andcameupwiththeirownsetofriskretentionguidelinesforqualifyingCLOtransactioninMay2013.TheUS’andtheEU’sriskretentionregimes,unfortunately,donotoverlapwitheachothermakingitverydifficultforCLOmanagerstostructuresecuritiesqualifyingforinvestmentsbyinvestorsfrombothsidesoftheAtlantic.
i. EURiskRetentionRegime
Witnessingthemarketturmoilinthefinancialmarketscausedbythesub-parperformanceoftheAssetBackedSecurities(ABS)duringthefinancialcrisis,thefinancialworldhadtopayacloserlookatthestructuringofsuchdeals.Large,unexpectedlossesaccompaniedbybigwrite-offsintheunderlyingcollateralofsuchsecuritiesledtheindustryparticipantsespeciallytheregulatoryauthoritiestobelieveintheoverlyrelaxedloanunderwritingstandards.TheBaselCommitteeonBankingSupervision(BCBS)wastherebymandatedbytheG20inApril2009tostudytheriskmanagementofsecuritizationsandanalyzetheduediligenceandquantitativeretentionrequirements.TheEuropeanCommission(EC)respondedbyimplementingtheArticle122aintheBankingConsolidationDirective–CRDIILegislative
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Package.Oneofthemaintakeawaysfromthisnewlegislationpiecewasthatasof1January2011,theEuropeanBankscanonlybeexposedtotherisksofinvestinginABSiftheoriginalissuer,lenderorsponsorhasretainedaneteconomicinterestofatleast5percent.Thisminimumretentionispopularlytermedastheriskretentionrequirement.ThelegislationalsoaskedtheCommitteeofEuropeanBankingSupervisors(CEBS)(precursoroftheEBA)toproposeguidelinesfortheconvergenceofthesupervisorypracticesinrelationtothefirstdirective.EuropeiscurrentlyintheprocessofimplementingBaselIIIproposalsintheformofCRDIVLegislativeDirectivesandtheCRR.TheCRRortheCapitalRetentionRequirementActintheCRDIVdirectiverepeatsalmostverbatimtheinitialriskretentionrequirementsestablishedinCRDIIandprovidesasetofguidelinesforitsregulatorybodiestofollowtochecktheimplementationoftheaforementionedlegislations.
TheCRRappliestosecuritiesthatwillbestructuredfromthedateofimplementationoftheaforementionedlegislationandtransactionsthatwerecomplianttothepublishedlegislationatthetimeoftheirstructuringinthepastremaincomplianttotheCRRevenpostitsimplementation.ThisisnoteworthyasthisstarklydiffersfromtheUSRiskRetentionRegimewherethenewlegislationappliestopast,presentandfuturetransactionswithanaddedriskthatanysuchnewlawinfuturewoulddirectlyimpactthetransactionsstructuredtoday.
ii. TheUSRiskRetentionRegime
TheBoardofGovernorsoftheFederalReserveSystem,FederalDepositInsuranceCorporation,DepartmentofHousingandUrbanDevelopment,FederalHousingFinanceAgency,OfficeoftheComptrollerftheCurrency,andSecuritiesandExchangeCommission(collectively,the‘Agencies’)onAugust282013re-proposedrulesforimplementingtherequirementsofSection941oftheDodd-FrankWallStreetReformandConsumerProtectionAct(the‘DoddFrankAct’).ThekeytakeawayofthesemodifiedrulesasentailedintheDodd-FrankActisthattheagenciesarerequiredtoprescriberegulationsthat:
a. Requiresecuritizerstoretainatleast5percentcreditriskofanysecuritizedassets(riskretentionrequirement)
b. Prohibitthesecuritizertohedgeortransferringallorpartofthecreditriskrequiredtoberetained.
Thisretentionrequirementisimplementedtopromoteanactivescrutinyandmonitoringoftheunderlyingassetpoolbythesecuritizertherebyaligningtheinterestofthesecuritizerwiththeinterestoftheinvestorstherebyeliminatingtheagencyproblem.
UnliketheEURiskRetentionrules,theUSRiskRetentionrulesapplytonotonlytransactionstobestructuredfromhereonwithbutalsotopasttransactionsthatwerestructuredwithoutcomplyingtotheseunpublishedrulesthen.ThisentailsabuybackofsomenotesfromtheequitytrancheinvestorstomakethesecuritycompliantwiththechangesproposedbytheDodd-FrankAct.Thatsaid,agraceperiodof2yearshasbeenprovidedtomakethesecuritiescompliantwiththenewriskretentionrulesoftheUS.
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iii. ThemajordifferenceintheUSandEURiskRetentionRules
Asdescribedearlier,thereisverylittleoverlapintheUSandEURiskRetentionRegimes.Althoughbothlegislations–theCapitalRiskRetentionActinCRDIVinEuropeandtheModifiedProposalsoftheSection941oftheDoddFrankActof2010,askforaminimum5percentriskretention,thereisnomentionofhowthisriskretentionwillbecalculatedandthereisalotofconcernoveralikeforlikemeasurementoftheaforementionedrisksinEuropeandintheUnitedStates.ButwewillassumethateveniftheassessmentofthecreditriskissimilarintheEUandintheUS,wearriveatoneofthemostimportantdifferencebetweenthetwolegislations–thedefinitionofthe‘riskretainer’.
BoththeUS’ModifiedRulesandEU’sRiskRetentionDirectiveaskstheissuingbodytoretainafixed,pre-determinedpercentageofriskbeforeaskingthirdpartyinvestorstoinvestinthesecuritytoaligntheinvestorinterestwiththatoftheissuingbody.
Asdiscussedabove,accordingtheEU’sCRRAct,theriskistoberetainedbytheoriginallenderorissuerandnotbytheCLOManagerwhomightonlybebuyingandstructuringtheunderlyingloansandthenmarkettothirdpartyinvestors.Therefore,ifabankhasmandatedaCLOManagertostructureandselltheirexposuretoleveragedloansontheirbalancesheet,thebanksareexpectedtoretainachunkofthecreditriskintheformoftheequitytranche.IncaseofasyntheticCLOtransaction,thebankscannot,forinstance,buytheCDSonthetrancheofthefirstlossintheCLOStructure.Thisismadetoensurethattheoriginallenderstillundertakesthenecessaryduediligencestepsanddoesn’tadoptlooseunderwritingpracticeswhenissuingtheoriginalloans.Thatsaid,itmakesitverydifficulttodecidewhotheissuingpartyortheoriginallenderiswhenloansfrommorethanonelendersaresourcedtobestructuredintoaCLOTransaction.Recently,aSpecialPurposeVehicle(SPV)formedbytheconsortiumoflendersoftheoriginalloanportfolioinvestsandholdstheequitytrancheoftheCLOTransaction.
TheUS’ModifiedProposalsoftheDoddFrankActontheotherhandasksthesecuritizer,orinotherwordstheCLOManager,toretainaminimumamountofcreditriskwhenissuinganABS.ThisisdonetoaligntheinterestsoftheCLOManagerwiththatoftheinvestors.TheriskretentionbytheCLOManagerwouldensureclosemonitoringandchecksbyhimorherontheunderlyingcollateralpoolonanongoingbasis.AnumberofCLOmanagershaveprotestedagainstthispracticeastheysaytheirprimarybusinessistobuy,structureandselltheloansfromaconsortiumoflenders(mainlybankingentities)andtheydonotgenerallyholdcapitaltoinvestintheaforementionedsecurities.ThefunctionoftheCLOManageristokeepacheckontheunderlyingpoolandreportinganydelinquenciesordefaultstotheinvestors.Thisfunctionneedstobefulfilledonanongoingbasisuntiltheendofthelifeofthesecuritiesandthenotes.GoingbythelogicoftheUSRegulators,ifandwhentheequitytranchegetserodedduetothefirstlossesincurredbytheCLOSecurity,theCLOManagerroleshouldbeeffectivelyoverastherewouldbenofurtherincentivetomonitorthecollateralpool.
AnothernoteworthydifferencebetweenthetworiskregimesistheapplicabilityofthelegislationsontheCLOStructures.InEU,thenewlegislationdoesn’trequireCLOtransactionsstructuredpre-financialcrisistobemodifiedandrestructuredtocomplywiththenewguidelineswhereasthisisnotthecaseintheUSwheretheoldertransactionsneedtobecalledbackinpartorasawholeandhavetobemadetocomplywiththenewModifiedProposalsoftheDoddFrankActtobecomeeligibleforinvestmentsfromUSinstitutions.
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Exhibit13belowshowstheslightoverlap,ifany,thatexistsbetweentheModifiedProposalsoftheUSandtheCRRActoftheEUregardingthequalifyingoftheCLOSecuritiesforinvestorsonbothsidesoftheAtlantic.
Exhibit14:OverlapbetweenModifiedProposalsoftheUSandtheCRRofEurope
PotentialRetentionProviders EligibleintheUS? EligibleinEurope?(fromJanuary1,2014)
CLOManagerasSponsor YesOnlysomeEUregulatedCLOmanagersthatmeetthedefinitionof‘Sponsor’
AffiliateofCLOManager Only‘majority-ownedaffiliates’ No
OriginalLenderYes
(LeadArrangerundertheAlternativeOption)
Yes,ifthedefinitionofthe‘originallender’issatisfied
OtherSponsor NoYes,ifthedefinitionof
‘originator’or‘sponsor’issatisfied
Source:D.Festa,N.Robinson&B.Youn,“CLO1.0vsCLO2.0–PartIIIofaseries”Milbank,Tweed,Hadley&McCloyLLP(November22,2013)
iv. MethodsofRiskRetention
UndertheEUCRRActandundertheoriginalproposalsoftheDoddFrankAct,theriskretentionproviderscouldsatisfytheriskretentionrequirementsthroughverticalriskretention,horizontalriskretentionoracombinationofbothinanL-shapedriskretentionstructure.UndertheModifiedProposalsoftheDoddFrankAct,theagenciesconsolidatedtheseoptionsintoacombinedriskretentionoptionthatwouldpermitanyoftheabovedescribedriskretentionfactorssuchthatthecombinedentityshouldbeatleast5percentofthefairvalueofallassetspostedascollateral.Thehorizontal,residualtranchecanalsobesatisfiedbytheestablishmentofareserveaccountintowhichcashequivalenttothe5percentrequirementisposted.
TheModifiedProposalsalsolistoutanimportantdetailthathasbeendefinedquitetroublesomebyseveralCLOmanagersoftoday.TheAgenciesstatethattheholderofthehorizontal,residualtranchesshouldn’tbeabletoreceivethepaymentsonthistranche’sfairvalueatafasterratethantheothernote-holders.Thisisquitedifficultsincethisimpliesthattheequitytrancheholderscannotreceiveanyexcessspreadsuntiltheendofthereinvestmentperiodtherebydeprivingthemoftheupsideofholdingtheriskiesttrancheforaverylongperiod.ThishasresultedintheinabilityoftheCLOManagertosuccessfullyplacetheequitytranchetothethirdpartyinvestorsandthehorizontaltranchehasbecomeoneofthemostcommonmethodsofriskretention.ThereisongoingdebateregardingthesamebetweentheCLOmanagersandtheAgencies.
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F. ExampleofapreandpostcrisisCLOtransaction
InthisexamplewewillseetwoCLOsissuedbythesameCLOManagerKKRFinancialin2005and2013andlookatthedifferentstructuresofthesame.Thestructuraldifferencesdiscussedinthepapersofarareglaringlyobviousinthetransactions.
KKRFinancialCLO2005–2 KKRFinancialCLO2013–2
SecuritiesOffered PrincipalAmount
Moody’sRating
ClassA-1Notes $545,000,000 AaaClassA-2Notes $150,000,000 AaaClassBNotes $57,000,000 Aa2ClassCNotes $64,000,000 A2ClassDNotes $64,000,000 Baa2ClassENotes $30,000,000 Ba2ClassFNotes $10,000,000 B2
SubordinatedNotes $98,500,000 N/A
SecuritiesOffered PrincipalAmount
Moody’sRating
ClassA-1ANotes $100,000,000 AaaClassA-1BNotes $10,000,000 AaaClassA-1CNotes $115,000,000 AaaClassA-2ANotes $38,000,000 Aa2ClassA-2BNotes $10,000,000 Aa2ClassBNotes $18,500,000 A2ClassCNotes $25,750,000 Baa3ClassDNotes $22,000,000 Ba3Subordinated
Notes $29,750,000 N/A
Aaatrancheis68.24%ofthetotalprincipalamount.
Aaatrancheis60%ofthetotalprincipalamount.
UnderlyingCollateralcomposedof:
• SeniorSecuredLoans• SecondLienLeveragedLoans• SeniorSecuredBonds• SeniorTranchesofotherCLOs
UnderlyingCollateralcomposedof:• SeniorSecuredLoans• SecondLienLeveragedLoans
DiversityScore:30WeightedAverageRatingFactor(WARF):2350WeightedAverageSpread(WAS):2.15%WeightedAverageCoupon(WAC):3.65%WeightedAverageRecoveryRate(WARR):44%
DiversityScore:50WeightedAverageRatingFactor(WARF):2850WeightedAverageSpread(WAS):3.70%WeightedAverageCoupon(WAC):6.50%WeightedAverageRecoveryRate(WARR):47%
WeightedAverageLife(WAL):9.0Years WeightedAverageLife(WAL):8.0Years KKRholds5%oftheSubordinatedNotes. KKRholds100%oftheSubordinatedNotes.Source:KKRFinancialCLO2005-2Prospectus,Moody’sRatingReport–KKRFinancialCLO2013-2
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G. PerformanceofCLO2.0ascomparedtoCLO1.0
OwingtotherecentissuancesoftheCLO2.0securities,ithasbeendifficulttoanalyzetheperformanceofthesetransactionsascomparedtothe
TherecentCLOTrackerFilesreleasedbyFitchandotherRatingAgenciesinJanuary2015includesfiveCLO2.0transactionswithacollectiveassetpoolofEUR1.8billion.ThetrackerdatafileshaveindicatedthattheCLO2.0havefaredbetterthanCLO1.0onawhole.
i. TheCLO2.0haveonaveragehad,onaverage,higherweightedaveragerecoveryratesthanseasonedCLO1.0transactions
ii. TheCLO2.0transactionhavelower‘CCC’bucketsthantheirCLO1.0counterparts.The‘CCC’bucketsforCLO2.0areonly2.08%asopposedto8.7%ofthatofCLO1.0
iii. TheborrowerpoolofCLO2.0hasalsobeenobservedtobemoregranularthanthatofCLO1.0.Onaverage,theCLO2.0transactionshave77obligorsascomparedtotheaverage62forCLO1.0transactions.ThisisnotthebestmetricofmeasurementthoughastheCLO1.0transactionsaremucholderandhavebeendeliveringandpayingdowntheirnotesasopposedtoCLO2.070%ofwhicharestillintheirreinvestmentperiods.
iv. Theaverageseniortranchecushionandthecorrespondingjuniortranchecushionhasvastlyimprovedaswell.
v. TheOCtestperformanceoftheseCLOshavealsoseenamarkedimprovementfromtheCLO1.0transaction.
MostoftheabovelistedimprovementsasillustratedintheFitchCLOTrackingDatareportofJanuary2015areadirectresultofthecleanerandsimplerstructureoftheCLO2.0transactions.AlotofemphasishasbeenlaidonmakingthesetransactionseasiertobeunderstoodbytheaverageinvestorandtherebyimprovingtheirstructureandmakingthemeasiertopassvariousreliabilitytestssuchastheOverCollateralizationtests.TherequirementsbytheregulatoryframeworksofCRDIVandDoddFrankActtohaveabiggercushionfortheseniortranchehasmadethe‘AAA’tranchesafertoinvestinalbeitwithlowerreturns.
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IV. CLO3.0–Volcker’sImpactonCLOs
TheOfficeofComptrolleroftheCurrency,theBoardofGovernorsoftheFederalReserveSystem,theFederalDepositInsuranceCorporationandtheSecuritiesandExchangeCommission(collectivelyknownas‘Agencies’),onDecember10,2013,adoptedthefinalsetofVolcker’sRules.TheseruleshavehadaprofoundeffectonUSCollateralizedLoanObligationMarketplace(CLO)byprohibiting‘bankingentities’fromretainingoracquiringan‘ownershipinterest’ina‘coveredfund.’
Eligible‘BankingEntities’includeallbankholdingcompanies,foreignbankswithUSBranchesandagencies,insureddepositoryinstitutions(e.g.MoneyMarketFunds)andaswellastheiraffiliates,franchisesorsubsidiaries.
‘OwnershipInterest’hasbeendefinedverybroadlybythe‘Agencies’.Accordingtothecurrentdefinitioneveninvestorsinthedebttranchecanqualifyashavingan‘ownershipinterest’inthefund.Itisdobecauseinthedefinitionof‘ownershipinterest’inaccordancetoasdefinedbyVolcker’sRule,anyinvestorthatcaninfluenceorhastherighttoparticipateintheselectionorremovalofaninvestmentmanager,investmentadvisororcommoditytradingadvisorofthe‘coveredfund’issaidtohavean‘ownershipinterest’inthefundirrespectiveofwhetherthesaidpersonorinstitutionholdsanyequityinthefundornot.SinceinatypicalCLOtransaction,amajorityofnote-holdersorholdersofthecontrollingclassofthesecuritywhichisusuallythetoptwotranchesofthetransactionhavetherighttoremovetheCLOManagerforcause.Asaresult,holderofeachoftheseseniordebttranchesissaidtohavean‘ownershipinterest’inthetransaction.
‘CoveredFund’areCLOtransactionsbutwithfullrecoursetotheissuingauthority.Therefore,allCLOsthatare‘investmentcompanies’(orSPVsissuingnotes)butfortheexceptionssetoutinSection3(c)(1)or3(c)(7)oftheInvestmentCompanyActof1940,aredefinedas‘coveredfunds’accordingtotheVolcker’sRule.
Section3(c)(1)oftheInvestmentCompanyActof1940statesthatafundnotownedbymorethan100shareholdersisexemptfrombeingcalleda‘coveredfund’andisdefinedasa‘privatefund.’
Section3(c)(7)oftheInvestmentCompanyActof1940statesthatafundwillnotbetermedasa‘coveredfund’ifitiswhollyownedby‘qualifiedpurchasers.’
ThesetwoexceptionsintheInvestmentCompanyActof1940arefrequentlyusedbyHedgeFundstoqualifythemselvesas‘privatefunds’insteadof‘publicfunds’therebyescapinggreaterscrutinyandregulations.
OwingtotheVolcker’sRule,a‘bankingentity’cannotinvestmorethan3percentofitsTier1Capitaltogain‘ownershipinterest’in‘coveredfunds.’Therefore,suchaninstitutionwouldhavetocountitsinvestmentinsuchafundtowardsthat3percentlimitordivestitsinterest.ThisisahugeblowtotheCLOMarketplacewhere,historicallyspeaking,bankinginstitutionshavebeenoneofthebiggestinvestorsintheseniormosttranchesoftheseCLOSecuritiesholdingmorethan75percentofthe‘AAA’CLOtranchesavailableinthemarket.
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A. VolckerExemptCLOStructures
CLOmanagershavetriedandtestedvariousroutestoexempttheirtransactionsfromthe‘coveredfunds’definitionsoftheVolcker’sRuleastheydonotwanttolosetheirbiggestinvestorsintheformofthebankingentities.Thereisrigorouslobbyingtakingplacebytheseinstitutionstoconvincetheregulatorsand‘agencies’toamenditsregulationstomakeitfairerfortheCLOmarketplace.SomeofthemorepopularmethodstoseekexemptionfromtheVolcker’sRulearelistedbelow.TheseCLOstructuresarecollectivelyreferredtoasCLO3.0popularly.
i. UsingSection3(c)(7)exemptionoftheInvestmentCompanyActof1940
ThisiscurrentlythemostfavoredandeasiestoptionavailabletotheCLOmanagers.TheCLOmanagersareplacingthetranchesofthesecuritiesprivatelyandonlyto‘qualifiedpurchasers’andcertainemployeesoftheCLOManager.Sincethe‘qualifiedpurchaser’getsabiggersayandthereforegreaterbargainingpowerintheCLOTransaction,heorsheisabletodrivethespreadsmuchtighterthanwhatitwouldbeifthetransactionhadbeenplacedintothemarket.
ii. LoanSecuritizationexemption
InordertoprovidesomerelieftotheCLOIndustry,the‘Agencies’agreedtoexemptloansecuritizationsfromthedefinitionof‘coveredfund.’Inordertoqualifyasaloansecuritization,theunderlyingassetsoftheABShavetobesolelycomprisedofloans.Thedefinitionofloansgenerallyexcludessecurities.CLOmanagers,beforetheintroductionofVolcker’sRule,investedapartoftheproceedsfromsellingnotesintosecuritiessubjecttocertainconcentrationlimits,includinginseniorsecuredbondsandhigh-yieldbonds.TheseCLOtransactionswouldnolongerqualifyundertheVolcker’sRuleexemptions.
AsimplesolutionisthattheCLOManagerstopsinvestinginsuchhighyieldbondsandothersecuritiesandmakesuphisorherportfolioentirelyofloans.ThisisnoteconomicallybeneficialtotheCLOManagerhowever,sincethehighyieldsecuritiesprovidedamuchhigherexcessspreadtotheequityinvestor(includingtheCLOManagerwhohasbeenrequiredtoretainaportionoftheequitytrancheundertheDoddFrankActof2010).Thishascreatedamismatchinthespreadsbetweenthefixedinterestratesnotesandthevariableinterestratesunderlyingassetsofthesetransactions.Therefore,theCLOmanagersarefacedwithanimpossiblechoiceofeitheralienatingtheirbankingentitiesinvestorsbynotcomplyingwiththeVolcker’sRule’srestrictionsordrivingawaytheirequitytrancheinvestorsbypromisingthemlowerspreadsthanbefore.IthasledCLOmanagerstoseekhigherspreadselsewhere,insecuritiesthatstillqualifyasloansunderthedefinitionprovidedbyVolcker’sRule.Lately,anumberofCLOmanagersareinvestinginsecond-lienloansinpursuitofhigherspreads.Thisiscounterintuitiveasthelessriskyseniorsecuredbondsaregettingreplacedbymuchriskiersecond-lienloansinCLOtransactions.
SomeCLOmanagershaveemployedamixedstrategy.Theyhaveuseda‘springingsecuritiesbasket’intheCLOdocumentationtoallowforalaterinclusionofsecuritiesiftheyadheretotheVolcker’sRule’sexemptioninthefuture.Thesesecuritiesarepureloansecuritizationotherwiseandhaveabiggerbucket
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ofsecondlienloansthanpresentinthepre-Volcker’sRuleCLOtransaction.ThisapproachwhilegivingflexibilitytotheCLOmanagerstotakeadvantageofanyrulechangesthatmighthappenasaresultoftheongoinglobbyingwiththe‘Agencies’regardingthedocumentationofCLOtransactions,doesn’tpromiseahigherreturntotheequityinvestorwhoisinvestinginitsriskiesttranchetoday.
iii. ExemptionunderRule3a-7oftheInvestmentCompanyAct
IftheCLOManagerisabletostructurehisorhertransactionsuchthatitiscompliantwiththeRule3a-7undertheInvestmentCompanyActof1940,thetransactionisexemptfrombeingtermedasa‘coveredfund.’Forthesetransactionstobecompliantwiththesaidrule,theyhavetofulfill,amongothers,thefollowingsalientfeatures:
a. Thesecuritiesissuedbytheissuerhavetoberatedbyatleastoneratingagencyandhavetofallinoneofthetopfourratingclasses
b. Theacquisitionanddisposaloftheunderlyingassetsonanongoingbasisisnotdoneprimarilytotakeadvantageofthemarketvaluefluctuationsofthesaidassets
c. Atrustee,notaffiliatedwiththeissuer,maintainsaseparateaccountwhereinthecash-flowsfromtheissuers’underlyingassetsaredepositedperiodically
Theselistedrules,someCLOmanagersbelieveareeasytofollowandwouldnotimpacttheeconomiesoftheCLOTransactionsinanyway.MostCLOmanagersdonotacquireanddisposeassetstocapturemarketvaluefluctuationsbuttoremovedeterioratingassetsfromtheirportfolioowingtodelinquenciesordefaults.Therefore,portfolioscomprisingofhighqualityassetsthatwouldqualifyinthetopfourratingtranchesandadheringtotheotherlistednormswillnotqualifyasa‘coveredfund’undertheRule3a-7oftheInvestmentCompanyActmakinglifemucheasierforCLOmanagers.Thatsaid,aCLOManagertryingtogaincompliancewiththeRule3a-7needstohavesolidspoliciesandproceduresinplacetoensuresoundtradingpracticesandperformcheckssoastoadherebythestrictguidelinesatalltimesorrisklosinghisorherlicense.
iv. Wholly-OwnedSubsidiaryExemption
IfaCLOisa‘whollyownedsubsidiary’ofabankingentity,itdoesn’tqualifyasa‘coveredfund’undertheVolcker’sRule.Therecanbeanexceptiontotheaboverulewhereinanunaffiliatedthirdpartymayholdupto0.5percentoftheCLO’sequityunderspecialcircumstances.ThisrulelookssimplebutisextremelydifficulttofulfillasthebankingentitywouldhavetheCLOonitsbalancesheetasitisassumingriskofthelowesttrancheandisunabletodiversifythesameduringthelifeoftheCLO.Moreover,itisforbiddentohedgeorbuyinsuranceonthebankingentity’sexposuretothisriskytranche.
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B. TheImpactofVolcker’sRule
Volcker’sRulehascomeasarudesurprisetotheCLOmarketparticipants,whoexpectedtheregulatorsandthe‘agencies’tobemorelenientwiththesetransactionsastheyhadtakenahugebeatingpostthefinancialcrisis.ThenumberofCLOtransactionsintherecentyearshadonlyjuststartedtoclimbuppostthemassiveslumpin2009and2010.TheVolcker’srulesrestrictionscoupledwiththecapitalrestrictionsthathaveburdenedthe‘bankingentities’recentlyhastakenahugetollontheCLOIndustry.ThefactthattheVolcker’sRuleaffectsnotonlythenewtransactionsbutallCLOdealsthathavebeencompletedbeforeandarestillheldbythedefined‘bankingentities’,hasresultedinasharpdeclineinthepricesofthetoptranchesofCLO2.0closedin2012and2013.
Somemarketobservers,though,areconfidentthatthe‘agencies’wouldnoticethenegativeimpactoftheVolcker’sRulesontheCLOIndustryandthestructuresoftheVolcker’scompliantCLO3.0.MostCLO3.0,especiallypureloansecuritizationstructuresareriskierthanthecorrespondingCLO2.0transactions.Thatsaid,anumberofCLOmanagerstodayareissuingCLOsbasedononeoftheexemptionruleslistedabovewithRule3a-7beingthemostpopularamongtheCLOmanagers.Thesenew-ageVolckercompliantCLOsarecollectivelytermedasCLO3.0.
AnimportantimpactoftheVolcker’sRulehasbeenthechangeintheinvestorbasefortheAAAtranche.Bankshavenowtakenabackseatwhileinvestingintheseniormosttrancheandincreasedspreadshavemanagedtoattractotherinstitutionalclientssuchasassetmanagersandinsurancefunds.Exhibit15belowshowsthesameinmoredetail.
Exhibit14:OverlapbetweenModifiedProposalsoftheUSandtheCRRofEurope
Unfortunately,sincetheCLO3.0areextremelynewandalmostallofthemareintheirreinvestmentperiods,itisimpossibletoascertainthestructuralstabilityandperformanceofthesetransactions.
HedgeFunds
AssetManagers
Insurance
Banks
AAAInvestorbase2011-2013
Pension HedgeFunds
AssetManagers
Insurance
Banks
AAAInvestorBase- 2014
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Conclusions
TheCollateralizedLoanObligations(CLOs)areassetbackedsecuritieswithacollateralmainlyformedofloansandothersecuritiesthatissuenotestoinvestorsfrodifferenttranches.Thetranchesaremadeinadecreasingorderofrisksuchthatthetoptranchesdon’tabsorbanylossesofthedefaultsoftheunderlyingtranchesareerodedaway(cashwaterfall).Thesetransactionsaremainlyusedbybankingentitiestodiversifytherisksassociatedwiththeleveragedloansontheirbalancesheetsandbettermanagetheircapital.Sincethesetransactionsarerelativelysafeandprovideahigherspreadthanothersecuritiesinthemarket,differenttranchesofthesesecuritiesareabletoattractdifferentinvestors–bankingentitiesinvestinthetoptranchestogetlessriskyassetsontheirbalancesheets,institutionalfundsinvestinjuniortranchestogetgoodspreadswithlimitedassociatedrisksandhedgefundsmainlyinvestintheequitytranches.CLOsarealsoagreatwaytoprovideliquiditytotheotherwiseilliquidcorporateandindividualloanmarket.Henceitisamarketthatismuchneededandissupportedbythegovernmentsforthedevelopmentandgrowthoftheireconomies.
Firstsetupintheirtruestformin1990s,CLOshavehadaturbulentpast.TheoldvintageCLOsofpre-crisiseragavealotoffreedomtoCLOmanagersthatallowedthemtomodifytheCLOstructurestomakeitmoresuitableforinvestors.Insearchofspreads,unfortunately,someCLOmanagersintroducedcomplicationsthatwhencoupledwithseveremarketconditionsof2008resultedintheunderperformanceofmanysuchCLOtransactions.
ThebankingentitieshavehistoricallybeenoneofthebiggestparticipantsintheCLOIndustryusingthesesecuritiestodiversifyoracquirerisksontheirbalancesheets.Itisbecauseofthisexposureofthebankingentitiestothesesecuritiesanditsimpliedimpactonthepublic,theregulatorsandagencieshavebeenkeepingawatchfuleyeonthestructureofthesesecurities.Theyhavebeencontinuouslyproposingnewrulesandguidelinestomodifythesesecurities.TheCLOsofnewervintagehavedisplayedtheiradaptabilitytoconformwiththeserules.TheCLOmanagershaveissuedseveralCLO2.0conformingtothesenewguidelinesin2011and2012.TheCLOMarkethasthereforeseenaresurgencesinceastheinvestorsareabletoinvestinmoresecureandstableCLO2.0transactionsforwiderspreadsascomparedtotheirCLO1.0counterparts.TheregulationshaveborefruitasisevidentbyRatingAgencies’reportsontheCLO2.0performances.
Muchmorerecently,USAgencieshaveproposedtheVolcker’sRulesthathavedisruptedtheCLOIndustryyetagain,especiallyintheUnitedStates.Volcker’sRuleshavemadeitextremelydifficultforbankingentitiestoinvestinCLO1.0orCLO2.0structuresastheyhavelimitedthebankingcapitalthatcanbeattributedtoinvestmentincoveredfunds–adefinitionthatencompassesalmostallCLO1.0andCLO2.0structures.ThereareseveralwaysthathavebeenexploredbywhichCLOscanbestructuredtopreventqualifyingasacoveredfundtherebybeingexemptfromVolcker’sRule.Althoughsuchstructuringgenerallyincreasestherisksmoreoftenthanreducingitleadingtolobbyingregardingthesamebythemarketparticipants.Butfornow,suchnewage,newvintageCLOsof2015and2016aretermedasCLO3.0.
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