At a time when global capital markets enter a fifth year of stagnation, one segment of the credit markets is seeing signs of recovery, and whilst the collateralised loan obligation market is not yet up to par with the pre-credit crisis peaks, the year to date has seen the highest level of activity since 2007. During the first six months of this year, US$17.9 billion of CLOs were issued in the US, compared to US$12.3 billion for all of 2011, and the general feeling is that post Labour Day, the summer-lulled market will pick back up again and we could end the year at US$25-30 billion of issuance.
The deal pipeline is strong and managers are seeing the appetite of traditional investors in AAA rated tranches, such as the Japanese banks and pension funds, increase, albeit cautiously, with one eye on the eurozone. The investor demand for the product means a knock on demand for the underlying assets themselves, being commercial loan collateral and that availability of credit is aiding the post credit-crunch recovery in the US.
Back-to-basics: So what is a CLO?
A CLO or 'Collateralised Loan Obligation' is a term used to describe a type of structured finance transaction. Typically a CLO issuer will be a Cayman Islands incorporated exempted company and that issuer will issue several tranches of notes, which is debt, with an expected rate of investment return. The total amount of debt issuance on any one deal is large, totalling anything from US$200 million to US$1 billion. The notes are tiered, such that one tranche receives payments (interest and any principal due) on a payment date and, if additional funds are available, the next tranche of notes will receive payments. The top slice is often called the triple A debt because it receives the highest rating from the rating agencies (AAA). Investors in this piece typically have a conservative investment strategy and are risk averse. Down at the bottom of the 'waterfall' sits what are called 'equity investors', this subordinated debt (lowest tranche of notes) receives no fixed rate of return but basically receive the remaining profits of the deal after the higher tranches have been paid. These investors have greater tolerance to risk and, if the deal is performing well, they will see a greater rate of return. The benefit of a CLO to investors is that they are able to gain exposure to an investment product typically reserved for direct bank lenders and loan originators.
What is the collateral?
The proceeds of the issuance of the tranches of notes will be used to buy a bundle of commercial loans. These are generally large broadly-syndicated loans advanced by a lender to 'Corporate America' in an amount of US$10-20 million, which the lender then sells to the CLO issuer, using the proceeds to carry on its lending business. The Cayman based CLO issuer is the entity that holds the loan, takes the risk of such loan defaulting and uses the proceeds of the underlying loan payments to pay out the obligations on the notes to the CLO investors. The bundle of loans in a typical US CLO have a diverse spread in terms of the underlying obligors across numerous sectors of the economy (such as telecommunications, metals & mining, oil and gas, engineering, healthcare, entertainment, leisure, chemical and retail corporations) and geographically spread across North America. In choosing the pool of collateral, the intention is to spread the risk so the assets are not based in any one sector or location.
Weren't CLOs involved in the financial crisis?
At the heart of the financial crisis lay a different type of financial product, the CDO, which is a 'Collateralised Debt Obligation'. The assets held by a CDO issuer were a mix of numerous types of debt assets and other highly complex financial instruments. In particular, CDOs included high volumes of securities ultimately backed by sub-prime residential mortgages often concentrated in particular US States (such as FL, AZ and CA). When the US residential market began defaulting, that caused defaults by the CDO issuers and financial catastrophe for those who had bought or guaranteed huge amounts of these CDO securities, for example Lehman Brothers and AIG.
CLOs of the pre-credit crisis, known as CLO 1.0, managed to remain relatively unscathed with nominal defaults because of the nature of the underlying collateral. Today's CLO 2.0 has, with the benefit of hindsight, improved further in terms of documentation and the underlying asset quality. To obtain the best ratings on the notes, the rating agencies are looking for the pool of collateral to include predominantly senior secured loans and only allow a small amount of the proceeds of issue to be used to purchase second-lien or even unsecured debt. Consequently, CLOs are now seen as incredibly robust funding vehicles that have proven the tests of time.
Who is involved?
A CLO transaction involves numerous parties and the quality of the team and legal counsel is critical given the complexity of the transactions and size of these deals. Many of the 'bulge bracket' investment banks act as arrangers and underwriters of CLOs. They help structure the deal, pull in investors and assist in the marketing of the deal. There is a collateral manager who will manage the underlying assets and produce reports on the asset performance. There will be a notes trustee (typically the trust arm of the major banks such as Wells Fargo, US Bank National Association, Bank of New York Mellon, Citibank, NA) who act for the benefit of the noteholders, reviewing the collateral and collateral manager performance, noteholder communications as well as holding the underlying collateral as security for the secured parties in the transaction. Both the arranger and the collateral manager will have their own US onshore counsels which are usually the large international law firms based in New York as the transaction documents are predominately governed by New York law.
Cayman provides the legal jurisdiction for US CLO issuers, based on our time zone proximity to New York and the provision of quality professional services in the jurisdiction which are attractive features to underwriters, collateral managers and their counsel. There will be Cayman counsel for the issuer, the issuer's independent Cayman directors and corporate administrator. The CLO is not a tax driven transaction, but the use of Cayman enables the transaction to go ahead without adverse tax consequences and attract many non-US investors. Some of the world's largest asset and investment management groups actively partake in the CLO market, whether as collateral managers or their private equity and fund businesses investing in the notes. While such groups might be seeing other areas of their business generating fewer profits (ie traditional investments in stocks and shares), they are seeing impressive revenues from CLO management fees and returns in some cases of 10-15 per cent on the subordinated debt tranche. With the heightened involvement of private equity and funds in the secondary loan market, some might say they are morphing into quasi-lending institutions. The post credit crisis market has seen significant levels of CLO manager consolidation as some of the largest private equity/ fund houses bulk up their credit desks.
Why is this significant for the US economy?
The availability of credit to US companies is an essential part of the US, and, therefore, global economic recovery. Without long-term debt finance as a cheap source of funding, companies can fail to meet the day to day demands on their business. That is where CLO's step in. While a CLO issuer does not originate, or provide finance directly to companies, they do provide a secondary market for those loans. Originators that lend to corporate America sell their loans and use the funds to continue to lend. The CLO market is the buyer for a good portion of commercial loans originated in the US. In 2008/2009 when the markets froze, companies needing to borrow suddenly found that the cost to obtain a loan increased because traditional sources of funds, eg banks, stopped lending. Demand on the CLO side means the cost of that credit stays reasonable.
While the hedonistic level of 2006 and 2007 issuances might be relegated to history, the element of optimism returning to this area of the financial markets can only be a good thing for the overall economic outlook.
Previously published in Cayman Financial Review, November 2012
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