Collateralized loan obligations are the biggest investors in the $1.2 trillion leveraged loan market, yet for months they’ve been bullied by hedge funds and other money managers exploiting a glaring weakness in their structures.
Now, they’re fighting back.
Brigade Capital Management, Blackstone Group Inc., CIFC Asset Management and Bardin Hill Investment Partners are among the firms looking to change the terms of the CLOs they oversee to put them on better footing when companies they’ve lent to can’t meet their obligations, according to people with knowledge of the matter. Collateral managers are often handcuffed in distressed situations due to strict checks on the risks they can take.
The constraints have allowed sophisticated investors to profit at their expense. Some have gone so far as to arrange transactions that intentionally shift value away from the structures, market watchers say. CLO firms had responded by inserting language into new deals that provides more flexibility to hold troubled assets. But with the coronavirus pandemic kicking the default cycle into high gear, a number of shops are now trying to revamp outstanding transactions as well in an effort to improve recovery values.
“Top managers are looking at global amendments that would deal with the issue for most or all of their existing” CLOs, said Joseph Beach, a partner at law firm Cadwalader Wickersham & Taft. “You’re going to see a wave of amendments come out. The big names have already crafted these documents.”
Representatives for Brigade, CIFC and Bardin Hill declined to comment on their efforts to rework deal terms.
“Despite the fact that CLO portfolios broadly performed in line with or better than expectations in the recent disruption, we’re always working to strengthen the structures to make them more protective of our investors’ capital,” said Rob Zable, a senior portfolio manager of U.S. CLOs at Blackstone.
The limits on CLOs – which package and sell leveraged loans into chunks of varying risk and return – frequently prevent them from investing in high-risk assets such as workout loans or equity stakes in troubled companies.
The rationale is that such wagers could jeopardize returns for owners of the safest securities that CLOs issue, while disproportionately benefiting investors in the riskiest or highest-returning ones, known as the equity.
Yet in some situations – including the restructurings of marketing firm Acosta Inc. and retailer J.C. Penney Co. – these constraints have dramatically cut into the amount of money that CLOs can recoup. In fact, CLO holders have recovered 20 to 30 cents on the dollar less than other first-lien creditors in certain instances, according to Barclays Plc.
Brigade has already won approval from investors to amend most of the CLOs it oversees, said the people familiar, who asked not to be identified because they aren’t authorized to speak publicly.
The changes will allow CLO equity holders to inject new capital into distressed portfolio companies seeking to restructure their loans. The amendments are structured so that the equity holders assume all the added risk, though debt holders – especially mezzanine investors – could potentially share in the benefits stemming from improved recoveries, the people said.
Some collateral managers are even exploring allowing outside money into established portfolios to provide rescue financing, though that’s still in the conceptual stage, according to market participants.
“It gives the threat of fighting back more teeth,” said Lauren Basmadjian, a senior portfolio manager at Carlyle Group Inc. “Certain investors think that they can take advantage of CLOs because of the documents, but CLOs will have options for other capital.”
Investor Pushback
Market watchers caution that the changes being made to existing CLOs aren’t as robust as those seen in new or refinanced transactions, where documents are negotiated from scratch.
Moreover, given the drive to allow CLOs more leeway is still in its infancy, only about 5% of the market will have provisions that allow them to more fully participate in restructurings by year end, according to an Aug. 31 report from Wells Fargo & Co.
Some CLO debt investors – who in general want to limit exposure to stressed assets and are cautious about giving managers too much latitude – may push back against the changes if they’re seen as being too lax.
On the flip side, equity investors may also be wary of ceding too much recovery value to debt holders who face little additional risk.
Eagle Point Credit Management, which oversees more than $2.5 billion in CLO assets and is an equity investor in certain Brigade deals, says the amendments are a positive development but that it wants to see adjustments that more directly reward the investors providing the additional capital.
“There isn’t a silver bullet for any of this, but each one of these fixes is a step in the right direction,” said Eagle Point founder Thomas Majewski. “They have the potential to be pretty effective.”
Volcker Reprieve
Changes to Volcker Rule regulations set to go into effect Oct. 1 will make it easier for CLOs to purchase certain non-loan assets, which should also give them more leeway in restructurings.
That’s key as U.S. institutional term loan defaults – already at more than $50 billion this year – are forecast to surge to more than $200 billion by the end of 2021, according to Fitch Ratings.
Ultimately, some market watchers say that the agreements firms like Brigade and Blackstone reach with investors could serve as templates for how other collateral managers approach negotiations over deal documentation, facilitating easier and faster adoption. Still, others counter that such a transition will likely take time.
“Only a portion of CLOs will have this ability in this default cycle,” Carlyle’s Basmadjian said. “It’s probably the next cycle where you will see closer to 100%. But you have to start somewhere.”
