The U.S. CLO market is experiencing another rash of refinancing, defying expectations for a slow start to the year.
Like the refinancing that managers raced to complete before Dec. 24, 2016, this activity is driven by a desire to avoid retaining skin in the game, in the form of 5% of the economic risk of deals. Managers of existing collateralized loan obligations deal who wished to make extensive changes, such as raising additional funds or extending the investment periods of deals, had to do so before Christmas Eve or they would no longer be grandfathered from the Risk Retention Rule.
But there is another, much more narrow exemption that is driving the current refi wave. It only allows managers to lower the coupon rate; any other changes will trigger the requirement for the management company to take a minimum 5% stake in the notional value of a CLO ($25 million for a $500 million CLO pool, for example). The refinancing must take place within four years of an issuance, typically when a CLO is ending its reinvestment period.
This exemption was spelled out in a “no-action” enforcement letter issued by the U.S. Securities and Exchange Commission to Crescent Capital 18 months ago.
Since Jan. 1, there have been 13 CLOs with notional values totaling more than $8 billion that have refinanced, all of them originally issued in 2013 and 2014, when the cost of issuance was much higher. Managers taking advantage of the exemption so far include Blackstone/GSA, Credit Suisse, Babson Capital Management, and Symphony Asset Management.
The latest deal priced Monday: New York Life Investment Management refinanced its $323.5mn Flatiron CLO 2013-1 via Bank of America Merrill Lynch, according to JPMorgan high yield/leveraged loan research.
This activity marks one of the busiest Januarys (a traditionally slow month for CLO issuance) of the past six years, and builds on the year-end refi momentum that drove the market to a record-setting $43.6 billion in refinance deal volume in 2016.
“We were all very busy at end of year putting together deals that were going to be completed before the risk-retention enforcement deadline,” said Paul R. St. Lawrence, a partner at Cleary Gottlieb Steen & Hamilton in Washington, D.C. “When that wave started to die down, that’s when we were first hearing from clients they were interested in pursuing these Crescent-style refis at the beginning of the year.”
Both St. Lawrence and the Loan Syndications and Trading Association have pointed to both the Crescent letter and current market conditions for the vigorous refi deal activity so far.
There are likely to be more refinancing. Estimates are that more than $150 billion in existing CLOs are hitting the end of their reinvestment periods in 2017 and 2018, making them candidates for a retention-free refinancing under the “no action” letter’s unofficial guidelines.
Under the SEC’s guidance, nothing else in the deal can really change – not the capital structure, the principal amount of the notes, the priority right of payment, voting and consent rights, and maturity date.
“Moreover, the investment criteria cannot change, no new assets will be securitized in connection with the refinancing (though active management may continue), no additional subordinated interests will be issued, and the identity of the holders of the subordinated interests cannot change,” the LSTA noted in a recent newsletter to its members.
In the letter, the trade group pointed to the “relatively high cost of funds” back in 2014 compared to market conditions today, which makes refinancing attractive. It noted that in the first eight January refis midway through the month, the average AAA spread dropped from 151 basis points above Libor in original notes to 129 basis points in refinanced notes.
One example of this was the refinancing this month of Invesco Senior Secured Management’s $535 million Limerock CLO II.
Invesco refinanced five classes of notes in the deal, including $406.25 million of Class A notes (now designated ‘A-R). Invesco was able to reduce the coupon on the ‘AAA’-rated paper from 150 basis points over Libor to 130 basis points. Reductions in coupons were achieved across the board: the new Class B-1-R replacement notes ($59.75 million) was reduced from 201 to a spread of 175 basis points over Libor, and Class C-1-R notes sized at $47 million is now Libor plus 255 basis points vs. the former 285 basis point spread.
Invesco also gained lower rates on two fixed-rate tranches, according to S&P; the $20 million Class B-2-$ notes is down to 3.65% from 4.39%; and the Class C-2-R notes dropped to 4.65% from 5.2%.
No other aspects of the deal were altered.
Other managers issuing replacement notes on 2014 vintage deals for more favorable rates included the $1.29 billion Babson CLO 2014-III; the $644 million Symphony CLO XIV through Symphony Asset Management; Och-Ziff Loan Management’s $491 million OZLM VI; Bluemountain Capital Management’s Blue Mountain 2014-1 deal issued with $513 million in notes; and Credit Suisse’s Madison Park Funding XII ($798 million).
While refinance activity has been frenetic, a single new CLO has come to market so far this year: The $500 million Venture XXVI CLO transaction managed by MJX Venture Management (a newly founded arm of MJX Asset Management that will manage the company’s CLO portfolio). It is also the first U.S. deal whose risk retention compliance is compulsory, under the new standards.
Venture XXVI was underwritten by Jefferies. Last week Moody’s Investors Service and Fitch Ratings issued preliminary ratings on the deal, including the $320 million triple-A rated senior tranche that comprises 63.7% of the capital structure.
While the structure is largely unchanged from last year’s deals, the most significant feature of the deal is its standing as the first new-issue CLO to be launched in the new risk-retention era (it is both U.S. and Euro risk-retention compliant). While many deals have been structured since 2015 to meet the guidelines, MJX’s deal is the first required to meet the standards – and Moody’s likewise has had to introduce new methodology assessing the deal’s risk should the manager fall out of compliance (through, for example, an improper hedging or transferring of the risk-retention interest in the deal).
“In our analysis, we considered the possibility that the manager might not be risk retention compliant,” said Al Remeza, an associate managing director for Moody’s structured finance ratings group. “We looked at the CLO’s provisions that safeguard investors in case a manager cannot continue with his duties as a manager. In the worst case, if there ultimately is no manager, there is a trustee that would effectively ensure that payments would be made, and the deal would become static.”