Non-investment grade corporate loans are in high demand, but financing to warehouse them for deals is scarce, so CLO managers are reaching into their tool boxes for something that hasn’t been used much since the financial crisis: delayed-draw funding.

Collateralized loan obligations issue bonds and use the proceeds to purchase a portfolio of noninvestment grade corporate loans. Managers want to acquire the collateral as quickly as possible in order to avoid paying interest on the bonds before they can collect interest on the loans.

There are several ways to address this problem. Prior to 2007, it was fairly easy to obtain a line of credit from a bank to warehouse the loans to be securitized. But these days few financial institutions are willing to tie up their balance sheets with warehouse funding.

Another strategy is to “print and sprint,” that is to issue bonds and quickly acquire existing loans in the secondary market. This was a common practice last year. But money has been pouring into the loan market from all quarters, bidding up secondary prices to levels that reduce the potential for arbitrage – although loan prices have come down from their highs amid the recent turmoil in the broader credit markets.

This means that CLO managers must often wait to buy new loans when they are issued, which takes much longer. To minimize the negative carry, some managers are using a third strategy: They are structuring deals that fund at a future date.

In June, American Money Management Corp. closed on a term funding facility with an initial investment of $30 million from equity holders and an unfunded class A of delayed draw notes. Over the next two years, noteholders may advance funds to the manager in $5 million increments up to $240 million, according to a presale report published by Fitch Ratings.

In May, WhiteHorse Capital closed on a similar facility with an initial investment of $25 million from equity holders and $141 million class A of delayed draw notes, according to Fitch.

And in March, Valcour Capital Management closed on a term facility with an initial investment and delayed draw tranche of the same size, according to Fitch.

The Royal Bank of Scotland was the lead manager on all three deals.

There have also been a handful of CLOs in which the majority of the senior tranches fund immediately, but a single, smaller tranche funds at a later date. In March, the Carlyle Group issued Carlyle Global Market Strategies CLO 2013-2, which includes a $352.5 million tranche of ‘AAA’-rated notes that funded at closing and $35 million of ‘AAA’-rated delayed draw notes, according to rating agency presale reports. Noteholders receive interest only on the drawn portion of the notes and are entitled to a commitment fee of 0.575% on the undrawn portion, according to a presale report published by Standard & Poor’s.

At least two other firm followed Carlyle’s lead: Shenkman Capital added a $40 million delayed-draw tranche to its Brookside Mill CLO and Neuberger Berman included a $35 million tranche in its Neuberger Berman CLO XIV. Both deals closed in May.

Derek Miller, a senior director at Fitch, said that both delayed draw tranches and term funding facilities give CLO managers more flexibility to ramp up deals over time.

“A year ago, CLOs were pricing and closing in two weeks, and at close had traded, if not settled, on 70%-80% of their portfolios,” Miller said. “What we’ve seen since January is most CLOs are taking four to five weeks between price and closing.”  Delayed-draw funding “gives managers additional time to source collateral.”

Scarce Collateral

CLOs have raised $41.5 billion through June 21, according to research from Wells Fargo. But they are not the only source of demand for loans. Bank loan mutual funds had pulled in nearly $26 billion of new money at mid-month. That’s in addition to money raised by private loan funds.

In comparison, $585 billion of loans were isued through June 24, according to Dealogic.  Of that figure, $342.7 billion, or nearly 60%, were refinancingsor repricings of existing debt; so net issuance of new loans is just $242.7 billion.

“A year ago, loans suitable for a new-issue CLO were trading at less than par, at 99 or 99.5. So a manager could source a full portfolio in the secondary market if they wanted to,” said Miller. In comparison, he said, new issue loans are bought at part or slightly less than par.

“Now the same secondary loans are trading at 101, 101.5, or 102 … it’s difficult for managers to purchase a whole portfolio of secondary loans and have it make economic sense for the deal,” Miller said. “So you see a mix of new issuance and secondary loans. To make the economics work, managers likely need to purchase loans in the new issue market or secondary prices need to drop.”

Although loans have sold off since the Federal Reserve started talking about slowing its purchases of bonds, prices have held up better than other kinds of fixed income. “The loan market is incredibly healthy now, maybe too healthy considering that the rest of fixed income markets, particularly emerging market debt and high yield bonds, have had outflows,” said Mark Okada, chief investment officer at Highland Capital Management.

“High yield is off 150 basis points this month and loans are off 30 basis points; the normal correspondence is 60-70 basis points, so you’d expect loans to be off one [percentage] point, but it’s not because of good inflows,” he said. “I see that as a sign of health.”

“The flipside is that a lot of repricings have failed; they’re not getting done,” Okada said. “It’s killed the refi, reprice movement. That’s good for us.”

Highland, based in Dallas, manages approximately $20 billion in CLOs and other credit products and alternative investments.

Delayed-draw funding has other uses besides allowing managers to bring CLOs to market more quickly. It is also an efficient way to finance the purchase of collateral with delayed draw features, such as revolving lines of credit.

“Sometimes you see a delayed draw feature in a deal when there is a large concentration of revolvers in the portfolio and the manager wants to mitigate the negative carry,” said John Timperio, a partner in the structured finance and securitization practice at law firm Dechert.
Timperio said that Dechert is working on a couple of deals that will have a revolving tranche of notes. He said this feature, which is a little more complex than a delayed draw tranche, was seen in CLOs issued pre-crisis deals as well.

The reintroduction of delayed funding features comes amid other moves to give CLO managers more flexibility to source collateral, such as larger allocations to covenant-lite loans and high yield bonds as well as revolving lines of credit. This year, it has not been uncommon for new CLOs to have the ability to put as much as 70% of assets to work in loans with less restrictive covenants, for example. That’s a big rise from the 30% to 40% covenant-lite buckets that were the standard practice for deals over the first three quarters of 2012, according to research published by Wells Fargo.

Delayed draw features are also popping up in securitizations of other kinds of assets, such as auto loans. In these deals they are called prefunded tranches and they have raised concerns about the credit quality of future collateral. In a June 18 report, Moody’ Investors Service cited the increased use of prefunding as one of several risks in subprime auto deals, along with weaker underwriting and stiff competition among lenders, that it said will lead to higher credit losses. The danger is that issuers may use these commitments from investors to purchase loans before they are made to expand lending too quickly, the rating agency said.

That would seem to suggest there’s a risk that delayed draw funding in CLOs could lead to higher credit losses by adding to the competition for loans. So far, however, rating agencies don’t seem to be concerned.

Sign of Market Strength?

For one thing, managers don’t have to draw down on the funding commitments if they can’t find suitable collateral. And the commitment fees they pay on the unfunded portion of commitments do not have a big impact on the economics of deals.

“Assuming the portfolio parameters are the same, failure to draw a delayed draw tranche would be positive for senior and mezzanine tranches because they would benefit from greater credit enhancement,” said Fitch’s Miller. In comparison, he said, “the equity [holders of the most subordinated tranche] would prefer a full draw to maximize leverage.”

If anything, participants say, the reintroduction of delayed funding is a sign of the CLO market’s strength.

“It shows we can take a technology that was in CLO 1.0 and reintroduce it into the current market as a way of making equity returns work a little better in light of spread compression,” Timperio said.

And Okada said that, rather than introducing risk, delayed draw features do “just the opposite. When you put them in a structure you don’t have to reach for risk; you’re more patient,” he said. 

In general, “as a fund manager, we’d always want to have more flexibility on the asset side, a bigger high yield bucket, the ability to buy other things, that creates more diversity.  It’s a good risk management tool.”

Risky or not, not all investors are willing, or even able, to commit to invest in a CLO at a future date.

“The challenge is always finding the parties who can satisfy rating agency criteria for delayed draw or revolving note counterparties,” said Timperio.  “That’s typically an ‘A1’ short-term rating or an ‘AAA’ long-term rating. You need to make sure that when you make the draws the counterparty can do it. Obviously, the universe of parties that can satisfy those criteria is not infinite.”
Timperio said these investors would primarily be banks and highly-rated institutional investors.     
  
The Bank Bid for Triple-A Tranches

Banks are some of the biggest buyers of CLOs, or at least the senior tranches of these deals. Since the first quarter of 2010, banks and thrifts have grown CLO balances by close to 135%, while CLO holdings as a percentage of banks’ total securities have climbed more than 75%, according to research published on June 14 by SNL Financial.

This might seem ironic, since banks are in the business of making loans themselves. But CLOs allow smaller banks that may not be able to participate in large syndicated loans to get exposure to a wider range of borrowers in a variety of industries.

“Some banks buy the senior tranches (of CLOs) expressly to get a diversified portfolio of corporate credit assembled by a top-tier manager,” said Timperio. “A lot of banks have a regional footprint or have lending that is more relationship-based,” he said. “This gives them exposure outside their footprint.”

Take First Niagara, a community bank with approximately $35 billion in assets serving Upstate New York, Pennsylvania, Connecticut and Massachusetts: Its CLO holdings jumped to nearly $1.6 billion, or 13.14% of the bank’s total securities, in the first quarter of 2013, compared to $800.1 million, or 5.52% of total securities, in the first quarter of 2012, according to SNL.

Gregory Norwood, First Niagara’s chief financial officer, told SNL that this was part of the bank’s acquisition strategy when it purchased 195 HSBC USA branches. “Since we didn’t buy a lot of loans with that acquisition, we wanted to buy credit assets that began to mimic the assets we would have bought,” he said.

According to SNL data, 21 of the 28 U.S. banks and thrifts that held CLOs at March 31 have increased their CLO holdings since the first quarter of 2012.

Banks may ease back on CLO growth thanks to a change in deposit insurance rules that took effect on April 1. Assets now factor heavily into calculations of deposit-insurance premiums, and the rules require higher assessments for even the least risky CLO tranche, those rated ‘AAA.’
The Federal Deposit Insurance Corp.’s rule change was the impetus for delayed draw funding in at least one CLO that priced before April 1.

Aegon USA Investment Management’s Cedar Funding II CLO was structured with delayed draw notes in each tranche to speed up the transaction for bank investors that wanted the deal to close by March 31, according to Erez Biala, co-head of global CDO trading at Jefferies, the deal’s underwriter.

Dodging FDIC Rule Change

The deposit insurance rules apply to loans and CLOs issued on or after April 1; those issued before that date are grandfathered.

Biala said that Cedar Funding II is the first CLO Jefferies has underwritten that has a delayed draw and the first CLO ever that consists entirely of delayed draw tranches.

The banker declined to comment on how Aegon will draw on the funding commitments, saying the mechanism is proprietary. But he said that, in general a draw mechanism is negotiated between the CLO manager and investors, so it varies from deal to deal. In most cases, managers have the ability to draw down on commitments in more than one increment, because that is more efficient. If they draw too much at once, they would have to pay interest on money before they can put it to work.

Although the deposit insurance rule change undoubtedly brought forward some CLO issuance that might have occurred later in the year, no one’s expecting the bank bid to disappear.

“The FDIC didn’t slow people down, there’s just a bit of pause,” Okada said. “It’s a really complex formula to get to … every bank is different as to how [a CLO] rolls into its risk-based capital equation.”

With new issue triple-A CLO tranches pricing at 125 basis points, “CLO debt is well-priced for banks that are driven by risk based capital rules and lots of liquidity,” the CLO manager said. “That’s why the market is open and why we see spreads coming down by year end…  We think it will continue to tighten to 100 basis points.” 

Timperio also sees no drop in demand for CLOs. “Dechert has a pretty good visibility on the pipeline of deals; we see a lot closing in the third and fourth quarters,” he said. “It’s hard to envision not hitting the high end of forecasts for full year issuance, in other words $70 to $80 billion.”

If loans continue to sell off, fewer of these deals might have delayed draw tranches, however.
Biala noted that CLOs with delayed draw tranches are still not as common as they were before the financial crisis, because investors are still not as comfortable with CLOs or as open to complex features that boost yield.

Now, “across asset types, no one wants anything complex or funky,” he said. “Even though the [CLO] market has tightened over the last couple of years, it’s wide to where it was five or six years ago. Spreads on triple-As are in the low 100s; back when they were in the 20s, investors were willing to look at other permutations because they were starved for yield.”

The banker said that the retreat in loan prices over the last couple of weeks has made it a little easier to ramp. That means investors can be a little more choosy and are less likely to commit to fund CLO tranches at a later date. “There’s a lot of supply looking to come to market and the demand is a little less.”  

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