On the long and winding road to recovery for structured products, 2011 marks a year of modest improvement in the CLO space. While storm clouds and speed bumps continue to loom on the horizon in the form of unpredictable regulatory developments, a weakening economy and European contagion, it is becoming more evident that a market whose very existence was once threatened to be subsumed is reemerging from the ashes of the recent financial crisis.
Activity in the Rule 144A/Reg S CLO space continued its rebound in 2011 with approximately $10 billion in closed or projected-to-close deal volume. This is up from roughly $5 billion in 2010, but on the low end of the range analysts had predicted. Throughout the year, CLO liability spreads have continued on a downward march (with some recent hiccups) and the investor base for all tranches of the capital structure (including, in some instances, even CLO equity) has expanded as (i) awareness continues to grow about the differences between CLOs backed by senior secured US corporate credit and CDOs backed by RMBS and ABS, however similar the acronym used to denominate the deals, (ii) an increasing number of investors desired to gain exposure to US corporate credit and (iii) more investors are becoming aware of the risk-adjusted opportunity in the CLO space relative to other types of ABS investments. Despite these positive developments, a CLO collateral manager's ability to speak for a substantial portion of the equity remains a key differentiator in getting deals done.
CLO NEXT GENS
In terms of the technology, CLOs proved their worth over the past three years with the structures performing as designed. The CLO "Next Gens" of 2011, in comparison with the "Classic" CLOs of 2004-2007, feature lower leverage, higher credit support, shorter reinvestment periods, maturity and non-call periods, smaller CCC buckets and higher spreads. Less leverage and higher credit support has allowed for greater flexibility in deal structures (i.e., in recent deals we have seen slightly larger buckets for covenant lite loans and deferrable securities). Despite such differences, we expect CLO Next Gens to slowly trend towards convergence with many of the attributes of Classic CLOs, as new and returning investors have been attracted by the resiliency of the CLO structure during the downturn. Additionally, a quick scan of the CLOs of 2010 and 2011 also show an uptick in business development companies ("BDCs") entering the CLO market. BDCs, similar to venture capital and private equity funds, are created to help grow small companies in the initial stages of their development. In constant need of liquidity, some BDCs are looking to the CLO market as an attractive alternative to warehousing arrangements with banks due to a cheaper blended cost of capital, lack of market value triggers, greater trading flexibility and higher implied advance rates.
The CLO market continues its attempt to digest legal and regulatory developments in the US and abroad. In the US, joint regulators are still working out the parameters of risk retention in CLO transactions. In Europe risk retention rules became effective on January 1, 2011 pursuant to Article 122a of the European Union's Directive 2006/48/EC ("Article 122a"). As a result, European credit institutions, managers and investment banks are working out compliance strategies with the requirements of Article 122a. Uncertainty surrounding the requirements of Article 122a will continue until more European CLOs are issued.
THE ZING CASE
Recently, a distressed debt investor purchased the most senior tranche of notes issued by Zais Investment Grade Ltd. VII ("Zing"), an offshore CDO-squared vehicle, while Zing was in default. The investor's objective was to liquidate Zing's assets as quickly as possible to realize a prompt return on its investment. However, liquidation under Zing's indenture required approval from 66.67% of each class of rated notes, and all tranches junior to the investor's objected to such liquidation, preferring to wait for any left over runoff from the collateral, rather than accepting the likely result of being left with no distributions. In furtherance of its strategy of forcing liquidation, the investor filed an involuntary chapter 11 petition against Zing, citing the fact that the indenture's non-petition clause did not restrict the most senior tranche from filing. The bankruptcy court allowed this petition to proceed, holding, among other things, that despite its off-shore incorporation, Zing is a "debtor" in the US due to its on-shore investment, record-keeping and reporting activities.
The Zing case is significant to the CLO market because a sizable minority of existing CLO indentures, like the Zing indenture, contain non-petition provisions that do not preclude the most senior tranches from filing. A simple antidote to the Zing result is making sure that non-petition provisions in deals restrict all tranches from filing. Other recommended approaches to prevent the enforceability of non-petition provisions from being challenged by any tranche include (i) giving other noteholders the right to seek equitable relief to prevent the filing and (ii) requiring the CLO issuer to contest the filing.
With increased issuances in 2011, the future of CLOs looks brighter as new and returning investors begin to recognize the consistent value offered by CLOs. Overall, we expect modest improvement in the CLO space to continue in 2012.