The slowly reviving CLO market is getting a boost from an unexpected source: one of the biggest financial blowups in history.
Lehman Brothers Holdings reached an agreement last week with WCAS Fraser Sullivan Investment Management to run a portfolio of approximately $5 billion of commercial loans. Fraser Sullivan would transfer approximately $3.6 billion of the loans into a series of collateralized loan obligations
The deal, which was filed with the U.S. Bankruptcy Court in Manhattan Wednesday, would generate between $1.6 billion and $2 billon for the Lehman estate and its creditors.
The first CLO, backed by at least $500 million of loans, would be issued within six months of the court’s approval of the asset management agreement; a second deal, also backed by at least $500 million of loans, would be issued within the first year.
Fraser Sullivan would serve as portfolio manager for the remaining $1.6 billion of loans that Lehman has determined are not eligible to be sold into the CLOs, either because the loans contain unfunded commitments, the borrowers’ credit ratings are below certain levels, or the loans permit borrowers to capitalize interest payments, among other reasons.
Judge James Peek of the U.S. Bankruptcy Court for the Southern District of New York will hold a hearing on the proposed transaction on Aug. 17.
“Commercial loan market conditions have significantly improved, and the market values of many of the loans in the commercial loan portfolio have similarly improved from the historic lows that existed shortly after [Lehman’s September 2008 Chapter 11 filing],” Lehman said in the filing.
The failed bank expects that many of the commercial loans it holds will be repaid in full upon maturity, but some 30% are not scheduled to mature before 2016. Securitizing them allows Lehman to accelerate distributions to creditors while maximizing the value of the assets, according to the filing.
“The economic benefit Lehman and its creditors will receive from the receipt of such cash in advance of the normal run-off of the loans based on their maturity schedules exceeds the anticipated costs associated with the CLOs,” Lehman said in its filing.
The firm considered other options for monetizing the commercial loans, including selling the individual loans or entire portfolio, but it determined that doing so in a short period of time would adversely affect their values. Lehman also considered using the portfolio as collateral for a bank loan, but the two banks it discussed this possibility with were not willing to lend on as favorable terms as it could get by securitizing the assets.
Lehman said it will retain 100% of the equity interest in the transactions, “thereby preserving upside of the CLOs.”
Lehman said there is ample authority under Section 363 of the U.S. Bankruptcy Code for the approval of the asset management agreement and proposed sale of a portion of the portfolio to a CLO issuer.
The commercial loan portfolio includes $5 billion of funded and $1.5 billion of unfunded high yield and investment-grade corporate loans, special purpose vehicles and junior debt, as well as equity securities obtained through restructuring. It is comprised of loans to approximately 200 borrowers, 75% of them in North American and 25% of them European or Middle Eastern. The weighted average maturity of the portfolio is 3.5 years.
Lehman discussed entering into an asset management agreement with one other CLO manager, not named in the filing, but chose Fraser Sullivan because it was able to negotiate more favorable terms with the firm and because of Fraser Sullivan’s experience—it has brought five CLOs to market since 2006, the most recent one in February 2011.
Lehman will pay Fraser Sullivan a management fee of 30 bps per year on the amount of the funded loans and the value of any defaulted loans or equity interests, court records show. Fraser Sullivan may also receive a success fee of as much as $5 million, at Lehman’s discretion.
Management fees on the CLOs won’t be established until their launch but are expected to be 25 bps per year based on the outstanding principal amount of the loans held by the CLO. Lehman estimates the aggregate fees will be about $3 million for the period from Sept. 1, 2011 through Dec. 31, 2011, $9 million for calendar year 2012, and $8 million for calendar year 2013.
As part of the deal, three employees of Lamco, the asset management unit Lehman spun out of its bankruptcy case, will be retained by Fraser Sullivan.
Lehman’s decision to securitize its loan portfolio comes as CLO issuance has started to pick up, with $5.8 billion coming to market in the first half of 2011 and another $1.3 billion pricing in the first weeks of the third quarter, according to Fitch Ratings. Forecasts for total 2011 issuance range from $10 billion to $15 billion. That would be two to three times greater than the $4.3 billion issued in 2010, but nowhere near the close to $90 billion in 2007 and $100 billion in 2006.
Although Lehman, through its financial adviser, Lazard Freres, sought other offers for the management of its commercial loan portfolio, the firm managed to keep its plans to securitize the loans quiet. Two CLO analysts said they had not incorporated prospective issuance from Lehman into their forecasts. However, one of the analysts said his forecast included an unspecified number for “wild cards,” or deals he didn’t anticipate, and that any deals brought to market on behalf of Lehman could fall into this category.
Before filing for bankruptcy in 2008, Lehman was the fourth largest investment bank in the U.S., and it regularly originated, syndicated and traded commercial loans. It also originated loans through its affiliates Aurora Bank and Woodlands Bank.
