CLOs Increasingly Seeded by Rated Warehouses
Competition for leveraged loans is tough, and that’s forcing some of the biggest buyers to tap new sources of financing.
Collateralized loan obligations typically acquire a portfolio of below-investment grade loans in advance of selling debt to their ultimate investors. To do this, they require the assistance of banks and other major lenders, who provide warehouse lines of credit. CLO managers tap these credit lines as they ramp up their portfolios.
The problem: Ramp up periods are lengthening due to low loan issuance and stiff competition from other buyers, such as mutual funds and exchange-traded funds. The percentage of loans in the JPMorgan Leveraged Loan Index trading above par, or face value, in the secondary market has reached a three-year high of 71.5%.
So rather than overpay for existing loans, CLO managers prefer to patiently wait to buy new loans as they are issued.
Yet banks are loath to make warehouse lines available for too long. (Possibly more than a year, for a European CLO.) It ties up capital and introduces regulatory risk. And if the CLO is not completed, the loans would need to be liquidated.
That is why, in the view of rating agency DBRS, investment banks such as Natixis, RBC and RBS are increasingly bringing in outside investors to help finance these warehouse lines. Key to that is obtaining credit ratings for the facilities.
“The larger banks are looking to syndicate some of that warehouse risk to third parties, and some of those third parties will need ratings,” said Jerry van Koolbergen, a DBRS managing director and head of the agency’s global structured finance practice in the U.S. and Europe. “That’s the new dynamic we’re seeing in the market.”
In the past year, the agency recently reports, lenders have increasingly structured warehouse lines to look much like CLOs themselves, with two or more classes of debt that are tranched by credit risk and sold to insurance companies and pension funds as a means of sharing the risk.
DBRS issued ratings (both public and private) on 14 such facilities last year. It did not provide a comparable, year-earlier, figure, but a February report says that rated warehouse line began to “fully emerge” in 2016.
Rated lines become more attractive to lenders when the loan markets tilt toward issuers in a sellers’ market. “Providers that typically ask for a CLO rating may decide they don’t need a rating for shorter term warehouses,” said van Koolbergen. “Longer term warehouses increase uncertainty, and that’s where a rating could be helpful.”
Shorter Terms than CLOs, but Concentrated Assets
Most rated warehouse lines issue two tranches of notes. The senior tranche typically carries a rating that is investment grade, but a few notches below the triple-A rating on the senior tranche of a fully-funded CLO. The subordinate tranche is typically rated below investment grade.
For example, in September 2016, Moody’s Investors Service assigned an A2 rating to the $175 million senior-advance delayed draw notes of a warehouse transaction for OHA Credit Partners XIII. The line was used to assemble the collateral for a $410.5 million CLO that Oak Hill Advisors launched in December.
And in March, DBRS said it expects to assign an A to the senior tranche of a European warehouse facility for Barings; the subordinate tranche is provisionally rated BBB (low).
Both traditional and rated warehouse lines are structured with CLO-like tenors (the Barings warehouse has a legal, final maturity of 2031), even though they are intended to provide bridge financing, until the manager of a deal has assembled anywhere from 30% to 50% of its targeted portfolio. They typically are used to finance a single deal, rather than multiple deals, and are then dissolved.
By necessity, CLO warehouses are also smaller and more highly concentrated than their successors CLOs. In a report published in January, Moody’s noted that rated warehouse lines tend to have lower diversity in the industry mix of borrowers than their successor CLO debt instruments. They have higher single-issuer concentrations and sometimes weaker credit quality, Moody’s notes.
To offset these risks, managers are using greater “subordination,” or issuing smaller tranches of senior notes, according to Moody’s analyst Oksana Yernovska. In a telephone interview, she said CLO managers are also agreeing to more restrictive covenants on warehouse lines, such as restrictions on industry concentration or requiring lender consent on asset sales.
Why would an investor put money to work in a CLO warehouse, as opposed to (or in addition to), the CLO itself? Many want shorter-term exposure to leverage loans, rather than weighted average life of eight years or more for CLOs.
“The shorter life reflects the key purpose of the transaction, which is simply to acquire assets for a conventional deal rather than to engage in trading activity that extends the life of the warehouse transaction beyond the average life of the initial assets,” Moody’s stated in its January report. “Indeed, the expected life for a warehouse transaction is about one year as the parties involved expect the deal to be redeemed upon the closing of the traditional CLO.”
Lenders without a long track record in warehouse lines may gravitate toward rated facilities to better display deal criteria, such as coverage tests, to investors and potential deal participants. “That’s [especially] important for lenders who are emerging in the space” with an eye toward syndication, said Christopher Duerden, a partner at law firm Dechert LLP specializing in structured finance and securitization.
Duerden pointed to another factor contributing to the need for rated warehouses: companies have been refinancing their outstanding below investment grade corporate loans in order to take advantage of more attractive financing. This adds further to the time needed to assemble portfolios of collateral for new CLOs.
Rated warehouse lines bring a level of “comfort” to CLO managers, who can structure the deals on the same CLO platform, recruit a first-loss holder, and choose to bring in equity partners after consulting with a lead lender, he said.
An eventual pickup in loan issuance or fall off in competition from other loan investors could lessen the need for rated warehouses. Or banks could simply decide to stop offering them, as they did after the financial crisis. At that time, CLO managers were forced to “print and sprint,” issuing long-term CLO notes and quickly put the proceeds to work acquiring loans in the secondary market. It wasn’t until 2014, amid a surge in CLO issuance, that warehouse financing became near ubiquitous. Up to 80% of CLOs issued that year relied on warehouse financing, according to Moody’s.
But for now, banks are finding it’s not just enough to provide a line of credit – not with regulatory pressure to reign in their leverage, the opportunity to serve additional lines of investors and bank participants and with loan prices soaring.
“The last year has been a roller coaster,” Duerden said.