A growing number of companies are looking to amend their covenants to give them the flexibility to avoid a default.

And where there’s an amendment, there’s a group of lenders who have to sign off on it. For CLO managers, it’s becoming increasingly difficult to decide whether to do so, market participants say.

There are a number of factors that make a company want to seek an amendment. However, the outcome for lenders, including CLOs, is pretty black and white: either say no and let the company default or say yes and get a higher spread and other perks.

However, there is a tradeoff. CLO managers, like other lenders, have to consider if the higher coupon from the amended loan is worth a potential lower recovery if the loan winds up defaulting later.

“The upside for a CLO manager to approve an amendment is that the manager gets incremental money that he wasn’t expecting. But the downside is that if a company is asking for amendment; that means there’s probably a problem,” said Adam Cohen, the founder of Covenant Review, an independent research provider.

All lenders have to deal with these decisions, but CLO managers face additional considerations. The higher coupons that come with an amendment benefit a CLO’s equity tranche — a tranche of unrated debt—while a lower recovery value hurts senior tranches, according to a recent report from analysts at Barclays Capital.

In addition to higher excess spread, the equity tranche benefits from an amendment because in most CLOs, the upfront amendment fees are treated as proceeds on the interest and are therefore paid to the equity tranche as long as it is within limits set by its overcollateralization tests. OC tests require a CLO to maintain a certain mix of assets, limiting the size of the lower-rated and equity tranches. On the flipside, senior secured tranches might wind up feeling the pain of an amendment down the road because the recovery on the loan may be diminished later. And the promise of a strong recovery is why senior secured lenders invest in the senior tranches in the first place.

But rejecting the amendment may cause the loan to default, which could force the company into bankruptcy and even liquidation, leaving senior secured lenders with a lower recovery value anyway. This would also cause a ratings downgrade, which puts more pressure on CLOs in regards to their OC tests. Failure to pass such tests normally ends subordinate management fees and cash flows to the equity tranche.

“From the standpoint of a CLO manager, there is less of a benefit from forcing a loan into default than from keeping the loan current and continuing to receive the subordinated management fee,” said Eduard Trampolsky, vice president of structured credit strategy for Citigroup Global Markets and author of Citi’s CLO Monitor.

Existing and future CLOs will have to accommodate a corporate landscape where these types of decisions are commonplace, sources said. That means managers will have to spend even more time analyzing credit agreements and indentures.

“When constructing a CLO, you don’t have the time to read [credit agreements and indentures],” Cohen said. “But now a CLO manager has to evaluate an amendment to an agreement that he never read.” Cohen said he has seen an uptick in managers coming in to seek advice because they are not equipped to do the analysis.

The number of covenant amendments directly correlates to the condition of the economy. During 2007 and 2008 there were 123 amendments, compared with 51 amendments in 2004 and 2005. Approximately 30% of the underlying credits that CLOs are exposed to will violate their leverage covenants in the next year, said the Barclays analysts.

“Most of the deals stopped coming around mid-2007, and now a lot of names are trading at distressed levels. So a lot of companies can’t live up to the expectations that were written into their covenants,” a CLO manager said. “If you’re a company, you had to prove that your value would go up to secure a credit facility. Now the same company is facing a situation where it has no choice but to seek an amendment.”

Ultimately, the decision to let a company amend its loan comes down to the lender. And if you are a CLO manager, that decision should be based on whether you believe the company will survive, as well as what the recovery is on the loan now compared to what it could be down the road, the Barclays analysts said. Moreover, managers are more likely to take a fundamental view of companies if they are valued at market value, they added.

“In the end, you want to get your money back and get paid for the risk you took. When push comes to shove you want to make sure the deal holds out,” the CLO manager said.


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