Investors have willingly, if grudgingly, given CLO managers plenty of leeway in running their portfolio, for the privilege of staying invested, agreeing to loose restrictions on acquiring or holding on to particularly risky assets.
They may also be consenting to some changes in deal terms without even realizing it, Moody's Investors Service warns. In a report published this week, the rating agency pointed to "hidden risks" to collateralized loan obligations: indentures that "afford excessive amounts of flexibility to transaction parties, without any checks and balances."
While these provisions in transactions may seem harmless in a credit environment, they can negatively affect portfolio credit quality and the amount or timing of cash flow payments to debt investors. "Fully understanding the credit implications is key to properly assessing a deal’s credit quality," the report states.
Amendments that are being made with little or no noteholder consent include a deal conforming to ratings agency criteria, asset quality tests and trading rules. These changes include having no contractual restrictions against a manager unilaterally adopting an amendment, and allowing managers to decide even whether a noteholder can object to a change. New clauses allow noteholders only to vote based on a “material adverse effect” on the notes, for instance. And how is that “adverse effect” determined? At the manager’s discretion, Moody’s wrote.
Among the diminished noteholder rights Moody’s detailed in the report are restrictions that give noteholders only one or two days to object to material revisions in key CLO documents. Noteholders may also be “deemed” to consent to a change if they fail to make an immediate objection, the report states.
Investors can also find that the collateral management agreement allows a CLO to be reassigned to another manager, or the original manager removed and replaced without noteholder input. Managers are also successfully applying stipulations in which a noteholder can be forced to sell notes (even during the non-call period) if the investor chooses not to back a proposed amendment change.
Some document trend changes are the result of past loopholes in pre-crisis deals that both investors and issuers used to protect themselves during the financial crisis fallout. But even those have potential weak points with some of the loose documentation in play.
The report does not cite any recent examples of deal with such indentures. Instead, it points to past problems that have since been addressed.
In 2009, KKR Credit Advisors made an unusual move to cancel multiple mezzanine and junior notes that it owned in three of its CLOs without compensation. Each of the deals had breached its minimum overcollateralization levels as the portfolio’s asset values fell, so canceling the notes without paying them reduced the liabilities and immediately placed the OC levels into compliance.
Canceling its share of notes in the deal came at a cost to senior noteholders, according to Moody’s. Interest payments that would have been diverted to pay down principal on the higher notes due to the OC test failures were instead used to maintain the waterfall payments to the remaining uncanceled junior notes.
The slowdown in deleveraging caused expected losses to increase on the senior notes, the report stated.
CLO “2.0” documentation now generally prohibits noteholders from canceling notes without payments. If it is permitted, or if the notes are paid from equity contributions or other-than-principal proceeds, the notes will need to count as outstanding for accurate OC test purposes.
But some deal documents are being drafted today in which surrendering noteholders can be paid with principal proceeds. This can result in an understatement of the OC level, Moody’s notes, since there are no reductions in the level of liabilities used to calculate the ratio.
Involuntary bankruptcy protections have been enhanced in post-crisis CLOs. Senior-note investors generally no longer have a loophole available that allows them to push an issuer into an involuntary bankruptcy, as happened in 2011 when a group of noteholders filed a petition to place a 2005-vintage deal, Zais Investment Grade Ltd. VII, into Chapter 11.
The Zais Group's CDO noteholders took advantage of the deal’s non-petition clause that only prevented junior noteholders from taking action. Subsequent CLOs have closed that loophole.
But the Moody's report cautioned that with the overall weakening of document protections, some deals are initially drafted without the necessary wording to ensure bankruptcy remoteness.
For example, Moody's stated some non-petition clauses do not fully spell out who qualifies as a noteholder beyond the original registrant. That means the provision would not cover subsequent beneficial owners, nor prevent them from taking action if they acquired enough noteholder consent for an involuntary filing. Such secondary market noteholders “would not be constrained by the non-petition covenant,” warns Moody’s, exposing "the CLO to bankruptcy risk.”
According to Moody's, however, these clauses are corrected before the closing of the deal, since the agency will not assign ratings to a deal with that type of gap in protection.