With so much CLO investment capacity going offline over the next few years, the loan market is getting creative in structuring deals to accommodate this waning investor class.
CLOs currently hold about half of the $500 billion in U.S. leveraged loan assets, but most of these structured investment vehicles were issued in 2006 and 2007 and are nearing the end of their reinvestment periods, which range from three to seven years.
Indentures vary widely, but many CLOs are limited to reinvesting unscheduled payoffs once they become 'static' and start repaying investor principal. Even then, they are prohibited from holding assets beyond a certain maturity. Older CLOs that are still actively investing may also be limited in what they can purchase by their weighted average life test requirements.
The $2.2 billion senior secured credit facility Kinetic Concepts completed this month is one example of what issuers may need to do to find a home for loans in the future. The seven-year facility, which backed Kinetic's $6.3 billion buyout by Canada's Apax Partners, the Canada Pension Plan Investment Board and Canada's Public Sector Pension Investment Board, initially appeared to be too big for the loan market to digest, but was eventually oversubscribed after lenders led by Bank of America Merrill Lynch carved it into smaller pieces, including a five-year term loan C. According to people familiar with the transaction, that tranche resulted from reverse inquiries from several older CLOs that did not want to buy a seven-year loan.
Jaime Aldama, head of U.S. credit and ABS structuring at Barclays Capital, said that in the future he expects more such shorter-dated tranches carved out of new facilities to fit within the maturity profiles and weighted average life covenants of older vintage CLOs.
Aldama said that, for companies looking to refinance, amend and extend agreements are commonly used to cater to managers of CLOs outside the reinvestment period. That's because extensions tend to be much shorter-dated than new loan facilities.
A New York-based money manager agrees that shorter-dated tranches could become a regular feature of loan deals, or at least of larger ones. Kinetic "pulled out all the stops to create that tranche," he said. While the term loan C was just $300 million, "it was more than 10% of the deal," he noted.
In the future, "if a loan is a little too big to clear from regular buyers, we'll see more of that," he said.
CLO investing capacity quickly declines over the next three years. JPMorgan Securities estimated that, of the $295 billion in outstanding U.S. arbitrage CLOs, $198 million are currently active, but that will fall to $143.67 billion in the fourth quarter of 2012, $64.71 billion in the fourth quarter of 2013, and just $11.2 billion in the fourth quarter of 2014.
So far this year, there has been $9.8 billion in new U.S. CLO issuance, with another $2.8 billion in the pipeline, according to Thomson Reuters.
Money managers are hoping that pension funds and insurance companies will eventually become big buyers of loans, picking up some of the slack, but wooing these kinds of investors is expected to take some time. And bank loan mutual funds, which until recently appeared to be plugging the gap, have been sustaining withdrawals for the past 13 weeks.
One thing that could slow the erosion of CLO buying power, if not stop it, is an ongoing review of collateralized loan obligation ratings by Moody's Investors Services. Earlier this year, Moody's changed its ratings methodology, removing a 30% default probability stress that it put in place in February 2009 in response to the extraordinary disruption in the capital markets following the collapse of Lehman Brothers. Many CLOs restrict a manager's ability to buy and sell loans used as collateral when the notes issued by the trust are downgraded. So the Moody's upgrades are paving the way for some managers to resume trading loans for the first time in two years.
In the first three months of the ratings agency's CLO sweep (June-September), it upgraded 2,377 tranches in 449 U.S. transactions, representing 73% of the total number of deals it had placed under review for a possible upgrade.
(Most of the transactions reviewed to date have been broadly syndicated CLOs. The remaining transactions Moody's will review over the next three months include SME CLOs, multi-currency CLOs, synthetic CLOs, and certain repackaged securities referencing these CLOs.)
As a result of the upgrades, there are now $28.97 billion of CLOs that are static, but able to invest unscheduled repayments, compared with just $9.66 billion before Moody's initiated its review. This will help as more CLOs enter their static period; in the fourth quarter of 2012, JPMorgan estimated there will be $45.40 billion of CLOs that are static but still able reinvest compared with $15.13 billion if there hadn't been upgrades; in the fourth quarter of 2013, there will be $69.09 billion instead of $23.02 billion; and in 2014, $85.14 billion instead of $28.8 billion.
Even CLOs that are able to resume trading as a result of the upgrades will be prohibited from holding assets beyond a certain maturity, however.
Bankers aren't the only ones thinking about ways to make it easier for CLOs to reinvest. CLO managers are also getting creative.
In May, S&P said it had seen several proposals from managers looking to increase the weighted average life of the assets in U.S. cash flow CLOs or extend their reinvestment periods.
"We believe these amendments may allow collateral managers to extend the life of the collateral within their CLOs," the rating agency said in a research note.
"Managers have told us that a longer WAL affords them additional flexibility to participate in 'amend to extend' requests when they are comfortable with the obligor's credit quality," the note said.