"There are snakes that go months without eating. And then they finally catch something, but they're so hungry that they suffocate while they're eating. One opportunity at a time." - Don Draper, Mad Men
The year 2009 was a year of mixed signals-on one hand, revised assumptions by rating agencies such as Moody's Investors Service and Fitch Ratings led to a series of downgrades. Fitch also cited concern that rising default levels, lower recoveries and refinancing risk may indicate even more downgrades in the future. On the other hand, trading prices for CLO notes made a dramatic rebound in the first half of 2009, and the first middle-market (MM) CLO of the year priced in December (NewStar Commercial Loan Trust, 2009-I). In addition, new warehouse-type securitizations have begun to emerge, with Ares Capital Corp. and Fifth Street Finance Corp. announcing deals with Wells Fargo in 2009.
Given how the year ended (which if not on a high note was certainly not the paralysis of the prior year's end), it is hard not to be cautiously optimistic about 2010. We think this coming year will be one where banks and investors pursue one opportunity at a time involving managers with credibility and deals that are conservatively structured.
Warehousing: New and Improved
With new MM CLO issuance dormant throughout much of the year, many funds, business development companies and specialty finance companies in the middle-market lending space aggressively sought out warehousing opportunities with banks and commercial paper conduits only to find that such financing was in short supply and when available prohibitively expensive. There were one or two notable exceptions involving banks that had been in the space since its beginnings and understood the risks and opportunities of lending to lenders. These banks provided structured loans utilizing proprietary technology that both drew on the past origination facility/warehouse technology but also contained some key alterations based on the lessons learned and experiences of such institutions during the credit crisis. Thus, the structured loans these institutions were willing to underwrite contained new mechanics around valuing loans, determining eligibility, determining who qualified as an independent director and consenting to amendments. Such facilities were typically made available only to fund senior secured loans serviced by established managers. As a result, the banks were also willing in certain cases to extend these facilities out and make them multi-year deals.
Consolidation and New Entrants
During the past two years, there has been both a winnowing out and consolidation process occurring amongst middle market lenders whereby some of the weaker and less well heeled players exited the space and sold off their middle market portfolios or merged into stronger rivals.
Recently, we are beginning to see signs of interest among some new entrants. This group includes some regional banks like Fifth Third Bank and Amalgamated Bank as well as some newly launched credit opportunity funds and separate accounts. If anything, this trend will continue to accelerate in 2010 due to, among other things, the continued capital shortfall serving the MM sector. A critical aspect to observe will be just how much debt financing these new entrants are willing to provide.
Discount Repurchases and Note Cancellation
With most CLO tranches trading at a depressed value, particularly in the first half of 2009, several managers pursued strategies designed to capitalize on this dislocation. While some managers simply bought CLO securities for their own account, on the presumption that the notes of their CLOs were undervalued, others took steps which more fundamentally altered the economics of the deals.
Although the middle-market space largely avoided the use or misuse of the strategies employed in the broadly syndicated CLO market, the moves by some managers to repurchase or cancel notes were representative of a larger debate that recurred throughout the year centering around how aggressively managers should interpret CLO documents which are silent or ambiguous as to whether or not certain types of transactions are allowed. From a legal perspective, the most conservative approach to these types of questions would entail a formal amendment process, including noteholder consent and re-affirmation of ratings from the rating agencies. From a manger's perspective, however, these hurdles alone can make the economics and the timing of the transaction unpalatable, thus leading some to try to utilize amendment provisions which do not require noteholder consent (usually necessitating the conclusion that there is "no material adverse effect" on the noteholders) or to simply conclude that actions which are not specifically prohibited are implicitly allowed. In these cases, the threat of litigation and the possible reputational fall-out from taking these "sharp-elbow" type actions is the only deterrent from plowing forward. In any event, the amendment provisions of CLO indentures and the degree of flexibility which should be given to managers to take unanticipated actions will likely be re-negotiated if and when the CLO market returns.
Re-REMICs
Another interesting development to watch for will be whether there are any "Re-Remics" of middle market CLO tranches. "Re-REMIC" is a term that has real estate roots but is used loosely to apply to re-securitizations across various asset classes. A classic Re-REMIC transaction would involve CLO notes that were initially highly rated ('AAA' or 'AA') but have been downgraded. These notes would be placed into a trust that issues new notes in two separate tranches, the highest of which is 'AAA' or 'AA'. For a bank or insurance company that has regulatory capital holding requirements, such a trade could, depending on what happens to the junior tranche that results from the resecuritization, provide the bank or insurance company with some capital relief. On the flip side, a hedge fund or other type of investor may do this same deal but retain the junior tranche that results and sell the senior tranche that has been created. The rationale with this type of deal is that the investor is already exposed to the risk associated with the first dollar of loss on the downgraded note, which it retains, but can simultaneously create a highly rated note that it can sell in the marketplace on more favorable terms. While there has been a lot of interest in Re-REMICs in 2009, only a few have actually been executed in the CLO space involving CLOs of broadly syndicated loans. Furthermore, European regulators purportedly have considered heightening capital requirements for re-securtizations, as they present the possibility that several notes held by an institution could actually represent a limited number of underlying assets.
Conclusion
While any predictions for 2010 are inherently uncertain given the number of present variables, there are some strong indications that investors are coming back into the market and new warehouse activity, followed by CLO issuance will occur - particularly by the end of the year. To the extent that middle-market CLOs come back, most players expect them to be more simply structured (with perhaps only two or three tranches), less levered (with an equity tranche of 20-30%) and shorter reinvestment periods.
The authors of the piece can be reached at John.timperio@dechert.com
Mary.bear@dechert.com
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