Best of Times, the Worst of Times
The year 2008 begins with a tale of two seemingly conflicted realities. One on hand, middle-market CLOs continue to perform well and to avoid downgrades. On the other hand, like the broader CLO marketplace, deal flow is diminished and sporadic, and investors remain jittery and continue to demand higher premiums for their risk. Although some of this disconnect may result from fears that a softening economy could give rise to higher default rates of underlying obligors in the future, it may also be explained by a general mistrust of structured products that has spilled over from the subprime blow-up or a lack of information regarding the degree to which aggressive lending practices have infected the MM CLO space.
As a result, investors and rating agencies are demanding more transparency and issuers are responding with more conservative structures and more explicit terms. Whereas in the past covenant-lite loans, second lien loans and PIK loans may not have been identified, new deals both define and place percentage limitations on them. Buckets for other types of debt, particularly distressed debt, have been significantly reduced and, in some cases, eliminated. Reinvestment periods have been shortened, and deals that are not fully ramped or only slightly ramped at closing are subject to increased collateral testing during the ramp-up period. Banks that finance warehousing deals are demanding the more robust documentation that is typical of evergreen-type warehouses, with a fuller set of representations, warranties, covenants and remedies in events of default.
Back to the Future
Over the course of the past six years, the evolution of MM CLO technology has been toward making MM CLOs look more like traditional arbitrage CLOs. One outgrowth, however, of the recent market turbulence has been a return to the technology of some of the earlier financing or "Business Loan Trust" deals as well as private MM CLOs.
Business Loan Trust deals were the first deals done in the middle market space (dating back to the ACAS Business Loan Trust 2000-1 deal), and are generally more conservatively structured and levered. These deals are typically issued onshore out of Delaware statutory trusts. Initially, they were collateralized by static pools of loans; however, more recently such deals have become managed and contained features to allow for replenishment of prepayment proceeds. Such deals also contain repurchase, substitution, back-up servicing, one-to-one asset to liability cash trapping mechanics and other structural features more akin to commercial ABS deals than traditional arbitrage CLOs.
Private MM CLOs also date their roots back to the first deals done in the middle market, which were asset backed commercial paper warehouses. Generally, private MM CLOs have capital structures characterized by one or more highly rated tranches (rated "A/A2" or above) frequently bought by commercial paper conduits and one unrated equity tranche retained by the sponsor. Such deals are usually done without any formal offering document which reduces the cost and timing associated with traditional CLO execution, and contain terms and provisions which are a hybrid of CLOs and commercial paper conduit securitizations. As private CLOs are transactions negotiated directly with the investor which is ultimately taking the risk on its own balance sheet, in the present environment these deals, not surprisingly, tend to produce more conservative structures and terms which tend to be more investor-friendly. In all types of deals, banks and investors also continue to demand higher levels of equity.
Interestingly, despite the recent volatility, new collateral managers continue to be attracted to the MM CLO space. Private equity firms, for instance, have shown an increased interest in acquiring collateral managers or becoming collateral managers themselves. Such draw may be explained in part by the strong track record of MM CLOs thus far, particularly in comparison with other asset classes. In addition, the recent liquidity crunch has created a buyers' market for those who are able to buy, with loans trading at attractive discounts to par and banks eager to offload risk from their balance sheets. Private equity firms with established reputations in the marketplace and long-standing relationships with investment banks are well-poised to raise money for new CLOs which can profit from this type of environment, as evidenced by the recent launches of CLOs by KKR Financial and The Blackstone Group. The extent that PE firms are seeking to acquire collateral managers (rather than launch CLOs themselves), may reflect a recognition that acquiring successful collateral managers along with the talent and expertise of its personnel may be necessary to navigate the CLO market and manage the collateral effectively. Further, the types of loans that PE firms generate in their buy-outs tend to fall on the lower end of the credit curve (B+', BB-' credits) as they are often associated with highly levered business-reorganization plans. To obtain more favorable execution in terms of ratings and capital structures, it might be advantageous to combine such loans with some higher-rated loans purchased in the open market, which established collateral managers would be well-positioned to do.
As loan credit spreads have widened and prices have dropped, a favorable investment environment has been created for credit opportunity funds, which generally seek returns and capital appreciation by buying loans at bargain prices and re-selling as conditions improve. Credit opportunities funds in many respects resemble market value CLOs using leverage to invest in credit assets, and, like market-value CLOs, are valued based on the portfolio's current market or liquidation value rather than the present value of the underlying obligations and expected cash flow, a value which, as investors have noted, may often be at odds with market prices.
However, rather than issuing rated debt in multiple tranches, these funds generally obtain leverage from a single financing source, often through use of a total return swap or an unsecured credit facility. As a result, managers of credit opportunities funds enjoy greater flexibility as they are not bound by the same rating agency constraints present in CLOs. While CLOs are subject to strict divestment rules when the credit of an asset deteriorates, credit opportunity funds are well-positioned to buy up these assets for bargain prices when they hit the market. Furthermore, in a credit opportunity fund, the manager controls and can adjust the amount of leverage the fund employ, thus giving it flexibility to adapt to changing market conditions by increasing or decreasing leverage. CLOs which issue term notes, on the other hand, are stuck with a constant amount of leverage over the life of the deal. This inherent flexibility allows a credit opportunity fund to reduce leverage as market conditions turn negative, or to invest more heavily in sub-par debt, which tends not to suit CLO structures as well because of their fixed high leverage. As a result, a number of asset managers in the MM space have established and currently manage credit opportunities funds, including NewStar Financial, Goldentree Asset Management, Columbus Nova, Guggenheim Partners and Babson Capital. In addition, middle-market private equity funds, such as Audox Group, have also launched middle-market credit opportunity funds.
One challenge facing credit opportunity funds is that the sources of financing have become more difficult as banks have become reluctant to lend. Thus, unsecured credit lines and total-return swaps used to finance these funds have become more expensive and the terms more scrutinized. As a result, managers have increasingly turned to single name credit default swaps and loan credit default swaps - derivatives which insure against a particular company's default - to provide financing. These types of single-name products also give more flexibility to managers as they are not bound by fixed-limit constraints pertaining to the overall portfolio that term financing agreements typically contain.
Although current market conditions are ripe for opportunity in this area, credit opportunity funds will not overtake CLOs, and as the markets improve the opportunities for buying assets on the cheap will start to diminish. In the meantime, however, collateral managers have redeployed staffing and resources to these areas as CLO work remains slow.
As we begin 2008, the big question on the minds of participants in the middle market space and the capital markets generally is when and at what levels will the market come back. Whether MM CLOs will come back has already been largely answered. MM CLOs along with CLOs have continued to get done even in the adverse conditions of the past several months. Given the continued volatility, any predictions about deal volume in 2008 are inherently unreliable. However, all of the above trends, combined with what will hopefully remain strong performance on the part of MM CLOs, will likely serve to increase investor confidence in MM CLOs in the market-place and foster a more favorable environment for new issuances beginning in the second half of the year.
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