It's harder to get financing to warehouse loans for a CLO these days.
Fortunately, you don't need it.
Back in the glory days, before the credit crisis, virtually all new deals were brought to market only after the manager used a line of credit to warehouse the collateral. Today, most CLOs are done without a warehouse, market participants say. And that is allowing lesser known managers with fewer resources to participate in the recent CLO mini-boom.
The history goes like this: At the height of the market in 2006 and 2007, conditions made warehousing a CLO common practice, necessary really, for the deal to make economic sense. That's because new-issue loans on the primary market sold at par, or very close to it, then traded up on the secondary market, often to the neighborhood of 101 or 102 cents on the dollar. So the only practical way for a manager to source collateral for a CLO was to build a warehouse of loans carefully plucked from the primary market over a period of months. "It was actually pretty difficult to buy loans on the secondary at that time," one CLO manager remembers. "You would have had to pay extra to get those loans. Back in '06 and '07, we issued 11 deals in total, and they were all warehoused. And in all cases, we acquired the loans at issue."
At the same time, investment banks enabled all manner of CLO managers, seasoned and not so seasoned, to complete deals by providing 100% warehouse funding. "Back in the day, the underwriters you signed up with, they would give you a warehouse," said a second CLO manager. "You wouldn't have to put up a nickel. They would take all the risk."
Much has changed since that time - including both market conditions and the amount of warehouse financing banks are willing to provide. But in their place another phenomenon is helping smaller CLO managers get deals done: They don't really need a warehouse.
The reason in a word is pricing. The credit crises sent loan prices into a tailspin. And while they've recovered substantially, it is still possible to buy a significant amount of assets on the secondary under par. Which means that a CLO manager can now print a deal, with the promise of what will be bought and at what price, then snatch up secondary market loans after the fact.
"There is a lot of appetite for this structure, so people are trying to capitalize on that thirst in the market," said Jocelyn Lynch, a managing director of corporate trust, investment managers, hedge funds and private equity at BNY Mellon Corporate Trust. "Who knows what's happening six months from now? If the investors are lined up and pricing is right, the perspective of [some managers] is why not get it launched and get going?"
Meanwhile, banks no longer provide 100% of the funding required to buy the initial loan collateral; they now typically require the CLO manager to put up roughly 20-25% of the "seed" money themselves, something a lot of smaller managers don't have the resources to do. So the deals getting done without warehouses wouldn't get done if a warehouse were necessary.
And while pricing and other market conditions can change, don't expect the banks to start taking on more risk.
"I think banks will continue to require a haircut [from CLO managers]," said a banker in the CLO structuring division of a large investment bank. "The size of the haircut will change depending on the volatility in the market, with higher volatility meaning the CLO manager will have to put up more money, and lower volatility meaning he'll have to put up less. But I don't see a return to zero haircut financing anytime soon."
Still, that doesn't mean we won't see an increase in the practice of warehousing.
"The utility of having or not having a warehouse is market condition related," the first CLO manager said. "It depends on the price of secondary loans versus new issue primary loans, but also on volatility."
In other words, "If the new issues coming out are very attractive, and secondary loans have run up in price, then the economic incentive for having a warehouse is much higher," said the banker. "And that's going to play to the advantage of managers that are able to provide [their part of the funding] for warehouses."
Indeed, some managers say that whether or not you need to warehouse your CLO, you should.
"I am a firm believer in that warehousing is always the best way to do a deal," said the second CLO manager. "It provides the manager and the investors with optimum optionality, because it allows you to buy over a long period of time and be selective and gradual about how you purchase the portfolio. Then if the market dips you can simply accelerate your purchasing, and if the market tanks you can just hold off. So there's no downside to warehousing, other than the costs.
"I will certainly admit that you don't need a warehouse," he added.
"There are market environments where you can thread that needle and create the same portfolio that I've been warehousing for a year and get the same debt prices. But that's going to be a rare instance."
Others are not so sure. The banker said that he had looked at the performance data for several deals his bank had done in the last year, and there wasn't a great deal of difference between those that had been warehoused and those that hadn't.