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PetSmart downgrades take a bite out of a handful of CLOs

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Downgrades of PetSmart's corporate and debt credit ratings could add further stress to the already thin cushions on collateralization and asset quality tests of some CLOs.

Managers of 24 collateralized loan obligations that hold a portion of the retailer’s outstanding $4.3 billion term loan B may have to trim their holdings of distressed assets to comply with their portfolio’s cap on triple-C rated holdings, according to Wells Fargo.

At least two others CLOs face the more serious problem: the Petsmart downgrades could trigger a critical interest-diversion test failure – an issue that is traditionally remedied by diverting cash flow that would otherwise go to holders of the "equity," or most subordinate CLO securities, and using it to acquire new assets.

On Tuesday, S&P Global Ratings lowered PetSmart’s corporate and secured debt ratings by two notches, to CCC+ from B, with a negative outlook. S&P based the downgrades on weak cash-flow expectations next year that S&P says will leave the company unable to deleverage from its current 8x debt-to-EBITDA level.

PetSmart ran up $6.2 billion in debt stemming from an $8.7 billion 2015 private-equity buyout led by investment firm BC Partners.

“The downgrade reflects our view that the capital structure is unsustainable at current levels of EBITDA, although we do not see a default scenario over the next year given liquidity and cash generation,” the S&P report stated.

More than $1.34 billion of the downgraded TLB is held in about 500 CLOs, according to Wells Fargo. Thomson Reuters LPC reports that PetSmart’s loan ranks 21st in total level of holdings divvied up between broadly syndicated CLOs. Four CLOs have the highest exposure in excess of 1.5% apiece, including the recently launched RR 1 deal from Apollo Credit Management (1.52%).

Of those 500 CLOs, 24 already have triple-C rated asset levels that surpass their portfolios’ allowances, which is typically 7.5% of the collateral pool, according to David Preston, the author of the Wells Fargo report. “These CLOs could potentially have to haircut excess of holdings of CCC-rated assets at market value,” he stated in the report.

Selling off CCC-rated assets often means accepting less than par, or face value, which in PetSmart’s case has been around $80 to $81 per $100, the report stated. (PetSmart was trading at just $76.766 per $100 on Wednesday before gaining to $80.25 on Thursday, according to market data research firm IHS Markit.)

At least two CLOs face minimum interest-diversion test failures, according to Wells Fargo. ID tests are considered “early warning” tests indicating that the value of underlying assets may be insufficient to meet the required overcollateralization levels over the face value of issued notes.

The report did not name the deals, however.

If a CLO is failing the interest diversion test, a manager may haircut CCC assets from the pool, or could divert a portion of deal cash flow usually targeted for equity toward purchasing new assets to increase the asset quality and overcollateraliation level of a pool. Only about a dozen CLOs failed interest diversion tests in 2016, according to Wells Fargo.

ID test failures were often associated with CLOs having exposure to distressed assets, such as poorly performing oil and gas loans last year. This year, retail loans are a growing weak point for CLOs, although such exposure is not considered critical to the market as a whole.

The largest holder of PetSmart’s debt is Angelo, Gordon & Co.’s Northwoods Capital X, a 2013 vintage deal, at 1.86%. But Northwoods has relatively light exposure to retail-sector loans (7.2% of the entire portfolio) and it has a 270 basis point minimum ID test cushion.

PetSmart maintains a single-B rating with Moody’sInvestors Service (B1), although the agency placed the company on a negative credit watch in September from weak second-quarter earnings performance.

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