One of the most talked-about events at Information Managment Network’s Second Annual CLO Conference took place before participants arrived.
On April 5, Standard & Poor’s sounded the alarm about loans with weak or non-existent maintenance covenants, which are playing an increasing role in collateralized loan obligations. The ratings agency warned that it would take this into account in rating deals.
S&P noted that the “demand pull” from CLOs themselves may be fueling the increased issuance of so-called covenant-lite loans. “We view the resulting lower recovery prospects as a critical factor we address when we rate CLOs,” it said.
Throughout most of 2012, new CLOs had maximum covenant-lite buckets of 30% to 40%, according to S&P. In the first quarter of 2013, the percentages trended toward, and even surpassed 50%, the agency said.
To take a recent example, the $500 million Apidos CLO XII, which closed in April, has a covenant-lite bucket of up to 60%, according to a presale report published by S&P.
Speakers on an IMN panel of investors in the mezzanine tranches of CLOs said it was worth paying attention to the size of covenant-lite buckets. Niraj Patel, a managing director at Genworth, pointed out that mezzanine CLO notes are “long-dated investments with no put option... you have to be very comfortable with the manager.”
Aaron Meyer, a principal at Silvermine Capital, said that, even in a low-default environment, “credit discovery matters,” and “the market should value it.”
The problem isn’t just weak covenants, according to S&P; it’s the fact that even the riskiest companies are able to issue covenant-lite loans. “Unlike pre-crisis covenant-lite loans that were generally limited to stronger borrowers, in our view, the recent wave of covenant-lite loans includes borrowers with weaker profiles.”
S&P also thinks that the credit cycle is entering into a period of deteriorating credit quality and, with the speculative-grade cycle becoming negative, recoveries can also become challenging for buyers.
The rating agency addresses this elevated credit risk through the recovery rate assumptions it employs in its cash flow analysis of CLOs.
Although many CLOs issued pre-crisis, including those with heavy concentrations of covenant-lite loans, performed well, S&P is holding new CLOs to a higher standard: In order to obtain a ‘AAA’ rating, a CLO tranche must demonstrate the ability to pay under economic stresses that S&P views as equivalent to the Great Depression.
Taking this stance could cost the rating agency market share in of one of the busiest sectors of the securitization market. CLO issuance reached $50 billion in 2012, and forecasts for this year range as high as $75 billion.
What’s more, not everyone shares the rating agency’s sense of alarm. Richard Farley, a partner at the law firm Paul Hastings, told ASR sister publication, Leveraged Finance News, that the “drivers for the healthy covenant-lite issuance are simply supply and demand. The robust nature and liquidity of the leveraged finance market are to the borrowers’ advantage.”
Farley said that, “outside of the middle market, it’s unusual to see something that’s not covenant-lite or carries with it a springing covenant on the revolver.”
However, not all covenant-lite loans are created equal. David Keisman, a senior vice president at Moody’s, said in a telephone interview with LFN that from a recovery basis, covenant-lite loans did “well overwhelmingly when they were well-structured loans. This means the loans had subordinated debt or had an underlying debt cushion beneath the first-lien. In our analysis, a 40% of balance sheet support below the debt is sufficient cushion.” —By Karen Sibayan
CLO M&A: Unmotivated Buyers, Unmotivated Sellers
Consolidation among managers of collateralized loan obligations has slowed considerably, and not just because so many smaller players have already teamed up with larger ones.
Instead, many smaller CLO managers are finding they don’t need the deep pockets and wide reputations of bigger players to bring new deals to market.
“A few years ago, there was a question if [some smaller managers] had the ability to build deals,” Christopher Allen, senior managing director at CVC Credit Partners, told attendees at the IMN’ conference.
CVC Credit Partners was formed last year when European private equity group CVC Capital Partners Group purchased Apidos Capital Management from Resource America.
But recently, Allen said, CVC was in talks to acquire another CLO manager that ended when the other CLO manger was able to issue a deal on its own.
“The market has opened to both existing players and to new platforms,” Allen said. That means “there’s not as much motivation to sell.”
This logic works both ways: Allen said that CVC has also backed out of talks to acquire a CLO manager because the firm realized it would be better off launching a CLO itself.
Among CVC’s most recent deals is the $500 million Apidos CLO XII, according to rating agency presale reports.
There’s another reason merger and acquisition activity among CLO managers has slowed, according to Michael Herzig, managing director at THL Credit Senior Loan Strategies and another panelist at the IMN conference: Buyers aren’t as motivated either.
Herzig said that in 2009, 2010 and 2011, “there was pressure to add credit to platforms, to have more products than private equity… So acquisitions were partly about adding to a product suite. There was a little meeting of the minds: a motivated buyer and a motivated seller.”
There’s less pressure to make such strategic acquisitions now, Herzig said. This makes acquisitions “tougher to do,” because they have to make more economic sense. —AB
Arbor Plans ‘Programmatic’ CRE-CLO Issuance
Arbor Realty Trust plans to issue CLOs backed by commercial real estate on a regular basis, according to Gene Kilgore, executive vice president of structured securitization.
In September 2012, Arbor issued the first CRE CLO since the financial crisis and the deal was so successful that the firm did another transaction two months later. Both were collateralized entirely by bridge loans and have two-year reinvestment periods.
“Frankly it was with some trepidation that we went to market” with the initial, $125 million deal, said Kilgore, who was speaking on a panel at IMN’s CLO conference. “There had been no deal since 2007; but it made too much sense not to do it.”
Arbor was “elated” with the reception to the deal, which it had marketed very narrowly, Kilgore said. The firm’s second deal, twice as big at $260 million, was met with even greater demand, and spreads tightened significantly.
Going forward “we intend to be programmatic” with issuance “to the extent the market is there,” he said.
Loans backing the first two deals were all multifamily, only because that is what Arbor had on its balance sheet at the time. However future deals could include some loans on commercial real estate. —AB
Emerging Market CLOs, Anyone?
Two of the IMN conference sessions were devoted to potential future uses of the CLO structure. At one session, executives from ICE Canyon, talked about their experience putting together a $600 million deal backed by a emerging market loans and bonds in October of 2012, the first of its kind since 2007.
Sajid Zaidi, an executive director at Morgan Stanley, said his firm has received a number of inquiries from firms interested in doing similar deals, but that nothing was imminent.
An even more prospective use of CLOs is as a vehicle for investing in infrastructure loans. Jay Grushkin, partner at law firm Milbank, Tweed, Hadley & McCloy, has worked on several of the six or so infrastructure CLOs that were brought to market pre-crisis. He noted that infrastructure CLOs were a tough sell, even then: Two were re-tooled for use as repo collateral with the European Central Bank. —AB
Fitch Sees CLO Issuance Leveling Off
Issuance of CLOs is likely to level off after “skyrocketing” in the first quarter, according to Fitch Ratings.
New issue volume increased nearly five-fold in the first quarter to over $26 billion compared with $6 billion in the same period of 2012. But, in a report published shortly after IMN’s conference, Fitch said much of the first-quarter volume was the result of deals being pulled forward ahead of a Federal Deposit Insurance Corp. (FDIC) rule requiring banks to consider CLO investments among “higher risk” assets.
Banks are important buyers of the top-rated tranches of CLO notes, but the FDIC rule, which took effect April 1, requires banks to treat all notes issued by CLOs as equally risky, regardless of their credit ratings.
The rule grandfathers CLOs issued prior to April 1, hence the push by originators to bring deals to market before the end of the first quarter.
Fitch noted that the general consensus remains that new CLOs will finish the year in the $55 billion-$75 billion range.
Despite the expected slowdown in issuance over the remainder of 2013, Fitch said, appetite for CLOs on the part of banks and other investors remains “robust.”
Given the relative lack of new loan issuance, this means that it will remain difficult for CLO managers to find sufficient loans to use as collateral for deals — particularly loans with strong covenants. —AB