There's more than one kind of CLO revival underway. Issuance of CLOs in the quasi-public 144A market has picked up dramatically since the financial crisis, thanks to the strong performance of existing vehicles. But, market observers say there has also been a pick-up in issuance of CLOs that are truly private, which have proprietary structures and only a handful of participants.
Private CLOs have been used for some time to finance less liquid loans, but during the financial crisis participants started using them to fill a gap in financing when it became more difficult to get standardized 144A CLOs off the ground. In some cases, private CLOs are used to provide bridge financing for CLOs that are eventually issued in the 144A market; in other cases, they are used by banks and asset managers as a longer-term vehicle to manage their exposure to middle market loans.
Little data is available about the private CLO market - estimates of its size range from $1 billion to upward of $10 billion. That represents a tiny fraction of the $300 billion of CLOs outstanding in the 144A market. However, participants agree that the private CLO market is growing, and is even attracting new players from overseas.
Here is a chart on CLO volume in the 144A market, representing signs of recovery:
Sponsors of more broadly distributed CLOs have typically relied on a line of credit with a bank to warehouse at least a portion of their collateral before issuing longer-term bonds in the 144A market. Proceeds from the bond offering are then used to pay down the line of credit and purchase additional loans. During the credit crisis, this kind of financing became more difficult to obtain, and it remains challenging.
Participants say this has provided a boost for private CLOs, in which a bank lends to a special purpose vehicle (SPV) set up by an asset manager, which in turn uses the money to purchase leveraged loans. Sometimes these loans are originated by the asset manager's specialty finance arm or they can be purchased from third-party lenders.
Private CLO structures also lend themselves to certain types of collateral unsuited for traditional structures issued in the 144A market. "There are times when asset managers or finance companies use [private CLOs] separately, to structure less diversified and 'chunkier' portfolios with features that probably could not be securitized" and distributed widely, said Mary Katherine DuBose, head of corporate debt finance at Wells Fargo. "But there are also times when [private CLOs] resemble and compliment CLOs in the 144A market."
Wells Fargo is thought to be the largest lender to private CLOs. DuBose said that, while there is no way to confirm that, the bank has made "quite a few sizable loans" to special purpose vehicles collateralized by pools of middle-market or large leverage loans.
"We were consistently lending in that market through the financial crisis, given the strength of our balance sheet, and that has benefited us," DuBose said.
SunTrust, Deutsche Bank and Natixis are also reported to be regular lenders to private CLOs, although those institutions did not respond to inquiries.
Ares Capital, GE Capital, American Capital and Apollo Management are among the asset managers said to sponsor private CLOs and source the loans.
A deal in late January by Ares Capital, an Atlanta-based specialty finance company, suggests the private CLO market is sufficiently large to attract new lenders. Sumitomo Mitsui Banking Corp. appears to have dipped its toe in the market for the first time, according to market sources, when it provided a $200 million revolver to Ares Capital JB Funding LLC, a special purpose vehicle that is wholly owned by Ares Capital and was set up to buy loans from its parent.
John Timperio, a partner at law firm Dechert LLP, which advised Sumitomo, said there are several features of the ACJB Funding deal that reflect the path the private CLO market has taken. Ares, which is publicly traded, disclosed in a regulatory filing that loans purchased by the SPV must be approved individually, rather than simply matching pre-established eligibility criteria. "That differentiates these deals from CLOs in the 144A market, where the originator or manager purchases assets that meet certain criteria," Timperio said. He added that banks began requiring loan-by-loan approval for private CLOs after the financial crisis.
Another difference ACJB Funding exhibits from pre-crisis private CLOs is the requirement to revalue the loans when defined credit events occur, such as default or bankruptcy of the obligor. Pre-crisis, Timperio said, loans would remain at the price at which they were acquired by the SPV.
Timperio also noted that the loan's eight-year maturity and three-year revolving reinvestment period, extendable by up to two years, were significantly longer than the typical three-year deals that were common before the crisis and allowed lenders to walk away from transactions after each year.
"Now, these are long-term type financings, similar to broadly syndicated CLOs," Timperio said.
Regulations emerging from the Dodd-Frank Act as well the Basel Committee may further bolster the CLO market, including private CLOs.
Both Basel II and Basel III increase the capital reserves banks must hold against derivatives, including those that financial institutions have used to allocate and transfer risk. And Dodd-Frank's Volcker Rule, for which regulators are currently digesting mostly critical comment letters filed in early February, would make it much harder for banks to hold those esoteric instruments on their books. Those requirements cast loan securitization in an attractive light.
Steven Kolyer, a partner at Clifford Chance, said he hesitates to describe private CLOs that aren't funded by third-party investors as a "product," in the customary sense that this word is used in the securitization industry, since these vehicles are not marketed and distributed to investors. Nevertheless, he said, lenders to SPVs may bring in one or more other other lenders, including banks as well as institutional investors, in an effort to tranche the deal and more effectively allocate their exposures.
"Banks have commonly used credit derivatives to manage their corporate exposures, and they could form tranches using total return swaps or credit default swaps (CDS). Now there are regulatory uncertainties to use CDS to transfer exposures between banks, and that may be part of what's driving [more private CLO issuance]," Kolyer said.
He said regulation that is anticipated to constrain banks' use of derivatives may be prompting more use of CLOs. "There's a recent impetus by some financial institutions to use note or loan structures instead of credit derivatives to manage a book of loans."
Presumably, some of the same regulations that are driving banks to get stop using derivatives to manage their exposure to loans could also discourage them from lending to CLOs, especially in cases where they might hold on to the riskier subordinated portions.
Timperio said the financial industry has argued that CLOs are more like mutual funds than traditional asset-backed securities and so should be accorded more favorable regulatory capital treatment, but it remains unclear how regulators will decide the issue.
Rising issuance of traditional CLOs in the 144A market could cut both ways for private CLOs, which tend to cost more to issue and are also less liquid.
The Royal Bank of Scotland (RBS) recorded 2011 issuance of CLOs in the 144A market at $12.6 billion, up from $3.8 billion the year before. The bank predicts between $12 billion and $14 billion of CLO issuance this year, and as of the end of February $3.6 billion had been issued.
It's possible that increased issuance of traditional CLOs could supplant private CLO issuance; on the other hand, it could provide more opportunities to use CLOs used for bridge financing. Either way, participants say, rising CLO issuance is symptomatic of broader demand for corporate loans, this demand will likely foster more bespoke transactions best suited to the private market.
The corporate loan market's strong performance and low incidence of default is attracting all kinds of investors, and many of them want to leverage their exposure.
"The primary vehicle to do that has been CLOs," said Justin Pauley, a CLO analyst at RBS. "CLOs are performing as well or better than before the crisis, and that's a big statement. Investors want a product that has proved itself -there hasn't been a single default in the CLO market."