Collateralized loan obligations have two years to become compliant with the Volcker Rule or lose their biggest investors banks -- but some CLO managers aren’t wasting any time. They are not only divesting any bonds backing these deals, they are also eliminating the ability to invest in bonds in the future.
The Volcker Rule prohibits banks from having an ownership interest in CLOs backed by anything but loans (and cash equivalents). That’s a problem for most CLOs printed in 2011, 2012 and 2013, which tend to have the ability to invest 5% or 10% in bonds. This qualifies them as a “covered fund” under Volcker. And because banks tend to own the senior debt securities issued by CLOs, which give them the ability to remove the managers, for cause, they can be considered to have an ownership interest in these deals.
The Federal Reserve has given banks until July 2017, in most cases, to conform their CLO holdings to Volcker. So there is no longer such a sense of urgency in the CLO market. By that date, most deals issued before 2014 will have exited their non-call periods, making it possible to refinance them. And a refinancing is an opportune time to amend a CLO’s investment restrictions.
Still, some managers aren’t waiting around. In April, Golub Capital Partners CLO 10 entered into a supplemental indenture intended to make it compliant with Volcker by prohibiting investments in non-loan securities, according to Moody’s Investors Service. Moody’s published a report saying that this change in investment criteria did not affect its AAA’ rating on the deals senior tranche. (Moody’s does not rate any of the deal’s subordinate tranches.) The CLO is managed by an affiliate of Golub Capital, a money manager with $10 billion in assets.
Golub isn’t alone.
John Timperio, a partner in the structured finance and securitization practice at law firm Dechert, has worked with a number of CLO clients to strip out the ability to invest in bonds; and it expects that more managers will do so.
CLOs can’t amend their investment criteria without the consent of the holders of the junior-most securities issued by these deals, known as the equity. In all of the deal amendments that Timperio is familiar with, the CLO equity was held by the manager or an affiliate of the manager, making it much easier to reach an agreement.
It is fairly common for managers of middle market CLOs to retain the equity in their deals, but there are also a number of larger managers of CLOs backed by broadly syndicated loans that hold the equity or have an affiliate the holds the equity. “It cuts across a random group of manages, but the common denominator is affiliates with deep pockets,” Timperio said.
“Obviously, the low hanging fruit was done kind of quickly, but there will be a continued focus on amending more of these as we go along,” he said.
In cases where the CLO equity is held by a third party, there is going to be some horse trading. Removing the bond bucket is negative for equity holders, since these securities only receive whatever cash flows are left over after note holders are paid, and bonds are typically among the highest yielding assets in the pool of collateral. “I’m not sure there’s a market standard,” for amending such deals, Timperio said.
In many cases, managers aren’t just amending CLOs to remove the ability to invest in bonds; sometimes they are also removing their ability to invest in letters of credit. “There are differing views as to whether an LOC is a security,” he said. Amendments may also tweak the definition of a loan participation agreement. Depending on the way this agreement is structured, it could be construed as a security.
CLOs are also being amended to redefine what constitutes and acceptable cash equivalent. When cash comes into CLO, say from an interest or principal payment on a loan in the trust, the trustee will park these funds in certain high quality, short-term investments until the manager can use it to purchase additional assets or make interest or principal payments to note holders. “Funds can only invest in loans and cash equivalents, so what’s a cash equivalent also comes under scrutiny, in addition to bonds,” Timperio said.
Banks are also looking at other strategies for getting their holdings into compliance with Volcker, such as waiving rights that might confer an ownership interest in the deal. “To my knowledge, this hasn’t been pursed on a wide scale yet, but it is a solution we’ve looked into for clients,” he said. “It has some negatives, namely giving up rights to remove manager in situations where there’s a breach for cause.”
It’s also not a sure thing, since regulators have yet to provide specific guidance that waiving rights to remove a manager would result in not having an ownership interest. “A lot of institutions, based on analogous actions by regulators, believe that option is out there.”
“There are multiple strategies” for making CLOs Volcker compliant, “but stripping out bond bucket is cleaner, and clearly the one being pursued the most at the moment.”