The Evolution of CLOs and their Role in Restructuring Scenarios

Welcome to the 124th Pari Passu Newsletter, 

Big week for the Pari Passu Newsletter. On Tuesday, we published our first Pari Passu Premium (PPP) writeup on Air Pros, first large-scale HVAC Restructuring. Today, we are back with our weekly free post!

Imagine you are inviting a large group of family members to your birthday party. Your uncle, grandparents, friends, nieces, and nephews all have their favorite flavors. Some prefer plain vanilla, while others prefer dark-rich chocolate. A few prefer more niche flavors like pistachio. Instead of serving them individually, it’s much cheaper and safer to bake one gigantic cake layered with all the different flavors. 

Today, we will explore an interesting asset class called Collateralized Loan Obligations (CLOs) that embody this packaged structure. Historically, as one of the safest classes, CLOs have rarely been associated with distressed situations. However, as their investments increasingly gain more exposure to potential restructuring scenarios, CLOs have been tasked with navigating a new challenge: what will they preserve, and what will they sacrifice? 

Collateralized Loan Obligations (CLOs) Overview 

You might have heard about ‘Collateralized Debt Obligations (CDOs)’ during the Global Financial Crisis, but let’s make sure to differentiate these two very distinct asset classes. CDOs were poorly structured, risky financial instruments packaged with subprime mortgage securities – loans given to borrowers with poor credit histories. As real estate values plummeted, mortgage borrowers missed their payments, and many CDOs defaulted. Banks, originators, and credit rating agencies did not actively monitor the true risk behind these bundled loans, misleading investors that they were investing in a secure asset class [1]. 

On the other hand, CLOs stood well during the GFC, with record-low default rates at 0.88% from 1994 - 2009. The global CLO market has reached $1 trillion [2], but the complex nature of the asset class and its shifting role in restructuring has not been understood widely, even among institutional investors. Currently, the biggest CLO managers include Blackstone GSO, CIFC Asset Management, and PGIM Inc.[3]. 

Let’s step into the shoes of a CLO manager. Your primary goal is arbitrage – to capture the difference between ‘assets’ and ‘liabilities.’ Firstly, you buy up leveraged loans that fund companies, usually non-investment grade, for their M&A, leveraged buyouts, dividend payments, and reinvestment activities. As investors in these loans, you collect the interest payments from the companies. The important distinction from a traditional investor is that CLOs want to create a portfolio of loans rather than investing in single names. When leveraged loans are packaged together, the default probability decreases significantly as risk spreads across many loans. This portfolio of loans is considered your assets, or ‘collateral’ supporting the CLO. 

But where would you get the capital to create this portfolio? You would need to finance it by issuing different tranches of debt backed by the pool of leveraged loans purchased. The CLO capital structure is much more intricate than the usual corporate capital structure. While it consists of both debt and equity, the debt is further ranked from AAA to BB tranches depending on the seniority of receiving cash flows and exposure to loss from the loans. AAA tranches usually represent 60-70% of the capital structure, while the AA to equity tranche takes up a significantly smaller portion. As compensation for taking on the highest risk of potential losses, any leftover cash flows are absorbed by the equity to enjoy the most upside [1]. 

Going back to the cake analogy, CLOs offer tailored options to lenders with varying risk appetites. The safest AAA tranche is preferred by banks, which are obligated to retain high-quality capital to meet regulatory requirements, and insurance companies, which prioritize steady streams of income. As the tranches are rated lower, investors such as structured credit funds and hedge funds aim to capture a higher price appreciation while taking on greater risk [5]. Later in the article, we will dig deeper into the challenges CLO managers face in restructuring when balancing varying interests across the investor base.  

In summary, CLO managers buy leveraged loans packaged into a portfolio to generate income from interest payments. To fund this purchase, they issue new debt ranked by the riskiness of the underlying loans to sell to investors with varying investment strategies. The manager keeps the interest income left from the leveraged loans after repaying their investors. For example, if a CLO was financed by debt at a coupon rate of SOFR+200 but the underlying loans return SOFR+300, the CLO would capture the excess returns of SOFR+100 multiplied by the dollar amount of debt.

Brief History of the Leveraged Loan Market and the Evolution of CLOs

Here’s a quick overview of the history of the leveraged loan market to understand the larger role CLOs have played in the last decade. Since the 1980s, money center banks such as J.P. Morgan have served as borrowers’ partners as they offered valuable services such as financing LBOs and providing strategic advisory services. As traditional banks began to stray away from this business due to higher costs and regulatory scrutiny [6], non-bank lenders, such as CLOs, private equity, and private capital, stepped in. 

Leveraged loans supplied by the broadly syndicated leveraged loan (BSL) market have been a popular source of funding for companies with highly levered balance sheets and lower credit ratings without a proven financial history. Nowadays, large public companies with stable financial records, from Burger King to Dell Computers, also rely on leveraged loans. While these loans are senior secured, they carry a higher risk than traditional bank loans and are rated BB+ or lower. In return, investors are compensated with higher coupon rates yielding at least 125 basis points above a benchmark interest rate. Since these loans are larger and may have a larger impact on one lender, commercial or investment banks ‘syndicate’ the loans to distribute the default risk among different investors, including mutual funds, CLOs, hedge funds, and alternative asset managers. 

Since its origination in the 1980s, CLOs have gone through three stages of transformation. The first vintage, CLO 1.0, was a mix of high-yield bonds and loans to offer streams of cash flows from debt instruments. Having survived through the GFC, CLO 2.0 offered higher credit support and reduced the reinvestment period into other loans, reducing exposure to volatile market events. The most current vintage of 2014, CLO 3.0, limits high-yield debt to represent below 10% of the portfolio and has an increased cushion of junior debt and equity [5]. However, along with the evolving credit markets, CLOs have been faced with new challenges. 

Before the GFC, CLOs were limited to buying secondary loans rather than directly investing in companies, putting them in a disadvantaged position to earn returns compared to direct money investors. Immediately after CLOs were revived after the GFC, CLO lenders only represented 25% of the leveraged loan market. By 2022, they have purchased 70% of all leveraged loans issued. Borrowers and sponsors have become highly dependent on the buying activity of CLOs, and when issuance slows, market demand for loans and companies' ability to borrow becomes very limited [7].

Until recently, CLOs didn’t have the same incentive as traditional lenders to negotiate with borrowers to mitigate individual loan losses because they had diversified exposure to risk across the portfolio. Without these ongoing relationships, private equity sponsors have been taking more aggressive positions with CLOs during restructurings and pursuing options to maximize equity value. However, along with many lenders, CLOs have experienced the serious consequences of investing in leveraged loans structured as  ‘cov-lite’ in a low-interest rate era. Cheap capital allowed borrowers to negotiate lenient terms, opening up loopholes to pursue aggressive business and organizational structures without the consent of lenders [8]. What’s more alarming is that some credit docs simply did not include any terms resembling a covenant [9].

Despite CLOs supporting the growth of the leveraged loan market, their engagement in restructuring scenarios is relatively new as an asset class. Historically, CLOs have been open to financing debtor-in-possession (DIP) loans, which offer a super-priority status in bankruptcy to be repaid first. The high interest rates on DIP loans made it an attractive option to boost portfolio returns [7]. However, in the past few years, sophisticated PE sponsors and borrowers increasingly pursued aggressive out-of-court solutions to raise new capital by pitting lenders against each other. Since DIP financing is limited to in-court, CLOs would lose their preferred senior status in out-of-court situations where lenders fiercely compete to secure the best economic terms. Let’s dive deeper into how CLOs are faced with balancing different counterparty relationships as they enter more complex scenarios while protecting their investment objectives. 

The Typical Lifecycle of a CLO  

What makes CLOs special is that the CLO manager’s responsibilities and risk tolerance change over their lifecycles [5]. For example, participating in restructuring would be more attractive during…

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