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? 

But First, a Message from BetterPitch

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 the reinvestment period to improve the portfolio’s credit quality, while it is less reasonable to engage in uncertain, time-consuming valuation fights during the repayment period. CLOs are legally obligated to repay their investors within 12-13 years, but the expected timeline of repayment, weighted average life (WAL), is usually 6-10 years. Depending on the stage of the lifecycle, the CLO manager’s responsibilities change as outlined below: 

1. Warehousing (3-6 months): warehouse providers, such as banks and financial institutions, offer short-term term financing for managers to initially purchase the leveraged loans (the ‘assets’) before the closing date. These warehouse loans are expected to be paid off with capital raised from issuing the new debt tranches

2. Ramp-up (1-6 months): as managers can self-fund themselves with the issued debt, they have moved away from relying on short-term warehouse financing to long-term financing. Now, they purchase additional loan assets to complete the portfolio and perform monthly tests assessing the portfolio’s ability to cover interest and principal payments 

3. Reinvestment (1-5 years): managers use interest income and principal repayment if the loans have matured to manage the portfolio actively. Based on their investment outlook, managers can trade loans to adjust exposure to different borrowers and improve the portfolio’s credit quality

4. Non-call (first 0.5-2 years of investment): managers can decide to ‘call’ the CLO by refinancing or paying off the loans earlier than the maturity date, which can be attractive during a lower market rate environment demanding less interest payments. During this period, the majority of holders of the equity tranche can’t refinance the debt tranches of the CLO. This is meant to protect the interest payments flowing through the debt holders with predictable cash flows before a potential restructuring

5. Repayment and deleveraging (1-4 years): using the cash flows from interest income and principal returned from the purchased loans, managers pay off the debt tranches in a waterfall structure. The cash flow trickles down from the AAA to BB tranches based on their seniority, with the remaining cash flows going to the equity holders

6. At Maturity: After the portfolio of loans is sold and the debt has been paid down, the CLO fund closes. Any residual cash flows are for the CLO manager to keep

Significance of CLOs in the Current Market Environment 

There can’t be a better time to look into CLOs to understand their changing roles in restructuring. Given that rating downgrades have been found exclusively in the US CLO market and US credit docs are significantly looser, this post is exclusively focusing on US CLOs. Currently, the amount of BBB names that could go under a rating downgrade due to negative cash flows is largely held by CLO investors, which would trigger a massive sell-off of loans and different lenders to drive restructuring scenarios with these discounted loans. Specifically, the 2020-22 vintage investments with weaker credit metrics are expected to undergo a greater rating downgrade, which is currently undergoing the reinvestment period [10]. However, as 40% of US BSLs have exited their reinvestment periods by 2023 [11], not all managers would be actively purchasing new loans to prioritize returning capital to their investors. This tasks managers to carefully evaluate the realistic parameters and risk rewards between participating in liability management exercises, negotiating with borrowers, or managing the portfolio’s exposure to different loans. 

To preserve liquidity, the capital structure of many borrowers has become loan-heavy or first-lien only as junior debt costs 2% more in coupon rate on average. This could lead to saving hundreds of millions of dollars of interest payments for capital-intensive businesses seeking regular debt financing. Compared to a decade ago, when 35% of issuers had a thin level of junior debt, that percentage reached 65% in 2022 [12]. 

As shown in the graph above, the recovery on first lien debt, designed to guarantee high recovery rates from having first claims on collateral, has dropped to a mere forty-five cents on the dollar. In contrast, ‘multitiered’ capital structures had stable recovery rates as junior debt could act as a cushion to absorb losses before hitting the senior debt. When a distressed company’s collateral deteriorates, many lenders become more aggressive to maximize their share of a shrinking pie. CLOs are finding it increasingly difficult to maintain full recovery as other lenders are equally motivated to protect their ‘senior-secured’ status. 

While there are many triggers behind a company’s restructuring, the most recent triggers were from liquidity issues, as seen through the significant increase in distressed exchanges in 2024. These exchanges often are pre-emptive measures from borrowers to prevent filing for bankruptcy by negotiating renewed terms on their debt. At the same time, it indicates borrowers’ worsening ability to meet debt obligations and a heightened risk of default in the market. To raise new capital, borrowers have structured deals to maximize the best economic terms that favor direct money lenders over CLOs. From the borrower’s point of view, they can negotiate flexible pricing terms on new pieces of debt or equity with multiple interested lenders willing to support the company in the long term. Also, as passive investors, CLOs have not established ongoing relationships with individual borrowers due to the wide range of names they have to monitor and have viewed junior parts of the capital structure as too risky. The rest of this article will explore the specific restrictions on CLO investment strategies and recent developments. 

Restrictions on CLOs as a Safe Asset Class

The role and expertise of the CLO manager are extremely important, as active management can improve the returns of a CLO portfolio [1]. At the same time, all CLOs are expected to comply with strict requirements to minimize the risk of default through certain coverage tests. These tests are frequently carried out by the ‘collateral administrator’ to ensure the manager is meeting requirements in the CLO documentation. However, if the manager wants to amend the documentation, they would have to work with the trustee, who represents the interests of the investors of the CLO portfolio [2].

• Overcollaterization Test (OC Test): the principal value of the bank loan collateral pool should exceed the outstanding principal of the CLO debt tranches. If this test is not met, the cash flows that would have been distributed to the equity would be used to pay down the senior debt tranche [14]. Managers prioritize meeting the OC Test as violating it would reduce their professional fees, damage their reputations, and lower returns for CLO equity investors [15] 

• Minimum Rating: Different investors are subject to certain regulatory requirements around the rating of debt they hold. For example, the Basel III regulation requires banks to maintain 7% ‘Tier-one capital ratio’, which would be IG CLOs rated BBB- or above. However, the CLO rating is not affected by the corporate credit rating of the same issuer, as CLOs have diversified exposure across different credits [16]

• Industry Diversification: loans are spread across 150-450 borrowers, with under 2% invested in loans of a single borrower [5]. This allows CLO investors to hedge against the volatility of revenue streams for cyclical companies during economic downturns 

• Maximum Default Basket: foundational fund docs restrict CLOs from holding an allocation of more than 7.5% of their portfolio in CCC or lower-rated debt. Violation of this clause would lead to haircuts for the equity, erosion of collateral value that makes it harder to meet the overcollaterization test, and trading restrictions [15]. Cash flows will be redirected from the lower tranches to paying down the senior tranches first. If other loans downgraded to CCC or lower take up a higher proportion of the portfolio, CLO managers would have to sell other CCC-rated debt that is priced higher. For example, when Altice France was downgraded to CCC, 13% of US CLOs breached the 7.5% threshold, forcing them to sell other loans at a steep discount [16] 

• Credit Quality: strong credit support as they are mostly first-lien senior secured loans sitting on the top of the capital structure and would have senior claims over the collateral in a bankruptcy. Smaller borrowers with weak financial track records are usually avoided due to low liquidity, which refers to the level of trading activity in the secondary market 

• Investment Period: CLOs have a limited time to invest funds between the initial portfolio phase and the repayment period

Factors Behind the Success of Returns on CLOs

In the investing world, ‘edge’ often refers to various factors that can drive an investor’s returns in a competitive market: scale, industry expertise, relationships, first-mover advantage, and the due diligence process. These are applicable to drive CLO returns, but here are a few factors especially relevant to the asset class. 

• The expertise of the CLO Manager: Out of the 175 CLO managers across investment firms, each manager prefers a certain type of portfolio management style with varying abilities to effectively manage a portfolio of hundreds of names [5]. Given the rapid changes in regulations and the application of CLOs, a manager with experience and insights into past market cycles, such as the GFC and 2016 energy crisis, would help them navigate worsening credit market environments

• Active Management: Managers often actively monitor potential violations of coverage tests and receive detailed financial statements. Specifically, they would have to watch out for signs of deterioration in the collateral base and the amount of junior debt as a cushion to absorb any loss first [1]. However, there are realistic limitations to monitoring every single situation and credit document for hundreds of issuers, especially if the teams run very lean [9]

• Exposure to Rating Agencies: Defaults have been shown to be correlated with rating downgrades from the rating agencies. Sometimes, rating agencies lack a nuanced understanding of each credit and downgrade issuers that may have the potential to recover their financials. Another concern is an unwarranted downgrade of a high-quality issuer on the basis of operating in the same industry as lower-quality peers undergoing a wave of downgrades [9]. Unfortunately, a downgrade sparks investor anxiety, heightening interest rates on future debt issuance and forcing low-risk appetite lenders to sell out their positions

The Dilemma of the CLO Manager: Sell or Restructure? 

While no singular investor in the CLO can shape the restructuring plan because their stake in the broader portfolio is small, CLO managers have a fiduciary responsibility to serve the best interests of all investors. Sticking to one investment strategy as a typical investor would make the most attractive restructuring solution clear, yet the CLO manager needs to strategically balance the competing interests across a diversified investor base and different stages of the portfolio’s lifecycle. For example, a senior debtholder in the CLO may prefer the overcollaterization tests to fail so that their debt can be paid down first in seniority. On the other hand, CLO equity holders would seek to maximize collateral value to enjoy the remaining cash flows, preferring to participate in the upside of a restructuring. 

Over time, CLO portfolios have increased exposure to the same group of borrowers to meet their diversification requirements. This is also because the growth of CLOs has outpaced the number of borrowers needing leveraged loans since 2007. One of the most defining characteristics of CLOs is the restriction to keep CCC or lower-rated loans under 7.5% of the portfolio. As CLO managers are forced to sell off these loans, other managers could feel obliged to sell their position, creating downward pressure on the loan’s trading prices. 

Here’s where we need to understand the market’s psychology in today’s wave of ratings downgrades. Theoretically, CLOs are not impacted by how the market perceives the investment’s value, referred to as ‘marked-to-market’ [13]. Primarily, they are only expected to demonstrate the ability to pay down the debt tranches within the agreed repayment period. This has allowed them to weather more volatile market environments [1]. However, relative to stocks and bonds, the lower-rated tranches of CLO debt are illiquid – harder to trade –  in the secondary markets [16]. Whether or not a CLO manager has a positive view of a borrower’s credit quality, they would feel pressured to sell loans with high perceived risk as other market participants rely heavily on the rating agency’s assessments. The longer the manager holds onto the discounted loan, the larger the loss it would incur due to the smaller number of interested buyers. More opportunistic funds would buy up these discounted loans to seek significant returns during a restructuring. While this may not be an ideal outcome, let’s remember that 40% of CLOs have exited their reinvestment period and are entering the repayment period. Simply put, at this stage of their lifecycles, they don’t have as much luxury to opportunistically buy up new loans to compensate for holding onto poorly performing ones. But despite these challenges, CLOs have learned their lesson that sometimes it is worth being involved with restructuring directly. 

Acosta Case Study: Motivations Behind Increased CLO Participation in Restructuring 

Let’s dive deeper into Acosta’s restructuring to understand why CLOs might want to have a stronger presence in restructurings [17]. Acosta is a US-based marketing firm that offers sales and marketing services to retailers. Failing to meet obligations for its $3bn of debt from The Carlye Group’s leveraged buyout and facing industry headwinds, it filed for a pre-packaged Chapter 11 Bankruptcy in 2019 that settled into an agreement within a month. While bankruptcies can span up to years when counterparties engage in long, messy valuation fights, Acosta settled into negotiation with creditors not because interests were perfectly aligned but because of the practical limitations of the CLOs. 

1.  The Restructuring Support Agreement (RSA)  

Acosta proposed a restructuring support agreement (RSA) to lay out plans before filing Chapter 11, which also gave insights into how each class of debt would be treated. As outlined below, their main goal was to convert $2bn of debt to equity and raise extra capital. From Acosta’s standpoint, deleveraging would free up extra cash originally meant for interest payments to be reinvested into turning around their business. 

• $150mm new money debtor-in-possession (DIP) facility to fund future business operations 

• First lien lenders: 85% of the new common stock + first lien subscription rights or cash subject to a cap

• Senior Notes: 15% of new common stock + senior notes subscription rights or cash subject to a cap

• $250mm in new equity capital 

2. Key Lender Positions and Negotiating Leverage

In bankruptcies, the impaired class of creditor groups are allowed to vote on the plan of reorganization. For a plan to be accepted, it must be voted by creditors holding at least two-thirds in amount and more than half in number of allowed claims of the class. Here, the first lien claims, representing $2.14bn of debt, and senior notes claims, representing $840mm of debt, held the voting power. 

Distressed investors Oaktree Capital, David Kempner Capital Management, Nexus Capital Management, and Elliot Management formed an ad-hoc committee supporting Acosta’s RSA. Together, they held 70% of the dollar amount of the first-lien loans. The ad-hoc committee, confident in the upside of Acosta’s long-term value, did everything to boost returns: they funded the DIP to enjoy a higher interest income and a super-priority status above existing secured debt. They also exclusively participated in the $65mm preferred equity raise, a type of junior debt offering higher coupon payments. Preferred equity was attractive to all investors given its higher interest income, voting rights in the reorganized company, and downside protection from being senior to common equity. By directly providing Acosta with new capital, the group could gain significant ownership to determine the borrower’s future capital structure and business operations.  

On the other hand, the 18 investment firms holding 60 CLOs held the majority of the first-lien ‘minority’ claims. However, these CLOs were not ‘minority’ lenders in the traditional sense. The sheer number of claims they represented gave enough votes to block the above plan and demand a renegotiation, as the distressed investors did not meet the second requirement of holding more than half the number of the allowed claims. Below is a comparison of how the first lien minority lenders managed to extract $70mm more value at the expense of concessions from the distressed lenders: 

3. Key Takeaways 

How should we interpret this outcome? For the first-lien minority lenders, a small win was still a win. The most noticeable improvement was the increase in preferred equity participation rights. Initially, minority lenders were excluded from discussions to fund preferred equity due to restrictions placed by their indentures. To work around this realistic limitation, they leveraged their voting power to the best of their ability. They also obtained some DIP financing, which is the type of senior secured debt that aligns well with a CLO’s risk appetite, and early acceptance premium, which is rewarded to creditors who agree to the plan before the deadline. 

However, the best economic terms still belonged to the distressed investors, who also ended up with a significant boost in capacity to fund the preferred equity. Even with some concessions, they could own around 80% of Acosta after emerging from bankruptcy. In the next section, we will examine how CLO indentures since 2020 have addressed these issues by increasing flexibility for the types of restructuring scenarios in which CLOs can participate. 

It’s also pretty interesting to see how CLO managers gradually sold out positions in Acosta, as shown in the significant drop in CLO rankings from 70 to 702 when they filed, which measures how widely the loan is held by CLOs relative to the other loans. In the early innings, the downgrade from B- to B only dropped the CLO ranking by 17, and the market price only declined from 94 cents to 88 cents. However, the downgrade to CCC and the announcement of the bankruptcy triggered a massive drop in both rankings and market prices. By the end of 2019, the CLO was trading at 18 cents on the dollar [18]. Not all CLOs align in interests from diverging views on the risk-reward of restructuring and their exposure to the particular loan. For the remaining CLOs entering into a restructuring, they would have to fight an uphill battle against aggressive lenders that gain leverage through purchasing junior debt or equity. In the case of Acosta, 18 investment firms held 60 CLOs, meaning a single firm can have multiple claims through owning multiple CLO funds. Going forward, it would be interesting to see if investment firms holding multiple CLOs would be treated as distinct creditors for voting purposes. 

The Evolution of CLO Loan Documentation 

Much of the flexibility for CLOs navigating distressed scenarios has been allowed after CLO managers started to modify the parameters in the language of loan documents. As a caveat, these changes will not happen overnight, and the market has yet to see more concrete use cases accounting for specific types of loans and restructuring scenarios.                                                                                                           

• More Distressed Exchanges: Historically, CLOs have been restricted from reinvesting their loan proceeds into companies under distress. As the number of distressed exchanges skyrocketed and the period of distress extended from the Federal Reserve’s rate hikes, there have been more ‘carveouts’ – exceptions – to this criteria. Instead of holding a piece of distressed loan, CLOs have started to actively participate in exchanges where the borrower either issues a new piece of debt with better economic terms than old debt or converts debt into equity. 

Initially, CLOs were able to exchange a piece of distressed debt for another piece of distressed debt from the same obligor. The creditors of the newly issued debt expect debt repayment from the same borrower or obligor. Now, they can exchange debt with a different obligor and use interest payments from the loans to carry out the exchanges [20]. An obligor refers to a broader set of legal entities responsible for paying down the debt, which could include the borrower but also ‘guarantors’ who will step in to meet debt obligations if the borrower defaults. From the creditor’s perspective, they may favor exchanges with the same obligor due to uncertainty of the credit risk in the new obligor, which could subordinate their position and impact the priority of debt repayment. However, from the CLO’s perspective, if they can exchange debt with a new obligor that is financially healthier with better collateral, it would diversify credit risk and reduce the likelihood of rating downgrades. 

Swapping out individual assets boosts the portfolio’s overall credit quality as long as the newly exchanged assets promise a higher recovery and are senior to the existing asset. Without these provisions, CLO managers may have no choice but to receive heavily discounted cash or become subordinated in LMEs where their senior secured position becomes useless [21]. For example, a borrower may decide to create a non-guarantor subsidiary to execute a drop-down transaction, which transfers collateral away from existing lenders to raise new capital. Lenders are unable to gain access to the assets and cash flows of this subsidiary because it does not guarantee the debt. These subsidiaries may also structurally subordinate the original lenders by granting priority in payment to the subsidiary’s lenders, making the senior position effectively likely to end up being useless. 

• Work-out Loan Participation: To qualify as a ‘collateralized obligation,’ assets must meet certain standards such as ratings, maturity date requirements, and concentration limits. While CLOs are still limited from directly investing in or purchasing new distressed loans, they can now participate in ‘workout loans’ to provide additional liquidity financing. These are meant to protect existing investments that have unexpectedly become distressed yet are still subject to a cap to prevent the portfolio from being diluted with lower-quality debt. The most recent use cases are participating in uptier exchanges, and these terms will become more important if CLOs decide to question the legal validity behind an LME. If they are treated unfairly in LMEs, the workout loans will bolster their legal argument that they were willing to negotiate with the borrower and lenders and give them power to push back on unfavorable terms [22].  

Implications to CLO Participation in Restructurings 

Besides the technical limitations for CLOs to take on new equity in restructurings, CLOs are motivated to receive the best economics in their debt investments. If CLOs have significant control over restructurings, restructuring solutions would tend to avoid debt-to-equity exchanges, which convert debt into newly issued shares in the company. With improved liquidity, a borrower can reduce its total leverage and interest payments to the best position for a potential turnaround in business operations. Other investors or potential acquirers would also be much more willing to interact with a company with a cleaner balance sheet. There are a few motivations behind creditors who would favor this solution. Firstly, having ownership in the equity grants the opportunity to enjoy unlimited upside if the business recovers, which may lead to more attractive returns compared to little to no recoveries on the debt. However, this comes with a conviction in the long-term value of the distressed company. Secondly, investors would want to avoid the time, uncertainty, and costs demanded by a formal bankruptcy process. Finally, equity ownership gives more control over a company’s strategic decisions and business operations, which may better protect its interests in a restructuring. 

What causes this strong aversion to restructured equity among CLO managers? By nature, CLOs are designed to secure steady streams of cash flow, making debt align better with their investment strategy. Equity in a distressed company, on the other hand, is extremely volatile and illiquid. A single litigation headline or signs of unfavorable restructuring outcomes can wipe out the equity value, with few investors willing to purchase such distressed securities. While it is possible to receive equity in a restructuring, these can easily be discounted or punish the entire portfolio due to failing to meet overcollaterization tests. Even more, upon converting the debt into equity, cancellation of debt income (CODI) is generated, which may generate greater tax liability that outweighs equity returns. CODI occurs when debt is canceled, reducing the tax burden for borrowers but lowering returns for CLOs as they have forgone interest income they could have earned to repay their investors [23]. 

A relatively common scenario, Deluxe Entertainment’s Chapter 11 reveals the outcome of limited CLO participation in restructuring scenarios. In 2019, the digital media content distribution company wanted $25mm additional funding to continue its business operations and avoid filing for bankruptcy. To address its $1bn debt, they announced a spin-off of a business segment to raise extra cash, yet S&P downgraded the company by three notches to CCC-. To handle things out-of-court, Deluxe offered investors the option to convert the existing term loan into 65% equity and contribute new money. However, even with the intention to participate, CLO investors could not work around their loan documentation. The only exception was the minority CLO investors with remaining availability for their CCC bucket, yet this was not enough to prevent them from filing [24]. When CLOs represent the majority of the lender base, their limited participation leads to an unfavorable drain of time and resources for borrowers, even when out-of-court solutions are viable. 

The main concern with CLOs preferring to add more leverage while limiting equitization is the creation of ‘zombie balance sheets’ struggling from high leverage. Not all companies fall into distress because of the same reasons. Some are high-quality businesses that have been unable to service their interest payments from the sheer amount of floating-rate debt from a leveraged buyout. Some cyclical companies in a trough have short-term issues that may be relieved soon. However, some are companies with broken business models in a structurally declining industry. Even if they are able to generate cash to cover their interest payments, these zombie companies have limited options to address the actual debt load [25]. For these reasons, some ‘zombies’ have been in Chapter 22 – filing for bankruptcy twice. 

However, even though CLOs are open to pursuing borrower-friendly restructuring solutions that extend a company’s runway, realistic limitations prevent them from meaningfully generating returns. To receive the most economical terms in restructuring, they would need to participate in ad hoc committees that can vote on restructuring support agreements (RSAs) by amassing more than 51% of total votes. Non-participating lenders are usually forced to accept unfavorable pricing on newly issued debt, a subordinated position in the capital structure, and lose access to key assets. However, CLOs have not been able to exert enough negotiating leverage to demand favorable terms and have been discouraged from participating in certain deals. In many cases, traditional lenders may have pre-established relationships or pursue aggressive strategies that do not suit the risk appetites of CLOs, as demonstrated in the Neiman Marcus negotiations. Instead, CLO managers may simply opt to protect the value in the triple AAAs rather than increase exposure in the riskier tranches [9]. 

The conflict of interest between CLOs and other lender groups is apparent, but this can also be found among the CLOs. The primary conflict of interest can arise from the different parts of the capital structure represented by each CLO manager. As CLOs are assessed based on the total portfolio performance, some managers may simply not allocate significant time to participate in a restructuring if they are hedged by other loans. Other conflicts may arise from the distinct portfolio management style of CLO managers, as some tend to have a higher risk appetite to seek returns from lower-rated tranches [9]. This lack of consolidation could make it difficult for CLOs to decide upon an agreed valuation and debt treatment in relation to direct money lenders. 

Future Outlook 

CLO default rates, compared to its peer asset classes, still remain low at below 1% in 2023 [10]. The Fed has discouraged banks from holding too many leveraged loans, but by no means would downgrades affect the entire banking system as banks are heavily exposed to the AAA tranches [1]. However, given that the lower-rated tranches are more heavily exposed to certain industries, such as the telecommunications and media sectors, which constantly need to raise capital to meet their capital-intensive projects, CLOs would inevitably have to participate in new money deals. 

A continuous development for the CLO and borrower relationship in restructurings is the rise of private credit as an attractive source of financing. Borrowers underqualified for traditional bank loans have started to actively finance deals with private credit funds, given the higher level of customization and pricing flexibility [26]. Leveraging their relationship with borrowers, private credit funds may be able to negotiate better terms and buy up discounted debt to control restructuring processes. Not only would private credit directly compete with the traditional DIP financing offered by CLOs, but it could also remove CLOs from the capital structure if their newly injected capital pays down the CLO’s existing debt. Recent partnerships between Citibank and Apollo to build a $25bn private credit platform create more competition that could potentially reduce negotiating leverage for CLOs [27]. 

Sources: [1], [2], [3], [4], [5], [6], [7], [8], [9 - Interview with CLO Analyst], [10], [11], [12], [13], [14], [15], [16], [17], [18], [19], [20], [21], [22], [23], [24], [25], [26], [27] 

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