The European collateralized loan obligation (CLO) market continued its revival for most of the first quarter in 2022, building on its resurgence since the 2020 pandemic. Though various macroeconomic factors--like the rising interest rate and higher default expectations--have dampened the CLO issuance engine, they have not stalled it completely. Year to date, managers have priced 44 transactions for a total issuance volume of €17.92 billion (compared to €21.5 billion across 53 transactions in the same period last year).
S&P Global Ratings previously highlighted changes observed in the CLO landscape resulting from the COVID-19 pandemic (see "New Features Continue To Appear In European CLOs," published on Sept. 1, 2021, and "Redesigning The CLO Blueprint After COVID-19," published on April 21, 2020). As the pandemic pushed market participants to consider changes to issuance structures and CLO documentation, new, lasting CLO features started emerging in 2020, and continue to do so well into 2022. The old-style 'cookie-cutter' image of European CLOs has long departed.
CLOs Are Fighting Back: Uptier Priming/Asset Drop Down Transactions
Given the move into a wider distressed environment, European CLOs are implementing new concepts as they prepare for potentially rising defaults and restructuring cases.
Asset drop down/uptier priming transactions are liability management techniques that have been more prevalent historically in the North American corporate space than in Europe. These features are being introduced this year in European CLOs to allow portfolio managers (PMs) to take defensive measures against some strategies that could otherwise transfer value away from the CLO and impede recoveries.
Asset drop down transactions
Asset drop down allows companies (which act as collateral, underlying the CLO) to move assets outside the scope of existing creditors' covenant groups and transfer them to either newly created or pre-existing "unrestricted" subsidiaries in the group, thereby removing the assets from the scope of the CLO.
The unrestricted subsidiary then could use newly unencumbered assets to secure new financing, which becomes problematic for the CLO as the existing creditors are de-collateralized. These unrestricted subsidiaries typically have little or no other indebtedness, so participation in the new debt raised by the unrestricted subsidiary is usually prohibited for CLOs, for example due to the minimum indebtedness eligibility criteria in CLO documentation.
Based on our review of transaction documents for recent European CLO issuances, the new asset drop down language considers the minimum indebtedness eligibility criteria on an aggregate basis (across both the unrestricted subsidiary and the original obligor of the existing loan). This change aims to allow a CLO to participate in--and hold--the new debt raised by these unrestricted subsidiaries.
Examples of priming transactions include J Crew, Cirque du Soleil, Travelport, and Party City (in the U.S.) and Intralot in Europe (see "A Closer Look At How Uptier Priming Loan Exchanges Leave Excluded Lenders Behind," published on June 15, 2021).
Uptier priming transactions
Uptier priming allows companies to amend the existing secured loan documents to permit new "super-priority" secured debt. Participation in the new super-priority tranche can be limited to the sub-set of existing lenders that consent to these amendments. This group can roll up some or all of their existing loans into the super-priority tranche, resulting in the further subordination of non-participating existing lenders.
This is a challenge for CLOs because non-participation would render their existing loan subordinated and therefore negatively impact their position both on enforcement and future financing or restructuring. This could also decrease the expected recoveries on the asset.
The proposed new language would allow CLOs to participate in these transactions, disregarding certain requirements outlined in the eligibility criteria and concentration limits, such as loans maturing after the legal final maturity of the CLO.
Examples of uptier priming transactions include Serta Simmons, Boardriders, and TriMark.
Existing lenders that cannot participate may end up de-collateralized (in asset drop down transactions) or subordinated to the new super priority tranche (in uptier priming transactions). Concepts like loss mitigation obligation (LMO) and workout obligation (WO) technology in CLO documents could still allow CLOs to participate in restructuring of assets. These new concepts mean to expand the scope of options for CLOs to continue to hold these assets and maintain value for the CLO investors.
Liability Management Techniques
While a transaction's underlying assets typically drive overall credit performance, the structural features dictate how cash proceeds are allocated in specific situations (for example, upon an overcollateralization test breach). Like all structured securities, CLO transactions usually include an array of transaction-specific features that provide various levels of protection to the different noteholders throughout the capital structure if certain conditions are met. The most common triggers, or tests, in CLO transactions pertain to overcollateralization (O/C) and interest coverage (I/C).
With increased liability costs seen today, CLO structures are proposing to incorporate delayed draw notes, turbo O/C tests, interim payment dates, and additional compensation. These features usually take effect in less favorable markets to allow PMs to better manage the CLO's cost of debt by aiming to reduce the most expensive liability first.
The delayed draw tranche
Europe saw its first subordinated delayed draw tranche rated in 2020, as a mitigant to the significant increase in the CLO's cost of debt during the COVID-19 pandemic.
This feature allows the issuer to subscribe the notes on the issue date. Then, after the issue date, when the cost of debt becomes more manageable for the PM, the issuer may sell these notes, and the issuance proceeds would then be transferred to equity noteholders (who, on the closing date, would have typically chipped in a higher proportion of funds to get the CLO issued).
From our ratings perspective, if the terms and conditions of the delayed draw notes do not differ from the assumptions made in our analysis, we view this feature as credit neutral.
Some CLO documents propose holding the issuance proceeds in the principal account before flushing them down to equity noteholders, which could inflate certain CLO tests like concentration limits and par coverage tests. In those cases, we would typically look for features--such as not giving credit to the principal amount received from the notes' issuance when calculating various tests--to mitigate the associated liability risks. At the same time, if there is a class F O/C test required to be met in the CLO documents, we deem the notes to be outstanding for the test, whether they are issued or not.
CLOs often employ O/C tests to protect the rated notes in a deteriorating credit environment. An O/C test fails if the ratio of the collateral to the relevant notes is less than a required threshold.
Turbo redemption differs from standard O/C tests in the way they pay down the notes. It reduces funding costs in a moderately stressed market by using excess interest proceeds, usually the proceeds remaining after all interest payments have been made on rated notes, to pay down a transaction's highest-yielding liability. This feature typically helps PMs manage CLOs' cost of debt. (For more information, see: https://www.spglobal.com/ratings/en/research-insights/videos/2019-12-11-clo-simplified-turbo-redemption).
Interim payment dates (PDs)
We have observed in some transactions the introduction of interim PDs post reinvestment period where the PM, on the CLO's behalf, can redeem the notes under the note payment sequence from the amounts standing to the principal account and accrued interest using the interest account.
PMs can trigger this feature only once a month and on a pre-determined date. The transaction documents typically have the provision to notify S&P Global Ratings before the interim PDs.
This feature could benefit the CLO structures in reducing their liability cost sooner (rather than waiting for the quarterly PD). During the post reinvestment period where CLO documents restrict the PM from active trading into new assets, this feature would allow CLOs to pay down the liability rather than hold proceeds from asset paydowns into a bank account yielding low or no interest.
Based on our analysis of one of the amortizing CLOs in our rated universe, this feature would typically benefit the senior notes. However, as there is less excess spread available in the transaction (as PMs switch to monthly PDs from quarterly PDs), mezzanine and junior notes--which pay a higher rate of interest--could be worse off from a cash flow perspective.
A recently rated CLO introduced a one-time payment compensation to the rated notes. In addition to the amounts otherwise payable as the interest amount for certain classes of notes, in this transaction a small additional amount will be paid as interest on the first interest PD after the issue date. This amount will come from the initial reserves funded by the CLO to cover the transaction's initial set-up costs.
In our analysis, the additional compensation was credit neutral from a ratings standpoint, considering the amount was paid to the noteholders out of the initial expense reserve.
Other Structural Mitigants To Address The Increased Cost Of Debt
We are also seeing more cost reduction strategies, like smaller senior fees. Also, fewer CLOs now have form-approved swaps at the issue date in comparison to 2021. Some CLOs are also proposing a reduction of the senior management fee following refinancing of the notes after the end of the non-call period.
Further, in European CLOs, typically the I/C ratio at 'B' rating levels was not applicable, and the 'B' O/C ratio was applicable only after the reinvestment period. Recent proposals to remove the 'BB' I/C ratio are also being proposed in European CLO documents.
Generally, CLOs have a reinvestment O/C test set at the class F notes' level (at 'B' rating levels) and a class F O/C test post reinvestment period. Recently, we have seen no class F coverage and the reinvestment O/C test at the class E level ('BB' rating level).
Other techniques used to tackle the rising cost of debt include focusing on negative cash and par leakage controls.
Longer time to calculate I/C
In recent CLOs, PMs are proposing to carry out the I/C test calculations from the third IPD (as opposed to the traditional second IPD), although this feature hasn't launched yet. This delay would enable transactions to adapt to the long first interest period in some of the new loan issuance transactions where the debt is launched and syndicated (sold) to CLOs ahead of closing. For example, if the issue date of a CLO is in May, the debt would be launched and syndicated to CLOs and investors in January or February of the same year. The funds are committed during this period, but no interest accumulates in Europe (in comparison to the U.S. where there is usually a ticking fee associated with these scenarios).
Focus back on the trade date cash balance
There are several opportunities where attractive asset prices could persuade PMs to actively trade in assets that could help them better manage their CLO liabilities while managing the portfolio's credit risk. In some cases, PMs trade in new assets with the presumption that they will be able to sell assets at a later date. The risk of over trading amplifies during the post reinvestment period, where the portfolio becomes more concentrated.
To discourage PMs from over trading, especially in a bearish environment, CLO 2.0 (issued during the COVID-19 pandemic) transaction documents have routinely asked to track negative cash via the trade date cash balance test. This test ensures that the amount outstanding in the principal account is not below a certain threshold (typically, no greater than 5.0% of the portfolio balance).
Par leakage controls
For rated debtholders, preserving the principal in CLO assets has always been paramount. However, for equity investors, CLOs have traditionally allowed a small percentage of principal to be leaked to equity (typically restricted to 1%). CLOs have also allowed trading gains to go to equity investors without the money flowing through the waterfall. This may add a dimension of incentives misalignment, since the equity holder may receive payments earlier, irrespective of the CLO's ultimate performance. To address this risk, some CLOs now require higher hurdles to be met by the PM before leaking par to unrated noteholders, such as measuring credit risk before transferring principal out of the CLO pool.
Certain CLOs require the release or sale of all LMOs that were bought using principal proceeds before excess gain can be moved out. Furthermore, some CLO documentation also restricts transfers from the principal account if the cash balance is negative (for example, due to unsettled trades). Other common hurdles require the portfolio balance be greater than the reinvestment target of the CLO and all the coverage tests be satisfied.
Lately, the traditional 1% leakage has further reduced to 0.5% of the pool balance.
Changes To Concentration Limits
CLO portfolios usually have concentration limitations--meaning the managers cannot just buy any loan they want, rather they must abide by these limitations when altering the portfolio through trades.
Recent CLOs have proposed some changes to the traditional buckets European CLOs see, including:
- Removing the proportion limits on assets that have credit estimates;
- Increasing buckets for portfolio companies (any company that is controlled by the PM or its affiliate) or loans originated solely by the PM; and
- Increasing buckets for covenant-lite loans, fixed-rate assets, and discount obligations.
We consider most of the changes as credit neutral mainly because of other mitigating factors in CLO documents (e.g., to mitigate the removal of the credit estimate bucket, the assets in the portfolio must be rated, and there are very few credit estimates in Europe). That said, some of the concentration limits, such as the higher exposure to portfolio companies may lead to interest misalignment with CLO noteholders.
Some CLOs are also proposing more flexibility, especially in the post reinvestment criteria. Proposals include requiring fewer concentration tests be satisfied (some CLOs have proposed only needing to meet the 'CCC' concentration limit), reinvestments of credit improved assets being added back in CLO documents, and block trades (trading plans that allow satisfaction of reinvestment criteria on an aggregate basis) being applicable throughout the life of the CLO (as opposed to only during the reinvestment period).
We have also seen proposals of static CLOs with either an un-ramped pool or a very short reinvestment period.
ESG Language In CLO Documentation
As ESG considerations grow in importance, European CLO documentation has evolved in terms of ESG screening language and reporting requirements. Negative screening via the eligibility criteria has gained widespread adoption in European CLOs with the list of industry and conduct-based exclusions continuing to grow. Positive screening language with the use of ESG scores and more comprehensive ESG reporting is also becoming more frequent. Further, CLO documentation now includes ESG-related costs being paid out of administrative expenses and, in some transactions, clarification that ESG margin ratchets are carved out of the definition of step-down securities. The ESG screening in European CLO documentation does not affect our credit and cash flow analysis or the application of our CLO methodology, but nevertheless could factor into manager asset selection, which could influence portfolio composition (see "How is European CLO Documentation Evolving To Address ESG Considerations," published on June 9, 2022).
Preparing For The Next Downturn
European CLO issuance post-credit crisis has evolved to respond to changing market conditions, which has led to their stellar performance over the past 15 years. We believe CLO structures and documentation will continue to evolve in response to market developments and meet equity and debt investors' expected returns. Depending on investor appetite, macroeconomic conditions, and default expectations on the underlying assets, we could see more managers seek to broaden their options in terms of what they could be allowed to do under the CLO documents in preparing their CLOs for the next downturn.
Editors: Ana Maria Oliver and Zander Mapes. Digital designers: Joe Carrick-Varty and Monica Robert.
- CLO Insights: New Features In European CLOs For 2022, Sept. 7, 2022
- How is European CLO Documentation Evolving To Address ESG Considerations, June 9, 2022
- New Features Continue To Appear In European CLOs, Sept. 1, 2021
- A Closer Look At How Uptier Priming Loan Exchanges Leave Excluded Lenders Behind, June 15, 2021
- CLO Spotlight: Redesigning The CLO Blueprint After COVID-19, April 21, 2020
This report does not constitute a rating action.
|Primary Credit Analyst:||Abhijit A Pawar, London + 44 20 7176 3774;|
|Secondary Contacts:||Rebecca Mun, London + 44 20 7176 3613;|
|John Finn, Paris +33 144206767;|
|Emanuele Tamburrano, London + 44 20 7176 3825;|
|Research Contributor:||Harshala Koyande, CRISIL Global Analytical Center, an S&P affiliate, Mumbai|
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