2. WHO ARE THE PARTICIPANTS?
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2. Who are the participants?
2. Who are the participants?
The most important participants in a CLO are the investors, but there are several other parties involved. We will describe the manager’s role in chapter 4. Here is a run-down of some of the other participants.
The issuer
The issuer is central to a CLO, but it is in some ways the least real. CLO securities are issued by a special purpose vehicle – technically a company, but one that has no staff and that exists only for the purpose of issuing these debt securities. Unlike investors in a corporate bond, CLO investors cannot meet with the issuer, they can’t question its managers and they can’t sue it.
If they were to turn up at the registered address of the CLO, typically in the Cayman Islands, investors would find themselves in the offices of a firm such as Maples Fiduciary or Walkers. These firms specialise in setting up and administering special purpose vehicles and funds but do not get involved in any way in the investment activities of the CLO.
The reason CLOs are issued by a special purpose vehicle is to keep them legally separate from the other parties to the transaction, in order to protect investors in the scenario where one of these parties becomes bankrupt – see box (left).
Staying remote from bankruptcy
All securitisations in the US and almost all in Europe explicitly enshrine “bankruptcy remoteness”.
One element of legal bankruptcy remoteness is the creation of a special purpose vehicle (SPV). This is a corporate entity entirely separate from the arranger, originator, trustee, portfolio manager, and so on. The SPV holds legal title to all assets and is the only party that has a legal obligation to abide by the various contracts of the transaction, including honouring the CLO debt.
Imagine a bank wants to create a CLO from its own designated loans both to get funding for its loan portfolio and to reduce its exposure to the default risk of the loans (which should also reduce its regulatory capital). This is called a balance sheet CLO.
Let’s say this originator bank has credit rating of single A. If the bank enters bankruptcy after launching the CLO, the bankruptcy court may rule that the loans within the CLO are still the property of the failing bank and, therefore, that these loans should be treated as general collateral of the defaulted bank available to all creditors.
It’s highly likely the CLO debt investors in this unfortunate ruling would be considered creditors of the bank. It may be that these “CLO creditors” should have priority recourse to the specific loans of the CLO. But perhaps not. You never know what will happen in bankruptcy. It’s also possible that the court would “place a stay” on the loans within the CLO to give the court time to ponder the issue and then later decide to leave the CLO unmolested.
Either situation would be bad. When investors buy a CLO debt obligation, they do not wish to bear the default risk of the originator bank. The concept is therefore crucial to the CLO’s ratings. If there is no bankruptcy remoteness, then even the most senior CLO tranche should not have a rating higher than that of the originator bank (single A in our example). The legal elements in the US that establish bankruptcy remoteness are:
- the legal separateness of the SPV (already mentioned)
- a “true sale” of assets from the originator to the SPV
- absence of dependence of the SPV on the originator for operational functions
- absence of control of the originator over the activities of the SPV.
With the exception of the first, these are all legal judgments. But typical securitisations employ standard and time-tested methods such that many law firms will write legal opinions at the launch of a securitisation that a future bankruptcy court will view the transaction as banktupcy remote.
The arranger
The arranger or underwriter of a CLO is an investment bank whose role is to structure the deal (that is, figure out what its rules should be) and sell the CLO notes to investors.
The arranger receives a one-off fee for its work. Fees in post-crisis CLOs are usually between 80 and 120 basis points (0.8-1.2%) of the total deal size. In addition to structuring the deal and placing the notes, there are several other functions that the arranger may carry out.
Often, though not always, the arranger will provide warehouse funding for the deal when it is in the ramp-up stage (see chapter 3: How does it happen?).
The arranger is described in the prospectus as the initial purchaser. This reflects the fact that the arranger legally buys the CLO liabilities once they are issued on the closing date. This ownership is largely a legal formality, since most of those notes are then sold within the same day to the investors who are already lined up to buy them. This arrangement is the same as that used for underwriting and selling most corporate bonds.
However, in some cases, the arranger will retain some notes after the deal is priced. For example, it may find it hard to place some liabilities from the CLO and the arranger may then buy some itself to ensure that the deal can go ahead. Retaining some notes may also help the arranger to make a secondary market in the bonds from the CLO. However, arrangers are generally unwilling to hold bonds for long periods of time. The investment bank that arranges a CLO is often the most active market maker for the bonds in the secondary market (see chapter 10: How the secondary CLO market works).
Most banks that arrange CLOs also have secondary desks. Investors who want to buy a bond from a particular CLO in the secondary market will often approach the arranger of that deal first. This is partly because the arranger may have retained some bonds after pricing. During the life of the CLO, the arranger has an advantage as a secondary market maker in that it knows who the original investors were in each tranche, and may therefore be able to find securities for secondary buyers.
Most CLOs have only one arranger. In some cases, however, more than one firm shares the underwriting duties. This may happen where smaller investment banks have differing skills and access to different groups of investors, for example. The rankings of the biggest CLO arrangers change over time, but a handful of investment banks are consistently active in the market (see tables below).
Law firms
Since there are many parties to a CLO, a number of law firms are involved. At a minimum, the CLO arranger, CLO manager and trustee will each employ a separate firm to negotiate and create the deal’s various documents. Large individual investors, such as a majority equity investor, will often also employ a law firm.
A CLO will typically include the following documents, although there may be any number of additional side agreements, hedge contracts and legal opinions.
- The indenture, a contract between the issuer and the trustee
- The collateral management agreement, a contract between the manager and the issuer
- An offering memorandum or prospectus, setting out the terms of the notes for prospective buyers and warning them of the risks
- An interest rate hedge agreement – an interest rate swap – between the issuer and a swap counterparty (most often the arranger) to hedge interest rate mismatch within the CLO.
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Trustees and portfolio administrators
The governing document of a CLO, the indenture, is a contract between the issuer and a party known as the trustee. The trustee is usually a large commercial bank. Typically, the bank will have an arm that specialises in carrying out trustee and similar roles in the securitisation business. In common parlance, the term trustee is often used to cover two separate roles that have historically been carried out by the same firm – the role of trustee and the role of portfolio or collateral administrator.
The role of the trustee is to represent the noteholders. Much of the time, the trustee needs to do nothing. But if the manager wants to change the terms of a CLO and this requires a noteholder vote, then the trustee is responsible for contacting investors and arranging the vote.
When there is a disagreement between the different parties involved (for example, between the manager and disgruntled investors), the trustee needs to decide which course of action is consistent with the indenture. When disagreements turn litigious, it is the trustee who is likely to be sued. Therefore, trustees will sometimes turn to the courts to resolve disputes, seeking a ruling about how some particular clause in the CLO documentation should be interpreted. Sometimes, the trustee will also request (and pay for) a legal opinion from an independent law firm to give it direction on a specific question.
The portfolio administrator is the party that runs many of the practical and accounting functions of the CLO. It books and settles trades following the manager’s instructions. It calculates whether the tests are in compliance each month, makes payments and issues reports to investors. The administrator will typically carry out a reconciliation with the manager at the end of each day to check that the CLO has been managed according to the manager’s instructions. But it is the portfolio administrator which decides what amounts should be paid to which investors on each payment date.
If the CLO hits an event of default (see chapter 3: how does it happen?), the portfolio administrator switches from taking direction from the manager to operating the CLO at the request of the controlling class of investors. CLOs rarely disclose the amount of fees the trustee and portfolio administrator receive. Usually, these are included in a general category of administrative expenses. However, in a fairly typical CLO, the two combined may receive an annual fee of around one basis point (0.01%) of the CLO’s total size a year.
Law firm fees
CLOs are an important source of fees for some law firms.
The advisor to the arranger can expect to be paid as much as $400,000 in a typical deal.
The law firm advising the manager might get one-third of that amount, and law firms advising the trustee or individual investors might get paid $40,000 to $50,000.
The legal advisor to the issuer (responsible for setting up the special purpose vehicle in the Cayman Islands or a similar jurisdiction) would typically also be paid something like $50,000.
Ratings affect who gets paid
In some cases, the rating of the assets can affect the rules about which investors get paid what and when.
For example, most CLOs limit the amount of assets rated below single B. If the CLO breaches that limit, senior investors can receive principal back earlier than they would otherwise (through the overcollateralisation mechanism).
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Rating agencies
Almost all CLO liabilities (except equity tranches) are rated. This means that a company specialising in assessing credit risk, such as Fitch, Moody’s or Standard & Poor’s, has given an opinion about how likely it is that the company that issued the note will default (or about how much money an investor holding the bond can expect to lose). Many investors such as insurance companies and banks require the bonds they buy to be rated. Others, such as hedge funds, do not. But even these investors would generally not buy an unrated CLO note because they would worry about their ability to sell the bond to other investors if it was not rated.
Ratings are an integral part of a CLO, with the rating agency or agencies monitoring the deal’s performance through its life and upgrading or downgrading the various notes if necessary.
Ratings are important to a CLO in other ways, too. Most of the assets that a CLO buys are rated, and the CLO’s rules limit what assets the manager can buy, based on their rating and their industry classification (see chapter 6: Understanding the tests).
The different methodologies used by the rating agencies to rate CLOs (described in more detail in chapter 7: Debt tranches and ratings) can have a big impact on the way a CLO is structured. Arrangers usually discuss a planned CLO with officials from one or more rating agencies to ensure that it will gain their desired ratings. This is especially the case where the arranger or manager plans to introduce some new feature or type of asset in a CLO for the first time. The rating agency can, in effect, block the introduction of a feature by indicating that it would not give the proposed CLO the ratings its arranger is seeking.
When that happens, an arranger could choose to use a competing rating agency instead, provided that is acceptable to investors. But it is clear that rating agencies have a big influence on the structure both of individual CLOs and the market as a whole.
For example, following the wave of defaults in 2000 and 2001, in which unsecured bonds suffered much worse recovery rates than many had expected, rating agencies changed their assumptions on unsecured recovery rates. This made it much harder for securitisations of unsecured bonds to achieve the ratings that they had before. A given deal would need a larger equity tranche than before the change and this would produce lower returns for equity investors. As a result, issuance of CBOs – securitisations of high yield bonds – dried up almost immediately. It would be many years before they returned, leaving only the loan-backed CLOs that remain popular today.
Before the financial crisis, it was common for CLOs to be rated by three rating agencies. Since the crisis, this has become rare. Most are rated by either one or two agencies. This is partly a reflection of changing rating agency methodologies. But it also reflects a changing investor base, with many more CLOs being sold to investors who do not require multiple ratings.
Rating agencies are paid both an initial fee to rate the CLO and an ongoing fee to monitor the deal and keep the rating up-to-date. Typical upfront fees for each rating agency are in the region of between three and 10 basis points (0.03% to 0.1%) of the amount of notes the agency rates. Surveillance fees are usually half to one basis point a year to each rating agency.
It might be expected that rating agencies would compete for the business of rating a CLO by using methodologies that make it easier to achieve high ratings than their rivals. However, since rating agencies rely on their reputation for providing independent and consistent ratings, they have a counteracting incentive to maintain stringent ratings.
Investors
Investors are the most important, and often the most numerous, participants in a CLO. A large range of different types of investors buy CLOs, and the makeup of the market varies greatly, both over time, and across the different types of debt that a CLO issues.
The most senior CLO tranches are designed to be very low risk investments with a low return to match. Historically, banks have been by far the biggest investors in the most senior triple A tranches.
Before the crisis which started in 2007, many banks bought triple A securities from CLOs and other securitisations and hedged the risk with an insurance company in what was referred to as a negative basis trade (conducted using a credit default swap). The idea was that the package of the CLO security and the insurance company guarantee on that security left the bank with virtually no risk and a small income. Regulators also regarded this trade as having virtually no risk and gave it favourable capital treatment.
In reality, banks and regulators overlooked the risk that the insurance companies themselves would collapse. Post-crisis, banks very rarely buy CLOs as negative basis packages, but many continue to buy senior CLO tranches outright.
However, demand for senior CLOs from banks is much less than it was pre-crisis, partly because of new banking regulation. Other types of investors, notably US insurance companies and US pension funds, have taken up some of the slack by buying triple A CLOs.
Historically, insurance companies and mutual funds have been most active in triple B and double B tranches but they have become more active in buying single A and double A notes since the crisis.
Most of the tranches below single A but above the equity tranche are bought by specialist funds such as hedge funds. Historically, another big part of the investor base for these so-called mezzanine notes were CLOs themselves, with CLOs often including a handful of assets in their portfolio that were issued by other CLOs.
Post-crisis CLOs are typically not allowed to own CLOs. However, CLO managers will often manage separate funds to invest in their own and other managers’ CLOs.
The market for equity tranches has always been extremely varied and includes hedge funds, wealthy individuals, pension funds, the CLO managers themselves and publicly listed investment funds.
Who is in control?
Most post-crisis CLOs have a single investor which owns a majority, and in some cases all, of the equity tranche.
This anchor investor will typically be involved in the deal from the earliest stages (see chapter three: How does it happen?) with the arranger bringing in other investors at a later stage to take smaller portions of the equity.
By virtue of holding a majority of the equity, the anchor or control equity investor enjoys important rights. Most notably, it can decide when to call a CLO (see chapter 3: How does it happen?). It can also, depending on the specific rules of the deal, decide who should be the replacement manager if the original manager resigns or is sacked by the senior noteholders.
The control equity investor should not be confused with the controlling class of investors. The controlling class is the most senior class of debt outstanding at any time, and it enjoys important rights to make decisions if the CLO performs badly.
Notably, if there is an event of default, the holders of this class can usually sack the manager and decide when to liquidate the CLO portfolio (see chapter 3: How does it happen?).
The controlling class investors can also usually sack the manager “for cause” (such as breaching the collateral management agreement). However, bank investors in CLOs have increasingly waived this right in response to the Volcker rule (see chapter 12: CLOs and regulation). It is not yet clear if bank investors will reassert those rights following the amendments to the Volcker rule that became effective in 2020.