3. HOW DOES IT HAPPEN
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3. How does it happen
3. How does it happen
In a world in which investors are constantly seeking new investment opportunities, managers are constantly seeking new mandates and arrangers are constantly looking to do deals, any of these parties may initiate a CLO.
The beginnings of a CLO
The manager may well start the process, asking investment banks to pitch to arrange its next CLO and sounding them out about the kind of deal that the arrangers think possible. How big can it be? At what price can the notes be sold? What fees can the manager charge? And so on. An established manager is almost certainly already talking to investors who could play the anchor role of control equity investor even before they pick up the phone to a potential arranger.
Equally often, especially with less well established managers, the beauty parade works the other way, with arrangers looking to select a manager for a particular equity investor.
In some cases, there is no single anchor investor, but rather the investment bank starts to sell equity to many different investors. Usually, a deal goes through an equity marketing phase followed by a debt marketing period. However, for most of the time since the financial crisis, finding triple A investors has been a crucial constraint on the market. Therefore the arranger (or sometimes the manager) will seek to put in place senior debt investors early in the process.
In the warehouse
Once the arranger and manager have sufficient certainty that they can begin the process of marketing the CLO’s various securities, the manager will move quickly to start to ramp up the portfolio – in other words, it will start to buy the loans and, sometimes, other assets that will form the collateral for the CLO. Starting the ramp-up early is crucial when a manager is looking to put together a portfolio from scratch and at times when assets are particularly hard to find. Even if the bulk of the CLO’s assets come from a single source (such as an older CLO or fund that is being wound down), there is still likely to be a period during which the manager is building the CLO portfolio before the CLO notes are sold.
During this period, known as the warehouse phase, the embryonic CLO needs equity capital and debt funding. Sometimes the manager itself will provide the seed capital for the CLO, perhaps through another fund that it manages. In other cases, the control equity investor will commit capital early to the future CLO. In a few cases, warehouse equity will come from a third party which does not expect to invest in the planned CLO.
Equity capital alone, however, will not buy enough assets to get the CLO started. Equity needs to be leveraged by borrowing. This debt funding, known as the warehouse facility, usually comes from the arranger but sometimes from another commercial bank. This facility differs from the debt that the CLO will issue once it comes into proper existence. For one thing, it is expected to be paid back more quickly. Most warehouse lines have a legal maturity of no more than one or two years, and their pricing incentivises managers to use them more quickly than that.
Another way that warehouse funding differs from CLO funding is that the funds are in most cases lent against the market value (rather than the nominal par value) of the portfolio of loans that the manager buys. If the value of the loans declines beyond a certain point, the bank can require the equity investor to provide additional capital. If the equity investor cannot do that, the bank can seize the loans.
This is no mere theoretical risk. When loan prices dropped sharply in late 2008, many funds that had market value leverage, including some CLOs in their warehouse phase, were unwound with the leverage providers keeping the loans.
Sometimes, CLO warehouse lending takes the form of a total return swap. This means that the bank lender is legally the owner of the assets which act as security. The bank passes to the equity investor the income and any capital gains or losses from the loans. More commonly, the warehouse funding takes the form of a loan to the special purpose vehicle that will become the CLO. Usually, the market value triggers in these loans are set considerably “out of the money” – that is, equity investors will only need to provide additional capital if the value of the portfolio falls significantly.
Typically, the warehouse lending facility provides less leverage than the CLO will have once it has closed. The cost of financing is also somewhat lower than for the final CLO. This reflects the shorter maturity of the warehouse loan and the fact that arrangers see warehouse lending as a way to compete for CLO arranging business, rather than as a source of profit in its own right.
Going to market
While the manager is buying loans for the future CLO’s portfolio, the arranger will be working to sell the CLO liabilities. Often, the arranger will organise a roadshow, taking key individuals from the management firm to meet potential investors in different cities and countries. The arranger will prepare marketing documents such as a pitch book, a glossy publication describing both the deal and the manager, a termsheet outlining in brief the proposed terms of the different notes, and a draft prospectus or offering memorandum (OM). This is a longer document comprising key parts of the indenture along with details of the legal form of the notes (and laden with legal disclaimers and a lengthy risk factors section to protect the arranger against future lawsuits by unhappy investors).
The marketing process typically takes two to three weeks from launch (when the details of the deal are circulated to market participants) to pricing. However, this is often preceded by a period of several weeks of “soft marketing” in which the arranger sounds out potential investors and tries to ensure that a few key buyers are in place.
At any given time, certain tranches will be harder to sell than others. Therefore, the arranger builds an order book for the securities during the marketing process, working hard to sell the less popular tranches and choosing which investors should receive good allocations to popular tranches – a process known as syndication. The arranger can also tweak the tranche structure of a CLO in response to investor demand, increasing the size of one tranche and reducing another.
One important calculation that needs to be agreed between the arranger, the manager and some key investors at this stage is known as sources and uses. This is a simple table showing what money will come into the CLO on the first day of its existence (that is, the proceeds of all the CLO debt and equity issuance) and what money will go out. Outgoings at this stage include one-off fees – of which the arranger fee will be the largest – and note discounts.
The arranger may sell notes at a discount because a particular tranche is hard to sell. Or, just as likely, discounts may reflect the preference of certain investors to buy a bond with a price lower than par (and a correspondingly lower coupon). In either case, they affect the returns for equity investors because they change the timing of cashflows: less money enters the CLO on day one but less is paid out on each payment date.
The sources and uses calculation does not form part of any of the CLO’s legal agreements and it is not routinely disclosed to note investors. However, the manager will need this information, and equity investors will typically demand to see it.
-9 months
Planning/soft marketing
Manager and arranger discuss creating CLO.
Arranger in discussion with a bank which it believes would be interested in buying the entire triple A notes.
Manager knows a fund manager that would be interested in taking equity.
-8 months
Warehouse opens
Anchor equity investor provides capital for warehouse and arranger provides financing.
Manager starts buying loans.
-2 months
Marketing launch
Arranger circulates terms of the deal to prospective investors.
Arranger and manager go on brief roadshow meeting investors in New York, London and one other major city.
-1 months
Pricing
Deal terms and allocations are finalised.
CLO is now 70% ramped up.
Arranger gathers together remaining documents and manager steps up pace of ramp-up.
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Closing
CLO comes into legal existence.
Management fees and interest on the notes start to accrue.
CLO is 90% ramped up.
+4 months
Effective
Manager is satisfied with the yield and diversity of the portfolio and declares the deal effective.
Rating agencies confirm that the portfolio satisfies their requirements and the CLO tests start to apply.
+6 months
First payment date
CLO pays first coupon on notes and makes a healthy distribution to equity investors.
+2 years
End of non-call period
Equity investors may now call the deal but choose not to do so.
+4 years
End of reinvestment period
The CLO starts paying down its most senior notes.
In this deal, manager still has ability to make some new purchases.
+7 years
End of reinvestment period
The CLO starts paying down its most senior notes.
In this deal, manager still has ability to make some new purchases.
+7 years 1 month
End of reinvestment period
The CLO starts paying down its most senior notes.
In this deal, manager still has ability to make some new purchases.
Life story of a
typical CLO
Life story of a
typical CLO
First payment date nerves
First payment date nerves
Payment dates are key events in the life of a CLO. Most CLOs have payment dates each quarter, though some – especially European deals – pay once every six months.
On each payment date, the portfolio administrator assesses whether the deal is in compliance with its various tests, and calculates how much money the CLO should pay in interest, fees and equity distributions. Later in the deal’s life, the portfolio administrator will need also to calculate how principal proceeds should be distributed. However, this is rarely relevant on the first payment date.
The period up to the first payment date is often a few months longer than subsequent payment periods. This gives the manager time to ramp up the deal and ensure that there are sufficient proceeds to pay interest on all the notes. A large first payment distribution to equity investors may be a good indication that ramp-up has gone well and that the manager has amassed a high yielding portfolio.
Pricing and closing
Once the arranger has found buyers for all the CLO’s tranches and decided how much of each investor’s order will be filled, the deal is ready to price. On the pricing date, order sizes and prices for each security are confirmed to investors, and the investors commit to buying them at this price.
The CLO does not come into legal existence at this point. Rather, the arranger sets a date, usually around one month in the future, when the various contracts that form the CLO will come into effect and when investors will make payment for their securities.
This later date is known as the closing or settlement date. The CLO’s legal existence begins at this point. The CLO manager begins to earn fees and interest starts to accrue on the CLO notes.
While most of the CLO’s key documents will exist at the pricing date, between pricing and closing the arranger will gather together some of the supporting legal documentation. These may include legal opinions to provide investors with assurance that the notes meet certain requirements, and side agreements between various parties to the CLO.
Because CLOs are always sold as private placements, the prospectus is not finalised until pricing (except for those rare deals which do not include any US investors). In other words, all investors buy the CLO based on a draft or red version of the prospectus which is, in theory, subject to change. Following pricing, the arranger’s lawyers will produce a final prospectus. (One of the many – presumably unintended – consequences of US securities laws is that the final prospectus only comes into existence once it has ceased to serve its intended purpose of informing investors about what they are buying.)
In theory, a CLO could fail between the pricing and closing date. However, this has never happened during the history of the CLO market. (It is thought to have happened at least once in other areas of securitisation.)
Going effective
Once the deal prices (giving reasonable certainty that liabilities are locked into place), the manager is likely to step up the pace of acquisitions for the deal’s portfolio. Upon closing, the deal starts accruing interest on the CLO notes, and the manager needs to ensure that there is sufficient cash coming into the deal to make its interest payments.
The point at which the CLO is fully ramped up is known as the effective date. This is the point at which the various tests start to take effect. The manager can declare the deal effective at any point before a pre-agreed cut-off date which might be four months after closing in the case of US deals and a few months longer for European CLOs. It is in the manager’s interest to make sure this happens well within the pre-established time limit. In order to make the deal effective, the manager needs to get the rating agencies to confirm the rating of the notes and that the deal is passing its tests.
If the manager fails to declare the CLO effective by the cut-off date it may be forced to start paying down the CLO notes. In practice this is unlikely to happen. The CLO manager can almost always find some assets to buy even if they are not those it considers ideal (see chapter 4: How are CLOs managed?).
Supplemental indentures
Supplemental indentures
A common supplemental indenture being discussed in 2021 is the addition of bond buckets to CLOs now that the Volcker rule no longer restricts CLOs from owning them.
This is reversing the wave of supplemental indentures in 2014 and 2015 when managers were proposing to restrict or eliminate a CLO’s ability to buy bonds as the Volcker rule was implemented.
The reinvestment period
The CLO now enters what should be the most productive period in its life in terms of producing income. Between the closing date and a predefined date in the future, the CLO is said to be in its reinvestment period. This means that the manager is able to trade the portfolio and reinvest the proceeds of loan amortisation and repayments.
Life after reinvestment
After the end of the reinvestment period, this changes. The precise rules of what a manager can and cannot do after the reinvestment period vary from deal to deal. The general idea is that the manager will not buy new assets and that prepayment and amortisation proceeds will be used to pay down the CLO’s liabilities.
In some deals this is strictly enforced, with the manager prohibited from making any new purchases. In other deals, the manager is able to make some new purchases, for example, where it sells assets that have deteriorated in creditworthiness (known as credit impaired sales) or those that have improved in creditworthiness (known as credit improved sales). In practice, of course, many trades could be said to fit into one of these two categories.
The reason CLOs vary in this respect is that different parties have different preferences about the speed at which a CLO should wind down. Broadly, the manager would usually prefer to retain the flexibility to invest for as long as possible, and equity investors will usually share this view, since their distributions dwindle as the CLO portfolio shrinks. Note investors, by contrast, generally like to have as much certainty as possible about the length of their investment. Therefore, the crucial rules on post-reinvestment activity reflect the balance of power and the outcome of negotiations between the different parties at the deal’s outset.
Refinancing, repricing, and resets
One way that CLOs have changed since the crisis is that the new generation of deals give equity investors more possibilities to refinance CLO debt than older deals. Previously, the only possibility for equity investors to reduce their financing costs was to call the CLO in its entirety (once the non-call period had expired) and issue a whole new CLO.
Most 2.0 CLOs, by contrast, allow equity investors to refinance a CLO on a tranche-by-tranche basis. This means they can choose to redeem and re-issue individual tranches (once they become callable).
For equity investors this is valuable: it allows them to take advantage of falling spreads on certain tranches. For debt investors, it is generally a bad thing: it increases the chances that their CLO tranche is called early, forcing them to replace their investment with a lower yielding new bond. On the other hand, if they buy the original CLO note at a discount to par, an early redemption will give debt investors an increased return. As a CLO gets closer to the end of its reinvestment period, the shorter tenor on its notes means these will refinance lower than on the CLO’s original formation.
A second option for equity investors is to reset a CLO. In a reset, the CLO reinvestment period and deal maturity are both extended. A reset achieves the same goal of taking advantage of falling spreads, while also extending the life of a deal making it a popular choice for managers and equity investors, and resets have become a key component of the market. In some months in 2021 resets equaled or exceeded new-issue volumes.
A final variation on this idea allows equity investors to reprint the coupons on individual tranches at the new prevailing market rate. This is known as repricing, but remains a very rare occurrence in the market.
Calling the deal
Long before a CLO reaches its official end date – that is, the legal maturity date shared by all or most of its notes – equity investors gain the right to redeem (or call) the CLO. As with many callable bonds, this call option does not exist from the moment the bond is issued. Rather, there is a period, often of two years, from the closing date during which the CLO cannot be called. This window is known as the non-call period. The non-call period exists to give debt investors more certainty about how long the bonds they own will be outstanding.
Figuring out when a CLO will be called is an important part of calculating how much it is worth (see chapter 9: How are CLOs priced?). Generally, equity investors can be expected to exercise their right to redeem once it makes economic sense for them to do so. In the real world, the decision to call can be influenced by other factors. But, by and large, equity investors will call the deal at the point when their return from the investment falls below what they could earn from a realistic alternative investment.
However, there is another important consideration to bear in mind. Equity investors may only call the CLO if the value of the CLO’s assets is sufficient to pay back all its notes in full. This ratio – between the market value of the portfolio and the repayment amount of the CLO notes – is known as the net asset value (NAV) of the CLO, and is also referred to as the market value OC. All CLOs include a rule that the NAV or market value OC must be positive for the equity to exercise the call.
When a CLO is called, the manager must sell its assets in order to repay the CLO notes. Often, the manager auctions off the collateral through a bid list. Once the assets are sold, the proceeds of the auction are used to repay the notes, with any money left over paid to equity investors as a final distribution.
But it doesn’t always happen this way. Sometimes, equity investors will call a CLO in order to roll it into a new CLO. The old deal’s collateral will not be auctioned off, but will be bought by the new CLO. Equity investors often choose to do this when their income from the old deal is diminishing, and when they believe they can lock in financing for a new CLO at a desirable rate.
A CLO afterlife
In either case, redemption is not necessarily the end of the CLO. It may not be possible to sell the assets in the portfolio immediately. Some may have been bought recently and are not yet legally owned by the CLO (in other words, the loan purchase remains unsettled). These assets will be sold later, with the proceeds passed on to equity investors in subsequent payments.
Many CLOs, especially those that have been outstanding for several years, will have experienced several defaults in their loan portfolios. The CLO will often have been given shares in a restructured company as part of a bankruptcy or out-of-court restructuring. Those share holdings are likely to be illiquid, and the CLO’s equity investors will often prefer not to sell them along with the CLO’s other collateral, fearing that they will only be able to do so at a distressed price.
So the CLO, having repaid its notes, may survive as an unlevered fund holding a small number of illiquid assets for some time – even for several years. The manager will continue to oversee the fund and will distribute money to its investors as it succeeds in realising the value of its remaining assets.
The official end
Most CLOs are called within a few years of the end of their non-call period. However, if that does not happen, most likely because the assets are insufficient to pay back the notes, the CLO will run until the legal maturity of the notes, which is usually around 10 to 13 years after the closing date. On legal maturity, the trustee will organise a sale of the assets to pay off the remaining notes, or as much of it as possible.
In some CLOs, there may be an auction two years before maturity which only goes ahead if it is likely to produce enough proceeds to repay all the notes. If not, another auction is scheduled for one year before maturity. If neither of these auctions goes ahead, the CLO continues until legal maturity. At that point, an auction will take place even if the proceeds are insufficient to repay the notes.
If there are not enough proceeds to pay back all the debt at legal maturity, then the CLO will enter an event of default.
Events of default
A number of other things can happen at various points during the course of a CLO’s life. For example, the CLO may enter a period in which it is prohibited from making payments to equity investors, or where interest payments to some junior debt tranches are suspended (see chapter 6: Understanding the tests). This happens when the CLO fails some of its key performance tests. If there is a particularly serious failure of these tests, or if it reaches legal maturity and is unable to pay back its debt, the CLO triggers what is known as an event of default.
Exactly what happens in an event of default varies from CLO to CLO. However, generally, all cashflows are diverted to pay interest and principal on only the most senior tranche of debt outstanding. And the owners of this tranche, which is known as the controlling class, take control of the CLO’s destiny.
The controlling class of investors may decide to liquidate the CLO immediately. They can also choose to wait and liquidate the CLO portfolio at a time of their choosing.
When it is liquidated, the CLO will pay down the remaining notes in order of seniority. It is easy to see that there may be conflicts between the interests of different classes of investors at this stage. Senior investors may prefer a rapid liquidation if there is sufficient value in the portfolio to pay their class of notes. Junior debt investors may prefer to wait. However, in an event of default it is always the controlling class that decides the timing of a liquidation.
Changing the rules
Since uncertainty is one of the only certainties in the world, it is quite possible that some of the parties to a CLO will want to change its rules at some point during the course of its life. CLOs allow for this possibility by laying down rules concerning supplemental indentures – in other words, amendments to the deal’s governing document.
Supplemental indentures are introduced for a large number of reasons. They may be necessary to accommodate some change in rating agency methodologies or to clarify some ambiguity in the original indenture, for example.
Some rule changes need to be approved by investors. Others do not. The rules about who needs to approve a supplemental indenture are complicated and, as with many other things, vary from deal to deal. Typically, significant changes need to be approved by a majority of each class of investors that are affected by them. Limiting, or unlimiting, a CLO’s ability to buy bonds, as described on the previous page, is clearly an example of a change that has a significant impact on the economic performance of the CLO. It would need to be approved by the most senior class of investors or, in some CLOs, by a majority of each class of investors.
However, other changes are more minor. A CLO’s indenture usually says that minor changes to correct an error or ambiguity in the original documents can be made without an investor vote. Other relatively minor changes require rating agencies to confirm that the change does not affect their ratings of the CLO notes (this is referred to as a rating agency confirmation) rather than an investor vote. Typically documentation changes will take place during the course of a CLO refinancing or reset.
Changing the players
The documents of a CLO also specify what should happen if any of the deal’s key participants – notably the manager, but also the trustee or any participant with an ongoing role – resign from their position.
There are also provisions allowing the manager of a CLO to be sacked against its will. This is sometimes possible if specified key individuals leave the management firm (where a CLO has what is commonly called a key personnel clause (see chapter 4: How are CLOs managed?). This would be an example of removing the manager “for cause”. Managers can also be removed “without cause” if sufficient investors vote for the change.