5. Understanding the cashflows

The big difference between a CLO and most other investment funds is that a CLO has to follow defined rules about the flow of money. These rules vary from deal to deal, but at their heart is a bargain between debt and equity investors.

In other words, CLO leverage is long term, locked in place and mostly free of mark-to-market constraints. In return for providing this extremely useful form of funding, CLO note investors benefit from a structure which means they get paid ahead of equity investors. They also get the benefit of mechanisms to repay debt early, reduce leverage and constrain the manager if the deal does not perform as well as expected.

Rather than considering a CLO a kind of fund, we can think of it as a mini corporation. It has assets and liabilities and a strict priority of seniority for the liabilities. As with a regular company, lenders give leverage to the equity. The big difference between a CLO and a “real” company, is that a CLO has no true management team that can change strategy, add more debt or issue further equity. Instead, the rules of a CLO make it a highly constrained corporate entity.

The first payee in the waterfall is the government. Although CLOs are set up as tax-exempt vehicles, they conventionally include a clause to pay any tax due as a top priority. The trustee’s fee and other crucial expenses also come near the top of the list, although often there is a cap on the amount of money that can be used to pay expenses at this part of the waterfall. At this point , the CLO also pays the manager its senior management fee.

These payments are small change compared to the big expense facing any CLO: the interest payments on its debt. These come next, with the first item being the interest on the most senior class of notes (if they are still outstanding), then the class beneath it and so on.

This part of the waterfall makes it clear how the different tranches of debt stand in relation to each other. For example, a CLO may have a tranche called the class B1 notes and another called the class B2 notes. If those notes appear in the waterfall sequentially, then it is clear that the class B2s are junior to the class B1s (and can be expected to carry a higher coupon). However, the class B1s and B2s may appear at the same point in the waterfall (with available cash split equally between them). In that case the two sets of bonds have the same seniority. In other words they rank pari passu, which is the debt market term for being on an equal footing.

For the most part, interest received by the CLO’s loans is used to make interest payments on the CLO’s notes. In some circumstances, interest proceeds are used to pay principal on CLO notes. These are discussed in the following chapter (see chapter 6: Understanding the tests). But if a CLO is performing as intended, it should not happen.

At the bottom of the interest waterfall, once all classes of debt have received their interest payments, comes the subordinated or junior management fee.

The very last item in the interest waterfall is to pay all remaining interest income to equity investors. As discussed in the previous chapter (chapter 4: How are CLOs managed?), this remainder is initially paid out just to equity investors. However, once equity investors have reached a predefined hurdle for their returns, the manager usually starts to receive its performance fee. So, for example, the waterfall may say that the equity investors receive all interest until their internal rate of return reaches 15% over the life of the deal. Beyond that point, interest income is split, typically 80:20 between the equity investors and the manager.

The first item on the principal waterfall is usually to make any payments to the CLO’s note holders that had been due under the interest waterfall but were not made for whatever reason. After that, principal is generally used to buy new assets for the CLO.

However, there are several circumstances in which the CLO stops using principal to buy new assets, and instead pays down the principal of the CLO notes in descending order of seniority. These are:

• When the CLO has been called.
• When the CLO reaches maturity.
• In the very rare instance where a manager declares that it cannot find suitable assets to buy and elects to make repayments.
• When the CLO is outside its reinvestment period. However, it is only true to say that the CLO stops buying new assets completely post-reinvestment in some CLOs. In many CLOs, the manager is able to make some purchases. (See chapter 3: How does it happen? for more on the varied and complex rules on post-reinvestment purchases.)
• When the CLO is failing one or more overcollateralisation or interest coverage tests (see Chapter 6: Understanding the tests)

Reality is a little more complicated. It is not just the number of defaults that affects performance but the severity and timing of those defaults. Poor trading decisions on the part of the manager can erode cashflows even in the absence of defaults. And successful trading can make up for losses.

At its simplest, a CLO has a collection account, an account into which the CLO pays all the proceeds from the collateral it owns. These proceeds are deemed to be either principal proceeds or interest proceeds. A few days ahead of each payment date, the CLO transfers funds from the collection account to another account called the payment account. On the payment date, the payment account is used to make all the interest, principal and other payments under the cashflow waterfalls.

Most CLOs have several other accounts. It is common, for example, for CLOs to include an account in which to hold funds for revolving loans and drawdown loans. These are facilities which the borrower has the right to use but may choose not to use in full at a given time. The funds need to be available in case the borrower draws on the facility.

Some CLOs also include various accounts that act as a cushion or a reserve for future needs. For example, there may be an account into which the manager can put funds which can be used to buy equities following a debt restructuring. The balance of each account is listed in each monthly investor report (the so-called trustee report). This provides an important check for investors to be sure that the CLO is being operated as intended.