Guide to CLOs

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.
Balancing the needs of investors
CLO note investors provide leverage to equity investors, allowing them to increase the returns they would otherwise get from a portfolio of loans. This leverage is locked in place for several years. Unlike other leveraged credit funds, CLOs do not give debt providers the ability to seize assets or demand additional equity if the value of the fund investments falls. (Except, as we will see, in certain circumstances).
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.

Valued at par

The performance of any investment over any given period is a function of the cash it pays out and the change in its original value.
For many investors in many kinds of investment, value means the market value of an investment. It would seem strange for an investor in Apple shares to ignore the daily changes in the share price.
But CLOs do not (for the most part) measure the performance of their loan investments in terms of their market value. Instead, loans are accounted for in terms of their par value. And this concept of par value lies at the heart of the mechanisms that govern CLO cashflows.
Par is the principal amount of a loan – the amount that is repaid at maturity or in instalments towards the end of its life. Loan prices are quoted as a percentage of par. An investor who buys a $2 million loan at par is paying $2 million for a loan that will repay $2 million at maturity. The investor may be able to buy the loan at 98% of par (or 98 cents in the dollar), which would mean that he pays $1.96 million for a loan that repays $2 million at maturity.
Because of their floating rate coupons, loans can be expected to trade at par much of the time. However, when the company issuing the loan is in trouble or if there is a shortage of buyers for a particular loan, it may well trade at a price below par. (Because issuers have the right to repay a loan at any time – usually for a 1% premium – loans rarely trade at more than 101% of par.)
The par value of a CLO is the sum of the par value of each of its loans. If a CLO manager buys a loan that deteriorates in value, this has no effect on the par value of the CLO portfolio (with a few important exceptions).
If a CLO manager is able to buy a loan at a price below par, the loan normally still counts at par value in the portfolio. This makes it attractive for a CLO manager to buy loans below par. The process of increasing the par value of a CLO portfolio by purchasing loans below par is often referred to as par-building.
CLO mechanics
There are two kinds of mechanism that exist to protect debt investors. One kind consists of the cashflow waterfalls or priority of payments. These are the detailed rules that set out who should get which amount of money and when. The second kind of mechanism is the various tests which are described in the next chapter (see chapter 6: Understanding the tests).
Interest waterfall
The interest waterfall is a series of rules spelled out in the governing indenture of a CLO. The rules say what a CLO should do with the interest it receives from the loans it owns. The term priority of payments describes exactly what they are. A CLO can make a particular payment only if there is enough cash left over after it has made every higher (or more senior) payment in the waterfall.
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.
Principal waterfall
Just as there are rules about what a CLO does with the interest it receives, there is another waterfall for all payments of principal, the principal waterfall. The CLO may receive a principal payment when a loan that it owns reaches maturity. But loans do not usually run to maturity. Instead, most of the principal proceeds come from early repayments, also known as prepayments. Prepayments occur when a loan issuer decides to pay back its debt early which, in most loans, it is entitled to do. Another source of principal is amortisation, the scheduled pay-down of loans as they approach maturity. But CLOs usually own few loans that are amortising, so this figure is relatively small.
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)
Illustrating the waterfalls
To figure out what is likely to happen during the life of a CLO, an investor needs to estimate how much interest and principal it is likely to receive from its portfolio of assets at what times and then follow it through the waterfalls. Several things affect the CLO’s incoming cashflow. One of the biggest is the number of defaults in the portfolio. Another is the speed at which loans prepay, or the prepayment rate.
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.
‘CLOs can have a bewildering array of accounts to receive, store and pay money’
Where does the money go?
CLOs have an often bewildering array of accounts that are used to receive, store and pay money. Each CLO’s indenture sets out the names of the different accounts it will hold and what they will be used for.
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.
Example of a CLO waterfall
These are the basic waterfall rules of a typical CLO. In practice, each CLO includes minor variations to these rules, which are spelled out in the indenture.

Interest waterfall

pay tax
pay administrative expenses up to the expenses cap
pay senior management fee
pay interest on the triple As
pay interest on the triple As
if failing the triple B OC or IC test, pay principal on the triple As, then double As, then single As and then triple Bs until the tests are back into compliance
pay interest on the triple As
if failing the interest diversion test use a proportion of the remaining interest proceeds (or less if that’s enough) to cure the test by buying extra collateral
pay interest on the triple As
if failing single A OC or IC test, pay principal on the triple As, then the double As and then the single As until the tests are back into compliance
pay interest on the triple As
if failing the triple A/double A overcollateralisation (OC) or interest coverage (IC) test, pay principal on the triple As and then double As until the tests are back in compliance
if the CLO has not gone effective by a set date, pay down principal in order of seniority
pay the junior management fee
pay any administrative expenses above the expenses cap
pay equity distributions up to the point that the manager incentive fee is triggered, splitting the remaining money 80:20 between equity investors and the manager

Principal waterfall

pay everything due under the interest waterfall down to interest on the most junior notes (11) if the interest waterfall was not sufficient to make those payments
pay down the principal of the notes in order of seniority if the deal is called or matures or if the manager can’t find any assets to buy
leave proceeds in the principal collection account ready to be invested in new collateral if the deal is in its reinvestment period (also post-reinvestment subject to the rules on post-reinvestment purchases).