Further Frontiers for CLOs
The general success of CLOs has led to regular innovation, often around the type of asset managed in the deal. The combination of equity with a long investment horizon, debt that stays in place through the ups and downs of collateral value and a role for active management makes a CLO a good vehicle for investors trying to finance asset portfolios. A few niches have managed to get a foothold—or more than a foothold—in the last few years:
- High flex CLOs that allow high ‘CCC’ exposures
- CRE CLOs that manage loans to real estate developers
High flex CLOs
High flex CLOs cater to managers and investors anticipating credit stress in the market for broadly syndicated loans. These deals come to market with overcollateralization tests that allow 20% or even 50% ‘CCC’ loans before the test fails. Compared to deals with a more typical 7.5% ‘CCC’ limit, the deals will have higher levels of subordination, among other things, and the debt usually will trade at wider spreads. The high ‘CCC’ allowance lets a manager absorb more downgrades in the loan portfolio without diverting equity or junior class cash flows and without forcing loan sales into a bad market to cure a failed test. Higher allowances also let a manager trade into ‘CCC’ credits that the manager thinks will perform well. High flex CLOs may also allow smaller lending facilities, more second lien loans or high yield bonds. This type of CLO suits a manager with deep credit expertise.
CRE CLOs have become a way to fund portfolios of loans to buildings in transition. A CRE developer may want to refurbish an existing building after long use or update or convert the building to a new purpose by putting in new technology, new floor plans, new elevators or other basic infrastructure. Most of these loans would not fit a typical commercial mortgage-backed security, and most would not fit many bank portfolios. That makes CLO financing compelling.
Just like a CLO backed by broadly syndicated loans, a CRE CLO manager can be active or passive. An active CRE CLO manager will reinvest principal from loan repayments or maturities or even actively trade the portfolio. A passive manager will launch a deal with the portfolio fully assembled and will use repayments and maturities to repay debt. The CRE CLO market has seen more passive than active deals.
- CRE CLO have features familiar to any CLO investor:
- A warehouse period: from a few months to up to a year or longer
- A ramp-up period after pricing: zero to three months
- A reinvestment period: typically 1.5 to 3.0 years
- A non-call period: typically 2.0 years
- Loan collateral: Mostly first-lien CRE whole loans or pari-passu participations
- Ratings: Moody’s for ‘AAA’, DBRS and Kroll for subordinate classes
- Protection tests: overcollateralization and interest coverage tests that amortize senior notes sequentially until tests pass
- Risk retention: since the originator is usually the manager of a CRE CLO, the manager retains risk
More room to innovate
The types of collateral included in CLOs has continued to expand. Investors and managers have brought deals backed by portfolios of both leveraged loans and high yield bonds. CLOs have included portfolios of investment funds. And some banks have weighed CLOs backed by the banks’ own portfolios of commercial and industrial loans, where the bank has the flexibility to bring loans in and out of the CLO as long as the portfolio stays within the guidelines laid out in the transaction. For banks, these balance sheet CLOs can be both a source of funds and a vehicle for reducing economic and regulatory capital.
CLOs continue a trend in capital markets of creating specialized vehicles for managing and funding assets and distributing the risk to the investors most willing and able to bear it. With enough transparency and alignment of interests between all the parties involved, CLOs and other vehicles bring more capital to creditworthy borrowers at lower cost. And that gives the businesses and individuals that make up the fabric of the economy a greater chance of success.