Collateralized Loan Obligations (CLO)

CLOs (Collaterized Debt Obligations) are structured finance securities collateralized predominantly by a pool of below investment grade, first lien, senior secured, syndicated bank loans, with smaller allocations to other types of investments such as middle market loans and second lien loans.

• CLO debt issued to investors consists of several tranches, or layers, with different payment priorities and, in turn, differing credit quality and credit ratings.

• The senior-most tranche is the most-protected and, therefore, has the highest credit quality and the lowest coupon.

• CLOs have structural features that serve as protection for the debt and equity investors, such as overcollateralization and interest coverage tests.

• Due in part to sound structural features, a low default rate environment for bank loans and prudent investment management, CLOs were considered “survivors” of the financial crisis (2008-2009).

• While they are historically less than 1% of total U.S. insurer cash and invested assets, CLOs offer an attractive yield alternative to traditional bond investments.

Special Purpose Vehicle (or “SPV”)

Trusts whose operations are limited to the acquisition and financing of specific assets into the pool that collateralizes the structured securities (in this case, CLOs); an SPV is the actual issuer of the CLO tranches.

Broadly Syndicated Bank Loans (BSLs)

As the largest segment of the leveraged bank loan market, BSLs are loans to companies with earnings before interest, taxes, depreciation and amortizations (EBITDA) over $100 million and with public credit ratings from the rating agencies. They are usually senior secured bank loans originated in connection with merger and acquisition activity or leveraged buyouts. They are also usually floating rate based on LIBOR.

Tranche

Class of debt within a securitization’s capital structure.

Closing Date

Date the underlying portfolio is fully ramped and coverage and quality tests begin to take effect.

Ramp-Up Period

Following the closing date, the months following (anywhere from one to four months) during which the CLO manager purchases the remaining collateral for the bank loan portfolio.

Effective Date

Date on which the Ramp-Up Period ends and when the coverage tests begin to apply.

Non-Call Period

First two years of the transaction’s life where the bond holders receive a yield spread specified at closing and the bonds cannot be called.

Reinvestment Period

Two- to five-year period during which the CLO manager is able to buy and sell collateral for discretionary, credit-impaired and credit-improved purposes. Investors do not receive principal payments during this time. Maturing collateral and prepayments are reinvested in new collateral.

• Investor proceeds are used to purchase a portfolio of leveraged bank loans, whose principal and interest are used to pay debt service to the noteholders, with any remaining amounts paid out to the equity investors.

• For “traditional” CLOs, the collateral pool primarily consists of below investment grade, first lien, senior secured broadly syndicated bank loans (usually at least 90% of the total portfolio).

• CLOs consist predominantly of middle market loans as the underlying collateral.

• In the early stages of structuring a CLO, bank loans are purchased by the CLO manager and warehoused (usually for a period of three to six months) prior to the transaction’s closing date.

• Upon closing, the transaction then has a ramp-up period during which time the CLO manager purchases additional collateral to complete the portfolio.

• Thereafter, there is a reinvestment period, which lasts anywhere from two to five years, whereby trading of the bank loans may occur. That is, during this time, the asset manager may purchase or sell bank loans to improve the portfolio’s credit quality.

• After the reinvestment period has ended, the CLO manager uses proceeds from interest income on the bank loans, bank loan repayments and maturities to pay down the CLO debt in order of priority/seniority (known as the amortization period), and distributes any remaining proceeds to the equity investors as their return.

• A CLO is also structured with a “non-call” period in the first two years of its life immediately following the closing date. After this period, the majority equity investor can call the deal (redeem it in full) if the transaction achieves a particular yield spread, and the CLO debt holders can be paid back in full.

• Cash-flow distributions on payment dates (also known as the “waterfall”) begin with payments to the senior-most CLO tranche, which receives the highest claim on the flow of funds, followed by payment to the lower-rated tranches, in order of seniority. Any funds that remain at the end of the waterfall may be distributed to equity investors as a return on their investment.

• Depending on size, a typical CLO manager will have one or more portfolio managers (sometimes they are asset-type specific), credit analysts (who may be industry specialists or generalists) and operations professionals.

CLO managers are responsible for investment management decisions for the CLO’s underlying portfolio. As such, they must have the appropriate infrastructure in place to properly manage the transactions. This not only includes having seasoned portfolio managers and credit analysts as part of the team, but also experienced operations professionals and appropriate data management systems in place. Therefore, a comprehensive assessment of a potential CLO manager’s infrastructure is essential for investor (i.e., insurer) review, in order to derive comfort with their ability and experience as a CLO manager.

Depending on size, a typical CLO manager will have one or more portfolio managers (sometimes they are asset-type specific), credit analysts (who may be industry specialists or generalists) and operations professionals. CLO managers may include affiliates of private equity firms, hedge funds, large financial institutions and banks, and insurance companies, too. CLO managers typically receive a senior management fee as a percentage of the underlying portfolio of bank loans’ par value, as directed and prioritized in the aforementioned waterfall.

In addition to thorough credit analysis of the CLO investment, reviewing the infrastructure of the CLO manager is equally important for the investor. This “due diligence” is intended to help the investor ascertain whether the CLO manager understands the mechanics of the CLO structure and the credit assessment of the underlying assets (leveraged bank loans), as well as to derive comfort that the CLO manager is managing to investor interests (and not his/her own).

CLOs have structural features that serve as protection for the debt and equity investors, such as overcollateralization and interest coverage tests. These ‘tests’ are performed at regular intervals to ensure the CLO can meet its obligations.

Because of the 2008-2009 financial crisis, the Dodd–Frank Wall Street Reform and Consumer Protection Act’s (Dodd-Frank) risk-retention rules were created and into effect on Dec. 24, 2016, for ABS, CMBS, RMBS and similar securitizations. The rules are designed to prevent lenders from making risky loans, packaging them into bonds and leaving investors with all of the losses if/when payment defaults begin to occur.

Additionaly, Effective February 2018, a court ruling exempted traditional (BSL) CLOs from having to comply with Dodd-Frank risk-retention rules whereby the CLO manager would have been required to retain at least 5% interest in the total capital structure. The ruling is expected to benefit smaller CLO managers who would otherwise have been challenged to comply with the requirement (as they may not have had the ability to easily raise the large sums of capital needed to comply), and perhaps, they may have been prohibited from issuing new CLO transactions.

Note, however, that this exemption does not apply to middle-market CLOs as they are subject to the 5% risk retention rule.