Introduction to Collateralized Loan Obligation

Risky Collateralized Loan Obligations Spark Boom
From BizDevDigest http://www.bizdevdigest.com/ialt/bdd/issue.aspx?id=106

By now everyone knows that an estimated $1 trillion in global liquidity is mostly fueling the recent LBO boom. Question is what caused it? In part, the rise of so-called collateralized loans obligations (CLO), and the overall collateralized debt obligation (CDO) industry, have provided institutional investors funds for their illiquid fixed-income assets. The special purpose vehicles (SPV, usually sponsored by banks) that manage CLOs arrange their purchased loans into a portfolio made up of varying tranches. The SPV then issues unrated securities that are securitized by the SPV’s assets, which are the loan payments the CLO manager maintains. CLO managers covet the loans’ high yield while investors can choose a tranch that fits their risk profile. In addition to mutual funds and hedge funds, CLOs bought a record $157 billion of leveraged loans in the first quarter of 2007. The volume of CLOs has nearly doubled to a record $97 billion in 2006 from $53 billion in the previous year.

Typically, CLOs have been the domain of investment banks. The banks set up SPVs for the purposes of selling portions of large portfolios of commercial loans (or in some cases, the credit risk associated with such loans) directly into the international capital markets, which would offer banks a means of achieving a broad range of financial objectives, including the reduction of regulatory capital requirements, off-balance sheet accounting treatment, access to an efficient funding source for lending or other activities, and increased liquidity. Bank CLOs would contain a mix of bonds and secured and unsecured commercial loans. Private equity CLOs that first surfaced in 2001 when Capital Dynamics and Deutsche Bank launched Prime Edge (the first ever CDO to be collateralized by private equity investments) contain loans that are tranched into four classes: senior, mezzanine, junior risk, and equity.

“CDOs of private equity would broaden the available investor base and allow portfolio investors a greater opportunity to invest in private equity,” wrote J. Paul Forrester, an attorney with Mayer, Brown, Rowe & Maw, about private equity CDOs. Private equity CDOs also add liquidity, transparency and discipline to this market. Huge demand from CLOs has contributed to low spreads and generally easy credit conditions to the benefit of private equity outfits.

Steven J. Adelkoff, a partner with Kirkpatrick & Lockhart Preston Gates Ellis LLP who practices structured finance and global capital markets, said CLO deals that involve assets held by private equity firms include mostly mezzanine funds or firms that lend second-lien loans. Sponsors of such CLOs (i.e. the private equity firm) may be required to invest in a mezzanine or equity tranche of the CLO to effectively sell the CLO in the market. By using a CLO structure, private equity firms can monetize their portfolios, providing more room in their warehouse lines to originate or purchase additional portfolio loans.

Mr. Adelkoff said he has seen a small number of PE firms sponsoring CLO deals, and he hypothesizes that the reason for the low number is that most PE shops with debt in their portfolios are making loans at the lower end of the credit curve (i.e. B+, BB- credits) . To get an optimal capital structure in a CLO, a significant portion of the underlying debt instruments are most often rated at BBB+ or above. A PE firm wishing to execute a CLO with a portfolio of its debt may need to look for a JV partner or other solution to combine the PE firm’s lower credit rated assets with higher grade paper.

Mr. Adelkoff said he does see room and the potential for PE firms to invest in CLOs, particularly in the lower tranches of the capital structure. He would recommend for interested private equity players to do the following:

• To either buy, hold, or trade an equity note or a BB, BB-, or a B+ rated mezzanine notes.
• To play in the credit-default obligation or credit default swap arena by selling protection for certain pieces in the CLO structure.
• To consider investments in the equity portion of the CLO structure.

Still, the risk-inherent in CLOs may persuade some to stay away from CLO deals. Business Week reported CLO managers encourage companies to take on more floating-rate debt, which cause problems like those now being felt by homeowners who took out adjustable-rate mortgages a few years back. CLOs also encourage companies to put up more of their assets as collateral for lenders, which during hard times could hinder their financial flexibility. At a recent CDO conference in NYC where arrangers, managers and investors discussed how the mortgage market’s sub-prime woes could be linked to the corporate world. They feared bad loans would mean an increase in warehouse risks and a stagnation or possibly even a halt in mezzanine ABS (asset-backed securities) CDO issuance this year.

The CLO market is largely driven by the rating agencies, Mr. Adelkoff notes, because of how managers are able to infuse their product with credit enhancements, which boost the ratings of the lower tranches in the CLO. Investment managers have been able to corral billions of dollars from insurance companies, pension funds, and ultrawealthy individuals around the world who crave AAA-rated investments and nothing less – certainly not loans to fund LBOs. Standard & Poor’s Leveraged Loan and Commentary calculated that about 60% of buyout loans were packaged into CLOs.

Patrick D’agostino, VP of investments at Boenning & Scattergood Inc., said he would not even go near corporate CLOs because of his clients’ investment profile and inherent risk. A lot of the buyout loans shuffled into the CLOs are financing deals that often come with risky business reorganizations. With loans from the same big deals spread throughout CLOs, the chance of LBO defaults is the number-one risk factor to the CLO-fueled boom. “Some people are just chasing yield, which is dangerous,” Mr. D’agostino said. Dangerous, but not surprising. Such prospects have not scared off private equity firms and hedge funds from forming their own CLO/SPVs.

Private equity firms and hedge fund managers are not looking to fund their own deals with their CLO startups, but to use the financial tool as an additional revenue stream. Kohlberg Kravis Roberts & Co., the big LBO house, two and one-half years ago started its own CLO, KKR Financial Corp., which it took public last year with a chief executive recruited from Wells Fargo & Co. Competing buyout giants Bain, The Blackstone Group, and Carlyle Group also have affiliates managing CLOs. Experts said such alternative asset managers can see firsthand the immense capacity of investors to finance loans that in the past were held mostly by banks.

Just a little over a month ago, hedge fund Epirus Capital planned to start parking investments in a series of collateralized debt obligations that managers would eventually issue. The vehicle is set up to invest heavily in CDO equity pieces, and elsewhere in the capital structure of CDOs that either issue credit default swaps or are backed by such instruments. It may also act as a counterparty in swap transactions. HedgeWorld.com reported that hedge funds’ expansion in the CDO and CLO sector is explained through the observation that the loan market has lived up to expectations over the past decade by generating a low alpha (but even lower beta) product. Thus, loans rewarded investors with superior risk-adjusted returns.

Mr. D’agostino and Mr. Adelkoff strongly urge CLO investors to do their due diligence before throwing money into these capital structures, which can range usually from 100 to 200 loans. The two men and other studies suggested:

• When investing in equity or subordinated debt of a CLO look at the legal structure. Investors should see if the loan’s underlying assets are conveyed to the SPV.
• Check to see if the SPV has properly pledged the loans for the benefit of the note holder.
• Look to see if there is a waterfall mechanism and understand how the flow of funds will fall.
• What credit enhancements are being used to boost the CLO rating.
• What kind of financial covenants are in the loan documents.
• Learn who is managing the portfolio and make sure that covenants like concentration levels, geographic risk, allocation of the underlying assets from the ratings perspective is being met.
• Review the tax structure, especially if it’s an offshore investor where one would want to know if he or she is going to get taxed in the U.S.
• Check to see what underlying assets are in the loan pool, who is managing them, what the concentration risk is, what the borrower’s risk is, etc.
• Ensure there is tight underwriting.
• What risk tolerance threshold the investor possesses.
• Review the bank’s (or PE or hedge fund) historical portfolio performance, origination and collection policies and practices.