As the market for new-issue collateralized loan obligation ("CLO") transactions continues its resurgence, deal documentation in CLO 2.0 transactions continues to evolve. Managers should be aware of the structural features that have become more common over the last several years in CLO 2.0 transactions.
- Senior noteholder input has become more prevalent, particularly in transactions that have an anchor investor in the senior class.
- Given the increased spread levels on senior notes compared to pre-crisis levels, refinancing and re-pricing mechanisms that allow CLO issuers to adjust the spreads post-closing have become popular.
- Additional features include limitations on specific activities of the issuer relating to reinvestment and amendment of underlying loans.
Features Affecting CLO Capital Structures
In many CLO 2.0 transactions, the noteholders agree to a mechanism to change the notes' spread during the life of the deal. The refinancing provisions allow the CLO issuer to lower the spread on the outstanding CLO notes as long as a number of conditions are satisfied. The refinancing is accomplished by redeeming outstanding notes and issuing new replacements.
The conditions for refinancing include:
- On the refinancing date, the sum of the refinancing proceeds and the CLO's cash balance (in its accounts and other proceeds) must be sufficient to pay the sum of the refinancing price plus any expenses related to the refinancing.
- The new notes' principal amount must be equal to the principal amount of the notes being redeemed.
- The new weighted average spread over LIBOR must be less than or equal to the existing weighted average spread over LIBOR.
- The stated maturity of the new obligations must be no earlier than the stated maturity of the existing notes.
- The refinancing agreements must contain limited recourse and non-petition provisions.
- A notice must be delivered to the rating agencies.
- The refinancing expenses must be paid or adequately provided for by the issuer.
While the refinancing mechanism offers a reasonably cost-effective way to lower the overall cost of funding for the CLO issuer, many CLOs incorporate a re-pricing mechanism, by which the CLO issuer can re-price the outstanding notes rather than going through the process of issuing new notes with lower spreads.
Typically, noteholders will have a 45-day notice period prior to the re-pricing. Notes held by any noteholders that do not consent to such re-pricing (the "non-consenting holders") are offered for sale in secondary market transactions.
Typical conditions for re-pricings include:
- Execution of a supplemental indenture dated as of the re-pricing date to modify the spread over LIBOR applicable to the class of notes being re-priced (the "Re-Priced Class").
- Confirmation by the issuer in writing that all notes of the Re-Priced Class held by non-consenting holders have been sold and transferred.
- Delivery of notice of the re-pricing to all rating agencies.
- Payment or provision for all expenses incurred in connection with the re-pricing.
Some deals may also include "make whole" provisions so that the senior noteholders are protected against and compensated for the early redemption or refinancing of their notes.
Limits on Note Cancellation
Unlike in pre-crisis CLO transactions, many indentures in CLO 2.0 transactions contain provisions that limit the impact of the cancellation of notes before their expected maturities. This is likely in response to certain legacy CLO transactions that experienced deal changes that were not originally intended.
These provisions focus mainly on the calculation of the coverage tests, which are based on the outstanding notional amount of the notes. To avoid any potential for improving the coverage test through the redemption or cancellation of junior notes (presumably acquired at a discount), the coverage tests are calculated without giving effect to such redemptions or cancellations. Another variety of this provision is to allow cancellations or redemptions to be reflected in the calculations only to the extent that the principal balances would have been reduced in accordance with the priority of payments for the relevant class of notes.
Alternatively, some CLO 2.0 transactions simply contain an explicit prohibition on the issuer's purchase and cancellation of its own notes.
Features Affecting Manager Activities
Along with the eligibility guidelines and the collateral obligation definitions, CLO 2.0 indentures contain provisions specifically limiting manager activities relating to reinvestment and amendment of the underlying loans.
Shorter Reinvestment Periods
Generally, reinvestment periods range from three to five years, compared to five to seven years in older, pre-crisis transactions.
In addition, some CLO 2.0 indentures contain provisions that explicitly allow reinvestments on a "trade date" basis immediately before the end of the reinvestment date. These provisions allow for asset purchases near the end of the reinvestment period that settle after the reinvestment period ends. Disputes arose in several earlier deals as to whether the issuer had authority to enter trades at or near the end of the reinvestment period that settled later.
Limits on Maturity Extension
In order to mitigate the potential for lengthening the amortization (i.e., post-reinvestment) period of a CLO, some noteholders negotiate for a specific prohibition on the manager's ability to agree to maturity extensions on the underlying loans. A typical provision would require that the collateral manager may affirmatively vote in favor of a waiver, modification or amendment of the underlying loan only if (i) the extended maturity is no later than the stated maturity of the notes and (ii) the weighted average life test is satisfied.
Extension of maturities minimizes the aggregate size of any loans that would qualify in the "long-dated" basket (i.e., loans that mature after the stated maturity of the notes). These long-dated loans may expose the transaction to market value risk because it is likely that these loans will need to be sold at the maturity of the notes.