The structured finance market is seeing a resurgence of investor interest in securities collateralized by senior and leveraged loan assets.1 These collateralized loan obligation or “CLO” products, especially the most senior tranches, have outperformed their RMBS and CMBS brethren during the post-20082 economic turndown2 and can provide attractive returns to investors without unduly increasing risk. Renewed market appetite for CLO products has re-energized advisers to CLO vehicles (“collateral managers”) that are already active in the space and has attracted interest from other asset managers, such as hedge fund advisers, with experience in the senior secured and leveraged loan markets.
This article is a brief refresher for existing and prospective collateral managers about key issues in the formation of a CLO. This article addresses both the start-up or “warehouse” phase of a CLO’s life and the securitization process itself.
A THRESHOLD REGULATORY NOTE: MOST COLLATERAL MANAGERS NOW MUST REGISTER WITH THE SEC UNDER THE INVESTMENT ADVISERS ACT
For purposes of the Investment Advisers Act of 1940 (the “Advisers Act”), a collateral manager is an “investment adviser” to the CLO and the CLO is the collateral manager’s “client.” This is important because while the structured finance market was in the doldrums after 2008, Congress was busy passing the Dodd Frank Act. Among its many other elements, Dodd-Frank eliminated from the Advisers Act, effective July 2011, the traditional SEC registration exemption for investment advisers with fewer than 15 clients. This registration exemption had been used by many investment advisers, even by those with billions of dollars under management including CLO collateral managers and advisers to hedge funds and private equity funds.
As a result of the old exemption’s disappearance and the $100 million-plus size of a CLO vehicle, a collateral manager to a CLO will now be required to register with the SEC as an investment adviser and thus become subject to the SEC’s adviser disclosure regime on Form ADV and the numerous substantive compliance requirements for registered advisers. While many existing or new collateral managers will have previously registered with the SEC, any prospective CLO collateral manager that has not undergone registration will need to attend to this extremely significant requirement before beginning operations.
NOT YOUR GRANDFATHER’S EQUITY ANYMORE
Another important difference between the re-emerging and the pre-2008 CLO markets lies in the role of equity. Despite the fact that default and recovery rates on CLO notes, which are secured by senior secured loans, have bettered those of most other structured finance asset classes during the last five years,3 the CLO market has been deeply chastened by post-2008 events.4 As a consequence, rating agencies and noteholders for new CLOs require more generous equity cushions than in years past. For example, in 2006 and 2007 it was not uncommon for CLOs to devote 8% to 9% of their aggregate capital-raise to “equity,” while today approximately 10% to 13%5 is the norm. This often drives collateral managers for new vehicles to search for one or two “anchor” investors to acquire the equity securities of the CLO. Robust equity support will also be crucial during the warehouse financing phase discussed below.
It is customary for the placement agent in a CLO offering to provide, or at least help arrange, bridge or “warehouse” financing to the CLO. The collateral manager uses this financing to assemble for the CLO’s account a critical mass of underlying loan assets prior to the CLO’s issuance of notes to investors at closing.
In deploying warehouse dollars, the collateral manager must balance its own interests with those of the warehouse lender and the equity investor(s) who are providing the lender with credit support. For example, the collateral manager needs to accommodate the lender’s desire to control risk by having input on loan acquisitions and dispositions and appropriate remedies relating to any material credit deterioration of the loans; the equity investor’s need to cap its credit support, ensure a fair and orderly liquidation of the warehoused loans if closing does not occur and obtain an opportunity to “cure” any deterioration of the asset pool with optional equity infusions; and the interests of all deal participants in managing downside risks, such as determining whether market conditions support a closing and, if not, providing for an unwind of the warehouse facility.
Given the importance of the warehouse facility, the collateral manager must resist any temptation to treat its terms as mere boilerplate. Deal participants will be rightfully focused on economic models, the terms of the proposed indenture and other key documents relating to the closing, but a collateral manager ignores the warehouse nitty-gritty at its peril. For example, are the documents’ definitions of “eligible loans” so narrowly or poorly drafted that appropriate loan investments could fail to satisfy such criteria? Do the cash waterfall and risk -sharing mechanics match the term sheet, and do they in fact work? If the closing does not occur, is it clear that the equity investor retains the “residual” after the warehouse facility is repaid? If the deal breaks, how are costs shared and are legal fees capped?6 Lastly, what are the procedures for removing underlying loans from the warehouse facility either because the collateral manager believes they may deteriorate in value or because they cease to comply with applicable eligibility standards?
A KEY DECISION: STATIC OR REVOLVING ASSET POOL?
One of the key issues in any CLO securitization is whether the CLO’s underlying asset pool will be subject to evolution or not. This choice is expressed in the CLO’s indenture. At one end of the spectrum is the socalled “static pool” approach, under which the composition of the CLO’s underlying loan portfolio is essentially established at or just following the closing. The alternative paradigm is an indenture that permits the collateral manager, over time, to reinvest in new loans some portion of the proceeds of the CLO’s portfolio. This approach is known as a “revolving pool.”
Even in the case of a static pool, the collateral manager may find it useful, and beneficial to all noteholders, to have some flexibility to reinvest loan proceeds under limited circumstances. For example, the collateral manager may want the right to reinvest unscheduled loan prepayments in new, replacement loans. Similarly, the collateral manager may wish to be able to dispose of credit risk obligations, i.e., loans the manager believes present a material risk of value deterioration, and reinvest the resulting sales proceeds in additional loans on behalf of the CLO.
In the case of a CLO with a reinvestment period, the collateral manager needs to ensure that both the loan eligibility criteria (e.g., first lien, senior secured loans, U.S. dollar-denominated loans, etc.) and portfolio balancing criteria (e.g., geographic and industry diversification, weighted average rating and life of the loans) do not inadvertently prevent the CLO from acquiring attractive loans or unnecessarily hamper the collateral manager’s ability to manage a large pool of assets. Given the extreme difficulty of amending an indenture post-closing, a tailor may not be available if the collateral manager subsequently discovers that the “suit doesn’t fit.”
THE COLLATERAL MANAGEMENT AGREEMENT
The collateral management agreement (“CMA”) establishes the advisory relationship between the collateral manager and the CLO. The collateral manager must fully understand and be comfortable with this contract’s terms. For example, the collateral manager should focus on the bases for removing the collateral manager as the CLO’s adviser (e.g., for “cause,” not for cause, failure of the CLO to satisfy specified financial tests, loss of key personnel, etc.) and on the bases for liability of the collateral manager to the CLO.
In addition, the collateral manager should pay close attention to the “tax guidelines” contained in the CMA. These are provisions designed to minimize the risk that the CLO will be engaged in a U.S. trade or business.7 While the tax guidelines are especially important if the CLO has a revolving investment period, the CMA in any case should provide that so long as the collateral manager complies with the guidelines, the collateral manager will have no liability if it is subsequently determined that the CLO has engaged in a U.S. trade or business.
MARKETING THE CLO
Effective marketing has of course assumed great importance in the post-2008 era, as prospective investors and their advisers exercise great caution when considering an investment in a new CLO. While a general discussion of marketing is beyond the scope of this article, it is worth pointing out that the desire to “sell” a new CLO product must be carefully balanced — as in the case of any securities offering — with liability concerns under the federal securities laws. Potential sources of liability for marketing materials, including the offering memorandum and investor pitch books, include Rule 10b-5 under the Securities Exchange Act of 1934 (which imposes liability for knowing or reckless misstatements or omissions in connection with the sale of a security) and Section 206 of the Advisers Act and its related rules governing advertising by SEC-registered investment advisers. Of particular concern in this area is the ability of collateral managers new to the CLO space to point to their previous investment results in other asset classes. All collateral managers should consult thoroughly with counsel about the content and use of their marketing materials.
CLOs customarily receive detailed financial information from borrowers pursuant to the terms of the credit agreements governing the loans in the CLOs’ portfolios. This means that the collateral manager, as the adviser to the CLO, will also receive a steady stream of information about the underlying borrowers and their affiliates. We note that in many cases the borrowers or their affiliates may have also issued securities and that the information provided to the collateral manager under the various credit agreements may constitute material non-public information relating to the applicable borrower and/or its affiliates. In particular, collateral managers need to be especially sensitive to Rule 10b-5 and insider trading issues and be certain that adequate procedures are in place to prevent the receipt of information that would “taint” such manager’s securities trading operations. Collateral managers should work closely with their counsel to ensure that appropriate policies and information barriers are in place to minimize the risks that such MNPI will be improperly used.
Successfully structuring a CLO requires careful consideration and negotiation of a variety of important issues. This is a challenging process for the collateral manager, but it can be made much easier with the assistance of experienced legal counsel.