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Victoria Zhuang

Tanvi Gupta

The recent entrenchment of liability management exercises in leveraged lending has shifted the priorities of the CLO market and, to some extent, rewritten the rules as US CLO managers and investors reconsider their strategies.

CLO exposure to LMEs that took place in 2024. Source: 9fin data. *Loparex and Alkegen includes US and European debt

This year, the volume of distressed exchanges resulting from LMEs has approached the record-high set in 2008, and it’s on track to significantly exceed that record by the end of this year. That’s according to data by JP Morgan as of 31 August, which Oaktree Capital Management cited in a September report.

Of the LMEs this year, Lumen’s debt exchanges ($3.3bn of CLO exposure), followed by Global Medical Response’s amend and extend of its roughly $4bn of loans ($1.9bn of CLO exposure) have affected CLOs the most, according to 9fin data. The margin on Medical Response’s loan picked up from 425bps to 475bps (and PIK interest of 75bps), which S&P described as not providing “sufficient offsetting compensation” when it lowered the company’s issuer credit rating to SD.

Managers are devoting more time to predicting and reacting to LMEs, given their ubiquity. “In these distressed situations, the thought process has changed over the past two to three years,” said Ian Gilbertson, co-lead portfolio manager for US CLOs at Invesco.

“We are definitely concerned and it has impacted our manager style,” another CLO manager said of LMEs. “It feels like collectively, lenders don’t have a lot of power right now.”

CLO equity investors tell 9fin that they are evaluating managers more closely for signs of how they would fare in the face of LMEs.

“Let's say a marginal 5% to 10% of the portfolio is at higher risk of LMEs. It clearly requires a significant shift in mindset and potentially a shift in resources. Managers that are ahead of the game will likely do better,” one CLO equity investor told 9fin.

Some strategies have been touted as beneficial for CLOs, like joining co-operation agreements, but these can have liquidity implications.

Just as cov-lite loans have become ingrained after overcoming initial resistance, LMEs have become a fixture in the landscape, one CLO manager said. In the coming months, thanks to interest rate cuts, “we think there will be an increase in LMEs because capital markets will be more open. Sponsors will take advantage, and push the transactions forward,” the chief risk officer from a CLO manager said.

The data clearly demonstrates that LMEs harm recoveries. Issuers that went through LMEs prior to filing for bankruptcy had a weighted average aggregate recovery of 47% for first-lien debt in 2023, while those without LMEs had an estimated 57% recovery rate, according to data from a June CLO report by Bank of America. In an example of how ugly LMEs can get, last year Cineworld involved some creditors in an uptier priming where recovery became 100% for participants in the priming, and was only 3% for lenders who were left out, the report said.

While LMEs may prevent immediate liquidity problems for a company, they often involve taking on even more debt in a move which might be viewed as prolonging the inevitable.

This leaves sicker companies with less valuable assets, a CLO manager said. Around 60% of issuers completing LMEs will eventually return to bankruptcy within four years, and long-term recoveries are expected to be only around 40%, down from over 80% in 2015, according to the Bank of America report.

As of the end of August, 55% of year-to-date defaults had undergone distressed exchanges, which are usually linked to LMEs, according to a report in September from S&P Global. In August alone, the vast majority of defaults, 82%, were from issuers that underwent distressed exchanges, the report said.

“There is a lot of panic around even the tiniest LME news,” one CLO manager told 9fin.

Another CLO manager added that this panic can be seen in the price volatility surrounding LME rumours and only becomes stable once there is clarity, but till then there are more cases of downside volatility than there necessarily needs to be. “There is a lot of worry in the system and you will see some loans that trade down to 60-70s and eventually come back in the 90s. Part of that fear is related to LMEs,“ they said.

“Firms with smaller positions, who think they could be taken advantage of, are usually the ones driving the price volatility,” added another manager.

But CLO managers exiting is not the only thing driving price volatility. As one CLO manager highlights that the panic surrounding LMEs has become a self fulfilling prophecy: “What’s annoying is that if you see even a speck of price movement, the advisors start flocking. But most large CLO managers are aware of it now, and collectively the decision is to sit on it and not panic — we will get advisers when the time is right.”

LMEs currently in progress held by US CLOs. Source: 9fin data.

Still an LME should not mean an automatic selling trigger for CLOs. Selling out prematurely could also kill the portfolio, according to a CLO equity investor.

“You can't be too trigger happy,” the investor said. “Otherwise you could face death by a thousand cuts. If you take relatively small losses on a lot of positions over time that cumulative loss generation can be quite significant.”

If an issuer decides to pull an aggressive LME, then the natural defence might logically be for all lenders to present a united front, sometimes in the form of a cooperation agreement, to prevent being primed and/or having anyone’s liens stripped. But, of course, there are barriers to achieving unity in this way, which means it often resorts to some lenders banding together and others being left out.

So, who’s in and who’s out? CLOs today resort to various routes to get a seat at the table.

In the first place, managers have to be large enough to be in the flow of information, in touch with restructuring lawyers and advisors to even be invited to an ad hoc group.

Often times, “groups just get to 51% and cut others out,” another CLO manager said. “Sometimes it’s a full 100%.” The larger players in the loan get priority access, as they could be “important in the next five transactions,” the manager said.

Small and mid-sized managers often aren’t as lucky. “We will never be in the driver’s seat negotiating the deal. We will never be that guy,” one such manager said. On occasion, if the manager has a large enough position in the deal, other lenders invite them to join. “Other times, we find out later and it’s too late, or we try to reach out to the law firms organizing the groups to get new information.”

A larger AUM manager told 9fin it had, by contrast, a five-person restructuring team dedicated to this purpose. “They're the ones making sure that we're in the right group and they are the ones that have all the relationships with advisors and are pre-empting situations,” the manager said.

Some CLO managers resort to teaming up internally (with units that also participate in a deal as lenders) to secure a spot on an ad hoc committee. Invesco, for example, has $16bn of AUM in CLOs but a total of $45bn of BSL AUM, Gilbertson said.

CLO portfolio manager Robert Schwartz, director of leveraged loans and US high yield portfolio manager at AllianceBernstein, said his firm gets by through help from its high yield team. “We have four BSL CLOs outstanding so we’re relatively small, but we have a $25bn high yield bond business,” he said. “So if we own $100m of the bonds and $10m of the loans, we are more likely to be included in negotiations than if we just owned $10m of the loans.”

However, mere size is not a panacea for LMEs, sources said. Even if a CLO manager is big enough to land an ad hoc seat and gets to benefit from an LME, that LME could be challenged later in court by other creditors and the legal fees of litigation could prove costly in themselves.

Although there has been some hope for the CLO market in the form of co-ops forming to protect creditors, presumably to be fairer than ad hoc committees that seek to cut LME deals with sponsors, in some cases these are not feasible options for CLOs, or have limited appeal, sources told 9fin.

One problem is that even if lenders join co-ops, those groups impose trading restrictions that limit liquidity.

Additionally, some members of the co-op may abandon ship once the term runs out. As an example, 9fin has reported recently on Elliott flip-flopping between whether it would stay in the extension of a co-op agreement for secured creditors to telco Altice France — the lender considered breaking away, but then decided to stay put. Elsewhere, such as Magenta Buyer and Bausch Health, Elliott has remained outside of the large co-ops and because of its large positions, it looks to strike its own, more favorable deal.

With the proliferation of co-ops, the question has been raised as to why CLO managers don’t take preventative measures in the primary market.

“I don’t understand why CLO managers don’t push back on loose loan docs. And I don’t like the excuse of ‘we’re too small’ because it doesn’t take them very long to form a co-op group. So why not just form a group right at the start and push back?” a CLO investor said.

It might be a case of more money, more problems.

In theory, yes, steering clear of loans with loose docs is a sound premise. But the reality is that sometimes there is a need to put money to work.

The rise of captive equity has contributed to this dynamic, a CLO investor said. “If you have a captive pool of assets that you can just tap when the arbitrage is not attractive, it may lead to too much appetite for paper.”

Hobson’s choice: Loan quality or spread?

Perhaps the best way to mitigate the risk of LMEs is to be disciplined from the outset.

For Tom Shandell, head of US broadly syndicated loans and CLOs at Investcorp Credit Management, the answer in this environment is to just say no to loose docs.

“In a new issue, we’ve decided as a firm that there are certain things we’re not going to allow happen, or be excluded, from a credit agreement,” Shandell said. “If they are, we just won’t play that loan.”

He cited J Crew, Serta, and Chewy provisions, often referred to as “blockers” (as they’re designed to block similar transactions to the one they’re named after from occurring).

“We’re looking to protect from a company’s ability to siphon assets into an unrestricted subsidiary, looking to protect against the company’s ability to change the waterfall of priorities without the approval of every lender so affected,” he added.

He said that there have been deals Investcorp has walked away from because those provisions weren’t included. There are exceptions to this rule, such as where it involves a higher quality company, or a sponsor that has demonstrated it is a “good steward of capital”.

Of course, taking a conservative approach involves a trade-off. “We’ve had to accept some lower spreads,” said Shandell, ”which we’re willing to do in this market because the cost of getting something wrong is too high.”

Other CLO managers have been hesitant to insist on blockers in loan documentation, fearing they would miss out on an oversubscribed deal.

“You can’t put in J Crew etc. language because then it will restrict the manager too much in what you can buy,” said a CLO PM.

In general though, several other CLO managers told 9fin that they’ve resorted to migrating up in quality with the loans they buy, to limit or avoid the possibility of LMEs down the road.

“For us, managing means being that much more vigilant in picking higher quality credits,” a tier one BSL CLO manager told 9fin.

CLO equity investor, Jim Smigiel, chief investment officer of SEI, told 9fin that LMEs have reinforced his company’s approach, which is to place a premium on manager selection. “When you hear people talk about CLOs, there’s not a lot of emphasis on manager selection going on.” Smigiel said he assessed managers for how they performed managing through a full credit cycle.

However, since LMEs are hard to avoid altogether, liquidity is often more important than just being one of the biggest holders. “We’ve moved towards large cap, more liquid loans,” in this environment, Gilbertson said of Invesco’s CLO management strategy. “The ability to sell a large liquid position allows for the preservation of value when you are not stuck in that loan and just along for the ride.”

CLO managers have to be solid in their convictions on a company — either holding firm, or exiting if they lose faith.

“If we think there’s a restructuring, we are leaning towards getting out earlier than later. That’s the only thing that smaller to medium sized managers can do,” a CLO manager said.

When a decently performing company with growing EBITDA experiences stress, Gilbertson said he has seen prices fall in some situations down to the 70s or 80s. Previously it would have only dropped a few points. This is partly because of perceived LME risk, and partly triple-C risk. With triple-C buckets elevated for much of the CLO market, there’s a lack of buyer interest in triple-Cs, he said.

There are benefits to being a smaller CLO manager in certain cases. “A lot of smaller AUM CLO managers talk about how they can be nimble, agile, trade out before the LME happens. In some cases, it actually happens,” a CLO mezzanine investor said, adding that they tracked third party data to see this.

CLO investors are also scrutinizing managers for adequate strength to handle LMEs in their credit analyst ranks.

“The fundamental question is whether they have enough credit analysts, and whether those credit analyst resources are dedicated to the CLO business or whether they are shared,” a CLO equity investor told 9fin.

Quality is more important than quantity, and “prudent allocation of resources” is key to staffing a credit team, the investor said. “Very often you see massive organizations that have a lot of bodies on a page, but really those folks are covering a huge amount of product.”

The investor said smaller managers could appeal to them by exhibiting thoughtful growth and portfolio design, and analyst teams that have deep experience in the industry. Winning CLOs should be constructed as portfolios only with credit names that the analysts understand well, and follow closely.

Some small managers might sit out more deals as a result of their selectivity, which could improve their appeal to equity investors, according to Andrew Robertson, a BSL CLO lawyer who is counsel in Seward & Kissel’s corporate finance group in New York.

“The smaller manager is in less of a rush to just buy assets to feed a large volume of deals and will, therefore, theoretically, spend more time in their selection than a large manager trying to deploy a large amount of cash to avoid negative carry,” Robertson said.

Managers are also directing their analysts to play through the motivations of why LMEs might occur and if they’re likely to happen.

“You’ll never have a sponsor come out 12-18 months before they do an LME and say, we’re thinking about this, it’s coming,” Gilbertson said. “But you can prepare for possible action given the circumstances of the situation. Is there an upcoming maturity? Is the budget projecting liquidity getting tight on the back half of the year? What happens if revenue or EBITDA are slightly lower than your forecast?”

He added that close relationships with sponsors can provide an insight in these situations. In fact, when analysing a primary loan, “who’s the sponsor?” and “what has their behavior historically been?” are key questions being asked.

In years gone by as a par lender holding a deteriorating credit at risk of an LME, the outlook would not have been great.

As one manager puts it: “CLO managers are often viewed as incautious, but people don't realise that we are constrained by CLO mechanics,” alluding to rigid CLO documentation.

Robertson said that previously, given the traditional eligibility criteria for CLOs, CLOs were prevented from being able to negotiate with issuers in an LME. “If they can’t participate, the other lenders take advantage of those limitations… they will try to cram down the CLO,” Robertson said.

That’s largely changed though, in the past five years. Now CLO documents routinely include language that permits the CLO to participate in workout obligations, including uptier debt, and loans purchased by subsidiaries of the issuer, he said.

“Uptier and asset priming have nuances that don’t always get added in,” Robertson said. “For example, if there’s a minimum facility size of $150m for assets that can be acquired by the issuer, you need to include a subsidiary of the issuer to provide the maximum flexibility for asset priming transactions,” he said.

Several CLO managers and investors spoke with 9fin about wanting to hold certain sponsors accountable who have repeatedly misbehaved and abused the goodwill of lenders through aggressive LME activity.

There should be a “risk premium in the market for bad sponsors” among private equity firms, a CLO equity investor said.

A CLO mezzanine investor said they had seen “hopeful news” recently in the LME space where a lead lender had proposed an aggressive transaction to the issuer but the issuer turned it down, suggesting the industry does have the potential to begin self-policing against LMEs. “Hopefully those forces will keep it in check,” the investor said.

CLO managers will need to cultivate closer ties to sponsors and issuers and stay close to other lenders, an official working at a CLO manager said. “Smaller managers have to be very proactive… We spend a lot of time identifying transactions that could go through LMEs. Not just traditional analysis. We think about actions other lenders would take.”

Ideally, CLO managers would collaborate more with each other over time on these transactions.

Additionally, “you need to make sure that the CLO manager’s team is plugged into what's happening with potential restructuring activity, such as advisors being hired and committees being put together,” an equity investor said.

But given that some find opportunity here, seeing a chance to pick up decent credits that others sold out of too early because of LME fears, that’s unlikely to create perfect unity between CLO managers.

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