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Victoria Zhuang

Investors and collateral managers in the US CLO market are calling for greater cohesion in the industry, as a rise in loan defaults brings the threat of loose covenants to life.

The ‘covenant-lite’ loan documents that have become widespread in a years-long hot streak for the credit markets can impact recoveries when borrowers default, and lead to higher losses. This can impact returns for CLO equity investors, and if it gets bad enough, for debt investors too.

“It’s an existential problem for the asset class as a whole,” said Dagmara Michalczuk, a principal and portfolio manager at Tetragon Financial Group, of loose covenants during a panel discussion at the Invisso CLO conferencein New York last week.

Already this year, issuers including Altice France — many of which are widely held in CLOs on both sides of the Atlantic — have threatened to impose losses on investors by using loose covenants to their advantage. This has prompted some CLO managers to search for other borrowers that might do the same.

Leveraged loan defaults are expected to be around 3.5% to 4% in 2024 which is well above the historical average of 2.5% since 2007, according to an April paper from Fitch Ratings. With interest rates expected to remain higher for longer, keeping interest costs high, there is little respite in sight.

As debt-burdened companies and their equity sponsors engage in more aggressive liability management exercises (see our latest US distressed weekly for a round-up of such situations), CLO managers are organizing more quickly with co-operation agreements that can help debt investors present a more unified front.

However, the market as a whole has been slow to band together, said Michalczuk during the panel discussion: “The CLO market has not consistently acted as one voice.”

Demand for US CLO paper remains high despite a lack of underlying new loan issuance, and spreads are expected to tighten further from current levels. When supply and demand are this out of whack, investors often settle for weaker protection in loan docs.

But that’s a problem, because recoveries on senior secured leveraged loans are lower than they have been — in part due to weaker protections in loan docs.

“The range of outcomes is also bigger,” said a conference attendee. “Some have zero recovery.”

Some investors in the CLO market are pushing back and demanding tighter covenants, focusing on specific areas of the documentation that can have a meaningful impact. This tends to work best in loan deals that are struggling to find demand, said Josh Eisenberger, head of US CLOs at Sculptor.

“On a more difficult new issue, we'll typically be a thought leader in saying, we'll participate in the loan, but we need something like 10% hard amortization to force deleveraging,” said Eisenberger. “We all know that companies can always find a way to avoid making ECF [excess cash flow] payments, which is why we prefer the hard amortization concept.”

Still, he cautioned that sponsors and lawyers are adept at finding new holes in credit agreements: “No matter how much work you do on the loan documents.… there always seems to be a way that sponsors and lawyers can find another workaround,” he said.

Another slightly less obvious impact of rising defaults is that they could threaten CLO equity returns by prompting collateral managers to be more conservative.

In the current environment, cautious managers are likely to trade out of triple-C loans — which offer higher returns — in favor of stronger but less yieldy credits. “Ideally, you try to sell ahead of anything going wrong, even if it doesn’t please the equity investor,” said another manager at the Invisso event.

Whether managers are driving higher returns by taking more risk or by managing their portfolios more cautiously, the hot market of recent months has made it hard to sort good CLO managers from less good managers (we covered this in our wrap of the DealCatalyst CLO conference).

But as losses compound, dispersion between managers is likely to increase, conference attendees said. The recent streak of new issuance has stuffed the market full of newly assembled CLO portfolios where “everything is clean” but this is unlikely to last, said one manager.

The growing middle-market CLO space is something of a bright spot in the battle against looser docs, said another conference attendee. Middle-market and private credit deals typically have fewer lenders, and thus tighter covenants, they said.

“Along with three to five like-minded lenders, we are holding the pen,” the attendee said. “So you're going to have a much more severe look.” Another attendee, however, cautioned that as interest grows in the middle-market CLO space, docs are liable to become looser.

Indeed, Japanese banks — which are often lynchpin investors in new CLO vehicles — are becoming more interested in middle-market CLOs. “There were a number of accounts that I've met with recently, where they hadn't participated in the past and they're looking at it now,” a source told 9fin.

Generally, Japanese investors prefer to work with arrangers who can be flexible, are good communicators, and who are understanding of their needs, a panelist said.

This speaks to some of the hurdles managers must clear in order to secure a Japanese bank investment: the deal has to get through an investment committee for approval, and the English documents have to be translated into Japanese.

To which point, a big challenge for some Japanese banks that are looking into private credit CLOs is the lack of transparency in those deals relative to the broadly syndicated loan market, according to market sources.

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Loose docs an ‘existential problem’ for CLO market, say US conference attendees

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