LONDON May 23 High investor demand for scarce US leveraged loans is forcing managers of new Collateralised Loan Obligation (CLO) funds to include delayed draw tranches to buy time to build up leveraged loan portfolios and keep the issuance of new CLO funds on track.
Three recently-priced CLOs have delayed draw tranches, including Carlyle Group's Carlyle Global Market Strategies 2013-2 CLO. The fund's highest rated paper includes $352.5 million of AAA notes and $35 million of delayed draw notes.
Delayed draw tranches help managers to avoid paying full liability costs until CLOs are fully invested.
Carlyle has six months to borrow the $35 million tranche before the spread rises to 115 basis points (bp) and investors will be paid a 57.5bp commitment fee while the funds are undrawn.
Buying US leveraged loans is becoming increasingly difficult due to thin supply and insatiable demand. More than $34 billion of new CLO money and $24 billion from retail mutual funds has poured into the market since the start of the year and is competing for assets.
CLO managers are buying time to put complete loan portfolios in place. Equity returns can suffer if funds are issued without full income-producing loan portfolios in place as they start to incur liability costs immediately after closing.
Although $262 billion of new leveraged loans were priced through April, only $58 billion was new loans, according to Thomson Reuters LPC data, which has left CLO managers short of new loan collateral.
CLO managers are being forced to pay up to buy new loans in the secondary market. Average bids on the top 100 most liquid leveraged loans recently hit multi-year highs of 100.57 according to Thomson Reuters SMi100 index.
"Strong loan demand has pushed up secondary loan prices and contracted spreads," said Maggie Wang, senior structured credit research analyst at JP Morgan.
"Delayed-draw tranches can improve CLO deal economics for equity holders by providing managers with additional time to acquire loans at a discount and optimise leverage in the deal," she added.
Shenkman Capital and Neuberger Berman followed Carlyle's lead by adding delayed-draw tranches on their new CLOs. Investors in Shenkman's Brookside CLO subscribed to a $40 million delayed-draw tranche, and Neuberger placed a $35 million tranche.
Delayed-draw tranches rely upon finding higher-rated investors, which could curb uptake of the feature, as lower-rated buyers could have to post collateral to buy the paper.
"While the delayed-draw tranche is very helpful for CLOs facing a longer ramp-up period, there is a limited universe of investors who can participate," said Eric Moser, a partner in the Alternative Investments practice at Milbank, Tweed, Hadley & McCloy.
Carlyle's delayed-draw note holders have to maintain an S&P credit rating of at least A-1. High ratings offset counterparty risk and the likelihood of creditors having problems funding their commitment.
Delayed-draw tranches were seen in the last CLO boom before the collapse of Lehman Brothers in 2008, but the feature is now favoured by smaller managers that lack the balance sheet scale to build loan portfolios quickly.
"Using delayed-draw tranches can alleviate some of the pressure on managers concerned about receiving favorable loan allocations in the new issue market" said Neil Weidner, a partner who specialises in securitization and structured finance at Cadwalader, Wickersham & Taft LLP.
"I think you are going to see more managers attempt to take advantage of the delayed-draw feature in the second half of the year as managers respond to the competitive environment for loan assets." he added.