June 26, 2020 / 12:27 PM / 11 days ago

CLOs seek to tie assets to loan index after missing out on Covid selloff

NEW YORK, June 26 (LPC) - US Collateralized Loan Obligation (CLO) managers are pushing to buy loans at increasingly reduced prices after being boxed out of distressed opportunities as the coronavirus pandemic took hold.

Onex Credit and Oak Hill Advisors are among firms that have sought to include a provision that ties the price at which loans can be added to their portfolios to a leveraged loan index, according to deal documents. Linking the ability to purchase discounted loans without penalty to an index responsive to market volatility would have allowed CLOs to better take advantage of plunging prices in March. Some CLOs have also pushed to lower the minimum price at which the investments can be bought.

CLO managers want more flexibility to buy distressed loans as defaults pile up, and the health crisis continues. The funds, the largest investors in the US$1.2trn US leveraged loan market, are constrained from buying assets trading below a certain threshold. Such restriction can leave the US$688bn US CLO asset class at a disadvantage vis a vis hedge funds and distressed debt lenders. Stocking up on discounted loans could help funds meet internal tests and boost returns to the most junior investors when the overall performance of the market improved.

The LPC 100, a cohort of the 100 most liquid US loans, dropped more than 21% from the start of the year to 77.87 cents on the dollar March 23, an almost 11-year low. Prices have since rebounded, and the LPC 100 sat at 93.79 Thursday.

“When you look at the performance of managers during periods of volatility – do you see better outcomes when documents are overly restrictive or when they have a little wiggle room,” said Dan Wohlberg, a director at Eagle Point Credit Management, which invests in CLOs. “Debt and equity investors have come to a determination that a slightly larger toolkit may be advantageous.”

DISTRESSED FLEXIBILITY

Many CLOs are permitted to buy loans, typically at 80 or 85 cents and higher, and mark the debt at par. If purchased below that level, a loan would be calculated in CLO tests at the purchase price.

CLO managers are now looking to tie the price at which a loan can be purchased to an index to account for market volatility rather than a set price. If a discount obligation was defined as a percentage lower than a loan index, it would have allowed managers to take advantage of loans that traded off significantly in March.

The provision emerged following the 2008 financial crisis but disappeared as markets improved. Now, some market participants want to bring it back.

“You want CLO managers buying cheap loans; that benefits both the debt and equity,” said Dagmara Michalczuk, a portfolio manager at Tetragon Credit Partners, which invests in CLO equity.

In the offering documents for Onex Credit’s OCP CLO 2020-18, there is an option for the discount obligation to be tied to a ‘leveraged loan index adjusted price,’ defined as the price of the S&P/LSTA US Leveraged Loan 100 Index multiplied by 90%.

Oak Hill is seeking to include similar language in OHA Credit Funding 6, a new fund it is raising, offering a variety of eligible loan indices including the S&P/LSTA US Leveraged Loan 100 Index, the Credit Suisse Leveraged Loan Indices, the Deutsche Bank Leveraged Loan Index, the Goldman Sachs/Loan Pricing Corporation Liquid Leveraged Loan Index or the Merrill Lynch Leveraged Loan Index, according to a deal document.

An Onex spokesperson could not comment. An Oak Hill spokesperson could not be reached.

Some senior debt investors have pushed back against the provision, wary it would allow a manager to buy too many risky credits.

There has also been a push to lower the minimum price at which debt can be purchased to 50 cents. According to Sean Solis, a partner at law firm Milbank, many CLOs have a minimum price at which loans can be purchased, often 60-65 cents.

“There were real opportunities to buy discounted loans in March that were trading in the 50s, but CLOs couldn’t buy,” he said.

Some investors have even allowed managers to purchase as much as 5% of additional loans below that 50-60 cents threshold because the manager is taking a significant haircut to buy the credit.

“You want tests that protect noteholders, but you also want to give managers enough flexibility to mitigate risk and generate value,” said Laila Kollmorgen, a portfolio manager at PineBridge Investments, a CLO investor. “It’s a fine line.”

CLO managers have previously sought the ability to swap deeply distressed or defaulted assets with other similar loans that may offer better recoveries as well as permission to provide rescue financing to distressed companies, Refinitiv LPC has previously reported.

As markets continue to deal with the pandemic, requests for additional flexibility will persist.

“In the CLO market, managers, equity and debt investors are coalescing around shared experiences and in some instances saying, ‘managers need the right tools to operate in this market,’” said Wohlberg. “We will continue to see some evolution around these abilities.” (Reporting by Kristen Haunss; Editing by Michelle Sierra)

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