Hedge Funds

Investors face new round of damage as CLOs falter

LONDON (Reuters) - Collateralised Loan Obligation CLO.L funds worth some 100 billion euros (92.31 billion pounds) in Europe are the next ailing asset class set to hurt banks, hedge funds and insurance companies.

Managers of smaller CLOs -- financial vehicles that invest in leveraged loans -- are running out of money to pay investors, staff and bills as rising defaults, downgrades and rock-bottom recovery rates slash their income.

Some smaller CLO funds have already stopped paying the junior management fees that make up two thirds of income to their managers, which will bring layoffs and leave skeleton staffs struggling to manage portfolios.

“All CLOs will have junior fees turned off, if not already then sooner rather than later,” a senior loan trader said, speaking on the condition of anonymity.

Inevitably, when the managers of the complex structured credit vehicles suffer, so will investors.

Already, holders of the lowest-rated CLO tranches are losing their interest income which is being diverted to pay senior noteholders, in what is viewed as a prelude to a wipeout that will ultimately see them lose their money.

Banks, hedge funds, asset managers and insurance companies are the buyers of CLO tranches, with hedge funds and asset managers typically piling in the riskiest tranches and banks in the safer AAA tranches.

Any damage from CLOs would follow on the back of writedowns by banks of more than $700 billion (476.8 billion pounds) from credit-related losses since the credit crunch began.


CLOs, the biggest buyers of leveraged loans used to finance private equity buyouts in the boom of 2005-2007, have suffered as the value of the loans declined, but are now facing tangible losses as companies default on their debt.

Market experts expect a round of consolidation that only the strongest CLO managers will survive.

“The only opportunity here is a consolidation opportunity. If a manager has no fees he’s dead and should surrender and let someone else manage the assets out over the next seven to eight years,” a senior leveraged banker said.

The number of CLOs in distress is rising as the credit quality of their portfolios continues to decline. Moody’s placed 2,600 tranches of U.S. and European CLO obligations totalling $100 billion on review for possible downgrade on March 4.

Bankers expect 25 percent of European CLOs to be in the vulnerable position of having turned junior fees off by April and the number could rise as high as 95 percent by year-end.

Stronger CLO funds are looking at taking over smaller rivals in the next six to 12 months to achieve economies of scale, and investors specialised in distressed assets known as vulture funds are also circling stricken CLOs.

CLOs survived a technical sell-off that pushed leveraged loans to 64.5 percent of face value, but baskets of 5-7 percent for the lowest-rated CCC risk have swelled to around 15 percent after recent downgrades, sources said.

This excess has to be marked to market, along with defaulted loans that do not pay interest, they added.

As a result, CLOs are breaching tests for collateral and interest cover which cut off funds’ revenue streams that pay managers’ fees and investors’ interest income.

“The analysts will be fired and the partners will become the analysts,” the senior loan trader said.

Managing the typical 80 to 100 credits in a CLO on a shoestring is deemed impossible, because it requires an active role to avoid debt-for-equity swaps and liquidations.

Defaults and liquidations of CLOs are viewed as unlikely as few investors are willing to unwind the vehicles at today’s low valuations but a fight to replace European managers is expected that could thin their ranks by two thirds, bankers say.


The composition of CLO portfolios will be critical to survival. Senior debt is averaging 64.5 percent of face value, which means that junior second lien and mezzanine loans have almost no value and junior-debt heavy portfolios will flounder.

The portfolios of some of the market’s biggest CLO managers are valued at around 55 percent of face value, according to research by Thomson Reuters Loan Pricing Corporation, giving an insight into rock-bottom valuations for smaller managers with more junior debt.

CLOs that have invested in the debt of other CLOs are also vulnerable. While few U.S.-style ‘CLO squared’ structures exist in Europe, some European CLOs have used a 5 percent bucket to buy structured paper in other CLOs, managers say.

Additional reporting by Jane Baird; Editing by David Cowell