Managers of collateralized loan obligations are turning back the clock to solve a vexing problem.
Corporate loans below investment grade are in high demand, but funds to warehouse them for deals are scarce. Banks are reluctant to provide the financing, and market conditions are curbing other sources.
So CLO managers have rediscovered a tool that had been sparingly used since the financial crisis: delayed-draw funding.
The change has helped sustain the CLO market, and it tells a lot about how the market works.
CLOs issue bonds and use the proceeds to purchase a portfolio of noninvestment-grade corporate loans. Managers want to acquire the collateral as quickly as possible, to avoid paying interest on the bonds before they can collect interest on the loans.
Normally there are several ways to address this problem. Before 2007 it was fairly easy to obtain a line of credit from a bank to warehouse the loans to be securitized. But these days few financial institutions are willing to tie up their balance sheets with warehouse funding.
Another strategy is to "print and sprint" that is to issue bonds and quickly acquire existing loans in the secondary market. That was a common practice last year. But money has been pouring into the loan market from all quarters, bidding up secondary prices to levels that reduce the potential for arbitrage. Recent turmoil in the credit markets has pushed loan prices off their highs, but they remain elevated.
This means that CLO managers must often wait to buy new loans when they are issued, which takes much longer. To minimize the negative carry, some managers are using a third strategy: they are structuring deals that fund at a future date.
American Money Management Corp. in June closed on a term-funding facility with an initial investment of $30 million from equity holders and an unfunded class A of delayed-draw notes. Over the next two years, noteholders may advance funds to the manager in $5 million increments up to $240 million, according to a presale report published by Fitch Ratings.
WhiteHorse Capital closed on a similar facility in May, with an initial investment of $25 million from equity holders and $141 million of class A delayed-draw notes, according to Fitch.
And Valcour Capital Management in March closed on a term facility with an initial investment and delayed draw tranche of the same size, according to Fitch.
The Royal Bank of Scotland (RBS) was the lead manager on all three deals.
There have also been a handful of CLOs in which the majority of the senior tranches fund immediately but a single, smaller tranche funds at a later date. In March, the Carlyle Group issued Carlyle Global Market Strategies CLO 2013-2, which includes a $352.5 million tranche of 'AAA'-rated notes that funded at closing and $35 million of 'AAA'-rated delayed draw notes, according to rating agency presale reports. Noteholders receive interest only on the drawn portion of the notes and are entitled to a commitment fee of 0.575% on the undrawn portion, according to a presale report published by Standard & Poor's.
At least two other firms followed Carlyle's lead: Shenkman Capital added a $40 million delayed-draw tranche to its Brookside Mill CLO and Neuberger Berman included a $35 million tranche in its Neuberger Berman CLO XIV. Both deals closed in May.
Derek Miller, a senior director at Fitch, said that delayed-draw tranches and term-funding facilities give CLO managers more flexibility to ramp up deals over time.
"A year ago, CLOs were pricing and closing in two weeks, and at close had traded, if not settled, on 70%-80% of their portfolios," Miller said. "What we've seen since January is most CLOs are taking four to five weeks between price and closing." Delayed-draw funding "gives managers additional time to source collateral."
CLOs have raised $41.5 billion through June 21, according to research from Wells Fargo (WFC). But they are not the only source of demand for loans. Bank loan mutual funds had pulled in nearly $26 billion of new money as of mid-June. That's in addition to money raised by private loan funds.
In comparison, $585 billion of loans were issued through June 24, according to Dealogic. Of that figure, $343 billion, or nearly 60%, were refinancings or repricings of existing debt; so net issuance of new loans is just $243 billion.
"A year ago, loans suitable for a new-issue CLO were trading at less than par, at 99 or 99.5. So a manager could source a full portfolio in the secondary market if they wanted to," Miller said. In comparison, he said, new issue loans are bought at part or slightly less than par.
"Now the same secondary loans are trading at 101, 101.5, or 102. It's difficult for managers to purchase a whole portfolio of secondary loans and have it make economic sense for the deal," Miller said. "So you see a mix of new issuance and secondary loans. To make the economics work, managers likely need to purchase loans in the new-issue market or secondary prices need to drop."
Although loans have sold off since the Federal Reserve started talking about slowing its purchases of bonds, prices have held up better than other kinds of fixed income. "The loan market is incredibly healthy now, maybe too healthy considering that the rest of fixed-income markets, particularly emerging market debt and high-yield bonds, have had outflows," said Mark Okada, chief investment officer at Highland Capital Management.
"High yield is off 150 basis points this month and loans are off 30 basis points; the normal correspondence is 60-70 basis points, so you'd expect loans to be off one [percentage] point, but it's not because of good inflows," he said.
Highland, in Dallas, manages approximately $20 billion in CLOs and other credit products and alternative investments.
Delayed-draw funding has other uses besides allowing managers to bring CLOs to market more quickly. It is also an efficient way to finance the purchase of collateral with delayed-draw features, such as revolving lines of credit.
"Sometimes you see a delayed-draw feature in a deal when there is a large concentration of revolvers in the portfolio and the manager wants to mitigate the negative carry," said John Timperio, a partner in the structured finance and securitization practice at law firm Dechert.
Dechert is working on a couple of deals that will have a revolving tranche of notes, Timperio said. This feature, which is a little more complex than a delayed-draw tranche, was seen in CLOs issued precrisis deals as well, he said.
The reintroduction of delayed-funding features coincides with other moves to give CLO managers more flexibility to source collateral, such as larger allocations to covenant-lite loans and high-yield bonds as well as revolving lines of credit. This year, some CLOs have been able to put as much as 70% of assets to work in loans with less restrictive covenants, for example. That's a big rise from the 30% to 40% covenant-lite buckets that were the standard practice for deals over the first three quarters of 2012, according to research published by Wells Fargo.
Delayed-draw features are also popping up in securitizations of other kinds of assets, such as auto loans. In these deals they are called prefunded tranches and they have raised concerns about the credit quality of future collateral. In a June 18 report, Moody's Investors Service cited the increased use of prefunding as one of several risks in subprime auto deals, along with weaker underwriting and stiff competition among lenders, that it said will lead to higher credit losses. The danger is that issuers may use these commitments from investors to purchase loans before they are made to expand lending too quickly, the rating agency said.
That would seem to suggest there's a risk that delayed-draw funding in CLOs could lead to higher credit losses by adding to the competition for loans. However, rating agencies seem unconcerned about that.
For one thing, managers don't have to draw down on the funding commitments if they can't find suitable collateral. And the commitment fees they pay on the unfunded portion of commitments have a small impact on the economics of deals.
"Assuming the portfolio parameters are the same, failure to draw a delayed-draw tranche would be positive for senior and mezzanine tranches because they would benefit from greater credit enhancement," Fitch's Miller said. In comparison, he said, "the equity [holders of the most subordinated tranche] would prefer a full draw to maximize leverage."
If anything, participants say, the reintroduction of delayed funding is a sign of the CLO market's strength.
"It shows we can take a technology that was in CLO 1.0 and reintroduce it into the current market as a way of making equity returns work a little better in light of spread compression," Timperio said.
And Okada said that, rather than introducing risk, delayed-draw features do "just the opposite. When you put them in a structure you don't have to reach for risk you're more patient," he said.
In general, "as a fund manager, we'd always want to have more flexibility on the asset side, a bigger high-yield bucket, the ability to buy other things, that creates more diversity. It's a good risk management tool."
Risky or not, not all investors are willing, or even able, to commit to invest in a CLO at a future date.
"The challenge is always finding the parties who can satisfy rating agency criteria for delayed-draw or revolving-note counterparties," Timperio said. "That's typically an 'A1' short-term rating or an 'AAA' long-term rating. You need to make sure that when you make the draws the counterparty can do it. Obviously, the universe of parties that can satisfy those criteria is not infinite."
Timperio said these investors would primarily be banks and highly-rated institutional investors.
Banks are some of the biggest buyers of CLOs, or at least the senior tranches of these deals. Since the first quarter of 2010, banks and thrifts have grown CLO balances by close to 135%, while CLO holdings as a percentage of banks' total securities have climbed more than 75%, according to research published on June 14 by SNL Financial.
This might seem ironic, since banks are in the business of making loans themselves. But CLOs allow smaller banks that are unable to participate in large syndicated loans to get exposure to a wider range of borrowers in a variety of industries.
"Some banks buy the senior tranches [of CLOs] expressly to get a diversified portfolio of corporate credit assembled by a top-tier manager," Timperio said. "A lot of banks have a regional footprint or have lending that is more relationship-based," he said. "This gives them exposure outside their footprint."
Banks may ease back on CLO growth thanks to a change in deposit insurance rules that took effect on April 1. Assets now factor heavily into calculations of deposit-insurance premiums, and the rules require higher assessments for even the least risky CLO tranche, those rated 'AAA.'
The deposit insurance rules apply to loans and CLOs issued on or after April 1; those issued before that date are grandfathered.
Still, experts predict steady demand for CLOs. "We see a lot closing in the third and fourth quarters," Timperio said. "It's hard to envision not hitting the high end of forecasts for full-year issuance, in other words $70 to $80 billion."
A longer version of this story appeared in Asset Securitization Report.