The leveraged loan market is finding creative ways to make up for the fact that a major buyer is soon to fade into the sunset.
Collateralized loan obligations hold about half the $500 billion in U.S. leveraged loans, but most of these vehicles, created in 2006 and 2007, are nearing the end of their three- to seven-year reinvestment periods.
Terms vary, but once they become static and start repaying investor principal, many are limited to reinvesting unscheduled payoffs. Even then, they cannot hold assets beyond a certain maturity. Older CLOs that are still investing may also be limited in what they can buy, by weighted average life requirements.
The $2.2 billion senior secured credit facility Kinetic Concepts completed in October is one example of what borrowers may need to place loans in the future. The seven-year facility, which backed Kinetic's $6.3 billion buyout by Canada's Apax Partners, the Canada Pension Plan Investment Board and Canada's Public Sector Pension Investment Board, appeared too big for the market to digest, but was eventually oversubscribed after lenders led by Bank of America Merrill Lynch carved it into pieces.
According to people familiar with the transaction, that tranche resulted from inquiries from several older CLOs that didn't want to buy a seven-year loan.
Jaime Aldama, head of U.S. credit and asset-backed securities structuring at Barclays Capital, says he expects more such shorter-dated tranches carved out of new facilities to fit the maturity profiles and weighted average life covenants of older CLOs.
For companies looking to refinance, "amend and extend" agreements, in which the existing lenders agree to extend the maturity of a loan, are commonly used to cater to managers of CLOs outside the reinvestment period, Aldama says. That's because extensions tend to be much shorter-dated than new loan facilities.
Shorter-dated tranches could become a regular feature of loan deals, or at least of larger ones, a New York-based money manager says. Kinetic "pulled out all the stops to create that tranche," the money manager. While the term loan C was just $300 million, "it was more than 10% of the deal," he says.
In the future, "if a loan is a little too big to clear from regular buyers, we'll see more of that," he says.
CLO investing capacity is scheduled to quickly decline over the next three years. JPMorgan Chase & Co. estimates that, of the $295 billion in outstanding U.S. arbitrage CLOs, $198 billion are currently active, but that will fall to $143.67 billion in the fourth quarter of 2012, $64.71 billion in the fourth quarter of 2013, and just $11.2 billion in the fourth quarter of 2014.
There has been $9.8 billion in new U.S. CLO issuance this year, with another $2.8 billion in the pipeline, according to Thomson Reuters.
Money managers are hoping that pension funds and insurance companies will eventually become big buyers of loans, picking up some of the slack, but wooing these kinds of investors is expected to take some time. And bank loan mutual funds, which until recently appeared to be plugging the gap, have been sustaining withdrawals for the past 13 weeks.
One thing that could slow the erosion of CLO buying power, if not stop it, is an ongoing review of collateralized loan obligation ratings by Moody's Investors Service. Moody's changed its ratings methodology, removing a 30% default probability stress test that it put in place in February 2009 after the collapse of Lehman Brothers. Many CLOs restrict a manager's ability to buy and sell collateral when the notes issued by the trust are downgraded. So the Moody's upgrades are paving the way for some managers to resume trading loans for the first time in two years.
Between June and September, the ratings agency upgraded 2,377 tranches in 449 U.S. transactions, or 73% of the deals it had placed under review.
As a result of the upgrades, there are now $28.97 billion of CLOs that are static, but able to invest unscheduled repayments, compared with just $9.66 billion before Moody's initiated its review.
This will help as more CLOs enter their static period; in the fourth quarter of 2012, JPMorgan Chase estimates there will be $45.4 billion of CLOs that are static but still able reinvest compared with $15.13 billion if there hadn't been upgrades; the number could grow to $85.14 billion instead of $28.8 billion in 2014.
Bankers are not the only ones thinking about ways to make it easier for CLOs to reinvest. CLO managers are also getting creative. In May, Standard & Poor's said it had seen several proposals from managers looking to increase the weighted average life of the assets in U.S. cash flow CLOs or extend their reinvestment periods. "We believe these amendments may allow collateral managers to extend the life of the collateral within their CLOs," the ratings agency said in a research note.
