NEW YORK, July 7 (Reuters) - Managers are considering embedding a new repricing feature in US Collateralized Loan Obligation (CLO) funds that would protect firms from regulation that requires them to hold 5% of their funds and save money on full refinancings.
The US$458bn CLO market is still analyzing new structures and features to help it to comply with rules in the Dodd-Frank Act that took effect in December that require managers to hold some of their funds’ risk.
Crescent Capital Group issued the first CLO with an Applicable Margin Reset (AMR) in June, which allows CLOs to be repriced without managers having to update regulatory valuation analysis or buy more retention. Other managers have also begun researching the structure, which is expected to be used more widely.
The “automatic feature of the AMR can be cheaper than going through a refinancing exercise and can be much easier because it’s baked in and automatic, which may be attractive to equity” investors, according to Sean Solis, a partner at law firm Dechert.
A record US$100.2bn of CLOs has been reworked this year, according to Thomson Reuters LPC Collateral. Junior CLO investors have pushed to refinance to increase their payouts as they receive the interest left over after debtholders are repaid, and lower coupons for senior CLO noteholders boost their payments.
Investment manager Sancus Capital Management began working on the AMR structure more than two years ago because the process of calling securities and re-issuing them to refinance a CLO seemed to be “unnecessarily complicated,” according to Olga Chernova, chief investment officer.
“We thought, ‘Why don’t we just build in a mechanism where the securities could be refinanced via an auction and people could bid, like in a BWIC, and if the clearing level is tighter, the coupon gets reset,’” she said.
AMR CLOs are modeled on auction-rate securities. Investors submit interest rates that they are willing to receive for owning the fund’s debt tranches. Offers must be lower than the existing spread.
Crescent’s CLO requires bids to be at least 10% lower, according to Asif Khan, who runs the new-issue CLO business at MUFG Securities and arranged the new fund. The investor with the lowest coupon offer wins and tranche spreads remain unchanged if no bids are submitted.
"Crescent continues to place a high priority on being an innovator in the CLO asset class, and we are pleased to partner with MUFG and Sancus by serving as collateral manager for the global launch of the AMR feature," a Crescent spokesman said.
Managers can either buy vertical strips of CLO funds, which are 5% of every tranche of the fund, or horizontal strips, which are 5% of the face amount of all of the fund’s tranches and held in the equity slice, to comply with the risk-retention rules.
Firms that buy horizontal slices have to give investors a fair value interpretation of the debt that they intend to hold.
A CLO refinancing is considered a new offer and sale of securities, and therefore requires the “sponsor” to comply with risk-retention rules, Solis said. As sponsors organize and initiate deals, this means that managers that own horizontal slices have to provide a fresh fair value analysis as part of the transaction.
As valuations are likely to be lower the longer that CLO funds are outstanding, managers would need to buy more equity to comply with the rules - unless they use an AMR structure.
A letter from the Securities and Exchange Commission in response to Dechert and Sancus in September said that the use of an AMR structure would not constitute an “offer and sale of asset-backed securities” and therefore managers would not need to rework valuations or buy additional equity.
AMR structures also allow managers to reprice CLOs faster and more cheaply than a traditional CLO refinancing, which allows CLOs to cut tranche spreads, matching lower returns from US leveraged loans.
More than US$358bn of US leveraged loans were refinanced in the first half of 2017, according to LPC data, as borrowers rushed to take advantage of increased investor demand for floating-rate debt on the back of rising interest rates.
MUFG has received several calls from interested CLO managers and is working on more funds with the AMR structure, Khan said. The bank is also working on using the feature in CLO resets, where the maturity of deals is extended to allow the funds to remain in place.
“The process makes CLOs more democratic because when the deal refinances, everyone can participate and it makes the process easier and the cost of the refinancing comes down,” Khan said. “This idea will grow; that’s our objective.” (Reporting by Kristen Haunss; Editing by Tessa Walsh)