LFI CLO Structuring Report: Battalion XII ‘rescue financing’ amendment going live, managers work toward standardization to raise recoveries

CLO managers are steadily implementing their ability to decide when to add new money on deals where it would strengthen a troubled loans recovery prospects as defaults rise and no end is in sight for the pandemic.

The highest-profile rescue financing amendments in the first half involve the $27 billion AUM Brigade hedge fund’s CLOs. Starting this August with Battalion XII, each deal will allow equity investors to “commit fresh capital for the sole purpose of participating in these workout situations,” according its June 6 Investor Letter. The resulting workout asset would not be counted towards any collateral quality or coverage test, or any other calculation in the deal.

Existing CLOs are generally bypassing note holder approval on recovery positive amendments by avoiding changes that would negatively impact the structure or prime equity investors, according to several legal experts.

Hyper focus on ripping out obstacles to maximizing loan recoveries, with no negative impact to the CLO structure, is the new normal in CLOs and generating billions in billable hours at law firms across the globe. As default rates have climbed in the Covid era and loan covenants have loosened, the average price of defaulted term loans have declined over time – implying lower recovery values for CLOs.

Motivating stakeholders is an increased divergence within recovery rates across lender groups with CLO managers pitted against distressed funds. For instance, the inability of CLO managers to participate in debt restructurings with new money in either the form of debt or equity has exacerbated losses in transactions.

Historically in existing CLOs, the purchase of debt (with the appropriate ratings) would likely have applied against CCC limits and the purchase or participation of equity offerings is either not permitted by indentures and/or in the past, was not eligible due to the Volcker Rule, which limits banks' trading activity. In some cases, however, CLO managers receive reorg equity as part of the restructuring (such as in the form of warrants), according to Pratik Gupta, CLO strategist at BofA Global Research.

“Flexibility to add new outside money to rescue a distressed loan benefits noteholders and equity tranches in a CLO by seeking to achieve a higher recovery,” said Laila Kollmorgen, a portfolio manager at PineBridge Investments, a CLO investor. “CLOs are meant to be managed vehicles, but the degree of malleability will vary depending on the skill and experience of the each manager.”

“The same elasticity in the hands of a manager with a poor track record could become a disaster,” she added  

Prominent examples of when CLOs have faced lower recovery prospects because of not having the ability to add debt or equity in negotiated forms, such as warrants, in restructurings versus other lenders include:

Acosta – A distressed group proposed an additional equity infusion into the company that CLOs could not participate in because of indenture restrictions (and Volcker rules then). The CLO investors together blocked a restructuring with a more favorable alternative. “Lots of deals, like in Acosta, you had to put money in to receive equity in the restructuring, and as a CLO you couldn’t, losing a lot of value,” LFI previously reported.

Cirque du Soleil – About a dozen CLO managers worked around indenture rules, such as not being able to buy equity, to maximize recovery for the vehicles.

Revlon – Various CLO managers objected to the restricting plan proposed, which involved the issuance of a priming term loan. CLO managers were not able to participate in the new issuance (as it would have counted against CCC concentrations), the new loan lowered recovery values for existing term loan lenders.

Serta Simmons – In the Serta loan, a group of CLO managers rallied successfully for better recoveries versus distressed funds. The situation, however, can be the exact opposite as well, writes Gupta. CLO managers typically are not sellers of terms loans as they turn distressed. As a result, in some cases at least the majority of the loan holders could be distressed fund which have purchased those loans at a steep discount.

Note that another CLO manager objected to the plan proposed by the majority of lenders (also CLO managers). As some credit agreements require only majority consent to issue a senior debt to the existing term loan facility, the distressed group can then further lower recovery values for CLOs by issuing a structurally senior loan.

Standardizing CLO rescue financing flexibility

Toward the goal of better recoveries and lower legal costs, separate from the Brigade proposal, several large CLO managers are collaborating on a “form” amendment for rescue financing flexibility, said a CLO executive involved in the process.

New-issue CLOs are getting rescue financing stipulations added, which is a positive in this risk-off environment, rating officials, CLO managers and lawyers report.

Insiders report that a major source of structuring language for manager flexibility for rescue financing comes from the post-Great Financial Crisis deals, such as collateralized bond obligations. Also, pre-Volcker rule deals, by the largest, repeat managers, like Credit Suisse Asset Management, said one law firm partner that runs a large CLO group.

CSAM is well-known in the CLO industry for having more flexible recovery language around the concept of "permitted use" than most other managers, he added.

New issue CLOs proactive recovery positioning

Many of the new documents now allow CLO managers to participate in equity offerings for entities where the vehicle previously owned the term loan. This could allow managers a greater say in the restructuring of the company and avoid situations such as that in Acosta, according to BofA.

Proceeds using interest and, or principal have variations across deals as to the kind of capital managers can deploy to purchase restructured loans and, or equity capital. In most cases, equity capital can be purchased using interest proceeds or using additional capital provided by CLO equity holders.

For restructured loans and work out loans, some indentures allow managers to use principal proceeds to purchase those assets, provided par coverage ratios are beyond a certain threshold, adds Gupta.

“From each credit crisis, the CLO structure has improved,” said a CLO manager. “CLOs are performing exactly as designed, which is giving investors’ confidence in the future of the product.”