Return of the CLOs

Collateralised loan obligations (CLOs) are re-emerging in the market. James Waddington, partner at Dechert, looks at the current trends in the market and considers the differences between CLOs 1.0 and CLOs 2.0.

Why have collateralised loan obligations (CLOs) re-emerged in the market?

It is a good investment product. It held up well throughout the financial crisis as opposed to collateralised debt obligations (CDOs), with sub-prime mortgage loans, which represented very poor credit. Also we are in a very low interest rate environment. People are looking for something with a better return.

Who is investing in the CLO market?

We are seeing a broad range of investors now. More people are coming into the market and, in part, that is due to them being a good risk-adjusted return. We are seeing banks, insurers, pension funds, hedge funds etc investing—a broad spectrum of investors.

Are there any restrictions on who is investing and issuing CLOs?

There are the normal securities law restrictions but nothing out of the ordinary. For example, you need to put in a minimum amount to buy a bond—obviously, a retail investor is probably not the right person to buy this.

The EU risk retention rules have had an impact on who can issue. You are required for an originator sponsor or original lender to hold 5% of any deal—5% of a $300m deal is a lot of money. Not everyone can do it and so there are some people who are being kept out of the market. The market is not growing in Europe to the same degree that it has in the US where it has seen phenomenal growth.

How are CLOs 2.0 different to CLOs 1.0?

They are fairly similar but with some basic differences. For example, CLOs 2.0 do not have securitisation buckets anymore and so you cannot put securitised assets into one.

The new regulations have had an impact. Investors are being very conservative and they are worried about regulations. We have seen investors look at these deals very carefully because they don’t want to have problems with their regulator later on. As a lawyer I have spent a lot of time explaining the structure to investors and making sure that they can be comfortable. In one sense this has had the effect that the regulators wanted—in other words, investors are being more careful and making sure investments comply with the rules. But also the rules are not that clear and there isn’t a lot of guidance from the regulators as to what is okay and what is not.

As a consequence we tend to end up with very conservative approaches or investors not entering into deals. In that sense the regulatory impact can be bad because it is preventing money from getting to the real economy. The borrowers on many of these loans in CLOs are midmarket companies which need the money. CLOs are a source of capital to the real economy and one of the impacts of the regulation has been to slow that down.

How has the increase in covenant-lite loans impacted the CLO market?

It has had less of an impact in Europe. Europe has always looked less favourably on covenant-lite loans. I do not think that we will know the impact until we have been through the credit cycle again, but when I talk to collateral managers, their view is that they would rather buy a covenant-lite loan from a good borrower than a loan with a lot of covenants from a bad borrower. Their view is that it is important to look at the credit and that is what matters. If you have a good manager who can put you into the right credit, the covenant-lite issue is less important.

James Waddington is a partner at Dechert. He advises on a broad range of finance and capital markets transactions with a focus on structured finance, securitisation and real estate finance.

Interviewed by Jon Robins.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

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