(Bloomberg) -- Collateralized loan obligation managers in Europe are preparing for the post-pandemic world of rising credit risk by adding more flexibility to their traditionally strict structures.
CLOs -- which package speculative debt into bonds -- have been including options to participate in restructurings and remain involved in financings even if they go south. And while managers don’t expect a sudden deterioration of junk-rated loans and bonds anytime soon, with defaults in Europe still historically low, they want to be prepared in case things sour.
“With the ability to follow their money, CLOs now have better options to sell out if they have significant concerns on poor recoveries or provide new money and benefit from the potential upside of any turnaround,” said Oliver Harker-Smith, a portfolio manager at Barings in London.
CLOs historically had strict checks on their documents regarding the risks they were able to take. This meant that more often than not they were forced to sell their positions in situations when borrowers got distressed. At the same time, CLOs often weren’t taken into consideration in restructuring processes because they were intended to be focused on performing credits.
Now, provisions such as loss-mitigation loans, or workout loans, are common in the documents governing CLOs. The features offer managers the flexibility to put new money into the restructuring of a loan they hold in their portfolio.
About 60% of CLOs issued in Europe last year -- or 156 deals -- included such language in their documentation, according to Daniel Kakonge, founder of Review Port, which analyzes CLO documents. That’s up from 27 deals in 2020.
The change in terms is an effort that started during the pandemic as the limits on CLO structures frequently limited managers’ options in high-stakes restructuring brawls, and dramatically cut the amount of money that they could recoup in distressed situations.
“The ability to put in new money financing could be pretty revolutionary if there is an upturn in the number of restructuring processes over the next couple of years,” according to Alex Martin, a partner at law firm Latham & Watkins in London.
Still, some investors, especially those buying top-rated notes, have previously resisted the changes, preferring managers to sell out of struggling assets and keep the portfolio clean.
To allay these concerns, caps limiting how much of a deal’s proceeds can be used toward buying these new assets have been included with the provisions.
“It’s not out of control,” Review Port’s Kakonge said. “Investors are limiting exposure to these obligations by capping how much can be bought.”
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