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January 17, 2020  

CLOs Seek Support for Distressed Holdings

Collateralized loan obligation issuers are looking into mechanisms that could afford them more flexibility in managing distressed collateral.

The hope is to avoid what happened in the case of Deluxe Entertainment. In August, the troubled visual-effects company sought additional funding from lenders in a bid to position itself for a turnaround. Blocked from taking more exposures to troubled borrowers, however, many CLO managers were unable to add to their positions — and wound up at a disadvantage to other creditors when Deluxe filed for bankruptcy in October.

A number of methods are under consideration, including the idea of seeking greater allowances for so-called protective advances, which typically take the form of cash injections by lenders seeking to preserve the values of their troubled-debt holdings. Because CLOs have strict limits on their exposures to the weakest borrowers, they often have been unable to participate in such arrangements.

Recently, however, issuers have been approaching lawyers at Dechert and Mayer Brown about how protective advances and other similar mechanisms might fit into their deal structures.

The primary constraint on a CLO’s ability to provide cash infusions consists of a limit on holdings of loans rated triple-C-plus or lower, typically equal to 7.5% of a portfolio. A deal that breaches that maximum must mark its assets to their market values when determining if it has sufficient over-collateralization.

The result is that CLOs whose “triple-C baskets” are full or almost full have little leeway to prop up struggling borrowers or add protection for those companies’ loan collateral. Deluxe’s request for more funding was particularly ill-timed in that respect, as it came shortly after S&P downgraded the company by three-notches to a “CCC-” grade.

In November, median holdings of triple-C-rated loans by CLOs issued since the financial crisis rose 20 bp to 3.7%, according to Moody’s (see article on Page 4).

Mayer Brown’s discussions about the protective advances have involved the potential exclusion of such investments from CLOs’ limits on triple-C exposures. “Investors really aren’t expecting CLOs to get stuck with a lot of this paper, but things happen, and they should think about what options a CLO might have,” partner Paul Forrester said. “There’s a good reason to think about a protective-advance exclusion to triple-C limits. It allows managers to avoid being taken advantage of, as they were with Deluxe.”

A greater allowance to participate in workouts could bring CLOs on more-equal footing with other creditors when it comes to maximizing recoveries on their investments, Dechert partner Christopher Duerden said. He also noted that more flexibility could alleviate difficulties for managers that hold similar positions across CLOs and other vehicles. “Trying to juggle the allocation of a restructured asset can be a headache, to say the least,” he said.

CLO investors might only be comfortable with protective advances by the most experienced managers. It also is unclear how rating agencies might view protective-advance exclusions or other workarounds. Moody’s, for one, looks at such measures on a case-by-case basis.

To the extent the added leeway would circumvent asset-quality measures, Moody’s would “see that as credit negative per our methodology,” senior analyst Peter Hallenbeck said. On the other hand, the agency does take into account a CLO’s potential to improve its recovery on a defaulted loan.

Tax considerations also could come into play. CLOs typically use offshore domiciles to avoid U.S. taxes, while relying on safe-harbor provisions for securities trading and investing. But advancing capital as part of a workout could be seen as loan-origination or restructuring activity in the States. That could cause a deal’s income to be taxed in its entirety at “branch-profits” rate as high as 30%, beyond the ordinary income tax of 21% for corporations.

A law firm could provide an opinion that a particular transaction doesn’t qualify as either origination or restructuring activity, but that would only happen as necessary. “There is no clear set of circumstances that has emerged that will allow us to say, ‘X, Y and Z is OK,’ ” Mayer Brown partner Russell Nance said.

If there’s a clear risk of triggering a tax liability, most CLOs allow for the formation of a “tax-blocker” subsidiary that could house the loan.

Another consideration: The Dodd-Frank Act prohibits banks from investing in securitizations of anything other than loans. Because banks are the biggest buyers of senior CLO notes, that could reduce the abilities of issuers to take equity or equity-like positions in dealing with troubled borrowers. “Currently, most CLO documentation requires the manager to sell any equity security obtained via a restructuring within a specific period of time. However, depending on the time allotted, this may not be practical and/or feasible,” Duerden said.

However, it typically is possible for issuers to obtain extensions.