CLO Issues in Workouts and Debt Restructurings

At the beginning of 2020, Collateralized Loan Obligations (CLOs) held over half of the US$1.2 trillion in outstanding US bank loans. Now that the COVID-19 pandemic has sent many borrowers in search of liquidity and ways to restructure their debt, CLOs are playing a greater role in the distressed debt playbook. CLOs are structured to be passive investors in the secondary market, so their place in workouts—by providing liquidity or exchanging debt for equity or subordinating debt—is limited, but as borrowers and investors try to creatively navigate the current crisis, the volume of debt held by CLOs is growing.

HOW A CLO WORKS

CLOs are structured credit vehicles that issue multiple investment tranches of debt, each with a separate risk profile based on the quality and priority of the underlying portfolio. The CLO uses the proceeds of these tranches to invest in a diversified portfolio of leveraged loans, which are primarily senior-secured loans made to below-investment-grade borrowers. Because of their tax structure and investment profile, CLOs remain largely passive investors in the secondary market.

Most CLOs are domiciled in offshore tax havens and structured to ensure that they are not subject to US income tax. The common tax safe harbor that CLOs rely on—“trading in stock and securities”—limits their ability to originate loans and generally requires them to only purchase assets in secondary-market transactions.

Also, in an effort to mitigate overall risk and to provide consistent returns, CLO documents typically include a variety of restrictions and concentration limits that set guardrails on the types of loans that can be held in the portfolio. Restrictions include industry- and issuer-concentration limits, coverage-ratio tests, a limit on the amount of lower-rated debt in the portfolio, and severe restrictions on acquiring and holding equity interests. For example, a CLO portfolio cannot acquire CCC-rated debt in excess of a percentage cap of the aggregate portfolio (7.5% is a common cap). This basket is typically reserved as “dry powder” by CLO managers who prefer to preserve the lower-rated debt capacity for downgrades or for debt exchanged through workouts.

CLOs also have a limited period in which they can invest funds after the initial portfolio is in place. The reinvestment period typically ends two years after the CLO raises funds and ramps up the portfolio. During this period the CLO can invest in new debt obligations and reinvest any funds received from repayment or refinancing of portfolio investments to rebuild and preserve the portfolio. When the reinvestment period expires, the CLO goes into “automatic mode,” receiving and distributing funds to investors as the portfolio amortizes down for the remainder of the life of the CLO.

CONSIDERATIONS AND RISKS FOR CLOs IN WORKOUTS

The typical CLO structure makes it difficult for CLOs to actively engage in workouts and restructurings. Tax exemption rules prevent CLOs from direct lending and therefore generally limit their ability to provide additional liquidity, rescue or DIP financings. And the concentration and quality limits on the portfolio restrict a CLO’s ability to compromise or exchange debt for lower-rated debt or equity.

These limitations not only affect the recovery rates for CLOs, but also limits their ability to participate in prepackaged plans and other restructurings. While restructurings that result in a mix of equity and notes might be acceptable to other debt holders in a workout, CLOs don’t have the same flexibility to compromise. Also, the various CLOs in a transaction may be at different stages in the vehicles life cycle, further complicating a “one size fits all” solution.

In Deluxe Entertainment, CLO debt-holders were initially willing to participate in an accelerated prepackaged Chapter 11 plan, which would have included at least US$25 million in incremental financing. But as the consensual plan progressed, the credit rating of the debtor’s term loan was downgraded to CCC, and certain CLO funds were no longer willing to consent to the prepackaged plan. The debtor and other investors were then forced into a more expensive and longer Chapter 11 process to implement restructuring.

Acosta, Inc., and J.C. Penny Co. are other examples where the workout structure was complicated by CLO limits on direct lending and holding downgraded debt or equity. The result: a CLO recovery rate 20 to 30 points below other par holders.

If a CLO receives non-qualified assets—such as low-rated debt or equity—in exchange for portfolio investments, it usually must divest these assets quickly, and this impacts recovery rates. Some CLOs use affiliates to offload restricted assets, which helps with a quick disposal, but recovery rates still take a hit.

To boost recovery rates, some CLOs provide for bankruptcy or restructuring exchanges for portfolio debt. These exchange buckets are subject to restrictions on the type and quality of debt received as well as overall caps on the percentage of the portfolio that can consist of exchanged debt.

Some CLOs have also made exceptions to their investment guidelines to allow direct lending—including rescue or additional liquidity financings—as protective investments to preserve existing portfolio investments that were not expected to default when acquired. The CLO is still prohibited for tax reasons from engaging in a direct lending investment strategy, but it can participate in loan workouts, including additional liquidity, if it is trying to protect an existing investment that has become distressed.  Like the bankruptcy-exchange exceptions, lending to protect value is also subject to limitations and caps designed to keep the portfolio from being diluted by lower-rated debt.

In addition to the direct restrictions of the portfolio investment guidelines, the brief reinvestment period, requirements that certain lower-rated and distressed debt be marked to market, and portfolio value coverage test all provide strong disincentives for a CLO to hold debt that other investors would customarily take as part of a consensual workout or reorganization plan.

Further, engaging in restructuring solutions presents CLOs with rating, tax, and credit concerns. Though Moody’s has stated its belief that CLOs are being proactive when they act to preserve the value of existing investments and that this is generally credit-positive, the rating agencies still evaluate each instance on a case-by-case basis. As for tax implications, a CLO must be careful to avoid taking any action that would remove its “trading in stock and securities” safe harbor or to behave like a US trade or business. Tax-blocker entities may be a useful tool here, but a CLO should be cautious of taking any action that would expose its funds to income tax.  Last, with respect to concerns about credit, any advance or exchange would need to be permissible under the CLO’s investment restrictions, including rating requirements and caps on permitted exceptions.

CONCLUSION

As we enter the next restructuring cycle, the sheer volume of debt held by CLOs is creating a new normal. Prepackaged plans, for one, are likely to take more time and, in some instances, may prove impractical if the debtor’s position deteriorates faster than consensus can be reached.

All of these issues, and how debtors and other stakeholders are addressing them, are evolving in real time as more and more debt enters into restructurings and workouts. Ultimately, all parties will benefit if complications and limitations are identified early, allowing for creative and flexible workout structures and strategies.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Jeff Norton, an O’Melveny partner licensed to practice law in New York, Sung Pak, an O’Melveny partner licensed to practice law in New York, John J. Rapisardi, an O’Melveny partner licensed to practice law in New York, Thomas W. Baxter, an O’Melveny partner licensed to practice law in California, Jennifer Taylor, an O’Melveny partner licensed to practice law in California, and Adam J. Longenbach, an O’Melveny counsel licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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