A Post-Closing Plan For Collateralized Loan Obligations Version 2.0
By Mark McMahon, Managing Director and Maria Nizza, Senior Director, Alvarez & Marsal Valuation Services, LLC
This article originally appeared on Alvarez & Marsal’s Action Matters column at www.alvarezandmarsal.com
With theresurgence of the CLO market now widely acknowledged, collateral managers are focused on new issuances. To reassure investors who are all too aware of the market's previous flaws, existing and prospective managers should consider the transition plan from a CLO's closing to the oversight phase, with a particular focus on valuation and investor reporting.
With forecasts of $60 to $80 billion in issuances for 2013, collateralized loan obligation (CLO) managers will focus on new issuances and attracting new investors. To accomplish this, existing and prospective CLO managers need to think about their transition plan from the closing of the CLO to the oversight phase. Doing so will ensure enough bandwidth to monitor closed deals while supporting new issuances, all of which provide reassurance to investors.
Here are the notable areas to emphasize when planning the second coming of CLOs.
- Financial reporting
A CLO is a structured product where a special purpose vehicle (SPV) invests in a portfolio of loans and issues multiple tranches of debt and equity. These tranches have varying degrees of risk and expected return. Payments to the tranches first derived from the principal and interest are generated by the loan portfolio, and then used to make payments in order of seniority. If cash collected by the CLO is insufficient to pay all of its expenses and obligations to investors, subordinate layers (tranches) suffer losses first.
The majority of CLOs are arbitrage transactions where the collateral manager purchases assets in an attempt to capture the spread between assets in the portfolio and the lower yielding liabilities issued by the SPV. By contrast, some CLOs are balance sheet transactions, which are primarily motivated by an institution’s desire to remove assets from their balance sheet in an effort to reduce regulatory capital requirements and improve return on risk capital.
It is important to understand that the CLO market is characterized by two distinct periods. CLO 1.0 (e.g., classic CLO, vintage CLO) refers to CLOs issued between 2004 and 2007. CLO 2.0 refers to CLOs issued after 2009. The key difference is that CLO 2.0 is defined by more conservative structures, such as lower leverage, shorter reinvestment periods and less ambiguous wording in the transaction documentation.
After the deal team has spent months developing the transaction documents, it is equally important to communicate any key details in the documentation to the rest of the team so that everyone is on the same page. One document to focus on is the indenture, which is the agreement between the issuer and the trustee. Basic examples to include in a checklist follow.
The end of the ramp-up period (the “Ramp-Up End Date” or “Effective Date”) marks the true closing and full funding of the CLO and is the first milestone. Understanding the timing and requirements is important at this time, including portfolio requirements and reports from third parties.
Timing of Reports
The indenture typically requires a trustee to produce both a monthly report and a note valuation report. The monthly report typically contains the portfolio listing and results of the collateral quality tests and concentration limitations, while the note valuation report also contains the distributions made during the payment date. There are accountants reports required in the indenture, but most managers find that a best practice is to develop an internal process to calculate and check the portfolio tests and payments made according to the rules in the indenture (the “Waterfall”). Differences in results should be discussed with the trustee and, if applicable, enhancements should be made to the trustee or collateral manager calculations.
Priority of Payments
The indenture details the distribution of interest and principal proceeds. It also mentions any alternate waterfall should the CLO default. As mentioned above, most managers have found that a best practice is to calculate the “waterfall” themselves. A few helpful features for investor and management reporting are:
- Projection of income from management fees and subordinated notes
- Projection of overcollateralization and interest coverage ratios
- Tracking of subordinated note internal rates of return.
It is also beneficial to track any agreements or disagreements between parties in the interpretation of the indenture.
Recent indentures provide more clarity on specific topics such as amend-to-extend activities, but there is still a long way to go. Until some form of standardization is established, documentation is specific to each deal – so it is helpful to communicate key nuances to the oversight team.
Is the CLO consolidated on the balance sheet? Review the consolidation rules regarding CLOs such as FASB Accounting Standards Codification ASC 810 Consolidation, which requires a reporting entity to consolidate a variable interest entity (VIE) if it is determined to be the primary beneficiary of the VIE. Currently, the rules state that if a manager determines that they are the primary beneficiary of the VIE or CLO, they may elect the fair value option to account for the assets and liabilities of the CLO.However, the FASB has proposed a new model for classification and measurement of financial instruments with comments due in May 15, 2013.
The accounting for the differences in fair value between the assets and liabilities has been inconsistent in practice throughout the market, so the FASB has issued a proposed accounting standards update (ASU), Consolidation (Topic 810: Accounting for the Difference between the Fair Value of the Assets and the Fair Value of the Liabilities of a Consolidated Collateralized Financing Entity (a consensus of the FASB Emerging Issues Task Force). The proposed ASU would require a reporting entity that measures the financial assets and liabilities of a collateralized financing entity (CFE) at fair value to determine the fair value of the CFE’s financial assets and liabilities in a manner consistent with how market participants would price the reporting entity's net risk exposure at the measurement date. Comments from market participants were submitted to the FASB in December 2012 and it is still on the FASB’s calendar for discussion.
Consolidated or not, most managers invest in the most junior or “equity” tranche of a CLO and may need to price their investments. There are several valuation methods available:
- Use of Broker or Third-Party Quotes
- Net Asset Value
Quotes will most likely be available for the senior tranches. In the last couple of years, the Securities and Exchange Commission has increased its focus on management’s responsibilities regarding fair values obtained from brokers and other third parties. Therefore, it is most likely that additional oversight procedures will be required.
The net asset value approach is sometimes used to estimate the value of the equity tranche. This involves obtaining a market value for the portfolio and then subtracting the balance of the liabilities to calculate the fair value for the equity. Critics of this approach claim it’s only reasonable if there is a strong possibility of liquidating the CLO. Otherwise, the approach ignores the payment rules in the indenture.
Finally, there is the mark-to-model approach which involves applying assumptions to the portfolio to generate cash-flows that run through the “Waterfall” and produce payments to the CLO’s tranches. Valuation models have taken on a range of methods from a single scenario approach to a multi-scenario approach. Given similar assumptions, the differences may not be material. For financial reporting, a single scenario approach may be enough as it tends to be more transparent and auditable.
One of the lessons learned from the financial crisis is that you cannot understate the importance of due diligence on the underlying assets. A standard model will incorporate assumptions for the portfolio such as default rates, recovery rates and prepayment rates. Recent valuation models factor in other attributes of the portfolio, such as a CCC bucket, LIBOR floors and ratings, based on the most recent financials of the obligor of the loans. Coverage tests and collateral manager performance relative to the market are also additional analysis used as input into the valuation. These enhancements can help uncover additional opportunities and risks in the CLO.
The market is poised once again to grow the CLO market. However, this time around, market participants are more experienced and applying more scrutiny around a manager’s governance process. The first year after issuance is critical as the CLO is ramping up its assets and operations. Having a robust post-closing plan will allow collateral managers to focus on new issuances, while ensuring issues critical to the oversight are addressed in a manner that ensures the continued confidence of investors.
Mark McMahon is a Managing Director with Alvarez & Marsal Valuation Services in New York and leads the group’s alternative investments services. He specializes in the valuation of illiquid securities and interests across various strategies and asset classes common to alternative asset managers. Maria Nizza, Senior Director, focuses on alternative asset manager advisory services and specializes in the valuation of illiquid and complex securities.
Alvarez & Marsal is a global professional services firm specializing in operational and financial performance improvement, turnaround and interim management, and business advisory services. For nearly three decades, Alvarez & Marsal has set the standard in working with organizations to tackle complex issues, boost performance and maximize value for stakeholders whether serving in advisory or interim management roles. For more information, visit www.alvarezandmarsal.com.