Understanding Collateralized Loan Obligations

(Estimated reading time: 4 minutes 27 seconds)

The article in brief:

A collateralized loan obligation (CLO) is a vehicle that alters credit risk by financial structuring and creates cash flow arbitrage to the equity investor.
Key structural features of a CLO include limited liquidity, especially for the more junior tranches, high levels of embedded leverage, and a wide range of return outcomes.
CLOs are complex structures requiring the application of a best-in-class valuation analysis, particularly in the weeks before year-end audits.

What Is a CLO?

A collateralized loan obligation, or CLO, is a structured finance security that is collateralized by below investment grade (typically B to BBB rated) broad market first lien senior secured loans with smaller allocations to other types of investments including second lien loans and unsecured debt. CLOs issue debt and equity (also referred to as mezzanine or subordinated tranches), and the CLO manager uses the resulting proceeds to acquire a diverse portfolio of bank loans, typically in the range of 150 to 250 individual loans, or more.

Growth of the CLO Market

Following the subprime mortgage crisis and resulting Great Recession, CLO issuance was virtually non-existent during 2008 and 2009. However, a combination of rising interest rates and below-trend default rates in 2010 resulted in exponential growth for the CLO market. The CLO issuance market remains robust and healthy, heading into early 2020. 2019 new CLO issuance of $118 billion declined 8 percent vs. 2018 levels, although 2018 new issuance was a record $125 billion.

CLOs are complex structures requiring the application of a best-in-class valuation analysis.

How is a CLO Structured?

The debt issued by CLOs is divided into separate, distinct tranches, each of which has a different risk/return profile based on its rating and priority of claim on the cash flows produced by the underlying pool of loans. Typically, CLO debt tranches are arranged with an AAA-rated tranche as the most senior, descending to AA, A, BBB, and BB-rated tranches (and sometimes includes a B-rated debt tranche), with coupons escalating for the increased risk of each tranche the further down the capital stack you go.

Cash flows received from the underlying collateral are first used to pay the coupon on the AAA tranche, with the remaining cash flows used to pay the coupon on the AA tranche, and the remaining tranches in order of priority via a waterfall structure. The residual “arbitrage” cash flows after all senior debt obligations and management fees have been paid then flows to the equity. The CLO equity investors essentially own the underlying managed pool of loans, and the CLO debt investors finance that same pool of loans.

Whereas collateral cash flow waterfalls from the highest-rated debt tranches at their respective contractual spread over LIBOR to the equity tranche, losses in the underlying collateral pool, either via principal impairment or cessation of interest cash flows, flow in reverse, from the equity to the AAA-rated tranche. This feature of CLOs allows the senior debt tranches to garner ratings higher than those of the underlying securities – AAA-rated tranches maintain a large loss cushion whereby a majority of the underlying loans would have to default without a recovery before the AAA debt principal balance becomes impaired.

Typical CLO equity IRRs range from 12 to 16 percent, commensurate with the inherent risk of the CLO equity’s first loss position. (All underlying loan defaults accrue to the equity tranche first before directly impacting any of the more senior debt tranche principal balances).

CLOs include structural features, as outlined in the CLO Indenture, which offer protection to the CLO debt investors. Some of these protections include interest coverage and over-collateralization tests. This prohibits the principal value of the CLO’s underlying bank loan pool from exceeding the total principal value of the notes issued by the CLO, as long as the CLO debt remains outstanding. If the principal value declines below the over-collateralization test threshold value, cash flows are diverted away from equity and junior CLO debt tranches and are applied toward senior debt tranche principal pay downs.

What is a CLO?

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The Lifecycle of a CLO

CLOs typically last a total of seven to ten years, inclusive of various lifecycle stages.

Warehouse Period
A warehouse provider finances the CLO manager’s acquisition of leveraged loan assets with the expectation of being repaid with the proceeds from a CLOs issuance. The warehouse period generally lasts from six to 12 months.

Ramp-Up Period
After closing, the CLO manager uses the proceeds from the CLO issuance to purchase additional underlying assets. The ramp-up period generally lasts from three to six months.

Reinvestment Period
The collateral manager is permitted, and expected, to actively trade underlying assets within the CLO and uses principal repayment proceeds from underlying assets to purchase new assets. This recycling of CLO capital is only permitted during the stipulated reinvestment period, which typically lasts from three to five years.

Non-Call Period
During the stipulated non-call period, the CLO debt tranches cannot be called or refinanced. Non-call periods typically span two years. Once the non-call period expires, the equity tranche investors are permitted to refinance the debt tranche positions.

Amortization Period
After the reinvestment period ends, the CLO enters its amortization period, which is the final stage of a CLO’s lifecycle. During the amortization period, cash flows from the CLOs’ underlying assets are used to pay down the principal of the outstanding debt tranches.

CLOs have proven to be a viable securitized product, having performed well throughout the Great Recession due in part to sound structural features, relatively low realized defaults for bank loans, and prudent active investment management.

Why Do Investments in a CLO Require a Valuation?

Valuation is a fundamental component of structured product investments. Prudent due diligence conducted by investors, auditors, and regulators dictates an expectation that a CLO manager will maintain well-documented accounting policies and procedures, valuation model assumptions and inputs, as well as financial reporting disclosures – nearly all of which have evolved in recent years. The CLO manager and equity investor alike tend to face challenges when it comes to determining a valuation framework.

While a CLO valuation leverages common model approaches, the assumptions driving the value of CLO debt and equity are nuanced, complex, and not-so-common. An independent valuation professional who can demonstrate a depth of knowledge through experience is best suited to manage the rigors of one of your firm’s most risky and material assets.

CLO vehicles are the lifeblood that helps keep the syndicated loan market humming. More than 60 percent of new issuance below investment grade loans are purchased by CLOs. CLOs offer debt investors an attractive yield alternative to fixed-rate bond investments given the floating rate nature of CLO debt tranches. Additionally, CLOs have proven to be a viable securitized product; CLOs performed well throughout the Great Recession due in part to sound structural features, relatively low realized defaults for bank loans, and prudent active investment management. Zero senior debt tranches recognized a principal impairment throughout the Great Recession.

For more information on the nuanced valuation mechanics surrounding CLOs, we welcome you to contact the article authors Shane Newell and Charles Paraboschi.