Faced with growing recession fears, European CLO managers have imported a new concept from the US as they seek to avoid being outmanoeuvred in a wave of restructurings.
The new language, which is designed to prevent rival creditors from cutting CLOs out of favourable distressed debt exchanges, will make its first appearance on this side of the Atlantic in Bain Capital Euro CLO 2022-2, which was priced in the last week of July.
The idea is to allow CLO managers to participate in the so-called priming transactions that companies have been known to strike with groups of creditors, to the detriment of others, by either shifting collateral into unrestricted subsidiaries – a technique known as asset drop-down priming – or layering in super senior debt ahead of existing loans, which is called uptier priming.
Such tactics have so far largely been confined to US borrowers such as J. Crew, Travelport, Revlon, Boardriders, TriMark and Serta Simmons Bedding. But as default projections climb amid a brewing energy crisis in Europe, CLO managers are aiming to put themselves in the strongest possible position ahead of any workout discussions that may arise.
“This is just the latest piece in a long list of new technology that we have helped develop over the years, starting with corporate rescue loans, then loss mitigation obligations, which allow CLOs a limited new money participation in what in the US are known as DIP loans: debtor-in-possession loans,” said John Goldfinch, a partner at Milbank in London, who has been working on some of the first European CLOs to incorporate the new language.
“We’re now taking it to the next step – to cover new restructuring strategies which were first seen in the US, in J. Crew, Boardriders and TriMark – and which have begun to spread to Europe, for example in Intralot. What we’re anticipating is that we will see these liability management techniques be used more in the European market where we get more distressed entities.”
Gradual evolution
Corporate rescue loan language found its way into CLO documentation in 2013, allowing CLO managers to lend to defaulted borrowers for the first time, though in a limited range of circumstances. Loss mitigation obligations were added more recently, in 2020, allowing CLO managers to play an active role in a wider range of workouts.
It was this that allowed CLO managers that had bought Austrian packaging company Schur Flexibles’ term loan B in September 2021 to participate in a debt-for-equity swap when the company was restructured this year following an accounting fraud scandal.
The new provisions for uptier and asset priming deals should give managers even more leeway to participate in a wider range of restructurings and even classify the resultant securities as collateral obligations, though with limits to prevent CLOs from turning into full-on distressed debt funds.
In the past, CLO documentation has typically limited CRLs to 4% of the collateral principal amount and LMOs to 2% of the target par amount, with further limits on cumulative LMO investments over the life of the CLO. The bucket for priming deals is around the 5% mark, according to a person a who saw the documentation for the Bain deal.
An investor who participated in the Bain deal told IFR the new flexibility was a reasonable request.
“Some managers may not choose to participate in the restructuring, but from a practical point of view, if the borrower has defaulted, a super senior loan plus equity may result in significantly higher recoveries. It’s only in the interest of the deal to allow that,” he said. “The chances are we may see some distress coming through. The features in the transactions are logically positioned to allow the manager to operate in periods of distress while providing ample protection to the bondholders.”
Catching on
The first US deal to feature the anti-priming language was Napier Park’s Regatta XXII in May, according to a market source, and at least one European manager besides Bain has been marketing a CLO that incorporates the mechanism. In time, it is expected to become as commonplace as CRL and LML provisions.
“Because this is so positive a concept for all creditors in the deal, although it needs to be explained to investors because it’s new, I’d expect it to percolate though the market quite quickly,” said Goldfinch.
But it may take some time for investors and credit ratings agencies to fully digest the implications of the new arrangement.
“We will be looking at these kinds of obligations with the same lens as LMOs as a starting point,” said Abhijit Pawar, an analyst at S&P. “In line with our rating framework, credit is typically given in our analysis when the new asset includes debt-like features or is otherwise rated. However, there are still some open questions as the language in CLO documentation evolves.”