Historically how have CLOs been involved in restructurings?
Nick Charlwood: To understand the context of how restructurings are evolving, you need to look at how the leveraged finance market has changed over the last 10 to 15 years. The two most important developments are changes to the transferability of debt and the loosening of covenants. This has impacted who is involved in restructurings and how they are shaped.
Historically, CLOs could not participate in new money for distressed credits and deals were principally designed by distressed credit funds with an eye on advantaging secondary participants over real money investors. The economics in return for participating in the new money were generous and those that didn’t participate could get pushed down the capital structure in one way or another, so the CLOs often lost out.
John Goldfinch: When you are looking at distressed credit, a CLO looks like just another creditor in the group, but they are in fact a very different beast. Whilst they are a lender of record on loans, CLOs did not historically participate in primary syndication and instead bought up loans in the secondary market. They were never designed to behave as active lenders, but rather as passive investors.
Prior to the global financial crisis, that was fine and CLO managers sat back and did not get involved in workout situations. They certainly could not put in new money and in the event of a restructuring would sell out, being completely unable to contribute to any value creation in a workout.
However, after a number of aggressive liability management transactions in the US where CLOs were treated harshly because other creditors had much more flexibility to respond, that has changed.
How is the market evolving as creditor bases become disproportionately CLOs?
NC: Alongside the watering down of covenant protections, the triggers for restructurings are more limited now. The main trigger is liquidity, which brings the new money need front and centre, so if CLOs can’t participate in that new money they are disadvantaged and unable to participate in the upside. Concepts like elevation, whereby the providers of new money achieve some sort of preferential treatment on their existing debt, are used to incentivize new money providers.
JG: When the CLO market first restarted post-GFC, the percentage of CLO lenders in any leveraged credit was typically below 25 percent, whereas today at least two-thirds of lenders are usually CLOs and in some cases 100 percent. They all have the ability to trade in and out of loans in the secondary market but most are now also taking down debt in primary syndication.
CLO managers were looking at restructuring deals, seeing that they were being offered far worse terms because of that inability to put in new money, and losing out in creditor-on-creditor violence situations in the US, so they were galvanised to react. While there was a view in Europe that creditor-on-creditor violence could not happen here in the same way, thanks to tighter intercreditor arrangements and reputational concerns in a smaller market, still CLOs started to think about what they could do to improve their position. Ultimately it was the financial restructuring of Austria-based Schur Flexibles in 2022 that provided the first real test of the ability of CLOs to participate in a workout situation that required new money.
The first thing that changed was that historically CLOs couldn’t even take modified obligations such as the debt on amended terms that lenders are offered in workout situations. So we saw an evolution to allow that; they still couldn’t participate in new money, but they could accept new terms offered to other lenders.
Next came moves to participate in new money. CLOs in the US have always been able to participate in debtor-in-possession (DIP) loans, seen as a safe asset class and a good thing for CLOs to invest in. So efforts were made to import DIP loans to Europe, creating the concept of corporate rescue loans, which allow CLOs to invest at any time in super senior debt issued as part of a distressed situation.
The definition of a corporate rescue loan is sufficiently broad that it allows CLOs to put new money into deals provided they tick the boxes of that new debt being super senior and rated. We saw CLO managers joining ad hoc committees to pressure borrowers to structure new money in a ways that allowed them to participate.
Next came a concept called a loss mitigation obligation (LMO) as a last-ditch attempt to prevent CLOs being squeezed out where the particular requirements of a corporate rescue loan were not satisfied. The LMO is designed to be so broad that whatever terms are offered, a CLO should always be able to participate, but the sources of money they can use are restricted, often only to available interest and usually limited to a small percentage of the overall portfolio. But the market came up with a concept that meant CLOs should always be able to participate, even if the funds available within the given CLO structure are limited.
What developments have we seen in Europe around priming transactions and creditor-on-creditor violence?
Tim Watson: CLOs were historically passive and inflexible in terms of what they could do and how they could trade. In the spectrum of managed capital, you had distressed credit funds and hedge funds at one extreme with huge flexibility and very limited parameters around their ability to hold equity versus debt and CLOs at the other end. It is almost always the case in a restructuring that there is an over-levered balance sheet so you either need to cut the debt or move it out of the operational group, so the ability to be agnostic around equity versus debt is valuable.
What we have seen in the priming transactions space, partly driven by covenants and partly by transferability, is that the classic distressed investor is now looking as much at participating in complex priming transactions as par investments as at buying debt at a discount in the secondary market and then participating in a restructuring. So it is an evolving spectrum.
JG: We are now seeing priming transactions that take advantage of either looser covenants to strip out assets into a separate entity that raises new debt, or take advantage of covenants to layer on new debt in a so-called up-tiering transaction. CLOs have a toolkit of different ways to participate, with priming transactions treated like corporate rescue loans in that CLOs can use principal proceeds to fund, even though there are some restrictions on that from investors and rating agencies.
What do all these developments mean for restructurings today?
NC: In any restructuring, you want to be aware of who all the lenders are. It is now a relevant consideration whether the CLOs involved are 2014 vintage CLOs or 2022 vintage
CLOs for example, because that will impact what they are able to do and what they can participate in if the imperative for the borrower is new money.
TW: We have recently seen the advent of double-dip and pari plus transactions, which represent the next generation of liability management transactions. Double-dip transactions effectively establish two new claims over an existing debtor, while a pari plus transaction, seen in Sabre last year, establishes an indirect claim on the existing debtor and a structurally senior claim on certain other entities.
The Sabre deal was not done in the context of a restructuring but two years in advance of a 2025 maturity, so we are seeing these kind of transactions used by companies to actively manage their capital structure and anticipate potential challenges, such as significant maturity walls and the likely capacity of the credit markets to refinance large capital structures in the immediate run up to those maturities.
JG: Bigger CLO managers may have 10 CLOs under management with different vintages and different abilities to participate in these transactions. On Schur Flexibles, we saw some managers working with a corporate rescue loan definition, some that had LMO technology and some that didn’t. So some CLOs could participate in priming transactions (with varying degrees of available cash) and others could not. Managers with broader portfolios of different CLOs and other funds have to think carefully about the best interests of their investors when looking to participate in fast-moving restructuring situations.
NC: One development we saw on the recent second restructuring of Vue Cinemas was that the new money was offered on an institutional basis, so existing lenders could participate or they could nominate an affiliate or related fund to participate. The elevation benefit they got for their existing exposure applied regardless of whether it was an affiliate participating or the lender of record. That was requested by CLOs become some of their vehicles had capacity to participate and others did not.
How do you see the market evolving from here?
JG: Fast forward 10 years from now and all the old CLOs lacking recent technology will have been wound down and the next generation of CLOs will benefit from the new tools. Until those vintages mature, managers are going to be stuck with some deals able to participate more or less easily than others. We will see a big sea change in the coming years as the market shifts.
TW: One way in which the advisory community can really add value on these transactions is in getting to an outcome that ticks as many boxes as possible for as many stakeholders as possible, all with wildly different entry points from an economic perspective. The developments in terms that allow CLOs more flexibility to participate ultimately will help get complex deals done, with the focus ultimately always being on driving value for the business.
