2021 looks set to become a post-financial crisis record year for European CLO issuance and refinancings, but amid the rush of activity we are seeing a concerning trend for weaker documentation in refinanced deals that in our view investors need to fight against.
According to data from Bloomberg, 31 new deals have been issued so far this year with a total volume of €12.5bn, and given the COVID-19 disruption in early 2020 it is little surprise that this is 60% higher than the same period last year. What is impressive though is that some 86 European CLOs (a combined €32bn) have been repriced or refinanced in full year-to-date. Going into 2021 we did expect to see a very active refinancing market, but €32bn exceeds almost all analyst forecasts and €50-60bn for the full year now seems achievable.
This refi surge is being driven mostly by 2017/18 and 2020 issued CLOs, vintages that are broadly ripe for refinancing since the former are reaching the end of their reinvestment periods and the latter were issued at 2020 spreads and are approaching the end of their non-call periods. This in itself isn’t particularly interesting, but behind these figures what we have seen is a bit of creativity from CLO managers and equity investors. Especially recently, we have seen CLO managers reprice the AAA notes of a deal and agree documentation changes with the (existing) equity investor and the (new) AAA investor, changes which of course impact bondholders all the way through the capital stack rather than just at the AAA level. Whereas normally we view buyers of AAA CLO bonds – often referred to as the “controlling class” of CLOs – as a relatively risk-averse bunch, lately we have seen them taking waiver fees in return for agreeing to what we would call more equity-friendly documentation.
Recently ICG and Carlyle, among other CLO managers, have managed to change some of the reinvestment criteria in repriced deals, changes which also impact mezzanine investors. This is particularly interesting when you consider that that some of the items being altered are those that tend to be carefully negotiated between managers and mezz investors before any new CLO is issued.
While some of these changes in our view don’t add material risk to bondholders, as a CLO investor we do expect the documentation we and others sign up to when a new CLO is issued to stay in place for the life of the transaction. We view this behaviour as unacceptable, and particularly curious at a time when Governance, with a capital G, is becoming ever more important. CLO managers can expect us to push back very heavily against such alterations. For us there are three likely implications from this emerging trend; we will haircut ESG scores for some CLO managers that show this behaviour, demand even stricter documentation for new CLOs, and price the added risk accordingly for managers that aren’t willing to agree to tighter language.
ICG priced the BB notes of its refinanced St Paul 7 CLO (after altering docs on St Paul recently) last week at 6.4%, versus Oaktree which refinanced the BBs of its (unaltered) Arbour CLO 2 at 5.8%, so we already see a gap opening – mezz investors don’t take kindly to unexpected increases in credit risk. However, this also shows there is demand for the ICG approach, with the 60bp yield pick-up clearly looking attractive to some in this low yield environment.
In the current pipeline for new CLOs we’re seeing an interesting dynamic where BBB, BB, and B investors are looking to impose new documentation to reduce the possibility of added future credit risk and things that could prolong the life of a CLO beyond the period they signed up for. Last week BNP Paribas Asset Management and Partners Group were among the first managers to agree language protecting mezzanine interests, and where certain parts of the prospectus can only be changed with consent from all debt investors rather than just the AAA holders.
This does not mean every CLO manager will take all the freedom they are afforded by a deal’s documentation. Indeed, the majority of managers have shown great prudence in managing CLOs for all of their investors, and especially through a turbulent year like 2020 we’ve seen good performance from many of them. However, we believe as investors we have to fight back against this sort of behaviour early in order to protect ourselves from future changes, since CLO equity can change hands and we don’t know which sponsor might be pushing for changes in a few years’ time.