CLO managers struggle for survival as fee-income waterfall dries to a trickle

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European CLO fund managers are facing the prospect of losing lucrative junior management fees for the foreseeable future. Some funds are breaching internal tests that gauge asset quality and are cutting costs so they can continue to limp along, several distressed-debt investors and CLO managers told Debtwire.

These funds face a difficult choice: liquidate some portfolios or transfer them to stronger managers. A handful of struggling managers have approached larger competitors about transferring but the skinny fees involved don’t provide much incentive to potential consolidators, said one of the CLO managers.

Managers of collateralized loan obligations sell senior and junior tranches of repackaged leveraged loans to investors. The CLOs are structured so the value of the underlying loan portfolio comfortably exceeds the size of the investment vehicle. Over-collateralisation (OC) tests typically require underlying assets to be worth 25%-30% more than the fund’s par value.

Four European CLOs are now failing their senior OC tests, up from just one last month, according to a Morgan Stanley research report. More than half of US CLOs are now in breach of their junior OC tests, according to the report.

Breach the OC test and the income and principal streams from the underlying portfolio stop reaching the lowest tranches in the CLO, and once that happens, junior noteholders no longer pay fees to the CLO manager. This is because most CLOs operate according to a cashflow waterfall, paying holders of AAA-rated debt first before moving down the capital structure. Mezzanine holders are paid and, eventually, dividend payments are made to equity holders.

Markets have already priced in an effective wipeout of certain equity tranches, Rosedale CLO I’s tranches rated below B was quoted in single digits this month, for example, while it’s A piece was quoted in the high 20s and its AAA tranche was talked in the 60s, according to a trading source and a sellside analyst. The deal’s default rate has already hit 7.5% and it is violating all OC tests, the analyst said. Rosedale did not respond to requests for comment.

Breaches are being caused by a combination of corporate defaults, loans trading at deep discounts and rating downgrades. Under normal market conditions a CLO manager cares little about individual secondary loan prices because most assets are not marked to market.

But when a borrower defaults on a loan, or when a loan starts trading well below par, the CLO manager has to price the asset at the lower of the market value or the assumed recovery value. CLO funds also have limits on how much CCC-rated risk they can hold, and once these ‘buckets’ have been filled they must be re-appraised, too.

After a year and a half of rating downgrades and sharp falls in leveraged loan prices, many CLO managers have renegotiated their OC tests downwards. Tests have typically been reset to ensure collateral values remain above 115%-120% of the CLO’s par value, said one of the CLO managers and one of the distressed-debt investors.

In many cases this has not been enough. “I can say with very strong probability that around 90% of European CLOs have now breached their OC tests,” claimed the same investor.

Survival mode Anecdotal evidence from noteholders suggests there have been many more breaches of OC tests than market participants are aware of, said the CLO manager. As a result, many fund managers are now only receiving fees from senior investors. “The cutting off of junior fees is the biggest issue for managers at the moment. Senior fees are enough to maintain a skeleton staff and keep the lights on, but not much else,” the CLO manager continued.

CLO funds that are part of a bigger organisation may survive longer, but most are poorly equipped to cope with rising numbers of debt defaults in an economic downturn, said a second distressed debt investor. “[CLOs] have been called a zombie asset class; the business model has ceased to work, and some funds face a slow, lingering death,” he added.

Several funds looking for breathing space have begun renegotiating the terms of their CCC buckets and deep-discount language with their investors. Others have explored the possibility of selling their portfolios to stronger managers, the sources familiar said.

“Most managers will balk at the idea, but some may eventually consider taking a replacement-manager role involving some form of fee sharing,” the second CLO manager commented. But for now, the economics of taking over busted deals aren’t attractive enough to bring new managers out of the woodwork, he said.

CLO managers can limp along after cutting off cash payments to equity holders, if costs can be serviced from fees generated by the senior tranches. “This isn’t particularly lucrative and many have been looking for alternative strategies such as setting up un-leveraged recovery funds,” the manager continued.

The CLO sector is ripe for consolidation, according to market participants. It will be difficult for managers with just one or two funds to survive, but the older and more established managers benefit from economies of scale, noted one former CLO employee.

But while scale reduces operating cost, the 15bps management fees most deals pay aren’t enough to offset for the heavy lifting and active management of defaulted portfolios, said the CLO manager.

The final twist of the knife could come when the value of a CLO’s underlying collateral reaches 100% of the investment vehicle’s value, triggering an event of default. Then the future of the CLO fund rests in the hands of its noteholders.

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