and a further diversified assets portfolio (subject to various tests and limitations to prevent high concentration or overexposure to certain sectors, for example).
The unique features, lifecycle and advantages of CLOs Whilst syndication and securitisation reduce lenders’ risk exposures, the issuance of a CLO provides investors with exposure to the underlying pool of corporate loans, enabling them to select securities within the CLO structure that match a risk–reward level of their own choosing. Two key features of CLOs that distinguish
them from other types of securitisations include the creation and lifecycle of the CLO, and the involvement of a CLO manager in actively managing the CLO.
Lifecycle and structure of a CLO A CLO manager establishes an SPV, and then creates a capital structure comprising various tranches, ranging from debt tranches rated AAA down to BB, with the sole equity tranche sitting below this (see Figure 1). Having raised capital from investors,
the CLO manager then participates in syndications, carefully researching and
Figure 1: Typical CLO structure Issuance proceeds Issuance proceeds
Portfolio of assets/loans
Special purpose vehicle/issuer
Noteholders/Investors AAA tranche
AA tranche
Principal and
interest from assets
Principal and
interest from assets
A tranche BBB tranche BB tranche Equity tranche
buying tranches of assets that match the risk–return expectations of their investors, known as the ‘warehouse period’. The ‘ramp-up period’ sees the CLO manager buy further assets using the issuance proceeds. The subsequent ‘reinvestment period’ sees the CLO manager trade assets (active management being a key distinguishing feature of this asset class, and is examined directly below), and the ‘post-reinvestment period’ or ‘amortisation period’ sees the CLO manager pay down the outstanding notes. Throughout the lifecycle of the CLO, interest and capital repayments received from the asset’s underlying obligors are then used to pay the CLO managers’ investors in line with the structure’s cash flow waterfall.
Role of the CLO manager Most securitised products are pooled by investment managers at two extremes, ranging from a static portfolio to a dynamic portfolio, the latter seeing new assets added to the portfolio only when other assets have had their principals redeemed. CLOs sit in the middle of this spectrum: their active management helps maintain (and can improve) the yield of the portfolio of loans within the CLO. The
CLO manager will mitigate any risk to the overall structure by continually performing various coverage tests on the portfolio. This crucial mechanism allows the manager to identify and correct any deterioration to the collateral. If the coverage tests are not meeting the necessary requirements, cash flows will be redirected from the lowest debt and equity-tranche holders to the more senior holders within the capital stack. While the CLO manager will decide which trades to make, these will be undertaken by the collateral administrator.
Role of the collateral administrator and trustee The role of the collateral administrator and the role of the trustee are typically carried out by the same firm. This is usually a large commercial bank like Deutsche Bank. The role of the trustee is to represent the noteholders in the transaction and to hold certain issuer covenants and the security package (for example, the accounts and loans) for the noteholders’ benefit. Should there be an event of default, the trustee can take control over the assets and bank accounts to protect the noteholder interests. If the CLO manager wants to change the terms of the CLO, then the trustee is there to represent the noteholders’ interests. The role of the collateral administrator is vital to the day-to-day running of the CLO. It books and settles trades and acts as a check/balance on the manager’s obligations to act in accordance with the governing CLO documentation. It obtains valuations of the underlying assets, calculates, and performs compliance tests including performance and hypothetical trade testing, administers the bank accounts, makes payments and issues monthly investor and interest payment date reports on the underlying assets. It will work closely with the CLO manager to make certain the CLO has been managed according to the underlying documentation. It also provides an important role if the CLO hits an event of default, as it will switch from taking direction from the CLO manager to running the CLO at the request of the trustee.
Collateral manager
Collateral administrator
Trustee Source: Deutsche Bank
Benefits of CLOs Thanks to the continuing improvements made from CLOs 1.0 to 3.0, CLOs today provide investors with several advantages. They can offer higher returns (over the long-term) than other corporate debt types and can do so on a relative risk basis. The risk–reward balance is particularly favourable given the higher tranches in the CLO capital stack are typically over-collateralised, and
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