COLLATERALISED LOANS
today have both more stringent collateral eligibility requirements and higher levels of subordination. Higher subordination provides credit enhancement (that is, more protection should coverage tests or other performance tests not be met) to holders of senior debt tranches, for example by redirecting cash from debt tranches and equity. The active management of CLOs
allows (subject to the specified and fixed ‘reinvestment period’ and factors such as the prepayment of loans) trades to be made to further protect the portfolio from losses and/or enhance returns. The final returns of a CLO for investors are therefore impacted by the skill of the CLO manager at every stage of the lifecycle, from structuring, analysis and selection of the credits, as well as in the active management of the portfolio. Even here, structural improvements brought in by CLO 2.0 have been made that enable the upside of active management while also providing safeguards, such as shorter call periods and shorter reinvestment periods.
Long-term capital in a vast (and growing) market These structural protections have pulled new investors into the asset class, while regulatory protections (such as the demise of proprietary trading by investment banks) have pushed old categories of investors out of the asset class. The result is that the pre-financial crisis ‘hot money’ that could be found investing in CLOs has disappeared, replaced by a return of strong and stable investors with longer-term horizons, such as pension funds, insurance companies, private equity houses and family offices. CLO issuance, on the back of record levels
of leveraged lending – hit record highs in 2021 in both the EU and the US (see Figures 2 and 3).
Regulation Among the key regulations governing CLOs are:
• In the US, the Dodd-Frank Act (which implemented the Volcker Rule)
• In the EU, the Capital Requirements Regulation, the Securitisation Regulation, and the Alternative Investment Fund Managers Directive
It is worth noting that, although the UK has left the EU, its own regime closely follows that of the EU, which is becoming the global standard. These involve aspects such as whether high-yield bonds can be included, and how (and how much) risk should be
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Figure 2: Annual EU CLO issuance Amount issued 45 30 15 0 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Source: Deutsche Bank Research Number of deals
120 100 80 60 40
20 0
Figure 3: Annual US CLO issuance Amount issued
200 150 100 50 0
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Source: Deutsche Bank Research Number of deals
400 300 200 100 0
retained by lenders and CLO managers (so-called risk retention, the compromise reached being 5%, albeit with increased reporting requirements). Such reporting initiatives include those aspects of the ‘Simple, Transparent and Standardised’ (STS) criteria within the EU’s Securitisation Regulation which are applicable to CLOs.
ESG On the subject of taxonomy challenges, from a somewhat slow start (the first CLO incorporating ‘ESG’ principles launched in 2018), ESG CLOs have become a very hot topic. A study by ratings agency Moody’s assessed that 85% of all new CLOs issued in Europe in 2020 and 2021 incorporated, explicitly or implicitly, sustainability factors. ESG definitions for investment purposes continue to evolve, although efforts are being made to standardise this through the EU Taxonomy Regulation, for example. This moving picture obviously also affects what is
deemed an ESG-compliant approach to CLO investment itself, ranging from ‘light green’ CLO products which simply use industry- based negative screening at one end, through to ‘dark green’ CLOs at the other, which have sustainable investment as their core objective.
Proven resilience The CLO structure has proven itself having weathered the global financial crisis (GFC), and two subsequent down-cycles (if one factors in commodities and oil). Bar a slight pause in March 2021, as everyone tried to get their bearings, Covid caused barely a blip in the market’s demand, supply or functioning. While the market took a couple of years to recover from the GFC, it only took a couple of months to bounce back from Covid. Each such challenge, from 2008 to 2021, has served to help tighten up the standardisation of CLO documents, creating a virtuous cycle which gives participants further comfort in the investment structure and market.
75
USD bn
Eur bn
No of deals
No of deals
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