Mechanisms to allow collateralized loan obligation vehicles to participate in distressed rescue financings are making in-roads into the European market, potentially helping managers to boost recoveries as default rates climbed above 3% this year.

At least two European deals to have priced in recent weeks in the European CLO market afford managers greater flexibility to participate in potential new financing initiatives by a borrower in default, provided this is an existing borrower within the CLO collateral pool.

This new feature, which has been imported recently from the U.S., could go some way to redress the balance of power at the negotiating table with distressed debt funds, which typically have more dry powder to pro-actively offer new money to firms in distress.

The 12-month default rate by issuer count on the European Leveraged Loan Index climbed to 3.33% at the end of June, the highest since November 2016, and up from 1.38% in January 2020.

In a debt restructuring situation where a business has a liquidity need, funds that own the existing debt typically offer new money — for example, in the form of a super-senior loan — to the company in distress. In the past, CLO issuers had few options through which to participate in such new-money tranches, missing out on potentially lucrative yields on the new debt pieces.

This situation has sometimes led to forced selling of distressed loan assets by CLO managers to distressed funds, thereby putting them in the driving seat.

"Until recently, there has been very limited ability for CLOs to inject new money in a distressed situation, whether in the form of debt or equity, with limited concepts around DIP financing in the U.S. or corporate rescue loans in Europe, putting CLO managers at a disadvantage to, for example, hedge funds and specialist distressed debt funds," said Franz Ranero, partner at Allen & Overy. "Yet some of these constraints have now been loosened as managers are given specific flexibility to use interest proceeds and excess principal proceeds to inject into an existing borrowing group."

Specifically, the new CLO documentation provisions are clauses such as "loss mitigation loans" or "workout obligations," which allow managers to bypass eligibility criteria to acquire distressed assets in connection with an existing borrowing entity.

For example, the €343.92 million Deer Park CLO for Blackstone/GSO Debt Funds Management Europe, which priced in August, includes a loss mitigation loan provision, allowing the manager to purchase assets of an existing collateral obligation in connection with insolvency, bankruptcy, reorganization, default, workout or restructuring. The cumulative aggregate outstanding principal balance of loss mitigation loans is capped at 10% of target par in this instance.

The €391.8 million RRME 4 CLO for Redding Ridge, which priced at the end of July, contains language that allows the manager to purchase workout obligations. This provides the issuer with the ability to invest in debt and non-debt assets of an existing collateral obligation offered in connection with a workout, restructuring, or bankruptcy of such an obligation, S&P Global Ratings wrote Aug. 27.

"The purpose of workout obligations is to maximize recovery value prospects of the related collateral obligation," the report said. Workout obligations are capped at 7% using principal proceeds and 10% if also using interest proceeds, according to the RRME 4 CLO documentation.

CLO investors have welcomed the new provisions. "I think it is a quite interesting — and positive — addendum, as it gives the CLO managers some flexibility, which has been needed, exemplified under the early stages of the COVID-19 shock," said one CLO note investor.

There are a handful of other CLOs in which the new provisions will be embedded going forward. "I think this will become a standard market mechanism as it is in everyone's interest across the capital stack to give the manager more flexibility in this way," adds Allen & Overy's Ranero.

S&P Global Ratings also views the arrival of the provisions as positive, but expresses caution in relation to potential par erosion. "Whilst the objective is positive, it can also lead to par erosion, as additional funds will be placed with an entity that is under distress or in default. This may cause greater volatility in our ratings if the positive effect of such loans does not materialize," said Rebecca Mun, structured finance credit analyst at S&P Global Ratings. "In our view, the restrictions on the use of proceeds and the presence of a bucket for such loss mitigation loans helps to mitigate the risk."

From US to Europe
As noted, the new features have made in-roads into Europe from the U.S., where provisions such as "defaulted exchanges," "workout loans," "restructured loans" and "specified equity securities" have appeared on a number of recent transactions, to allow managers to be involved in a workout or restructuring to improve recoveries.

Analysts at Wells Fargo Securities wrote on Aug. 31 in a research report titled "The CLO Salmagundi: What's Up, Docs?" that CLO managers and equity investors have looked to allow CLOs more flexibility in workouts, with a negotiation around which cashflows are used for new assets, and how the assets are treated in the CLO coverage tests and portfolio tests.

"We believe the tradeoff — more flexibility, but equity cashflows are used and assets don't get credit in coverage tests — is fair for noteholders," said the Wells Fargo report, which added that "2020 vintage CLOs will have better recovery outcomes aided by the new provisions."