U.S. collateralized loan obligations (CLOs) are seeing an increase in new indenture language that supplements (and perhaps complicates) the workout loan mechanics that have become commonplace in transaction documents. The updates mainly revolve around two restructuring strategies that have been used in the broadly syndicated loan market in recent years: uptier priming loan exchanges and asset drop-down transactions (the latter also known as collateral transfers). Both strategies fall under the broader category of liability management--a somewhat benign term that refers to the aggressive out-of-court restructurings undertaken by a small number of stressed companies in the leveraged loan market. These restructurings are often to the detriment of existing lenders, or a subset of existing lenders, including CLOs.

S&P Global Ratings believes the introduction of these concepts leads to two simple questions with complicated answers. Namely, what impact do the new terms and mechanics have on CLOs, and what changes to these restructurings (if any) led to the inclusion of these terms? In this report, we examine why CLOs are seeking flexibility to participate in workout loans. We also answer some frequently asked questions from investors around the various terminology and mechanics that are now prevalent and topical in the CLO market.

Frequently Asked Questions

What has changed with out-of-court restructurings?

Aggressive out-of-court restructurings have become more common in recent years as a small but increasing number of borrowers employ tactics that exploit generally loose and flexible loan document terms. Loan investors, including CLOs, have had limited success in their efforts to stem these restructurings, either through litigation that challenges completed transactions or attempts to tighten loan document terms to restrict future transactions. These types of restructurings, though still limited in number, can significantly weaken credit protections and recovery prospects for lenders who are unable to participate.

While most CLO investors seem to agree that taking defensive positions against aggressive out-of-court restructurings might be necessary under certain circumstances, they sometimes disagree on the types of guardrails that should be in place for CLO managers.

Why are CLO managers seeking flexibility to participate in aggressive out-of-court restructurings?

CLO managers feel strongly that they need the flexibility to partake in aggressive out-of-court restructurings to avoid incurring unnecessary losses. CLOs and other lenders who are unable to participate in new debt issuances from a restructuring obligor, whether via new monies or roll ups, run the risk of being left holding a loan that has lower value and diminished recovery prospects than it did before the restructuring.

Specifically, if a lender cannot participate in an asset drop-down transaction, it will lose access to certain collateral that was previously securing its position. And if the lender cannot participate in an uptier priming loan, its current position may become subordinated to the new debt and, often, to the previously pari passu lenders who participated in the restructuring transaction. In 2022, a single obligor used both strategies within a few months, illustrating the risks lenders may face (see "Envision Healthcare Corp.'s Two Major Restructurings In 100 Days," published Sept. 2, 2022).

Although structural mechanics provide significant protection to senior CLO tranches, the CLO is still exposed to the risks inherent with aggressive out-of-court restructurings. Diversification in CLO asset portfolios alleviates some of the hazard that the broader collateral pool faces. However, there is still the question of what, if anything, CLOs can do to further mitigate the consequences and potentially reduce the number of these instances in the leveraged loan market.

Do CLO investors benefit from managers having more flexibility to participate in these restructurings?

Yes, but it depends on what other guardrails are in place. In our analysis of prior restructurings, we noted that lenders who participate in uptier priming exchanges and asset drop-down transactions often have a more favorable outcome than those who are restricted from doing so.

We believe the flexibility to participate should largely focus on two things: defending existing positions to preserve overall portfolio quality and categorizing the proceeds from the new assets in a manner that ensures value remains with the CLO's secured debtholders. All investors should ultimately reap the benefits that come from these defensive actions, but it is important that the subordination on which CLO tranche ratings rely remains intact.

How do buckets affect workout asset flexibility in CLOs?

One risk mitigation method we often observe is the bucket approach, which limits the amount of new money a CLO can allocate to a restructuring borrower. Some investors prefer this method due to its simplicity and transparency, and because it limits the CLO's ability to use funds to a predetermined amount. However, if these buckets become full during periods of economic stress, the CLO may be exposed to the risk of being primed without the ability to defend its position by participating in new loan offering. As a result, the CLO could then end up on the wrong side of a zero-sum game (or perhaps multiple zero-sum games).

How does S&P Global Ratings analyze a CLO's ability to participate in workout-related assets?

We believe measuring workout assets as a percentage of target par can lack context and could restrict managers from engaging in defensive investing--even when past participation in restructuring transactions had proven to be successful. Our CLO methodology does not focus on bucketing exposure to workout related loans. Instead, it focuses on whether participating in a restructuring transaction will protect the CLO by improving the recovery prospects for existing debt (see "Global Methodology And Assumptions For CLOs And Corporate CDOs," published June 21, 2019). As a result, we believe the acquisition of higher quality workout-related assets or those that do not take funds away from the secured notes will not negatively affect the manager's ability to invest in future workout assets.

Broadly speaking, our approach contemplates:

• The source of the proceeds used to acquire the new workout-related asset;
• The underlying characteristics of that asset;
• Certain hurdles, the specifics of which depend on whether principal or interest proceeds are being utilized, being met.
• How the new attained asset will be carried in the transaction; and
• How the proceeds from the new asset will be disbursed to the CLO noteholders and whether the disbursement demonstrates that better recovery is the ultimate goal.

Regardless of our methodology, some investors continue to require that explicit bucket limitations are added to the indentures for new issue CLOs they invest in.

Are uptier priming loans and asset drop-down transactions new?

Uptier priming loans and asset drop-down transactions are not a new phenomenon. High-profile restructuring transactions have been using these strategies for the past five years, and most new U.S. CLOs have had the capacity to participate in workout-related assets since 2020 (see "A Closer Look At How Uptier Priming Loan Exchanges Leave Excluded Lenders Behind," published June 15, 2021). It is only recently new language has sprouted up that gives additional flexibility under these scenarios in U.S. CLO indentures.

Are uptier priming loans and asset drop-down transactions just new terms for workout loans?

Yes. Issuing new super-senior priming loans (uptier priming transactions) and engaging in collateral transfers (asset drop-down transactions) are two types of workout loan strategies used by distressed companies. Debt issued by an obligor undergoing this process would typically be classified as either a defaulted or credit risk obligation under the terms of a CLO indenture. Since most CLO indentures preclude adding defaulted or credit risk assets to the CLO, this classification would generally block any debt these companies offer from being purchased as a full collateral obligation and given par treatment in the transaction.

We believe the existing workout loan mechanics, which have strict hurdles and limitations for purchase and treatment, already grant CLOs additional flexibility to pursue uptier priming debt and drop-down assets under certain circumstances.

Are uptier priming loans a new category of asset in CLOs?

These new asset classifications are usually intended to be a subset of the existing terms (workout loans, collateral obligations, etc.) and, by extension, subject to the rules governing those terms. However, these classifications are often unclear in the initial draft of the transaction's governing documents, which can be problematic because they have significant consequences on the sources and uses of proceeds, hurdles, carrying values, and other aspects of the assets that the market has come to expect.

Assets in CLOs used to be effectively bifurcated. They were either a collateral obligation, which if performing received full par credit in the transaction, or an equity security, which received no credit. And there was a very distinct line between the two. Additional haircuts would then apply for certain subsets of collateral obligations, such as defaulted obligations, excess 'CCC' rated assets, discount obligations, etc. However, when workout and restructured loans were introduced, new categories of assets were created. Each was subject to its own rules regarding acquisition, carrying value, and use of proceeds. This still prevails today, but it's often unclear which category the new concepts of uptier priming loans and drop-down assets fall into.

What impact do the new uptier priming loan terms have on CLO indentures?

The actual impact of workout loan mechanics depends on the seniority of the CLO tranche in question, particularly the four key points highlighted below.

Carveouts in the collateral obligation definition.  CLOs have a history of including carveouts in the collateral obligation definition, and often for good reason. For example, without a carveout in a bankruptcy exchange, a defaulted obligation that is exchanged for another defaulted obligation would not be eligible to be treated as a defaulted obligation and given credit as such in the overcollateralization ratio. Instead, the asset would be treated as an equity security and receive no credit in the transaction, which might disincentivize CLO managers from making exchanges they deem beneficial to the CLO. This type of carveout is logical and results in the CLO indenture mechanics working as the transaction parties expect.

Recently, we have seen transactions where uptier priming loans are carved out of the clause that prohibits defaulted and/or credit risk obligations from being acquired as full collateral obligations. This is material because an asset that would otherwise have only been eligible for addition to the CLO portfolio under the rules for workout loans can now be acquired and treated as a normal defaulted obligation. As a result, the restrictions governing the source of the funds used to acquire workout loans would no longer apply, and the proceeds received from the new asset (the uptier priming loan) would be subject to different, and generally less stringent, recapture requirements.

Carveouts in the concentration limitations definition.  Concentration limitations have historically had carveouts that effectively increase the size of a bucket limit under certain circumstances. These have generally been limited to issues such as obligor or industry concentration limitations. However, uptier priming loans have been finding their way into new carveouts, and they often relate to what are arguably more meaningful limits, such as those for current pay obligations.

For example, consider a hypothetical 7.5% limit on current pay obligations. If there is a carveout for uptier priming loans, then the 7.5% threshold can effectively be exceeded. If the additional amount is capped at 5%, then the portfolio can now consist of up to 12.5% current pay obligations. If there is an open-ended carveout (i.e., one without an additional percentage limitation), then the entire portfolio could theoretically be current pay--as long as 92.5% of the assets are also considered uptier priming loan. While this is not a realistic scenario, it illustrates the point that carveouts can be used to bypass bucket limits.

Including uptier priming loans in the current pay concept.  Carveouts to the current pay obligation limit raises another important question on whether there is an overlap between uptier priming debt and current pay obligations. Classifying these assets as current pay has a similar effect as the carveout in the collateral obligation definition: it allows what would otherwise be a workout loan to be treated as a full collateral obligation. As a result, it also changes the rules around carrying value, acquisition, and the sources and uses of proceeds to acquire those assets.

An uptier priming loan is typically a new loan that is extended to certain lenders, which may include current senior secured loan holders (such as CLOs). In contrast, a current pay loan is generally a pre-existing obligation that continues to make obligated payments through a period of stress for the obligor, where any missed payments or distressed exchanges are limited to a more junior debt obligation from the obligor. In short, uptier priming loans do not fall into what the CLO market has traditionally considered current pay loans, especially when new money is being used to make the acquisition.

Uptier priming loans receiving DIP loan treatment.  Although there are some similarities between debtor-in-possession (DIP) and uptier priming loans, we don't view them as the same.

DIP financing is only available to companies that have filed for bankruptcy protection under Chapter 11 of the U.S. bankruptcy code. The DIP loans provided to these companies are generally used to support them through a reorganization plan. These loans are typically given priority over existing debt and are highly secured. There are also strict rules and oversight by the bankruptcy court, which adds another layer of protection to lenders.

Uptier priming loans are similar to DIP loans in that they are often given priority over existing debt. However, uptier priming loans lack the protections and oversight provided by the bankruptcy courts, and they don't need to adhere to the same set of rules and regulations. Empirical data on uptier priming loans is also limited compared to DIP loans. As a result of these differences, we do not apply our methodology on DIP loans to uptier priming loans.