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Key Issues in the CLO Market Today Moderator: Meredith Coffey, LSTA Panelists: Suraj Bhatia, Sumitomo Mitsui Wynne Comer, BAML Paul Hatfield, Alcentra Asif Khan, Mitsubishi UFJ Rachel Russell, Morgan Stanley Topics State of the CLO market today How CLOs are responding to the changing regulatory environment Outlook for the asset class State of the CLO Market Today CLOs Have Been A Success Story CLOs saw strong 20-year performance US CLO issuance recovers 120 100 80 US CLOs outstanding continue to grow 350 2009-2013 300 <=2008 250 200 150 100 Source: Moody’s, Thomson Reuters LPC Collateral Apr-15 Jan-15 Oct-14 Jul-14 Apr-14 Jan-14 Oct-13 CLOs performed very well during (and after) the Financial Crisis U.S. CLO issuance and outstandings have grown And this is a good thing! CLOs provide long-term financing to U.S. companies and stabilize the secondary loan market Jul-13 Apr-13 0 Jan-13 50 Oct-12 2014 2013 2012 2011 2010 2009 2008 0 2007 20 >=2014 400 Jul-12 40 CLOs outstanding ($Bils.) 450 60 2006 Impaired 1.1% 2005 Unimpaired 98.9% US CLO issuance ($Bils.) 140 CLO Asset Quality is Strong US CLO energy exposure is low US and European CLO CCC holdings decline 14% Energy Industrials 12% Materials 4% Technology S&P LSTA LLI US CLO 2.0 CDX HY (HY24) HY Cash CLO assets are strong Defaulted and CCC holdings are low Energy exposure is low Source: Bank of America Merrill Lynch, Morgan Stanley Dec-14 25% Jul-14 20% Feb-14 15% Sep-13 10% Apr-13 5% Nov-12 0% Dec-09 Transportation Jul-09 0% Feb-09 Consumer Staples Jun-12 US CLOs European CLOs 2% Utilities Jan-12 Healthcare 6% Aug-11 Media 8% Mar-11 Consumer Disc Oct-10 Telecom 10% May-10 CCC holdings (%) Financial CLO Spreads vs. Other Asset Classes AAA Relative Value 160 140 Spread (bps) 120 100 80 60 40 US CLO 2.0 Euro CLO 2.0 SFR Euro CLO 1.0 Private SLABS US CLO 1.0 IG Corp CMBS 3.0 Subprime Auto FFELP Credit Card UK RMBS FNMA CC 0 Prime Auto 20 Despite strong performance and quality collateral, CLO spreads remain wide relative to other asset classes Source: Bank of America Merrill Lynch CLO Liability Spreads are Narrowing US CLO spread ranges vs. end of April levels US CLO issuance and AAA spreads 16 Issuance Avg AAA spread* 12 10 spread in bps 170 160 145 US New Issue AAA 145 US New Issue AA 200 US New Issue A 290 US New Issue BBB 400 150 8 140 6 130 4 120 2 110 0 100 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 Thru 15 May US CLO issuance ($Bils) 14 180 160 200 260 300 360 410 475 650 US New Issue BB 610 CLO issuance was strong through April 2015 While strong issuance has supported AAA spreads, CLO liability spreads have narrowed recently *Excludes MM CLOs Source: Bank of America Merrill Lynch, Morgan Stanley 700 US CLO Asset-Liability Spread Narrows in Early 2015 CLO liability spreads vs. loan spreads 650 600 550 Spread (bps) 500 450 400 Loan Spreads All Loans (STM) 350 WA CLO Liability Spread 300 250 200 150 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 As US loan spreads tightened in early 2015, the asset-liability spread narrowed Source: Bank of America Merrill Lynch 0 12/31/2009 3/31/2010 6/30/2010 9/30/2010 12/31/2010 3/31/2011 6/30/2011 9/30/2011 12/31/2011 3/31/2012 6/30/2012 9/30/2012 12/31/2012 3/31/2013 6/30/2013 9/30/2013 12/31/2013 3/31/2014 6/30/2014 9/30/2014 12/31/2014 3/31/2015 Source: S&P Capital IQ/LCD 0% 0 Loan spreads/yields will see additional pressure from repricings Value of LIBOR floors may erode as interest rates rise 4/1/2015 3/1/2015 2/1/2015 1/1/2015 12/1/2014 11/1/2014 50 20% 10/1/2014 40% 9/1/2014 150 8/1/2014 100 60% 7/1/2014 Floor level 6/1/2014 200 80% 5/1/2014 Percent with floors 4/1/2014 100% 3/1/2014 Almost all loans have LIBOR floors (which are shrinking) 2/1/2014 250 Repricing volume ($Bils.) 300 1/1/2014 LIBOR floor (bps) Loan Spreads/Yields Under Continued Pressure Loan repricing activity returns in April 2015 40 35 30 25 20 15 10 5 US CLO Redemptions and Refinancings Accelerate Monthly US CLO Refinancing Volume 120 3.0 100 2.5 US CLO refi activity ($Bils.) 80 60 40 1.5 1.0 As loan yields narrow, arbitrage may be further reduced In turn, there could be more repricing or refinancing activity Source: S&P U.S. Structured Credit, S&P Capital IQ/LCD Apr-15 Mar-15 Jan-15 Dec-14 Nov-14 Oct-14 Sep-14 1Q2015 Aug-14 2014 Jul-14 2013 Jun-14 2012 Thru 15 May 2011 May-14 2010 Apr-14 2009 Mar-14 - Feb-14 0.5 20 0 2.0 Jan-14 Count of CLOs redeemed Annual Count of CLOs Redeemed How CLOs are Responding to the Changing Regulatory Environment The Volcker Rule: The Issues Banks are generally not permitted to “own” CLOs if the CLO has any non-loan investments Ownership applies to investment in CLO AAA or AA tranches if notes have ability to remove/replace CLO manager; other indicia of “ownership” may apply There is no grandfathering Almost all CLOs issued prior to the rule coming out (December 2013) originally had baskets for non-loan investments, and over half had at least one non-loan investment (like a HY bond) Banks were required to amend or divest non-compliant CLOs by mid-2015; however, the Fed extended the conformance period to mid-2017 for CLO notes owned by banks as of YE 2013 Approaches to Dealing with Volcker Rule Clear solutions SOTUS (Solely Outside the United States) Exemption “Volckerizing” amendments Sale of Notes Less clear solutions Waiving Removal Rights Seeking Forgiveness Penalties? Banks say that they simply must comply Risk Retention Rules Final risk retention rules require CLO managers (or a majority-owned affiliate thereof) to retain 5% of the CLO’s notes Forms of retention Vertical pro rata retention – 5% of the face value of each of the CLO notes Horizontal residual retention – equity in the amount of 5% of the fair value of CLO notes “L-shaped” retention – a combination of vertical and horizontal retention For a $500 million CLO, this would be $25 million, regardless of the form of retention Goes “live” on Dec. 24, 2016 (but managers are determining their compliance strategy now) Market is developing approaches like Capitalized Manager Vehicles or Majority Owned Affiliates Term financing may be available There are points of clarification that will be necessary Risk Retention & Refinancings: US CLO Non-call and Reinvestment Periods Shorten, then Lengthen in 2015 Non-calls, reinvestment periods adapt to changing markets Non-Call, Reinvestment period (yrs) 6 5 Non call Reinvestment 4 3 2 1 0 11/22/2013 3/2/2014 6/10/2014 9/18/2014 12/27/2014 4/6/2015 7/15/2015 CLO issuance date In 2014, most non-call periods were two years and most reinvestment periods were four years In 2015, uncertainty around the status of refinancings created diverse non-call periods Recently, some non-call and reinvestment periods have become longer Source: S&P Capital IQ/LCD Refinancings: An Example of Needed Clarification The SEC has indicated that CLOs issued prior to December 24, 2014 may be refinanced after December 24, 2016 without requiring risk retention as long as the only thing that changes is the coupon on the refinanced note. (For example, a CLO cannot be Volckerized during this refinancing.) CLOs issued after December 24, 2014 will be subject to risk retention if the notes are refinanced after December 24, 2016. CLO manager would likely only need to purchase and retain 5% of the new notes that are issued in conjunction with the refinancing, not 5% of the full CLO capital structure. What the 2.0 Manager Universe Looks Like Today 2.0 CLO AUM by manager type 40 Bank, $19bn, 7% 35 15 10 CLOs are managed by a diverse set of asset managers A number of CLO managers have less than $1 billion of 2.0 CLO AUM (though they may have AUM in other forms) Source: BofA Merrill Lynch Global Research, Intex, Fitch >$10bn $8-9bn $7-8bn $9-10bn AUM $6-7bn $5-6bn 0 $4-5bn 5 $3-4bn Alternative, $140bn, 47% 20 $2-3bn Diversified, $57bn, 19% 25 $1-2bn Boutique, $32bn, 11% 30 <=$1bn BDC, $11bn, 4% Count of managers Insurance, $15bn, 5% PE, $21bn, 7% Distribution of CLO 2.0 AUM Possible Risk Retention Approaches: Direct Manager Investment Third Party Investors $ CLO Manager Retention • Third party investors invest directly in the CLO manager • Manager invests in and funds the required retention amount Source: BofA Merrill Lynch Global Research, Dechert Possible Risk Retention Approaches: Majority Owned Affiliate (MOA) Third Party Investors $ Majority-Owned Affiliate (MOA) CLO Manager $ Retention Manager would continue to be the collateral manager and receive management fees while the retention pieces and associated cashflow would be held by the MOA To qualify as a majority holder, the manager must control the major economic decisions of the MOA and hold a controlling financial interest as determined under GAAP Source: BofA Merrill Lynch Global Research, Dechert Possible Risk Retention Approaches: Capitalized Manager Vehicle (CMV) Capitalized Manager Vehicle (CMV) CLO Manager Retention Specified Fee $ Staffing & Credit Services Third Party Investors Service Provider • Involves creating a new CLO manager which would manage the CLOs and hold the retention • Could be capitalized by equity or debt and equity with 3rd party investors investing into the CMV • Has to be self-managed and staff could be employed by the CMV or be obtained through a staff and servicing agreement • Substantive decision-making power would have to reside at the CMV Source: BofA Merrill Lynch Global Research, Dechert What are Managers’ Plans? How likely are you to issue new U.S. CLOs in the next two years? (Responses: 52) Very likely Quite likely Somewhat likely Not likely at all 0 20 40 60 80 100 (%) How do you plan to meet U.S. risk retention requirements? (Responses: 52) Horizontal interests Vertical interests L-shaped interests Eligible horizontal cash reserve accounts Varying on a deal-by-dealbasis 0 5 10 15 20 25 30 35 40 Note: Responses do not add to 100% as managers were allowed to indicate all options under consideration. Source: Fitch Ratings 45 50 55 (%) What are Managers’ Plans? What type of entity do you plan to use to achieve U.S. risk retention? (Responses: 51) Majority owned affiliate of manager Existing manager as sponsor New manager as sponsor (U.S. CLOs only) New manager as sponsor (U.S. and European CLOs) Varying on a deal-by-deal basis 0 5 10 15 20 Note: Responses do not add to 100% as managers were allowed to indicate all options under consideration. Source: Fitch Ratings 25 30 35 40 45 (%) Outlook for the Asset Class Outlook for the CLO Market Near term Last year’s US CLO issuance was $124 billion; what will it be in 2015? US CLO outstandings currently are $400 billion; what will they be at year-end 2015? CLO AAA spreads are in the high LIB+140s; where will CLO AAA spreads be at year-end 2015? Longer-term Will Risk Retention drive consolidation among US CLO managers? More than 100 managers issued US CLOs in 2014; how many will issue CLOs in 2017? Will Risk Retention reduce the number of CLOs that each remaining manager issues? Will the US and European Risk Retention Rules be harmonized? What will the 2018 CLO market look like?