Ares Management's latest collateralized loan obligation includes a wrinkle in its equity piece designed to entice investors who are restricted to buying rated CDO paper. The deal was priced last week and the equity piece is expected to be rated and classified as a triple-B tranche. Usually the equity piece is unrated and does not guarantee a fixed coupon. But the $50 million Class C notes of the Ares VII deal will be rated to the return of principal and a rated coupon, thereby giving the equity tranche the interest component of a bond even though the notes are truly equity in that they are in the first loss position of the capital structure, explained Elizabeth Russotto, senior director at Fitch Ratings. Deutsche Bank was the lead underwriter of the deal. Officials at Deutsche Bank and Ares did not return repeated calls.
The equity rating, which is commonplace in the synthetic market, was requested in order to enable some investors to participate, as many buyers are subject to rating requirements on structured investments, she explained. "Rating equity is becoming more common in cash flow structures," she said, adding, "as it improves the marketability of the deal." Despite having a fixed coupon --LIBOR plus 175 basis points according to Banc of America Securities research -- there is the possibility for higher returns from excess interest on the Class C notes, providing more typical equity upside. Sources said the investors in question were probably German, though this could not be confirmed.
This move is unusual as typically for the first loss piece to be rated BBB the underlying collateral has to be of very high quality, said Russell Hurst, director of CDO Research at Bank One. But if there is enough excess spread then it is possible, he said. By receiving an off-market coupon, there should be enough excess spread to support this, he added.
The structure is the same as a traditional cash-flow CLO, but the equity tranche may be rated because there is good recovery on the loan assets and sufficient excess interest to cover any losses on the portfolio, Russotto said. The equity rating on the cash-flow structure is similar to that of the rating of the synthetic Mincs transaction, she said. Another feature to the Ares VII transaction that benefits the entire capital structure, including the equity over time is the reinvestment diversion tests that trigger the purchase of additional collateral in the event that there is deterioration in the credit quality of the portfolio. The additional collateral serves to improve the economics of the transaction by providing more excess spread and better collateral coverage, she explained.