Until recently, the European CLO market could make a proud boast. There had been no impairments to any CLO liability tranches since the 2008 global financial crisis (GFC).
Earlier this month, Bain Capital Credit recorded the first impairment since the GFC on the ‘F’ notes of its Bain Capital Euro CLO 2018-1 deal. The ‘F’ notes originally received a B- rating, but were later downgraded.
The quality of the CLO’s loan portfolio had deteriorated over time, meaning that the proceeds of calling the deal would not repay all its liabilities.
When calling the deal, Bain agreed with investors to lower the outstanding principal amount on the 'F' notes. Of the notes’ total par value of €11.2m, noteholders received €7.4m.
The impairment on the Bain deal should be chastening for CLO mezzanine investors. For a long time, it appeared that these investors could have their cake and eat it.
They were paid spreads of 800bp or 900bp for investing in single-B rated notes that were, seemingly, never impaired.
But defaults and par losses in CLO portfolios can easily cause the single-Bs to go belly up. Single-Bs sit at the bottom of the CLO liability capital stack with only 6.5% credit enhancement on average.
As the Bain deal shows, the interests of CLO equity and liability investors are not always aligned.
Third-party investors, not Bain, held a majority of the equity in the Bain CLO and controlled whether it was reset or called.
The deal was priced in 2018 with exceptionally tight spreads and the equity investors had little incentive ever to reset the transaction and keep noteholders whole.
The low spreads would have produced an attractive arbitrage between the CLO’s asset and liability spreads. It is this arbitrage that funds cash-on-cash distributions to equity investors.
Distributions can continue while the health of a CLO’s portfolio inevitably worsens without fresh equity to replace distressed credits, making liability impairments more likely.
Even if equity investors receive nothing from calling a deal, providing further equity to reset the transaction may be unappealing.
CLO mezzanine investors need to be watchful of the credit quality of the loans managers hold. They are paid juicy spreads because CLO liabilities are exposed to very real risks.