Loyens & Loeff’s Siobhan McCarthy, Anne-Marie Nicolas and Vassiliyan Zanev on the collateralised loan obligation market in Luxembourg
The global collateralised loan obligation (CLO) market is significantly more developed in the US than in Europe. The European CLO market has increased in recent years and the volume of actively managed CLOs in Luxembourg is expected to grow due to the legal certainty granted by the Law of 25 February 2022. This law amended the Luxembourg law of 22 March 2004 on securitisation (the Securitisation Law) which now allows active management of debt assets held by Luxembourg securitisation vehicles governed by the Securitisation Law (also referred to as securitisation vehicles or SVs).
CLOs are a form of securitisation where the underlying receivables are certain categories of loans and bonds. A CLO transaction usually involves an orphan company (known as a special purpose vehicle or SPV) acquiring a portfolio of financial assets consisting of loans – and, in some cases, bonds – and issuing newly created structured finance instruments (being debt securities in the form of bonds or notes and often referred to as CLO securities) to investors. The CLO securities, which are divided into several classes or tranches of varying size, credit rating and priority ranking, are secured over the portfolio of financial assets the SPV previously acquired.1
CLOs are among the largest holders of leveraged loans. They are tranched securitisations, meaning that they invest in risky pools of leveraged loans using funds raised by issuing notes, or tranches, with different risk profiles.2
Because of their investment profile, CLOs remain largely passive investors in the secondary market. As the importance of CLOs increases, it is interesting to analyse their particularities in the distressed debt scenario following the Covid-19 pandemic.
1. CLO constraints in a post-Covid-19 era
The economic shock caused by the Covid-19 pandemic has sent many borrowers in search of liquidity and ways to restructure their debt. CLO managers face, however, some constraints that keep them from participating in restructuring transactions and affect recovery rates. More specifically, CLO managers are bound by certain restrictions in the CLO founding documents.
Restrictions in the CLO documentation
First, in order to mitigate overall risk and to provide consistent returns, CLO indentures usually include a variety of restrictions regarding the type of loans that the CLO can hold. These restrictions can range from industry and borrower concentration limits to coverage-ratio tests, limits on the amount of lower-rated debt in the portfolio and restrictions on acquiring and holding equity interests3. A good example of how limitations in the CLO documents can negatively affect a restructuring is seen with Deluxe Entertainment.
Deluxe Entertainment attempted to pursue a stapled, out-of-court, 24 hours prepack to overcome the financial struggles it was undergoing in 2019. As the consensual plan progressed, Standard & Poor’s downgraded the credit rating of the debtor’s term loan to CCC. Back at that time, the debtor’s liabilities included a loan held by several CLOs and, given the restrictions in some of the CLOs documents, certain of the CLOs that were willing to finance the debtor’s prepack were no longer able to do so (presumably because, as is the case with many CLOs, they were not allowed to hold in their portfolios more than 7.5% of CCC-rated debt). As a result, Deluxe Entertainment was forced to pivot towards a more expensive and longer pre-packaged solution.4
Some CLOs have also made exceptions to their investment guidelines to allow direct lending – including rescue or additional liquidity financings – as protective investments to preserve existing portfolio investments that were not expected to default when acquired. A CLO can participate in loan workouts, including additional liquidity, in order to protect an existing investment that has become distressed. Like the bankruptcy-exchange exceptions, lending to protect value is also subject to restrictions to prevent the portfolio from being diluted by lower-rated debt.
To overcome the constraints in the CLO documents and play safe regarding the tax exemption rules, CLO managers are starting to include in the CLO indentures provisions allowing them to purchase workout-related assets. These assets, which can only be purchased in order to improve recovery prospects for currently held distressed loans, are commonly referred to as ‘loss mitigation loans’ or ‘workout loans’.5
The introduction of loss mitigation loans or workout loans provisions give rise to new discussions such as how the loans are treated in the CLO coverage tests and portfolio tests or which cashflows (interest and principal) are used for new assets. As the new potential jurisdiction of choice for CLO transactions, Luxembourg will play an important role in these discussions, significantly contributing to the update of the CLO playbook.
2. Luxembourg as a new jurisdiction of choice for European CLOs?
Whereas Ireland has historically been the European hub for CLOs, the Securitisation Law has increased Luxembourg’s attractiveness to the CLO market now that it allows active management of debt securities, debt financial instruments and receivables provided that the SV is not financed by issues of financial instruments to the public. For the purpose of the amended Securitisation Law, an issuance of financial instruments will be deemed to be made to the public where the issuance (i) is not made to professional clients, as such term is defined in article 1(5) of the Luxembourg law of 5 April 1993 on the financial sector, as amended (which corresponds to the definition of professional clients for MiFID II purposes), (ii) relates to financial instruments having denominations of less than €100,000 and (iii) is not made by way of private placement.
Securitisation activities in Luxembourg could, until now, only be carried out passively by grouping together debts and receivables acquired in a portfolio and managing them pursuant to a ‘buy and hold’ principle.
The new article 61 of the Securitisation Law has been introduced to explicitly authorise the active management of debt securities, debt financial instruments and receivables securitised by the SV. Due to an increasingly expanded practice, it was appropriate to clarify in the Securitisation Law that it is possible for a securitisation vehicle to manage certain securitised assets in the limits set by the new article 61. The option of active management is therefore possible for a basket of risks, made up of debt securities, debt financial instruments or claims but is limited for SVs which are not financed themselves by issues of financial instruments to the public.
CLOs can be broken down into two types:
- Actively managed: this type of CLO aims to achieve a rate of return on the SPV’s assets (the CLO portfolio) which is higher than the cost of servicing the debt on its liabilities (the CLO securities).
- Not actively managed: The underlying portfolio remains broadly the same for CLOs that are not actively managed. The purpose of securitising these CLOs is mainly to remove assets from an originator’s balance sheet to achieve regulatory capital relief against its loan book.
Given that the previous version of the Securitisation Law did not permit active management, the vast majority of CLO securitisation transactions in Luxembourg were ‘balance sheet’ CLOs.
Active management is now being allowed for all debt portfolios providing that the financial instruments being issued by the SV are not offered to the public. This means that SVs will no longer be bound to the ‘buy and hold’ CLO strategy. They will be authorised to make active investing decisions on the assets in order to adapt to market developments. This will be performed by the SV itself or by an appointed portfolio manager.
Another advantage of Luxembourg is that its SPVs typically report in Lux GAAP and not IFRS, which is required in other jurisdictions and can be pricier. This might weigh in where clients are looking for simpler and less costly reporting models.
Luxembourg-based private equity firms
For private equity companies located in Luxembourg there are additional opportunities. Many private equity houses have active debt funds in Luxembourg, but until now have had to base their CLO activity elsewhere. With the Securitisation Law now amended, it may be possible to consolidate their activities by relocating the portfolio management of CLOs currently based abroad6. Using an actively managed Luxembourg SV able to compartmentalise senior tranches, unitranche and mezz debt could save on management and administration costs and bring more management efficiency.
As well as enhancing the environment for CLOs, the changes in the law also raise new opportunities for refinancing in Luxembourg – pursuant to the new Securitisation Law, financial instruments such as loans can be used for refinancings whereas the law previously required a security issuance by the SV. The replacement of refinancing by financial instruments instead of securities gives far more flexibility to the Luxembourg market, plus savings in transaction costs and time.7
Finally, it will now be possible for banks to participate in Luxembourg securitisations by making direct loans. This means that they will be in a position to intervene as investors in a transaction as well as lenders.8
Special thank you to Elvira Manzanedo Delgado who contributed to this article
Partner, Banking & Finance
Partner, Investment management
- Definition of CLO from Thomson Reuters Practical Law, updated in 2022. Available at https://content.next.westlaw.com/7-385-1862?__lrTS=20200912150358348&transitionType=Default&contextData=(sc.Default)&firstPage=true
- Are CLO investors underestimating tail risk in European markets? Sirio Aramonte Karamfil Todorov and Kristin Detering, BIS Quarterly Review, 19 September 2022: Are CLO investors underestimating tail risk in European markets? (bis.org)
- Norton, J.; Pak, S.; Rapisardi. JJ.; Baxter. TW.; Taylor. J and Logenbach. AJ. (2020). CLO Issues in Workouts and Debt Restructurings, O’Melveny & Myers. Available at https://www.omm.com/resources/alerts-and-publications/alerts/clo-issues-in-workouts-and-debt-restructurings/
- Indelicato, V. and Theodoridis, C. (2019). CLOs: A New Frontier for Distressed Investors. Proskauer Rose LLP. Available at https://www.proskauer.com/pub/clos-a-new-frontier-for-distressed-investors
- Stein, C. and Azzollini, P. (2021) CLOs and the Changing Landscape after COVID-19. ICLG. Available at https://iclg.com/practice-areas/securitisation-laws-and-regulations/1-clos-and-the-changing-landscape-after-covid-19
- New Luxembourg CLO law brings PE and private debt opportunities, Josephine Shillito, published on 10.02.2022; Delano: New Luxembourg CLO law brings PE and private debt opportunities | Delano News.