May 4, 2022 - Few people have a really good grasp of exactly how CLOs work – and even fewer of those people are employed by the SEC. To address this gap, the LSTA felt it would be helpful to include various educational materials with its comment letter on the SEC’s Proposed Rule on Private Fund Disclosure (“Proposed Rule”). In the letter’s exhibits, we attached a CLO White Paper (p 26), an illustrative diagram that demonstrates the key parties in a CLO (p 34), a redacted trustee report (p 80) and a redacted quarterly payment report (p 325). (We deciphered another exhibit, a Regulatory Impact Analysis, previously.)
CLOs are widely misunderstood investment vehicles, often thought – at least by some regulators and lawmakers – to be opaque, risky and under policed. In reality, governed by a clear and intersecting set of performance rules and disclosure requirements, CLOs are one of the most transparent investment vehicles available to institutional investors. Thanks in large part to these requirements – and the transparency and performance of their underlying leveraged loan assets – CLOs have outperformed equivalently-rated corporate bonds for nearly 30 years. Notably, their performance held up through both the global financial crisis of 2008-2009 and the Covid-19 pandemic of 2020-2021. In both cases, CLOs came through with nearly no defaults. How did we tackle these nuanced issues for smart laypeople? In the white paper, the LSTA:
- Explained that leveraged loans are merely loans to U.S. companies that are rated below BBB-/Baa3 by the rating agencies. And, that’s not a small universe: in the past 40 years, 71% of the corporate entities rated by S&P were rated below BBB-.
- Detailed the structure of CLOs, explaining their assets (leveraged loans), their capitalization (8-15% equity and 85-92% debt) and how they fund long-term assets entirely with stable long-term liabilities.
- Explained the origination, structuring and sale of CLOs and discussed the different investors – such as banks, insurance companies and funds – and their different positions in CLOs. Countering the contention in the Proposed Rule, we observed that CLO investors are hardly powerless; they demand – and play – a material role in the construction and constraints of every CLO.
- Reviewed the checks and balances that go into every CLO, from the rating agency (that reviews the CLO and rates its debt securities at inception, and reviews and reports on CLO performance and rating changes throughout the life of the CLO) to the collateral administrator and trustee (who track and measure asset and cash flows in and out of the CLO) to the independent auditor (who separately recalculates and tests the work of the collateral administrator and trustee).
- Discussed the transparency fundamental to a CLO, focusing on the monthly and quarterly asset level reporting and the CLO performance tests.
- Analyzed the performance of CLOs through a nearly 30-year history. Importantly, there have just been a handful of defaults among the thousands of CLO securities that have been issued. This is a markedly better track record than the default rate of equivalently rated corporate debt.
While the Proposed Rule suggests that private fund advisers might be conflicted and might not disclose sufficient information to investors about investments, fees, expenses and performance, we refuted this with evidence. (At least for CLOs.) The LSTA diagrammed the key parties and their activities in a CLO (p 34). The diagram shows that CLO managers are just one party, albeit a very important one, in the CLO ecosystem. The collateral administrator acts as the CLO’s bookkeeper and generates the periodic reports for investors. The trustee maintains custody of the assets and remits interest and principal payments. The auditor runs the Agreed Upon Procedures (“AUP”) that are designed to ensure the CLO is appropriately allocating cash flows, meeting obligations in the indenture and providing accurate information to investors. Rating agencies rate the notes and usually the loans themselves. The CLO manager, meanwhile, is tasked with managing the collateral pool – and simply doesn’t have the ability to dictate the disclosure or valuation of the assets.
Finally, to underscore the transparency of CLOs, the LSTA also submitted a redacted monthly trustee report and payment date report. These reports illustrate the wealth of information on the CLO’s collateral and performance – as well as the interest and principal payments – that already are available to CLO investors. With all these checks and balances and disclosures, there simply isn’t an opportunity to take advantage of investors in ways the SEC alleges may happen with private funds.