The percentage of troubled loans in Collateralized Loan Obligations (CLOs) is growing and market participants need to be aware of how their deals address such loans. The treatment of troubled loans in CLO deal documents are varied and complex. This is particularly important considering recent market turbulence, and the potential for increased financial stress in leveraged credit.
In this article we discuss one of the more recent terms to emerge in CLO deal docs: Loss Mitigation Obligations (LMO). LMOs allow CLOs to advance new money (either from principal or interest proceeds or both) to maximize the recovery of defaulted Collateral Obligations.
This is the first of 3 articles deep diving LMOs and related terms. This first article is a high-level overview. Part 2 will deep-dive into how LMOs and related terms are treated in CLO OC Tests, and how the LMOs yields / proceeds are treated. Part 3 will introduce a proprietary scorecard that scores these terms based on the degree of "equity vs debt friendliness".
LMOs and their cousins, parents, and siblings
What are LMOs, and how do related terms fit into the picture? LMOs are flexible tools that allow CLOs to advance new money (either from principal or interest proceeds or both) to mitigate losses and protect the recovery value of collateral obligations.
According to law firm AO Shearman, LMOs came about, "as a last-ditch attempt to prevent CLOs being squeezed out where the particular requirements of a corporate rescue loan were not satisfied. The LMO is designed to be so broad that whatever terms are offered, a CLO should always be able to participate. Still, the sources of money they can use are restricted, often only to available interest and usually limited to a small percentage of the overall portfolio."
There are several ways to view the various terms used to describe LMOs. Semeris takes a functional approach and evaluates the terms based on the actual legal description in the deal documents.
Semeris views LMO assets as belonging in 3 distinct functional categories, and the defining characteristics of each category have been validated by Semeris analysts.
These three categories are:
- LMO: our baseline for defining LMOs
- QLMO: Qualifying LMO, higher quality asset
- ELMO: Equity LMO, lower grade, equity-like asset
To understand the actual impact of the deal docs on the CLO debt, we need to look beyond the defined terms and evaluate the critical defining characteristics.
Semeris terminology is built on the primary "LMO" category, which includes the following core concepts:
- Purchased using IP or PP
- Is meant to boost the recovery of a related Defaulted Obligation or Credit Risk Obligation
- Is a Debt Obligation
- Not received in Exchange
- Does not satisfy the Investment Criteria
- Can be redesignated as a "QLMO" if it meets Eligibility Criteria / Definition of Collateral Obligation with carveouts
- Can be redesignated as a "Collateral Obligation" if it meets Eligibility Criteria / Definition of Collateral Obligation without carveouts
Our second category, Qualifying LMO or "QLMO" must also meet the following:
- Satisfies the Eligibility Criteria / Definition of Collateral Obligation with carveouts (such carveouts are sometimes built into the Eligibility Criteria / Collateral Obligation definition itself, so one may at first glance incorrectly assume some QLMOs fully satisfy the Eligibility Criteria / Collateral Obligation definition)
- They must rank no less senior than the related distressed obligation in terms of payment priority.
The third category, "ELMO", are not debt obligations, usually stocks, and various securities, that otherwise meet all of the LMO criteria requirements.
Key Takeaways
The recent turmoil in credit markets clearly demonstrates why understanding how troubled loans are treated in CLO documents is essential. LMOs add significant flexibility to CLO Collateral Managers, and at a high level, their presence in deal documents allows CLOs to maximize returns and recoveries. However, as always, the devil is in the details.
The tremendous variation across deals, plus significant manager discretion and possible conflicting interests, demands that investors pay attention to key aspects of how LMOs are used. Specifically, investors need to consider:
- How LMOs are defined and all related terms
- Restrictions and limitations
- Requirements for how LMO proceeds are divided between principal and interest
- LMO treatment in OC tests
- Whether the degree of manager discretion increases investor exposure to riskier assets, and/or reduces protection via weakening OC tests
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