At IMN’s London CLO conference on Monday, standardisation of documentation was a big topic of discussion. The consensus was that, in Europe at least, CLO 2.0 documentation has improved, but there were still big variations in language.
One panelist gave the example of two CLOs whose documentation included very different definitions of covenant-lite loans. Even though they held a lot of the same loans in their portfolios, quirks in the cov-lite definitions mean that one was ostensibly running a 29% cov-lite bucket, while the other’s was 0%.
Such quirks should surely not exist, particularly with a term as widely used as cov-lite. In the US market, this situation is reminiscent of some investors’ complaints that recently, total indebtedness language has loosened to the extent that middle market loans are beginning to creep into broadly syndicated CLO portfolios.
By lenders’ own admission, the definition of middle market lending is often hard to pin down. That vagueness is fine if you’re working on your marketing material, but if you’re putting your loans into a CLO that is going to be bought by a large number of disparate investors, it would make sense for the market to come up with some concrete definitions for the sake of clarity and delineation.
The problem is that while triple-A investors — especially those new to the market — would probably appreciate more clarity, having some level of confusion and disparity between different deals is actually a boon for larger CLO equity buyers, which have the resources to pore over documentation and work out where they can extract value and arbitrage.
That arbitrage would fade away with greater standardisation of documents, one investor argued at Monday’s conference. But it doesn’t have to. Having standardised definitions for terms like cov-lite wouldn’t stop CLO managers from structuring their deals to suit a particular equity investor, and what is more, it would improve liquidity.
Established investors might have to fight harder at their analysis and their relationships to find their precious arb, but it won’t disappear altogether. That applies to both the European market and the larger US market. The latter in particular, being a larger space with more players and therefore greater scope for variation, could particularly do with more standardisation, although for all the same reasons it is less likely to happen.
Speaking of which…
Discount margins are a very important measure in a new CLO, and while US arrangers have got better at disclosing them recently — after a rough patch in the second half of last year — there is still a long way to go.
There are many reasons why investment banks and CLO managers might not want to reveal the prices at which different tranches were sold. Anchor investors may be given one price, leaving an arranger to fill in the blanks with other, smaller bids. Managers may not want to reveal they were sold cheap. Revealing discount margins alongside coupons can be awkward in such situations, and many others.
Yes, it’s a private market. Yes, there’s no obligation to disclose price. But it’s to the detriment of transparency and, perhaps more important, accessibility, when DMs are kept secret.
Disclosure of these numbers is still ad hoc, and that still means that in some deals, certain investors have to take it on trust that they’re not being scalped. You could forgive them for not being entirely comfortable with that. No investor likes to feel like one of Goldman Sachs’s “muppets”.
Quite apart from that, greater transparency is a sign of good faith to regulators and lawmakers — and the CLO market could do with their support at the moment.