CLOs, a species of collateralized debt obligation, are special purpose entities that issue senior rated debt securities and junior unrated equity-like securities which provide different levels of exposure to a pool of loans owned, directly or indirectly, by the entity. The principal and interest payments on the securities issued by the CLO generally come from the principal and interest payments made by the borrowers of the loans held by the CLO and, in some cases, from purchases and sales of the underlying loans. The idea behind issuing multiple classes – or “tranches” in CLO parlance – of CLO securities is to reallocate the risk of underpayment or nonpayment on the underlying loans, and thereby diminish the risk assumed by the senior noteholders. In other words, if a pension fund wanted exposure to a loan used to fund a leveraged buyout in 2006, it might purchase the loan directly, but it would cease receiving principal or interest payments as soon as the borrower stopped making such payments. However, if the pension fund purchased senior notes issued by a CLO that held that same leveraged loan along with other leverage loans, a default by the borrower on that leveraged loan might not cause the pension fund to cease receiving principal and interest payments on the senior CLO note. This is because other leveraged loans in the CLO would, in theory, continue paying principal and interest, thus enabling the CLO to continue making principal and interest payments to its senior notes holders. Also, any underpayment or nonpayment on any of the underlying loans would first be absorbed by holders of the junior or “equity” notes. What this theory – and the associated AAA ratings of many of the senior notes issued by CLOs – did not take into account prior to 2008 was the possibility that all of the leveraged loans in a CLO could simultaneously stop paying principal and interest. In other words, the high ratings of senior CLO notes and the associated perception of safety was based on the idea that a diversified portfolio of otherwise risky loans to companies in different industries and geographies was considerably safer and less volatile than the individual loans in the portfolio – especially when the initial losses on that diversified portfolio were contractually allocated to other people. But credit markets seized up globally starting in 2008, CLO equity tranches were wiped out and CLO senior notes were revealed as significantly riskier than their coupons suggested. In short, CLOs got a bad name during the credit crisis, and from September 2007 until March 30, 2010 (three days ago), no new CLOs were issued. However, many CLOs remain in existence and various hedge fund managers currently manage CLOs, have managed CLOs or have the personnel and infrastructure in place to manage CLOs today or with minor adjustments. For example, the skill sets and infrastructure required to manage distressed debt or credit hedge funds are similar to those required to manage CLOs. Accordingly, for certain hedge fund managers, purchases of the contracts to manage those existing CLOs may offer a number of attractive features including: (1) an ongoing, reasonably predictable revenue stream; (2) “sticky” investor assets at a time when assets remain difficult to raise and retain; (3) a potential foot in the door with major institutional investors; (4) an asset (the management contract) that may be illiquid, and thus may be obtained at a discount to fair value; (5) forced sellers of management contracts; and (6) an “infrastructure arbitrage” (in the sense that certain larger hedge fund managers may enjoy economies of scale that enable them to manage a CLO at lower cost than smaller managers). For analysis of another situation in which an albatross for one hedge fund manager may be an opportunity for another, see “Will Reported Purchases by D.E. Shaw Hedge Funds of Assets in Other Hedge Funds’ Side Pockets Set a Precedent, or Highlight the Fiduciary Duty, Valuation and Other Challenges in Such Transactions?
,” Hedge Fund Law Report, Vol. 3, No. 11 (Mar. 18, 2010). To assist hedge fund managers in evaluating, entering and negotiating the CLO management market, the remainder of this article discusses: the mechanics of CLOs, including features relating to investments, fees, payment priority, ratings and withdrawals; recent precedent transactions involving sales of CLO management contracts; rationales for selling CLO management contracts; rationales for buying CLO management contracts; and key legal considerations in connection with purchases or sales of CLO management contracts, including consent requirements and how to avoid the assumption of liabilities of the prior manager.