CLO 2.0: How Can Hedge Fund Managers Navigate the Practical and Legal Challenges of Establishing and Managing Collateralized Loan Obligations? (Part One of Two)

While its much-maligned counterparts, collateralized debt obligations (CDOs) and structured investment vehicles, have languished, the cash-flow collateralized loan obligation (CLO) has emerged from the financial crisis relatively unscathed.  The issuance of post-crisis CLO paper has experienced a sustained resurgence, surpassing $53 billion in 2012 and catapulting past $27 billion in the first quarter of 2013 alone.  For many fund managers, managing a CLO may present a very attractive opportunity.  Unlike the standard hedge fund platform, a CLO can generate lucrative and stable management fees with minimal redemption risk during the non-call period while remaining largely insulated from market value declines.  Although the characteristics of the post-crisis “CLO 2.0” hardly represent a sea-change from the pre-crisis version, there have been a number of important structural developments.  The CLO 2.0 era has also ushered in changes to the underlying transaction documentation aimed at addressing various lessons learned from the failings of CDOs and other structured products during the market meltdown.  Despite the recent fanfare, there remain several practical and legal obstacles that a CLO manager can expect to encounter in the current market environment.  This article is the first in a two-part series discussing the practical challenges of establishing a CLO in the current market environment, and how CLO managers can address the challenges.  Specifically, this article addresses a number of common documentation requests by anchor investors in the most senior and subordinated (or equity) classes of the CLO capital structure and explores certain inherent difficulties in obtaining warehouse financing in connection with the ramp up of the CLO portfolio prior to the initial issuance of CLO notes.  The second installment in this series will present a brief overview of various legal developments that have or may alter the CLO management landscape, including (1) risk retention rules, the Volcker Rule and various Commodity Futures Trading Commission requirements under the Dodd-Frank Act, (2) enhanced registration requirements under the Investment Advisers Act of 1940, (3) the implementation of the Foreign Account Tax Compliance Act provisions of the Internal Revenue Code, and (4) Sections 409A and 457A of the Internal Revenue Code.  The authors of this series are Greg B. Cioffi and Jeff Berman, both partners in Seward & Kissel’s Structured Finance and Asset Securitization Group, and David Sagalyn, an associate in the group.  See also “Key Legal and Business Considerations for Hedge Fund Managers When Purchasing Collateralized Loan Obligation Management Contracts,” Hedge Fund Law Report, Vol. 3, No. 13 (Apr. 2, 2010).

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