Executive Summary: An Introduction to Collateralized Loan Obligations (CLOs)

Although CLOs sound complex and may elicit a measure of trepidation among those not actively involved in the industry, CLOs are relatively simple financing structures. In this summary of an article published in full on the ICG Client Lounge, Rob Faulkner and David Saitowitz explore the topic.

CLOs

CLOs are securitizations backed predominantly by a portfolio of senior secured loans, diversified across borrowers, industries and segments of the economy.
CLOs offer investors access to the senior secured loan market with tailored risk-adjusted return profiles, while benefitting from structural protections and favourable capital treatment.
Risk to investors is mitigated by performance tests, credit enhancement and active portfolio management.
CLOs are long-term investment vehicles with no mark-to-market triggers, which could otherwise force the sale of assets.
CLOs are an established institutional asset class with an investor base that includes banks, insurance companies and large asset managers.

Although CLOs sound complex and may elicit a measure of trepidation among those not actively involved in the industry, CLOs are relatively simple financing structures. At its most basic level, a CLO is a portfolio of senior secured loans against which a series of debt obligations are issued. The cash flows generated from the portfolio of senior secured loans are used to pay principal and interest on the CLO’s debt obligations. The debt obligations are “tranched” into various classes with different priorities in the CLO’s cash flow waterfall. Residual cash flows are paid to the CLO equity investors.

What is a CLO?

Institutional investors often access the senior secured loan market by investing in CLOs. CLOs are securitizations backed by a diverse portfolio of senior secured loans to businesses that are rated below investment grade. The CLO portfolio is comprised primarily of first-lien senior secured loans, although there may be small allowances for second-lien loans and unsecured debt.

CLOs are funded by layers of debt of varying seniority, and equity. The principal and interest received from the portfolio of senior secured loans is distributed according to a cash flow waterfall. The debt obligations have varying seniority in the cash flow waterfall, with residual cash flows being distributed to the CLO equity holders.

For the economics of a CLO transaction to work, the interest income from the loan portfolio must exceed the interest expense of the CLO debt obligations, with the CLO’s equity investors receiving the excess interest.