Private Equity CLOs - comment
Absence of evidence is not evidence of absence… Or so it has been going with the magic injection of equity into LBOs and leveraged refinancings throughout the pandemic. I know I’m naïve. So I only first observed this phenomenon on Lowell in 2020. We were proposing a refinancing transaction that would have bailed in the CDS sellers, only to see GS do the transaction without that mechanism, but with an extra €200m of equity instead. Expensive, we thought. That equity, we were later told, did not come out of Permira’s funds, however.
The FT delivered the answer this morning in an article highlighting a new practice among PE firms: Collateralised Fund Obligations (CFOs) or effectively CLOs repackaging portfolios of pref-equity exposures into structured vehicles and once again selling the tranches presumably to German Landesbanks and your pension fund. Risk of the sr. tranches is A+, because of their diversification. Never mind that interest rate risk on the debt stacks ahead of each exposure cuts across all of that systemically. So it’s been a great way of selling some of the interest rate risk that has now materialised.
On the one hand, we could see a market emerging for buying these structured securities at discounts, much as that has been popular following the financial crisis. If many of these vehicles ended up recovering significant proportions of their value, that was because interest rates dropped to save the economy. We think the same will happen again. Interest rates are spiking to catch inflation and that inflation will result at least in nominal growth. So we expect these vehicles to be well under water now, but they may yet nominally recover in time.
On the other hand, we are wondering about how these passive vehicles will impact any restructuring negotiations when along the way their portfolio companies require decisions, fresh cash, etc. PE firms will be yet further out of the money than published leverage stats suggest to on-BS bondholders and their incentives will be yet more warped. If you have further intelligence on these vehicles, we would love to learn more about them.