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Wilbur Ross offers concerns about CLOs
Bankruptcy King and billionaire private equity investor Wilbur Ross spoke to Reuters recently for an article on CDOs and CLOs and their potential impact on weighing down the red hot private equity M&A market.
Ross and other private equity executives point out that the growth of collateralized loan obligations and the broader collateralized debt obligations function as a double-edged sword for private equity. On the one hand, these financial instruments have fed the leveraged buyout frenzy, because they gobble up loads of debt issued by LBOs. But on the other hand, a CLO investor is probably more of a short-timer compared to an old lending institution that used to ride out the bad times with their clients.
The fear in the private equity market is that a crack in the credit cycle could first appear in the CLO market, which in turn could lead to a broader credit meltdown, or at least slowdown. The reason: Many CLOs and hedge funds have not weathered bad times, and many have done little due diligence into the company whose paper they’re holding. Should the company come under financial trouble, they’re inclination will likely be to sell, not hang with the company through the workout.
“What all of this will show — and it will show more as CLOs become more popular — is that risk management has not been very well practiced,” Ross says in the story. “That’s going to hurt a lot of people, and will ultimately explode the bubble.”
Below are snippets from the interview with Ross:
“I think there are some changes CDOs/CLOs has provoked. For one, there is no such thing as relationship banking anymore. Everything is transactional. If you were a borrower and you got in trouble, JPMorgan was interested in a long term relationship. Now they (creditors) don’t think in terms of relationships. They think in terms of individual transactions.”
In the old days, the big institutions were the lead banks, Ross said. “Nowadays, it’s not unusual in a $750 million loan transaction for a lead bank to have $25 million, with a bunch of CLOs having a bigger credit position. So the whole dynamic of a workout is different.”
“When trouble comes, they’ll start trading the paper. With Collins & Aikman, all bank debt has turned over about 2.5 times. So you come into a negotiation or something and you may have a totally different group of investors. That can have a destabilizing influence on workouts since deals tend to get split up in small pieces because CLOs and CDOs.”
Ross gave an anecdote of one hedge fund who took a $20 million stake in one of his portfolio companies. “I called him to thank him, but I told him that nobody from his fund came to due diligence. He said ‘I know that.’ I was surprised, and he said ‘we’re only going to put $20 million in we didn’t think it was worth sending anyone.’ So it makes me wonder, how many of these fellows are buying the things without due diligence.”
“Most CLOs/CDOs have a small staff and very few know about workouts. So if a $20 million piece goes bad, their inclination is to sell and you start to see more volatility in the markets. A bond could be at 90, 95 cents on the dollar. Then you have five CLOs come into the market at once. The next thing you know its at 70, then 50.”
“(CLOs) are less picky about covenants. There are few, if any restrictive covenants. They have been very generous in commercial terms but the difficulty is in the instability they can create. They’ve contributed a lot to the permissive nature of markets.”
Insider
