Major stakeholders in the securitized corporate loan market are headed for a showdown as a switch to a new benchmark rate looms over billions of dollars of outstanding deals.
The replacement of the London interbank overnight rate, which is being phased out over the next few years across the financial landscape, is pitting buyers of top-rated CLO debt against those taking the most risk, equity buyers. They're all vying to protect profits in the almost $570 billion of collateral loan obligations that mature after LIBOR disappears in 2022.
The plan to switch is inflaming tensions that had been building. The record spread between one-month and three-month LIBOR has squeezed CLO equity investors' profits and benefited debt investors, who get the higher rate. So when a new benchmark, most likely the Federal Reserve's Secured Overnight Financing Rate, is adopted, it could damp returns for debt investors.
"Debt investors want to preserve that mismatch," said Sean Solis, a partner at the law firm Milbank Tweed. "The problem is that asymmetry may change with a move to a new benchmark such as SOFR, and debt investors are fighting that."
The battle has created a roadblock to the replacement of LIBOR as the opposing investors lobby the Alternative Reference Rates Committee that's tasked with giving guidance on the change. Some think it might take years to reach a resolution even as other asset classes already have begun to make the change. That has fueled concern an agreement might not be reached before LIBOR disappears. The end result could be invalidated contracts or deals that need to be called.
Even if SOFR is adopted, debt investors have been lobbying for a so-called modifier included in deal wording in order to get higher payments, Mr. Solis added.
To be sure, it's still quite early in the process and LIBOR isn't expected to be gone for years. The rate committee is conducting outreach and might have enough time to address the issue. In September it issued a consultation to elicit public feedback on fallback contract wording for syndicated business loans and floating-rate notes, and it is likely to call for another consultation on securitizations, including CLOs, this month.
In the meantime, provisions are being added to deal contracts that allow CLO managers to select a replacement rate without the approval of debtholders if the new benchmark is used in more than half of the underlying loans, or one of the industry groups picks SOFR as the successor, said John Timperio, a partner at the law firm Dechert.
But the wording in other deals has been more explicit about the risks. A term sheet for a recent transaction from Wellfleet Credit Partners warns that nothing concrete has been decided about LIBOR going away, or what a potential replacement might be, and that may cause increased volatility in the LIBOR rate and underlying loans.
"You may have a real nightmare to get investors with competing interests to agree on this issue," said Laila Kollmorgen, a portfolio manager at PineBridge Investments in Los Angeles. "If you can't get debt investors to agree to adopt SOFR, what do you do? If this somehow ends up not being in the equity investors' economic interest, I can see deals being called."