The extension question

Here's a question for the ages: Why don't collateralized loan obligation funds want loans they hold to be paid back early?

The prepayment issue has become a big one for CLOs, which make up about two-thirds of the loan market, especially as companies struggle to manage the overhang of debt coming due in the next few years.

Take Nashville-based hospital operator HCA Inc. On June 18, it successfully persuaded lenders to give it an open-ended amendment that let it extend current loans or issue new debt or bonds to repay $10.5 billion in leveraged loans. All this came at the bargain-basement price of 5 basis points on the value of the loans (the company's original offer had no fee) and without "most favored nations" protection for existing investors, meaning they won't receive the same rights given to other investors in subsequent transactions.

While HCA didn't ask for an extension -- only the right to do so later -- it is interesting that investors in HCA's loans were so willing to give it the prerogative, and at relatively low rates, rather than forcing it to take out new loans to repay existing obligations.

Indeed, HCA has been aggressively working to whittle down its senior debt and earlier this year issued $1.5 billion of bonds, using the money to pay down the $12 billion in bank loans it had accumulated to fund its $33 billion buyout in 2006 by Kohlberg Kravis Roberts & Co., Bain Capital LLC and Merrill Lynch Global Private Equity.

On the face of it, prepayment would appear to be good for CLOs right now, considering most leveraged loans are trading below par value and funds could take excess cash to buy those loans at presumably attractive discounts. But this theory doesn't conform with reality, says Meredith Coffey, an analyst at the Loan Syndications and Trading Association. "A paydown at this moment is not something most CLOs want," she says. The reason: With virtually no new issues coming to market, CLOs with cash must chase loans in the secondary market. This is pushing up prices and reducing the attractiveness of discounts.

And it's not as though CLOs can buy all the loans available for sale today. In fact, most CLOs today will consider buying only about 60% of the loans available in the secondary market.

The reason: Overcollateralization tests meant to ensure that lenders to CLOs are protected against defaults in loan portfolios that secure their tranches. This means CLO managers must keep the value of portfolios at around 120% to 125% of the value of their liabilities. If, for example, a CLO has collected $100 in its senior and subordinated debt tranches, it must maintain a loan portfolio worth $120 to $125 to give investors a cushion.

However, the standardized rules that govern how loans count toward overcollateralization, or OC, tests force managers to heavily discount loans they buy at cut-rate prices. This is done on the theory that a loan trading at 60 cents in the secondary market carries greater risk of default and shouldn't be given the same OC weighting as a loan trading at par.

According to Deborah Festa, a partner at O'Melveny & Myers LLP, the OC tests stipulate that loans trading above 80 cents on the dollar are given par value with respect to the tests, but those trading below must be discounted. In fact, the situation is even more complex than that: Loans with a Moody's Investors Service rating of B3 or lower must be bought above 85 cents to get par treatment, while those with higher ratings begin to be discounted for OC purposes below 80 cents.

Standard & Poor's estimates that some 57% of loans in its index of leveraged loans are trading above the 80-cent mark, while the LSTA puts that number at 63% for term loans worth at least $500 million.

But, as Festa notes, there are only so many CLO funds that can get access to a limited amount of loans they would want to buy with excess cash. "If you're not a top-20 manager, the loans might not be available," she says.

Given that situation, it may be safer for CLOs to sit on loans they already own and jostle for better pricing when a company does come to them with an extension request.