§ 12.06 Warehouse Facilities and Collateralized Loan Obligations

• Jurisdiction: United States
• Publication year: 2022

§ 12.06 Warehouse Facilities and Collateralized Loan Obligations

[1]—Introduction

Many hedge funds originate or purchase loans and other debt instruments as an investment strategy. If a hedge fund is able to borrow at a lower rate than the interest it earns on its investments, leverage will be a yield-enhancing strategy. Hedge funds have been adept at taking advantage of the capital markets to borrow funds at rates that are relatively low compared to the rates hedge funds charge borrowers or earn on debt investments in the commercial loan market.

In particular, the market for one form of leverage, namely, collateralized loan obligations ("CLOs"), is used extensively by hedge funds that originate or purchase commercial loans.

[2]—Warehouse Facilities

A common precursor to a CLO is a warehouse facility, often funded by the investment bank that is arranging the CLO. The purpose of the warehouse facility is to enable the hedge fund to acquire or "ramp-up" a portfolio of sufficient size and quality to launch the CLO. The warehouse facility is likely to impose eligibility criteria similar to the ultimate CLO to ensure that the portfolio will be eligible for the CLO. Typically, the reinvestment period is short—intended to match the period thought to be necessary to launch the CLO. If the CLO fails to launch, then the terms of the warehouse may require the debt to be repaid. Alternatively, an extended amortization period may commence.

Warehouse facilities can also be of a more permanent nature and may represent a hedge fund's sole source of leverage for many years. Indeed, even during the years of the credit crisis when the CLO markets remained stifled, banks continued to provide leverage in the form of warehouse facilities or stand-alone credit facilities. The continued availability of warehouse financing since that time has supported the expansion of the CLO market.

A warehouse may be structured in a variety of ways. One common form is a note purchase agreement, where the borrowing entity issues notes and the note purchase agreement sets forth the governing terms. Some warehouses may take the form of a participation interest in the applicable portfolio of assets being granted to the bank. In another variety, the bank and the borrowing entity enter into a derivative instrument such as a total return swap. Many warehouse facilities are documented with a standard credit agreement.

Common issues that are the subject of negotiation by the parties to a warehouse facility include: the length of the reinvestment period (which may vary from a short period of a few months, to one year, to even longer, depending on whether the warehouse is a precursor to a CLO (and if so, how long it is anticipated that the hedge fund will need to ramp-up its portfolio) or a permanent liquidity facility (in which case the reinvestment period may go out several years)); whether there will be an amortization period at end of reinvestment period (if CLO fails to launch) to repay the facility, or will the debt incurred immediately become due; will there be a guarantee or other recourse to the hedge fund; and who bears losses on the portfolio if the CLO fails to launch and the portfolio is liquidated or purchased at fair market value by the hedge fund.

[3]—Common Characteristics

Whichever structure is used by the hedge fund to obtain leverage to fund a loan portfolio (CLO/warehouse/credit facility, etc.), certain common characteristics can usually be identified. These include:

• Eligibility criteria and concentration limits that dictate the types of loans that may be acquired under the facility.

• Revolving debt that will be used to acquire assets during a "reinvestment period" and to fund underlying commitments.⁸⁴

• An amortization period following the reinvestment period, during which the outstanding debt under the facility will be paid down as collections come in.
• A pre-determined "waterfall" of how collections on the investments will be applied, usually separated into a principal proceeds waterfall and an interest proceeds waterfall.

• Use of a special purpose, bankruptcy-remote entity as borrower or issuer.

• In the case of a "market value" facility, a mechanism to periodically assess the market value of the loans or securities in the facilities and reduce the outstanding advances if the aggregate market value of the portfolio has declined.

[4]—Collateralized Loan Obligations Structure

A CLO is a special purpose entity (the "Issuer") that owns, originates or acquires certain specified types of loans, subject to specified criteria and limits, and issues tranches of rated debt secured by these investments, with the collections received by the Issuer on its investments applied to payments due to the Issuer's debt-holders and other parties in a predetermined order. The higher-rated securities earn a lower rate of interest but are paid earlier in the priority of payments. CLOs are a form of securitization and may be subject to the risk retention requirements imposed by Dodd-Frank, the Securitization Regulations or the Final JRR Rules.⁸⁵

CLOs utilized by hedge funds are in some ways dissimilar from the general CLO market. The table below notes certain distinctions:

General market for CLOs	CLOs wholly owned by Hedge Funds
Equity owned by institutional investors (including hedge funds)	All equity owned by one hedge fund (although may be allocated to multiple related funds)
Managed by third-party collateral manager	Managed by the hedge fund's investment manager or an affiliate
Initial assets acquired from the market.86	Hedge fund contributes the initial assets
Initial assets usually contributed to the CLO entity at start of warehouse stage; additional assets acquired during warehouse stage usually acquired directly into the CLO entity
Non-consolidation and true sale opinions generally not required	One or both such opinions often required
Collateral management fee is key component	May or may not be a collateral management fee

[5]—The Collateralized Loan Obligations Entity

The Issuer under a CLO transaction will be a "special purpose vehicle." A special purpose vehicle (commonly referred to as an "SPV" or "SPE") is any entity whose governing documents limit the powers and purpose of the entity. The governing documents of the Issuer will generally limit its powers to acquiring the underlying loans (i.e., the pool of collateral for the CLO); issuing notes to investors in the CLO; entering into the CLO transaction documents (and the warehouse documentation, if applicable); administrating the pool of collateral; and related actions. Often, the vehicle is established in an offshore jurisdiction such as the Cayman Islands.⁸⁷

The organizational documents of the CLO will include certain terms that are intended to make the vehicle "bankruptcy remote." While this is standard for all CLO transactions, it is particularly focused upon in the case of a CLO sponsored by a hedge fund. This is because of the perception that there may be heightened risk of consolidation of the CLO with the hedge fund if the hedge fund files for bankruptcy. Negative factors that contribute to this perception are: the hedge fund and CLO are under common management; the hedge fund contributes the initial pool of assets to the CLO and retains the equity or most junior tranche of securities issued by the CLO; and the hedge fund may be the CLO's only source for additional capital. Rating agencies may also require non-consolidation and true sale opinions to the extent the loan portfolio that will be transferred to the CLO was held by the relevant seller for ninety or more days. For all of these reasons, a customary non-consolidation opinion is usually required to be delivered by the CLO's counsel at closing and a true-sale opinion may also be required regarding the initial contribution of assets.

The Issuer's counsel can generally deliver these opinions if it is satisfied that the governing documents of the Issuer contain customary provisions designed to make the Issuer "bankruptcy remote." These include:

• The Issuer has an independent director or manager whose consent is needed for a bankruptcy petition or other fundamental change.⁸⁸
• The Issuer has limited purpose provisions in its organizational documents to limit the scope of creditors.

• The organizational agreements include "separateness provisions" that prohibit commingling of the Issuer's assets with those of other entities and require the Issuer to maintain separate books and records and a separate identity from affiliates.

• All transactional documents that the Issuer signs must include customary limited recourse and non-petition language.

Counsel will also wish to confirm that the transactions between the hedge fund and the CLO will be viewed as arm's-length transactions. Factors to be considered include fair consideration for the initial transfer of assets and a management agreement that has arm's-length terms.

The securities issued by CLOs are exempt from the registration requirements under the Securities Act⁸⁹ because they are issued pursuant to private placement and resale exemptions under the Securities Act. CLOs are also exempt from registration as an investment company under the Investment Company Act.⁹⁰ In order to comply with the Securities Act, CLOs typically issue their securities only to qualified institutional buyers as defined in Rule 144A promulgated under the Securities Act (and, in certain limited circumstances, accredited investors, as defined in Rule 501(a) promulgated under the Securities Act) or to non-U.S. investors in offshore transactions pursuant to Regulation S promulgated under the Securities Act. In order to comply with the Investment Company Act, offshore CLOs typically also require that each of their U.S. investors be a "qualified purchaser" within the meaning of Section 3(c)(7) of the Investment Company Act but U.S. CLO issuers...