Gulf Stream takes Citi to task over Lehman par CLO structure

Gulf Stream Asset Management has recently published a recent report which takes Citi to task over its analysts’ recent comments on the Lehman “Par” structure. In a report entitled “CLO equity - performing as marketed” (see CLO pitch books were right about equity returns), Citi said that CLOs structured as par deals have underperformed on average. The bank analysts noted that if a par deal comes under stress, it is harder to get it back into compliance, and that more income is diverted from equity to meet losses than in a conventional deal.

Officials at Gulf Stream, which manages several deals using this structure, says that while it is true that par deals may have had lower cash on cash equity returns to date, par deals could ultimately perform better. They point out that in times of stress par deals divert income to buy new collateral by contrast to conventional deals, which pay down liabilities if they fail their overcollateralisation tests. This, they point out, has the key benefit of leaving the CLO’s liability structure in tact.

Par deals, like the Apex structure from Wachovia, do not have a junior OC test. Instead they have a borrowing facility provided by the arranger which the manager taps to make up for losses in the portfolio up to a certain amount. This loan must then be repaid out of income, reducing equity distributions but maintaining the par value of the portfolio.

The feature means that equity holders give up some income in the event of moderate defaults and, in return, escape the more penal effects of a OC test breach. The feature is particularly beneficial for mezzanine note holders, who only lose out on interest if a more senior OC test fails.