James Smallwood, senior associate at Allen & Overy, examines whether the foundations are changing for European CLO structures

What's in a name? Or, more appropriately for CLOs, what's in a number? And while there are many important numbers and figures in a CLO transaction (obviously), here and in particular, I'm referring to some pretty low digits – one, two and three. Or more accurately, 1.0, 2.0 and 3.0. As whenever there are times of market stress and change, inevitably CLO market participants wonder, are we seeing the emergence of CLO 3.0s? So, when we ask whether the foundations of European CLOs are changing, what we're really asking is – are we seeing the emergence of the next generation of CLO structures?

CLOs have always been complex beasts, evolving from earlier forms of securitisation. CLO 1.0s are used to refer to pre-financial crisis deals; CLO 2.0s in a European context to those deals issued since the market reopened in Europe in 2013. The general differences between these two types of issuances are well-known and well-publicised: shorter reinvestment periods, shorter non-call periods, generally lower leverage percentages, greater refinancing flexibility, risk retention requirements (in Europe at least), for example. And CLO 2.0s have been remarkably successful in moving on from the performance of pre-crisis deals – as shown most recently by their confident display through the pandemic.

I've lost track of the number of conversations over the years on whether market developments mean we're now into the realm of the '3.0' – and I get it, it makes for interesting market chatter, gives market participants something to write about (self-awareness intended!) and creates a bit of a buzz. Changes for Volcker, changes for US risk retention, changes brought about because of the pandemic. Each economic, regulatory and geopolitical hurdle thrown at this market over the past decade has led to such thoughts, and each time the moniker hasn’t caught on. Why? In essence due to both the structural changes being less dramatic than between 1.0s and 2.0s, and because the market's marketing men and women haven’t needed to reboot the sector, as was required after 2008/2009.

After the turbo-charged days of 2021, when lockdown loosening, central bank and governmental largesse contributed to a record year for Euro CLOs, 2022 is providing an entirely different challenge: crisis in Ukraine, inflation levels unseen for a generation and even Brexit back in the news. CLO spreads are up across the capital stack, new deal issuance is flat-lining and refis/resets are off the table for the foreseeable future. Deals are still pricing, albeit at a slower rate and after a lot of hard work tweaking the structure to appeal to investors – so does this mean the fundamentals are having to change as well? No – there is still a portfolio of actively-managed corporate loans combined with a securitisation wrapper, the cashflows are largely similar and the leverage is largely the same. Instead, deals are getting shorter, bond buckets are more important and structural adaptions like mezzanine turbo repayments are being seen again, and I'd argue that this flexibility and nimbleness has now become a central pillar of a mature CLO market. Indeed, the first European print-and-sprints deals for a long time only reinforce this.

So I’d argue that CLO foundations are broadly standard, stable and steady. Yes there is innovation and yes there is flexibility, but this represents a mainstay of modern-day CLOs rather than a fundamental change. Instead, what may really lead to fundamental changes to CLOs in the next few years and beyond will be the global decarbonisation push, represented right now by the burgeoning importance of ESG criteria in CLOs – changes to what types of assets can be held, how these assets are analysed and reported to investors and how CLO cash can impact real life companies fighting the climate crisis… now that sounds like a fundamental change.