Back in September 2013 we wrote "Coming Soon To A Theater Near You: MBIA's $1 Billion World War Z" in which we explained why MBIA will soon have a substantial problem (amounting to just about around $600 million) with several CLOs which we dubbed "Zombie CLOs" or as they were actually known, Zohar, on which it had written insurance, and which would become evident sooner or later once someone took a long, hard look at the collateral manager of the CLOs, namely Lynn Tilton's Patriarch Partners.
First, a little background on the Zohar CLO from our September 2013 article:
MBIA’s most recent issue is not new per se, as it dates back to 2003/2005 - as far as we can tell, however - the water looks like it is just starting to boil over and MBIA does not seem to have reserved for what appears to be a rather meaningful problem. According to preliminary analyses, it does not appear that MBIA has ever really addressed this particular $1 billion of Zombie CLO insurance on their books, which looks to be coming due in short order (unlike their well-followed RMBS issues and long-dated future CMBS losses).
These freshly-surfacing problems stem from a particular pair of Zombie CLO’s – Zombie-I and Zombie-II (along with Zombie-III, illiquid/black box middle-market CLO’s). While information is (intentionally?) difficult to gather, we have heard that MBIA would be lucky to recover much more than $400 million from the underlying insured Zombie assets over the next three years, which would leave them with a nearly $600 million loss on their $1 billion of exposure which would materially and adversely impact the company's liquidity. And as it may take them a while to liquidate assets in a sure-to-be contentious intercreditor fight – their very own World War Z – MBIA may well have to part with the vast majority of the $1 billion in cash, before gathering some of the potential recovery.
The CLO’s in question are actually called Zohar CDO 2003-1, Zohar II 2005-1, and Zohar III, but instead of paying royalties to the Kabbalah by continuing to invoke reference to it here, henceforth we will refer to each of the distressed “Zohar” CLO’s as “Zombie” I, II, and III, respectively. They full structures are shown below:
This is what we warned:
Zombie CLO’s are not Paying-Down – Underlying “Loans” are not True Loans
With absolute power over the whole closed system, as the Zombie collateral manager also controls the equity in the Zombie CLO’s (so much for the purported benefit of the new risk retention rules) and is also the controlling shareholder (in some cases CEO) of nearly all borrowers of Zombie loans and is also the “Agent” on nearly all the Zombie “loans” >>> the “loans” are not really loans. As both borrower and lender, any element of any “loan” can be amended at any time, as needed (maturity, covenants, interest rate, frequency of payment, etc.). Taken to the extreme, we have heard stories of (a) Patriarch Partners companies being liquidated/having substantial assets sold and leaving in-place Zombie collateral loans to a then shell entity devoid of meaningful assets and (b) companies with existing Zombie collateral loans filing for bankruptcy, then selling-to and being repurchased-via additional new Zombie loans, with both the old and new Zombie loans continuing to be held on the books of the Zombie funds. How can this be - who would let this type of circular arrangement without any checks-and-balances persist?
39 Small/Middle-Market Private Portfolio Companies Listed on the Patriarch Partners Website May be Difficult to Sell/Liquidate
- The www.patriarchpartners.com website lists 39 companies (some of which are essentially the same company by a few different names), which we believe contain nearly all of the Zombie funds’ collateral loans.
- Nearly all of these small/middle-market companies seem to be controlled by affiliates of the collateral manager – furthermore, many have limited franchises and continue to operate in distress; these companies may not weather the tumult of protracted uncertainty well (along with no ongoing funding), further limiting potential recoveries.
- The following (also from the Patriarch Partners website) is not what one would expect to read about the portfolio of loans in a CLO: "Although comprised of individual private equity investments, our portfolio of assets is managed as a global conglomerate, with a continued focus on synergies and ventures between companies that will enhance value. The investment funds managed by Patriarch currently hold equity positions in more than 70 companies, approximately two-thirds of which are control positions, spanning almost a dozen industries."
- We understand that nearly 100% of the capital for these 39 portfolio companies came from the Zombie funds, aside from a handful of true first-priority, third-party working capital facilities (asset-based loans/factoring lines, which will also tend to limit Zombie recoveries – a key question is therefore, how much of the meaningful (larger) companies’ equity is owned by each of the Zombie funds (vs. other/personal funds controlled by the collateral manager)?
Well, finally someone did take a long, hard look and today, our warning comes full circle following a shocker out of the SEC accusing Lynn Tilton of fraud and of "hiding the poor performance of loan assets in three collateralized loan obligation (CLO) funds they manage."
SEC Announces Fraud Charges Against Investment Adviser Accused of Concealing Poor Performance of Fund Assets From Investors
The Securities and Exchange Commission today announced fraud charges against an investment adviser and her New York-based firms accused of hiding the poor performance of loan assets in three collateralized loan obligation (CLO) funds they manage.
The SEC’s Enforcement Division alleges that Lynn Tilton and her Patriarch Partners firms have breached their fiduciary duties and defrauded clients by failing to value assets using the methodology described to investors in offering documents for the CLO funds, which have portfolios comprised of loans to distressed companies. Instead, nearly all valuations of loan assets have been reported to investors as unchanged from the time they were acquired despite many of the companies making partial or no interest payments to the funds for several years. Investors have not only been misled to believe that objective valuation analyses were being performed, but Tilton and her firms allegedly have avoided significantly reduced management fees because the valuation methodology described in fund documents would have given investors greater fund management control and earlier principal repayments if collateral loans weren’t performing to a particular standard. Tilton and her firms also consequently have misled investors about asset valuations in fund financial statements.
“We allege that instead of informing their clients about the declining value of assets in the CLO funds, Tilton and her firms have consistently misled investors and collected almost $200 million in fees and other payments to which they were not entitled,” said Andrew J. Ceresney, Director of the SEC’s Enforcement Division. “Tilton violated her fiduciary duty to her clients when she exercised subjective discretion over valuation levels, creating a major conflict of interest that was never disclosed to them.”
According to the SEC’s order instituting an administrative proceeding, CLO funds raise capital by issuing secured notes and using proceeds to purchase a portfolio of collateral typically comprised of commercial loans. Investors are paid based on cash flows and other proceeds from the collateral. The three CLO funds managed by Tilton and the Patriarch Partners firms are collectively known as the Zohar funds, and more than $2.5 billion has been raised from investors. Tilton’s investment strategy for the Zohar funds has been to improve the operations of the distressed portfolio companies so they can pay off their debt, increase in value, and eventually be sold for a profit.
The SEC’s Enforcement Division alleges that under the contractual terms of the deals, Tilton and her firms are required to categorize the value of each loan asset in monthly reports by using a specific method set forth in deal documents. To be assigned the highest category, a loan has to be current in its interest payments to the Zohar funds. The category of each asset impacts the calculation of a fund’s “overcollateralization” ratio, which reflects the likelihood that investors will receive a return on their principal. If the overcollateralization ratio falls below a specific threshold, Tilton and her firms are not entitled to receive certain management fees and may be required to cede more control of fund management to investors.
The SEC’s Enforcement Division alleges that rather than following the required methodology for valuing these loan assets, Tilton and her firms have maintained their control over the funds and preserved their management fees by not lowering an asset’s category until she decides to cease financial support of the distressed company. Thus the valuation of an asset simply reflects Tilton’s subjective assessment of the company’s future. Absent an actual overcollateralization ratio test, investors aren’t getting a true assessment of the actual values of their investments, which in reality have declined substantially.
The SEC’s Enforcement Division further alleges that Tilton and her firms were responsible for misstatements in the quarterly financial statements of the Zohar funds. When preparing these financial statements, they failed to conduct a required impairment analysis on the assets of the Zohar funds despite disclosures stating that such analysis had occurred. They also falsely stated that assets of the Zohar funds were reported at fair value. Tilton repeatedly and falsely certified that the financial statements were prepared in accordance with Generally Accepted Accounting Principles (GAAP).
The SEC’s Enforcement Division alleges that Tilton, Patriarch Partners LLC, Patriarch Partners VIII LLC, Patriarch Partners XIV LLC, and Patriarch Partners XV LLC violated Sections 206(1), 206(2), and 206(4) of the Investment Advisers Act of 1940 and Rule 206-4(8). Patriarch Partners LLC also is charged with aiding and abetting violations by the others. The matter will be scheduled for a public hearing before an administrative law judge for proceedings to adjudicate the Enforcement Division’s allegations and determine what, if any, remedial actions are appropriate.
The SEC’s investigation has been conducted by Amy Sumner, Amanda de Roo, and John Smith with assistance from Judy Bizu. Also contributing to the investigation were Allison Lee, Creola Kelly, and Brent Mitchell. The case has been supervised by Laura Metcalfe, Reid Muoio, and Michael Osnato. The Enforcement Division’s litigation will be led by Dugan Bliss, Nicholas Heinke, and Ms. Sumner.
All just as we warned would happen (and yes, this is bad news for MBIA), to wit: "It appears that MBIA is entirely unreserved for the ~$600 million of potential losses on their Zombie insurance contracts and may have to come out-of-pocket for almost $1 billion over the next ~three years – at the Barclays financials conference just two weeks ago, MBIA explicitly stated that their $500 million of structured finance reserves are almost entirely intended to offset CMBS losses (as opposed to these Zombie High Yield Corporate CDO losses)."
Finally, here is Lynn Tilton during better times, namely some time circa 1988 when she sent out the following "Dominatrix Santa" Christmas Cards to her ten best clients.
And here is CNBC's profile of the "super rich" Lynn Tilton:
Oh, and let's not forget the irony...