Structured Credit: Signs of life return to CLOs
Jennifer Bollen finds a re-birth in Europe’s CLO market, offering better pricing and lower risk – but facing significant obstacles to achieving maturity
In 2013 the European collaterised loan obligations (CLO) market – dead since the crisis – came back to life. The first post-crisis CLOs in the region finally emerged and by the first half of this year rating agency Standard & Poor’s had rated three new European CLO transactions worth a combined €925m.
Cairn Capital launched a €300m vehicle in February, Pramerica closed a €300m offering in May and Apollo Global Management priced its vehicle at €325m in April – the alternative manager’s first European CLO.
Meanwhile, ICG is planning a €400m CLO this year, to be arranged by Lloyds Bank, while US alternatives giant Carlyle Group is reportedly looking to launch a €300m CLO.
The activity has come as some market participants are confident that there is strong demand among investors increasingly seeking new sources of yield, but little competition in the CLO market. But managers are cautious about calling the true reopening of the European CLO market, which still lags the US by miles.
According to advisory firm Deloitte, US CLO issuance reached $54bn (€40.6bn) last year, its highest level for five years and about four times the amount issued in 2011, primarily as a result of investors searching for yield and low default rates among US corporates.
Regulation is cited as the single biggest hurdle firms face when attempting to launch new vehicles in Europe. The so-called ‘Skin in the Game Directive’ – or Article 122a of the Capital Requirements Directive – is expected to slow down the rebirth of CLOs in Europe dramatically.
The directive, which aims to align the interests of managers with those of investors, requires the sponsor of a CLO to retain a 5% exposure to the underlying assets. A previous wording of the rules – published in 2011 - allowed a third party to retain the 5% exposure in some circumstances, giving hope to smaller firms that may have less capital, but the rules have since become more restrictive. The current wording allows only banks or EU-regulated investment managers to provide the retention piece. This has the potential to stop many firms from coming back to the market with new vehicles.
“The wording will not completely stop the CLO market,” says Dagmar Kent-Kershaw, head of ICG’s credit fund management team. “What it will do is stop a number of managers from issuing. There are a small number of managers who have their own capital who meet the requirements.”
Gennaro Pucci, founder of credit hedge fund manager PVE Capital, agrees: “Five per cent is a big number for many managers, which means only the strongest will remain in place.”
Cairn is one firm that may face problems as a result of the rules – for its latest European CLO it retained skin by holding an equity tranche placed in a pension fund-backed structured credit vehicle. However, the rules remain under consultation and it is unclear what the implications will be for CLOs structured in ways that do not satisfy them. Cairn declined to comment.
The Capital Requirements Directive will be combined with an updated EU capital requirements regime, CRD III, due to come into effect on 1 January 2014.
Jonathan Butler, managing director and head of leveraged finance in Europe at Pramerica, says: “Some of the deals closed this year would no longer be eligible [after the recent proposals] but I don’t think it will prohibit European issuance. It will stop certain 122a structures.”
So-called CLO 2.0 models – the CLOs launched this year – are markedly different from their boom-era counterparts. Compared with older CLOs, the new transactions have simpler capital structures, no exposure to foreign exchange risk and include greater subordination for senior note holders, offering them more protection before any losses are incurred, according to Standard & Poor’s.
Kent-Kershaw says factors including the leverage multiples and the quality of the underlying assets were significantly more favourable than before the crisis. “The big difference in leveraged loans which are structured and issued now compared with pre-crisis is that leverage is much lower,” she says. “The equity contribution from the private equity sponsors is generally much larger. The structures of those loans are more conservative than pre-crisis and, significantly, the pricing of these loans is higher.
Pre-crisis, [pricing] might have been 225 basis points over Euribor. Now it’s more than double that.”
She added that CLOs’ investment periods had shortened to between three and four years, down from five, largely due to lower investor demand.
“The main difference [in new CLOs] is just in terms of actual capital structures,” says Tim Beck, manager of the Credit Opportunities fund of funds that Stenham Capital launched in January 2013. “The equity tranche tends to be thicker – if you’re buying senior or mezz tranches you are more loss-remote. There are additional differences between CLOs 2.0 and CLOs 1.0 and the investment periods tend to be shorter.”
Matthew Jones, an analyst at Standard & Poor’s, says he is seeing features on new European transactions that look very similar to pre-crisis deals, together with some new features common to US CLO 2.0. “Asset composition is similar, but some transactions include the possibility for higher proportions of fixed rate assets and, in particular, bonds and that’s in response to the availability of assets in the primary and secondary markets,” he says.
Pramerica’s CLO featured a much bigger proportion of the portfolio paying a fixed rate – 30% up from the traditional 5%, according to a statement, which Jones expects future CLOs to imitate to mitigate risk.
But while new CLOs at first glance appear relatively conservative, covenant-lite loans are making appearances due partly to the lack of an abundance of leveraged loans.
PVE’s Pucci warns investors to be cautious. “We expect there would be a relaxation in the upper limit of high yield bond and cov-lite loans due to scarcity in eligible loans,” he says.
“Since many CLO investors are ratings conscious, CLO managers need to pay attention to these concerns. Any change would most likely be modest.”
Banks and insurance companies – the traditional buyers for senior CLO tranches – remain the most prominent investors in the US, according to Pucci, but balance-sheet concerns among these firms in Europe means they are much less active in the region.
“With receded concern in the European sovereign debt crisis, senior European CLO tranches would likely be on their investment horizon,” says Pucci, who adds that hedge funds are still the major players in the junior tranches.
While investment managers see sufficient appetite among investors for the re-emerging CLOs market in Europe, there are clear limitations to its growth. First, the uncertainty surrounding ‘skin in the game’ will probably delay new launches and its impact on recent transactions remains to be seen. This is expected to stand in the way of efforts to bring more real money to the region, such as those outlined in the European Commission’s Green Paper on Long-Term Financing of the European Economy, published in March.
Second, a surge in new European CLO issuance without a big enough increase in leveraged loan issuance would work against the CLO market’s recovery, according to a report by Moody’s in April. It said a race among CLOs to ramp up portfolios would lead to a drop in underwriting standards or cause an increase in the use of “riskier or lower quality assets, such as non-euro-denominated assets or assets domiciled in Europe’s peripheral countries, which would in turn increase credit risk and hedging costs”.
Third, Moody’s said limited loan availability would continue to make it difficult to structure diversified CLO pools and create cost-efficient capital structures. It said: “A shortage of loan supply will increase the risk that a CLO will have to deleverage upon failure to ramp up the portfolio and be unable to reinvest scheduled or unscheduled principal proceeds.”