Investors blithe about rising LBO leverage
Cashflow arbitrage CLOs vied for attention in 2006 with the synthetic credit market. Cash deals had huge volume growth on their side — but the innovations in synthetic structuring came as thick and fast as ever. By Radi Khasawneh.
The European collateralised debt obligation market in 2006 was dominated for the second year running by record-breaking issuance of arbitrage CLOs backed by leveraged loans.
Despite fears of a downturn in the credit cycle, CLO managers and investors remain as gung-ho about leveraged finance as private equity funds.
Public issuance of synthetic CDOs, on the other hand, has been more patchy, and is now in danger of being overshadowed by a new product — the constant proportion debt obligation.
Bankers' hopes for a record year of arbitrage CLOs were easily exceeded in 2006, with Eu20.2bn of paper coming to market in the 10 months to November, according to Standard & Poor's, up from just Eu8.9bn in the whole of 2005.
According to CLO manager Harbourmaster Capital, there is now Eu54bn of European CLO paper outstanding, of which Eu27bn was issued in 2006.
The shortest explanation of why this has happened is that the number of active CLO managers in Europe has more than doubled, from 22 in 2005 to 52 in 2006, according to S&P.
But it takes two to tango, and investors were more than bullish about buying deals from managers untested in the European market. Both Investec Principal Finance and Blackstone Debt Advisors brought their debut CLOs to market in 2006, and managed to notch up two more each by early December.
Just as remarkable was the output of established players such as Alcentra and Harbourmaster Capital. Alcentra sold five deals this year, two through its Jubilee programme and three from the Wood Street platform, while Harbourmaster issued four, pricing Harbourmaster CLO VIII a mere eight days after the closing of Harbourmaster CLO VII in November.
Despite the spate of issuance, the incoming tide of demand was stronger, and pricing tightened. Triple-A bonds — which are often placed with monoline wraps in negative basis trades — tightened from around 22bp at the start of the year to reach record tights of around 20bp over.
At the double-B level the contraction was much more marked. New issue spreads came in from around 425bp at the beginning of the year to reach a new record of 335bp in September.
That level held as the floor for the rest of the year, with Carlyle Group's CELF III, Alcentra's Jubilee VII, Blackstone's Green Park and Babson Capital Europe's Duchess VIII all being priced at that level.
Whether these spreads mark the bottom of a cycle or are just a pause before a new round of tightening remains unclear.
"I personally think spreads are at their tights," says a portfolio manager at a large European CDO asset manager. "There is a ton of liquidity and negative basis trades are at their tights. Things are optimistic for next year, there are perfect conditions, with liquidity, investors chasing yield and demand across the whole capital structure."
Few market participants expect double-B spreads to narrow further, but they argue that senior tranches might tighten again next year.
"At the senior end, Basel II is likely to bring spreads in even further," says Alan Kerr, portfolio manager at Harbourmaster Capital in Dublin. Risk weightings will fall for triple-A ABS under Basel II.
"Spreads are already at their tights on the double-B level," Kerr adds, "and I am not that aggressive on those, although there is still a big pick-up for double-B CLOs over double-B corporate bonds."
Others, however, are less sanguine, pointing to the high degree of leverage in the underlying loan market, as private equity funds demand ever more aggressive terms from their lenders.
A Fitch report in November estimated that total debt on European leveraged buy-outs, including senior, second lien and mezzanine, was running at an average of 7.5 times Ebitda in 2006, an all time high.
If defaults rise, recoveries could be poor for subordinated positions, such as mezzanine and second lien loans, particularly since senior debt amortisation profiles have become much longer.
Many market participants expect a rise in defaults — the hard part is gauging when the credit cycle will turn.
"You have to be cautious about the credit discipline out there," says a senior official at one CLO manager. "We reject one in three deals we look at, although having said that, there are a lot of good companies being taken private."
The official expects leveraged loans to perform well next year, but believes a downturn is possible in 2008.
Another factor contributing to the rise in arbitrage CLO issuance is that as the market ages, more deals are becoming callable, which typically happens after five years. Prudential M&G, Intermediate Capital Group and Harbourmaster Capital all called CLOs and refinanced the assets last year. Equity investors in Harbourmaster CLO I took home a lifetime internal rate of return of 17%.
As more deals are called, investors will be able to gauge more clearly how different managers have performed over time, helping them to differentiate between managers in future deals. Spread tiering by manager is still fairly crude and visible only at the more junior part of the capital structure, but may become more apparent in the coming years.
In 2007, market participants expect the conventional arbitrage CLO market to converge with synthetic leveraged loan products.
Already, several banks have executed synthetic single tranche deals referencing leveraged loans — Deutsche Bank through its Moorgate programme, and more recently Barclays Capital with a private deal.
Central to this development is the iTraxx LevX index of leveraged loan credit default swaps (LCDS), which was launched in October with Barclays Capital, Credit Suisse, Deutsche Bank, Dresdner Kleinwort, Lehman Brothers and Morgan Stanley as licensed market makers.
Since the launch of the unified iTraxx and CDX indices for mainstream credit in April 2004, index trading has rapidly become central to the structured credit market. Proponents of the LevX believe the logic will be the same in leveraged loans, but there are doubters.
They argue that leveraged loans will be harder to trade in credit derivative form because each tranche of each loan is in some senses a unique instrument, that can be called or refinanced at any time — whereas an ordinary credit default swap can be settled by delivery of any one of a number of bonds.
The other main objections are that European LCDS documentation differs from that in the US, and that leveraged loans are private instruments, so it would be difficult for holders to trade LCDS in the public market unless they give up their private status.
The quiet machine
The public shopfront of the European synthetic CDO market was a quiet place in 2006, with few large deals. But the back rooms were a hive of activity, with numerous private transactions.
With little yield available on the mezzanine tranches of credit portfolios, investors had to move fast to find value when it appears. This pushed them towards quick, private, bespoke trades across the capital structure, from equity right up to leveraged super-senior.
Perhaps the most notable public deal was Axa Investment Managers' Jazz III, a hybrid cash and synthetic deal which issued $288.25m and Eu159m of notes through Merrill Lynch in August.
The first two Jazz deals, launched by Deutsche Bank in 2002, had pooled largely investment grade CDS and cash bonds, allowing the manager to switch between the two. Jazz III is like them, but also allows the manager to include loans and CDO equity.
It includes a 10% short bucket — bigger than in the earlier Jazz deals — for naked and offsetting positions.
"Jazz III had the option of trading in either cash or synthetic securities around approximately 150 different companies," said Paul Horvath, managing director of debt markets at Merrill Lynch in London. "What it did was very cleverly mix cashflow CDO technology with synthetic correlation technology to give Axa the increased flexibility to manage the deal in various widening and tightening spread markets. In this way it appealed to investors who are uncertain about the direction of spreads for the next seven years."
CDO tranches at the first loss position in a credit portfolio had been tipped as a strong contender this year, offering investors better returns than mezzanine and allowing banks to offload correlation risk. Banks were expected in particular to craft structures that allowed such equity tranches to get investment grade ratings.
Lehman Brothers priced one such deal for Prudential M&G called Bison, but few other public deals materialised, possibly due to investor uncertainty, but also because of the emergence of new competing products.
Away from traditional synthetic CDOs, the structured credit market enjoyed rapid growth in constant proportion portfolio insurance (CPPI) products.
These are instruments that offer investors principal protection through investing some of the capital in a zero coupon bond. The spare capital is invested in credit trading strategies to earn a return.
The appeal of CPPI lies in its flexibility, leaving managers free to pursue a range of different strategies, including basis trades, long/short individual names and net short positions on individual credits and indices.
The largest structure of this kind is believed to be AIG Global Investment Group's Axiom CPPI, lead managed by BNP Paribas. In late August the vehicle was tapped for a third time, as BNPP sold $89m of notes, mainly to Asian clients. The total size of the deal is now $655m.
Hoping to make the structure still more flexible, Société Générale introduced a gap value at risk (GVAR) product, allowing the manager to pursue multiple strategies with the risky portfolio.
The first such deal was the Eu250m Keolis, priced in late June for Axa Investment Managers. SG also brought a similar deal for Solent Capital, called Propellor.
"Propellor appeals to a similar community of buyers as other structured credit investments. It offers a diversified portfolio of market-neutral credit strategies," said Raymond O'Leary, partner at Solent Capital in London.
The other trend in CPPI was the move towards rated coupons. Most CPPI deals are rated for principal only, with a variable return. But that can make them hard for bank investors to match-fund, and requires a higher regulatory capital charge.
Throughout 2006 structured credit desks strove to develop a product that could be fully rated, including the coupon. The first to get there was ABN Amro, which solved the riddle by developing something new, the constant proportion debt obligation.
This is a hybrid between a CDO and CPPI, with no principal protection and a fixed set of leverage rules to ensure a constant return. Even more eye-catching than the rating — a pristine triple-A from Standard & Poor's — was the coupon of 200bp over Libor.
That return, achieved through an aggressive rules-based leverage strategy, was enough to beat any other competing structured product — sweeping aside mezzanine and even rated equity CDOs.
Investors' principal is held in a special purpose vehicle and leveraged up to 15 times with long bets on the iTraxx and CDX indices. Every six months these bets are unwound and replaced — if spreads have fallen, the SPV simply bets bigger to keep the premiums flowing.
Sceptics might argue that this is probably not the same kind of triple-A as the Swiss government, but at 200bp over, many investors are happy to participate.
"CPPI had greater interest from banks, but there was also interest from insurance companies and pension funds, whereas CPDO has a surprisingly blended investor base," says Andrew Feachem, structured credit marketer at ABN Amro in London.
The rules-based structure was easy to replicate and before long Merrill Lynch, Lehman Brothers, Barclays Capital and HSBC had jumped in with structures of their own. By the end of the year, an estimated 17 banks were touting similar structures.
Unleashed on to an unsuspecting CDS market in August, CPDOs began to bombard trading desks with bids for the investment grade indices, contributing to a sharp rally in October.
As credit spreads contracted, the headline-grabbing 200bp over Euribor that was offered in July and August became unattainable, sparking fears over downgrades.
In November and December, the emphasis shifted to more flexible variants on the CPDO that can cope more easily with changing market conditions. The next generation will include products referencing different asset classes and with different ratings, as well as managed deals.
The CPDO has already shown that it can exert a strong influence on the way credit is priced. Its efficient structure and leverage rules create a powerful source of demand for synthetic credit risk, pulling in spreads and setting a ceiling for future spread widening.
That influence is unlikely to die away and, as more types of credit are subsumed into the CDS market, it could continue to grow.
The CPDO also typifies another trend — the drive by rating agencies to broaden the range of risks they evaluate, beyond credit risk into areas such as market value and liquidity risk.
The CPDO is the logical extension of the type of analysis that began with structured investment vehicles and has been expanded to leveraged super-senior tranches, credit opportunity funds and rated CPPI.
"One interesting trend has been the rise in market risk assumptions in rating agency approaches," says Jonathan Laredo, chief executive officer at Solent Capital in London. "This is indicative of the growth of market value technology, with a slew of new deals in the market value space. The CPDO rating includes roll risk, and the banks are looking at where they can take this concept forward."
|Real estate CDOs arrive|
One category of CDO familiar in the US had not been issued in Europe until 2006 — the CRE CDO. This is an instrument parcelling various commercial real estate related obligations such as CMBS tranches, commercial mortgage 'B' notes and Reit debt.
In late November BlackRock Financial Management launched Europe's first example, worth Eu342.5m. Led by Morgan Stanley, Anthracite Euro CRE CDO 2006-1 was backed by CMBS tranches and subordinated 'B' and 'C' loans.
Many more deals are expected to follow, fuelled by the booming CMBS market in Europe, which is throwing off ever more 'B' notes and junior CMBS tranches.
However, the illiquidity of the asset class and reliance on the CMBS primary market to source assets may make it hard for managers to remain fully invested.
"CRE CDOs of 'B' notes, and the interest in doing them, is already driving the limited 'B' note market," says Ronan Fox, managing director in structured finance at Standard and Poor's in London.
Investec Principal Finance and Taberna Capital Management, a US asset manager experienced in CRE CDOs, are set to launch deals shortly.