Buoyed by new players and strong demand from investors, the European arbitrage CLO market is growing fast, catching up quickly with its older sibling in the US. But it is also facing fresh challenges. Aggressive structures in the leveraged loan market, falling credit quality, high prepayment rates and excess bank liquidity are all making asset managers' lives difficult. Some are now starting to explore alternative structures. Taron Wade reports.
Growth in the number of European arbitrage collateralised loan obligations (CLOs) has skyrocketed since January 2001 when AIB Capital Markets brought the first collateralised debt obligation of purely European leveraged loans to market.
Funds still make up slightly less than 30% of investors in leveraged loans, but the number of managers and funds continues to grow and they are now becoming a formidable force in the leveraged loan market.
Bank investors traditionally dominated the funding market for leveraged buy-outs in Europe. Now, even they are starting to admit that the CLO funds are making more of an impact and beginning to tread on their turf ? influencing the way LBO loans are distributed and packaged.
This subtle shift in power is indicative of the European market starting to move more towards the US model, where CLO and other fund investors comprise 80% of investors in leveraged loans.
But the CLO market is not without its teething problems.
The chief problem is a wider supply and demand imbalance in the overall European loan market, which has caused pricing on all loans to drop. This has forced banks to seek participations and arranging roles in the more highly-paid leveraged loan market.
This imbalance has created a situation where bank mandates to arrange transactions are hard to come by, but after a deal has been won it is easy to sell.
To win business banks are pitching structures to private equity sponsors with increasing leverage, fewer covenants and reduced pricing. And yet, this paper is flying off the shelf as banks, CLOs and even hedge funds clamour to invest in the asset class.
?Credit spreads have been tightening elsewhere so there is a significant increase in interest in the leveraged loan market,? says David Gillmor, credit analyst at Standard & Poor's in London.
Oversubscriptions and scale-backs on deals are problems for every investor in the asset class, but for CLO managers these difficulties are extremely pressing because they are under pressure to invest rapidly ? and in accordance with strict portfolio guidelines ? to generate enough returns to attract investors for the high-risk equity notes.
A slew of these aggressive leveraged loans this year, coupled with an increasing number of new CLOs, is forcing market participants to question whether the CLO market is overheating.
Most managers and CLO investors say the market is aggressive but hesitate to take the description as far as overheating, emphasising that leveraged loans are an asset class with extremely low historical default rates.
?The market does feel toppy,? says one CLO manager. ?Yes, we are increasing our scrutiny ? you have to be careful.?
Arbitrage CLOs: a brief history
The launch in 1999 of Intermediate Capital Group's Eu400m EuroCredit CDO 1 ? the first public arbitrage CDO backed by euro-denominated assets ? signalled the arrival of the arbitrage CDO as a new source of funds in the European high yield and leveraged loan markets. Since then the CDO, and in particular the CLO market has grown dramatically.
Selling the liabilities has not always been easy ? especially in 2003, when demand for CDOs in general waned amid broader credit concerns and macroeconomic problems.
Nonetheless, investor interest in CLO paper has remained strong, bolstered by historically low default rates and high recoveries, particularly when other CDO asset classes, such as synthetic deals backed by investment grade credits, have experienced severe downgrades.
More recently, narrowing credit spreads on ordinary corporate bonds have pushed fresh investors into the asset class, leading to a sharp contraction in CLO spreads.
The strength of demand for CLOs is driven, in part, by technical factors; but it is also underpinned by fundamental ones ? a strong legal framework for European leveraged loans, and a business culture where lenders have the ability to restructure bad loans to avoid default.
?Market practice is such that when things go wrong, lenders get round the table and sort it out,? says Rachel Hardee, analyst at Fitch Ratings in London, who specialises in rating leveraged loans and mezzanine. ?Historic default rates on leveraged loans are very low. This should prove sustainable as long as the position of secured creditor remains unimpaired.?
The early pioneers in the European CDO market, independent managers such as Intermediate Capital Group (ICG) or Duke Street Capital Debt Management, or larger fund managers such as Axa Investment Managers, are now a core of regular issuers, coming to market sometimes up to twice a year.
ICG, for example, was first and foremost a mezzanine fund, but has now closed three EuroCredit securitisations of senior leveraged loans and high yield bonds and two purely loan funds, Promus I and II.
More recently, a new, powerful form of investor has emerged in the form of arbitrage units set up by commercial banks.
NIB, Mizuho and Royal Bank of Scotland have all created bank arbitrage units that manage CLOs. SG CIB, meanwhile, is preparing its first arbitrage CLO and plans to launch it in the first quarter of 2005.
René de Laigue, global head of leveraged and acquisition finance at SG in London, says that forming a CLO management team gives the bank good arbitrage opportunities and helps diversify its balance sheet.
?No one knows what the effect of Basel II will be, so this will help us to diversify and have an off-balance sheet way to invest in leveraged loans.?
Mizuho launched its first CLO, called Harvest CLO I and backed by Eu514m of loans, in April. About Eu300m of the loans are from Mizuho's balance sheet, with the rest sourced in the market. The deal is expected to be fully ramped up by the end of this month.
The bank has been a player in the leveraged loan market since 1987, including investing in private equity funds directly, and believes a managed CLO is a natural extension of its business model.
?It increases our firepower in terms of buying assets,? says Jeremy Ghose, general manager and managing director, European markets at Mizuho Corporate Bank in London. ?Secondly, it is a money making machine for us. We generate fees by not doing anything differently ? we use the same people and the same processes as when investing from the bank's balance sheet.?
As the European leveraged loan market shifts closer to the US model and LBO structures are geared for institutional investors, banks will need more flexibility for investing in the asset class.
A third source of growth in the sector is private equity houses themselves. The Carlyle Group recently announced plans to start up a debt business and hired Mike Ramsay and Colin Atkins, portfolio managers from Prudential M&G, to run it. Other private equity houses have been rumoured to be looking at starting up similar outfits as well.
Sponsors call the shots
But this growth is not without its own repercussions.
The influx of new funds into the loan market, combined with excessive bank liquidity and other new investors such as hedge funds, is resulting in an LBO market with aggressive funding structures that favour private equity sponsors. Leverage ratios are increasing; not just on the most stable of companies, but on more cyclical businesses as well.
Consequently, CLO managers are increasing their scrutiny when it comes to new transactions.
?We are turning down more deals than we did one or two years ago,? says Nathalie Savey, head of leveraged loan investment at AXA Investment Managers in Paris. ?This is indicative of the market becoming more aggressive in terms of covenants, information rights and structures.?
Another CLO manager agrees that there is pressure on cash flow and recoveries in LBOs. He says that at this time last year he was rejecting about a quarter of all deals he was shown, whereas in the last month he had reviewed eight deals and only invested in half of them.
?It will be interesting to see how people react when things go wrong, especially at these leverage levels,? says Andrew Phillips, a director at Intermediate Capital Group in London. ?You hope that you made the right credit decisions in the first place and then need to be very vigilant in terms of monitoring your investments and portfolio ? but you also need to be prepared to sink your teeth in and get involved in workout situations.?
Some argue that one of the reasons the market may seem aggressive right now is because of the large number of companies being brought to the market for the second or third time, which means that they have proven track records and can sustain higher debt levels.
Low interest rates and the lack of other exit strategies such as initial public offerings and trade sales, have caused refinancings, secondary and tertiary buy-outs to become common features in the leveraged loan market this year.
?Default rates for leveraged loans have been extremely low, so the market can sustain being a bit more aggressive as long as on the transactions where the leverage has gone up, Ebitda is predictable ? which happens generally on secondary buy-outs and recaps,? says Daniel Riediker, partner and CEO at Alegra Capital, a CLO equity investor based in Zurich. ?The market is aggressive but not overheated.?
Nonetheless, more aggressive structures are also starting to affect average ratings in the sector.
Because most LBO transactions are not publicly rated, CLO managers must get a shadow rating for a deal to prove to their investors that the collective rating of the leveraged loans in their portfolios meet standards set out when the CLO is initially rated.
Fitch's Hardee says that many deals rated this year have lower ratings than in previous years.
?We are concerned with the aggressive leverage multiples we are seeing,? she says. ?Some investors are turning down transactions because of this but there are others in the market that are just seeking yield. This is the time in the cycle when deals are done that may become the next set of problem cases.?
?Anecdotally, we are seeing a small slip in the average ratings of leveraged loans,? says David Gillmor, a CLO ratings analyst at Standard & Poor's in London.
?However, we've rated a lot more deals in the past 12 months than we used to, so the distribution could be larger because of this. But I've compared the spread of ratings from 2001 to 2003 and they have been very consistent.?
But Gillmor notes that he has not collected the statistics for 2004 yet.
Managers are noticing a difference, however. ?We are seeing more transactions being rated B1/B+ whereas before there were more deals with Ba3/BB- ratings,? says Jonathan Butler, collateral manager at NIB Capital in London.
Debt investors are, in theory, protected from this decline in credit quality by strict portfolio guidelines such as the weighted average rating factor, or WARF.
But CLO managers do have flexibility when it comes to meeting these guidlines.
They can increase the diversification of the portfolio, the average spread or assumed recovery rate, which is determined by the country of the LBO.
?Managers are putting more flexibility into their deals,? says Marjan van der Weijden, senior director at Fitch Ratings in London. ?For example, transactions may include a grid with various combinations of weighted average rating and weighted average spread, allowing the manager to choose one scenario that at that time in the market is most appropriate. If the rating is lower, the spread will be higher and vice versa.?
Also, rating agencies favour structures that allow managers to pay down deals if the only available assets are risky.
?We would advocate features that allow managers to pay down deals in a pro rata fashion,? says van der Weijden. ?This is called a turbo feature and has been seen in the US and it is being talked about in Europe as well.?
This hint of a decline in credit quality has done little to dent debt investors' appetite for CLO paper, particularly at the triple-A level, where investors are protected not only by rating agency portfolio guidelines and minimum rating factors, but also high levels of credit enhancement.
In mid-September BNP Paribas' Leveraged Funds Group closed the Eu213m senior debt on its third CLO ? LFEC3 ? at 35bp over Euribor, the tightest spread on record for European arbitrage CLO paper.
Other investors in CLOs, however, are naturally concerned about a drop in credit quality as well.
?I think the market could use a default, so that it could go back to seeing that there is some risk in loans,? says Daniel Riediker at Alegra. ?There are a lot of professionals buying loans who have been through credit cycles, but there are also hedge funds buying into loans because they are a natural hedge against rising interest rates, and maybe they overlook the risk.?
Difficult market conditions are also focusing investors' attention on the management style and experience of the asset manager.
?You need to have a manager that is active in the primary loan market and therefore likely to be a player during primary loan syndication,? says Terence Shanahan, head of fixed income syndicate at SG CIB in London. ?There are some leveraged loan CDO managers who buy loans mostly in the secondary markets and that's a concern, as they are less likely to be involved in a workout, if required.?
The right relationship
But a more immediate impact for CLO managers of soaring demand in the loan market is the difficulty they face in sourcing assets.
Sourcing assets has always been a challenge for European CLO managers, who face a relatively shallow European LBO sector compared to the larger US market. Deals typically have ramp-up periods of up to a year.
More recently, these problems have been exacerbated by unprecedented levels of demand at the senior and mezzanine levels.
For example, funds were invited to lend ticket sizes of Eu10m for the institutional senior debt portion of the leveraged buyout of paper and packaging company Clondalkin. However, high levels of oversubscription meant that the funds were scaled back to a mere Eu4.9m.
More favourable financing levels, coupled with sluggish IPO markets, have also increased leveraged loan prepayments, leaving asset managers under pressure to reinvest excess cash to generate consistent equity returns.
?So far we've achieved returns within our target of 10-15% per year, but that doesn't mean that there aren't issues in the market,? explains Riediker.
?If asset managers sit on a lot of cash they hurt the returns of income notes. Prepayments generate cash and have always been an issue, but it is getting worse because managers are used to buying loans in the secondary market at less than par and buying deals in primary that only have leverage of three or four times Ebitda. They are now facing a difficult decision between holding cash and making an investment that might not fit their needs exactly.?
Rating agencies are acutely aware of prepayment rates and their potential to affect cash balances of CLOs. High rates of prepayment, however, are not a credit issue ? at least not until they reach such high rates as to affect a deal's ability to pay the interest on the bonds.
?We have seen a trend this year of increasing cash balances,? says Fitch's van der Weijden. ?We looked at 15 CDOs and in March 2003 the weighted average cash balance was 2% and in July 2004 it was 6%. That difference is not drastic, but it is a trend, and some of the deals had 10%.?
Increasing cash balances can potentially create negative carry in transactions. ?Ultimately, if the transaction does not generate sufficient spread it may have an effect on the deal's rating. It hasn't impacted the ratings on any European transactions yet, however,? van der Weijden adds.
Moody's looks at what modifying the amortisation profile of the asset portfolio would do to the transaction.
?But we don't specifically include prepayment risk in our models because the only real risk to the CLO is the cost of carry,? says Lisa Goldbaum, vice president and analyst at Moody's in Paris. ?We believe that this is more than compensated for by the reduction of the portfolio risk due to the prepayment.?
The need to be able to invest and reinvest cash quickly is making the ability to source assets one of the strongest weapons in an asset manager's arsenal when pitching equity and debt investors. And in the loan market, perhaps more than any other arena of the capital markets, relationships are key.
?There is a very high level of prepayments and there is pressure on managers, although it is somewhat manager-specific,? explains S&P's Gillmor. ?Those that have good access in the primary market are under less pressure.?
The CLO market has not so far separated out good and bad managers, but most market participants expect a tiering to emerge.
?It helps if you have a track record you can put up in front of investors and also show that you have ramped up in less time than what you are allowed,? said one European CLO manager. ?Some investors are asking us what proportion of deals we bought in the primary market as opposed to secondary.?
Unsurprisingly, managers are keen to differentiate themselves, to gain favoured status in primary distribution.
?Because we are able to participate as both a bank and a fund, we can take large tickets, which pleases both investment banks and private equity sponsors,? says NIB Capital's Butler.
Having a relationship with not only arranging banks, but also financial sponsors is emerging as a smart tactic for CLO managers. Mizuho invests in private equity funds, which can help on allocations.
?When we lead a deal we can allocate ourselves as a bank and as a CLO and we get invited by these equity houses because of our reputation and also because we invest in their funds,? says Jeremy Ghose.
Also, size does matter. ?It is clearly a positive factor,? says AXA-IM's Savey. ?AXA-IM has Eu800m of leveraged loan assets under management and this is a very important factor in the ability to source assets.?
High demand has also made sourcing assets more challenging at the mezzanine level ? the asset class that many CLO managers rely on to generate attractive returns for equity investors.
After difficulties in Europe with high yield bonds defaulting in 2001 and 2002, investors shied away from CLOs with high yield buckets and managers increasingly began including mezzanine buckets in deals.
?It is important to make sure managers have sourcing ability if there is a mezzanine bucket in the structure,? says Mark Moffat, head of European CDOs at Bear Stearns in London. ?If a manager is unable to buy enough mezzanine then the modelling assumptions may be inaccurate.?
These challenges notwithstanding, CLO managers insist that the sheer volume of deals coming to the market this year has allowed them to be selective. Although many of them are refinancings or secondary buy-outs, there is still the opportunity to see a lot of deals.
?Market conditions have been great for CLO investing as the number of new issues, including refinancings, has been substantially higher,? says Savey.
Also, there are some alternative strategies for dealing with prepayments. For example, AXA-IM's leveraged loan group, with the help of its research team, picks companies from its portfolio that it anticipates will refinance within three, six and 12 months. Then, if it spots an interesting investment opportunity, AXA will sell one of the loans it thinks likely to prepay, to make room for the new asset.
And prepayments are not necessarily always a bad thing. ?It is sometimes good from a pure marketing perspective to be able to quote a high churn rate because bad deals remain in a portfolio forever, while good deals prepay and refinance,? says Steve Chapman, head of leveraged loans research at AXA-IM. ?If we invested in bad deals we wouldn't have this problem.?
Despite all these teething pains, there is no doubt that the European CLO market is expanding and maturing.
One indication is the shift in the attitude about pricing on leveraged loans.
JP Morgan successfully syndicated the debt for the buy-out of hydraulic systems manufacturer Stabilus from Demag, even though it set pricing at 25bp less than usual on the ?B' and ?C' tranches.
And arrangers of the debt for recent buy-outs such as ATU, Grohe, United Biscuits and Weetabix have used reverse flex on the institutional tranches ? an early step towards using a supply and demand based pricing system.
Another change is in the distribution of loans throughout the structure of the deals.
When investing in LBOs, banks take pro rata pieces of the senior debt structure ? from ?A' through to the revolver. But there are carve-outs of the ?B' and ?C' tranches earmarked for institutional investors, the majority of which are CLOs.
In the European market the ?B' and ?C' term loans are still a relatively small proportion of the overall LBO structure. However, this is changing.
In the past, the ?B' and ?C' term loans taken together have composed less than half of the deal but bankers say ?B' and ?C' tranches of the deals structured this year have comprised about 50% of the debt.
In the US market, where institutional investors dominate, a much higher percentage of the debt is concentrated in the ?B' and ?C' term loans.
The problem, however, is that although CLO funds are now big investors in leveraged loans, in other respects they are still not big enough.
?We still can't structure deals geared towards European CLOs because it just doesn't feel like the real capacity is there,? says one arranger at a US investment bank. ?But until we do structure more deals aimed at CLOs there won't be enough supply for new CLOs ? it's a bit chicken and egg.?
One new avenue could come from alternative investment vehicles, which use leverage and may even borrow from CDO technology, but are designed to be more liquid for CDO investors, and less rigid for the managers.
?We're looking at funds that will allow us greater flexibility as a manager to invest in other asset classes,? says ICG's Phillips. ?We don't want to be a one-trick pony. With CLOs the restrictions imposed on the manager are very substantial ? and from an investor's perspective, the instruments are illiquid and somewhat unwieldly, albeit lucrative at the right point in the cycle.?
Managers say most of these new types of funds are unlevered or only ?lightly' levered ? between two and four times.
There is at least one of these types of funds already as Prudential M&G last autumn launched a new business line to build and manage leveraged loan funds for clients.
Stichting Shell Pensioenfonds, the Dutch pension fund of the Anglo-Dutch oil company chose Prudential M&G to manage Eu50m of leveraged loans. The fund does not use leverage and makes direct investments in leveraged loans through a segregated account.
?There are people who are trying to do two to four times levered, but in doing it you face the same issue [that you do with CDOs]: can you source the product enough to fill it?? says one manager. ?You might need to act more like a bank and do pro rata investing and offer a 7%-8% return because that would be deliverable. It would also be sensible to fund it using a revolver so that there is the flexibility not to draw when you aren't invested.?
Fitch's van der Weijden says the rating agency has been approached to rate loan funds that would be leveraged, but less leveraged than a CLO.
CLO investors are also trying to expand the market.
?We are thinking about new leveraged loan products with maybe just two parties: one taking the senior risk and one taking the junior,? says Alegra's Riediker. ?This would give us more flexibility to change the terms of the transactions.?
While CLO managers are facing challenging conditions, the market as a whole is still buoyant, creative and poised for further growth.
?The CLO market has gone from being non-existent to 30% of the leveraged loan market,? adds Riediker. ?I think that is sustainable and it can even go above that. I think we are one to two years away from the US market.?