At the start of last year, most market participants expected CLO formation to be sluggish in 2017. New risk retention rules that required managers to hold 5% of every deal were expected to dampen deal volumes.
“We went on record with an issuance forecast of $80bn-$100bn at the start of the year — and people said we were very aggressive!” says Tom Majewski, managing partner at Eagle Point Credit Management, which invests in CLO equity and junior debt. “It turns out we were at the conservative end.”
By mid-November managers had broken the $100bn mark for new CLOs. Including deals being refinanced and reset, investors eyeing the CLO market’s floating rate paper snapped up more than $250bn in the asset class during the year, according to Wells Fargo analysts writing in November.
Finding willing buyers was not a struggle in 2017, with heavy demand for CLO debt throughout the capital structure providing a strong backdrop. While Japanese buyers played a dominant role anchoring deals by buying triple-A bonds last year, CLO managers were able to expand the Asian investor base to include South Korean and Chinese investors, too.
However, the most significant shift in the buyer base was at the riskiest end of the capital structure, with a new influx of equity investors.
The onset of risk retention rules proved a watershed, changing dynamics for CLO managers, investors and investment banks.
One of the positive — if unexpected — impacts of risk retention was to bring in a host of institutional buyers to the CLO market through dedicated risk retention funds, such as Healthcare of Ontario Pension Plan (HOOPP), which sank $300m into a partnership with CIFC in September to finance the equity in about $7.5bn of the manager’s future CLOs.
Some managers set up funds to allow third party buyers to invest in their CLO equity, and sometimes that of other managers. GoldenTree Asset Management, for example, raised $600m from institutional investors for a risk retention vehicle in January last year.
Such buyers would be unlikely to look at investing in CLOs on an individual basis, says Mike Herzig, head of business development at THL Credit. “There was originally concern that the rule would make it harder to get CLOs done, but it has attracted a larger, deeper and more sophisticated pool of capital than we have previously seen,” he says.
Sourcing anchor equity investors has often been a sticking point for CLO formation. But with the surge of risk retention funds, it was no longer a headache for CLO managers last year. Existing investors that target CLO equity have mixed feelings about this new competition for equity paper, however.
Cara Roche, a portfolio manager at Zais Group, which both manages and invests in CLOs, says it has become more difficult to find majority positions in CLO equity. These give investors control over important strategic decisions, such as when to refinance the deal’s debt.
“If your strategy is predicated on that, it has become a difficult market,” she says.
But not all agree. Majewski says the growth of the market, encouraged by the volumes of new CLO equity money, has given third party funds more opportunities, rather than squeezing them out.
“In 2016, third party buyers took the majority of the equity in about 51% of CLOs issued,” says Majewski. “In 2017, up to the end of November, roughly 45% of CLOs issued had been structured with vertical retention and 55% went horizontally to captive majority funds. Even if the vertical proportion is slightly smaller, it’s a share of so much larger a notional amount that the opportunity is bigger for investors like us.”
Risk retention has also changed the way investment banks compete for mandates to arrange new CLOs. The structures typically generate about $1m in fees for banks, depending on the size of the deal.
Arranging banks would previously use their connections with key equity investors to attract CLO managers to their platforms. With a host of equity options available for managers, this is now less of a draw. Instead, arrangers are now putting more balance sheet to work to win business — offering longer warehouse terms, or providing financing options such as repo against managers’ risk retention requirements.
“A few banks are looking to attract more business as CLO placement agents by offering equity financing, and we welcome a more competitive market in that regard,” says Gretchen Lam, who serves as the portfolio manager of six CLOs at Octagon Credit Investors.
The loan market headache
With investors scrambling for CLO exposure, finding buyers was not a pinchpoint for CLO managers last year. But an aggressively expensive loan market became a headache that is set to get more painful in 2018.
Taken at face value, leveraged loan supply was impressive in 2017 — volumes hit $435bn by mid-November, making it the market’s best year since 2013 and the second highest amount since 2005. Net new issuance also jumped compared with 2016.
Wells Fargo data shows that there was net new issuance of $45bn, a 7% increase in outstanding paper last year (compared with the 0.8% growth in 2016).
Still, it has not been enough to keep pace with the demand for loan exposure, creating technical pressures that have swung the balance of power firmly towards issuers.
“A difficult technical environment has caused spreads to compress, and the balance to shift in favour of the borrower, even in the face of what have been pretty flat retail loan flows for much of the year,” says Lam. “There just hasn’t been enough net new loan issuance in 2017 to satisfy demand.”
With a benign credit backdrop, managers are broadly comfortable with underwriting standards. “We have seen leverage creep up but we are still not close to 2007 levels at this point,” says Lam. Debt service coverage ratios of about 4.2 have also remained broadly in line for several years and are well above the 3.0 and 2.9 times seen in 2006 and 2007, says Majewski.
But the pricing of credit is putting stress on the ability of managers to keep their portfolios within the standards set at the start of a CLO’s life, which govern the required spread and ratings that must be maintained.
“If the market continues to see spread compression, it’s going to be increasingly difficult for some CLO managers to stay fully invested. In many CLOs, it is becoming increasingly difficult to preserve both ratings and spreads,” says Lam.
In an expensive loan market, managers must decide whether to creep down the credit spectrum for cheaper loans, pushing up against the rating test, or to buy better rated credit above par, reducing returns. Managers can get boxed in, says Lam.
“The universe of loans that can fit in the fund shrinks — those loans are typically trading at meaningful premiums because of above-market spreads.”
As a result, many CLO funds are running high cash balances because managers cannot buy the right loans at the right price. Given the cost of the debt on the structure, equity returns can suffer.
“New CLOs shouldn’t have matrix pressure because they can set their tests based on where the market is today. Older funds, especially 2016 vintage CLOs that are still within their non-call periods, may struggle,” says Lam.
“Nearly every CLO matrix is right down to the wire now,” says Majewski. “Collateral managers have to be picking up nickels and dimes right now, buying up $500,000 pieces of loans, and they need to find names below par to make it work. When 65% of the secondary market is trading above par, this is where collateral managers need to be able to make smart credit decisions.”
This late in a credit cycle, credit selection is more about avoiding losers than it is about picking winners, says Herzig, particularly when some managers were burnt by the slump in energy-related credits in 2015 and early 2016.
“This far into a credit cycle, managers don’t feel they should be stretching too far on credit risk,” he says. “CLO managers are generally trying to minimise credit mistakes rather than taking aggressive positions in discounted names.”
Managers are also wary of a loan market that is priced so tightly that there is little room for error or corporate underperformance. This could create more pronounced bouts of volatility this year.
“The loan market doesn’t feel weak on a broad basis, but it feels impatient on any credit that misses its numbers, or expresses uncertainty over its business plan. There is little tolerance,” says Herzig.
Conditions in the loan market are not expected to get any easier in 2018. Private equity firms pushed more aggressive terms into documentation last year, on top of covenant-lite structures that have become an accepted norm.
There are also concerns over talk in Washington of rolling back leveraged lending guidelines, which could encourage more aggressive underwriting.
“We have seen an acceleration in the loosening of terms in the past three or four months — larger restricted payment baskets, incremental debt provisions, the ability to unrestrict subsidiaries, changes to the pro rata waterfall language,” says Lam. “These have given borrowers more flexibility to remove assets and/or cash away from the restricted entity [that investors lend to]. If there is a default or a credit issue this will ultimately reduce recoveries,” she says.
“It remains to be seen how disciplined underwriters would be in the absence of regulatory guidelines,” Lam adds. “Hopefully we have all learned something from the crisis, but I wouldn’t be surprised to see leverage go up if the guidelines are removed.”