European CLO market adapts to the challenges of the COVID-19 era (executive summary)
The period since March has been a turbulent time for financial markets, and the CLO sector in Europe dealt with a complex set of disruptions when the pandemic arrived this spring. From sudden and acute stress at the corporate level to an unprecedented shift in working conditions, CLO players in Europe experienced more uncertainty that hasn’t been seen since the last crisis. Yet, the market has adapted, and while the shape and size of deals may be different, CLOs in Europe are pushing ahead. BNY Mellon and GlobalCapital gathered a variety of market experts to discuss the present state and future prospects of the European CLO market.
Adaptability and resilience
Despite the intense volatility that battered the market in March and April, European CLOs have been surprisingly adaptive, navigating distress and re-opening in the COVID-19 era after only a brief pause in new issuance. Meeting for a virtual roundtable held by BNY Mellon on June 9, a panel of experts from the investment management, legal and trustee spaces say that while CLOs have seen innovation since the outbreak, the market hasn’t quite made the leap to a 3.0 era.
Instead, the period since the arrival of COVID-19 has been characterized by small tweaks and adaptations that have allowed a number of warehouse deals to progress and clear the pipeline while working in a greatly accelerated timeframe. According to the panel, the market has shown a resilience that has allowed it to function at high efficiency while navigating the disruption brought on by the pandemic.
Loan downgrades jump
“The run-up to the April payment dates was extremely demanding due to a volume of downgrades, with impact to CCC buckets and tests requiring lots of care and attention from us and our clients, but the situation has eased somewhat through May”, says Paul Murphy, director at BNY Mellon Corporate Trust. “Overall the EMEA CLO’s have held up well with attention now turning to the July payment dates.”
The sector in Europe was perhaps better prepared to endure the sudden bout of volatility compared to the US, speakers say. The lower proportion of triple-C loans in European CLOs is a notable difference between the geographies, according to Marcus White, senior investment analyst at Prytania Asset Management.
“European CLOs have fared better than those in the US so far, and I think that is largely driven by positioning of the European market going into this crisis,” says White.
“Regarding triple-C buckets, in Europe they were averaging 1%-2%, compared to around 4% in the US. Today they are around 7% in Europe versus over 10% in the US.”
As to whether the crisis has seen a shift in the type of reporting or actionable data required by collateral managers, arrangers or investors, Murphy believes there has been a trend in the market for some time for more readily available and usable data. Systems in place at BNY Mellon prior to the COVID-19 outbreak gave the firm a strong position to start from once the crisis hit, and Murphy says that the trustee platform has been very closely engaged with the market to make sure accurate and usable data continues to flow to clients.
“This is a big focus for us currently as we made a decision last year to transition to a new loan administration platform It has given great opportunity to build a much more integrated technology solution which enhances process automation and allows real time client access via LoanArcSM,” says Murphy
New approach to new issuance
Allen & Overy senior associate James Smallwood notes that the flexibility seen in new deal documentation is “part and parcel” with how the market in Europe has progressed in the decade since the last financial crisis, and that the level of resilience in this period is emblematic of a mature marketplace. CLOs priced in the months since the outbreak are essentially CLO 2.0 transactions, but the sector has reached a point where it can easily make small changes to accommodate the unprecedented situation and help deals clear the pipeline.
“It is really just small amendments we are making that come from the commercial decisions between various players. These include smaller deal sizes, increased credit enhancement, shorter reinvestment periods and shorter non-call periods. All of those points together work to ensure deals can get over the line,” says Smallwood.
The biggest change, Smallwood adds, has been the compressed timeline for getting deals done in the COVID-19 era. Whereas the time between the first drafting of deal documents to pricing was previously around six weeks, the market since March has been doing the same work in a fortnight. It has required a higher level of coordination and cooperation from all parties, from managers, to rating agencies, to investors.
The reduced timelines between pricing, issuance and deals going effective has been a significant change through this period, agrees BNY Mellon’s Murphy. “As Trustee, close coordination and open communication channels across parties has been critical factor in ensuring that the post COVID-19 deals have successfully launched”, says Murphy. Other innovations have been seen from managers like Fair Oaks Capital, which priced a Euro CLO in May with a delayed draw feature on the double-B tranche. The manager had experience issuing delayed draw tranches in its US operation, and its European deal in May also included other post-COVID-19 markings such as smaller deal size at €251.6m and a shorter reinvestment period.
“Through the end of April and May, we’ve been surprised at how quickly the market has rallied and how quickly primary reopened,” says Roger Coyle, partner at Fair Oaks. “We’ve seen a lot of CLOs put on downgrade watch, with many loans downgraded to B3 and triple-C, but defaults haven’t even started to increase. So I think it is surprising to see how quickly the market has rallied, much faster than it did in 2016 even though the underlying issue is more serious.”
Coyle adds that true innovations or wholesale changes to CLO structures are difficult in this period, with a widening spread environment and a shifting supply-demand balance. It is likely, he says, that once the market enters a more normalized period, CLOs will return to their four and a half year reinvestment periods in Europe and five year reinvestment periods in the US.
BNY Mellon is also highly focused on preparing clients to comply with disclosure requirements in the templates laid out by the European Securities and Markets Authority (ESMA) as part of the European Securitization Regulation that came into force on January 1, 2019. Beginning in March of last year, BNY Mellon has been a part of a wide industry group tasked with hammering out the details of complying with the new disclosure regime, helping position managers and CLO issuers to comply when templates are approved by the European authorities and become effective over the summer.
“We were able to have a strong dialogue over a number of months and reach a broad level of consensus on the responses for each data point, because many were not naturally easily applicable to a CLO transaction,” says Murphy. “What also came out of it was a clear level of division of responsibility between the administrator and the manager and it worked well to create a good awareness of the new requirements. As a result, despite a very detailed level of oversight, it has brought us to a good place for when the templates go live.”
Like every other employment sector, financial services sent the majority of their employees to work from home when the lockdowns began around the world. For CLOs, the period of remote working has been surprisingly smooth and, according to the speakers, few processes were disrupted.
“From a BNY Mellon perspective, like all organizations, we put a lot of time and effort into contingency planning. But also like most organizations, the requirement imposed where everyone needed to work from home at a very short take-up, without any real full test basis, was a huge challenge, but overall it has gone better than we could have expected,” says Murphy.
Some obstacles have popped up when roadshowing deals, says White, especially for new managers that may need a level of in-person communication to explain their business and their transaction to potential investors. CLO marketing, especially at the formative stage, is still a physical exercise, with managers either hosting investors in their offices or hitting the road to walk them through the offering. Even seeing a manager’s workspace, their set-up and their trading floor can provide a level of comfort for investors.
“Roadshows are purely physical, and the only time that might be different is if you are already comfortable with a particular manager,” says White.
For Fair Oaks, Coyle says that the firm’s experience has been “similarly painless,” especially as the market has simultaneously transitioned to a much higher speed of execution for new deals. The success has partly been a function of much of the sector already moving to electronic systems and signatures.
“I think the bigger challenge we face, bigger than moving out of the office, will be moving back in,” says Coyle. “It will be hard to go back to the way it was when people expect flexible work from home arrangements, but these can be more difficult to manage than having everyone working remotely. Planning for the return is a real challenge, especially if social distancing in still in place.”
Overall, if the market does end up working remotely for the foreseeable future, this test period has proven that it can be done easily, the speakers agreed, and people in the market have shown themselves to be remarkably adaptive to the situation.
“What we have works very well, and a number of CLOs that have priced in the last six to eight weeks have gone directly onto our new platform. So the technology has worked well and we’re managing comfortably now and likely for the foreseeable future. Our teams have been working in partnership with our clients who are also at home but by exhibiting a high degree of flexibility on both sides, while challenging at times, it has proven to be successful,” says Murphy.