European CLO market adapts to the challenges of the COVID-19 era (full transcript)
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 uncertainty not 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 market experts to discuss the present state of the European CLO market and its prospects.
Roger Coyle, partner, Fair Oaks Capital
Paul Murphy, head of EMEA relationship management — investment managers, BNY Mellon
James Smallwood, senior associate, Allen & Overy
Marcus White, senior investment analyst, Prytania Asset Management
GlobalCapital: How has the CLO market in Europe fared since March? Paul could you start us off with some perspectives on what you have observed in this period?
Paul Murphy, Head of Investment Managers for Corporate Trust in EMEA, BNY Mellon: Speaking from a trustee role, what we did see through March and April in particular was a significant volume of collateral downgrades. The immediate impact to CLOs was increased triple-C buckets, reduced cushions on OC tests, and naturally an increased level of management and oversight on the part of investment managers across their portfolios. We saw a very active level of engagement through that period, and we worked closely with the IM’s in ensuring all data and tests were complete and accurate.
We are now through the key April payment date period with the next one in mid-July. And so far, from where we’re sitting, while it has been a hugely active period, the EMEA CLOs seem to have held up reasonably well.
Issuance has continued but it’s definitely off compared to where it was last year, which is not surprising. Deals are a little bit different in terms of their shape and size as they’ve come through but the positive thing is that activity has continued with pre-COVID 19 warehouses progressing. With regard to rating downgrades, they seem to have eased up, which is a good thing, but the market will turn their sights to the June financials and see where we go from there.
GlobalCapital: Marcus, can you tell us about what you are seeing from your perspective at Prytania?
Marcus White: Prytania Asset Management: I would say that the European CLO markets definitely seems to have fared better than the US. I think that’s largely driven by the positioning of the of the European market. Going into the crisis for now the US, if you think about triple-C buckets and defaults starting in January, averaged triple-C bucket in Europe was maybe 1%-2% versus around 4% in the US. Today, I think there is around 7% triple-C in Europe versus about 10% plus in the US. And we also saw a gradual pickup in in defaults in the second half of 2019 in the US whereas Europe remained largely benign.
As Paul was mentioning, in terms of OC cushions going into the crisis, European CLOs were definitely in better shape and had more cushion to withstand that downgrade tsunami that we saw through March in April.
In terms of markets reopening, I would say the European CLO market certainly does feel like its reopened. I think we’ve seen about 10 deals so far since April and more in the pipeline. And unlike in the US where you might see pre-COVID-19 warehouses being priced alongside deals which are genuine print and sprint deals, I think in Europe, it’s typically be pre-COVID-19 warehouses that are getting done. I think that’s kind of a natural evolution and a difference in dynamic between the US and Europe. The average size of European transactions has been smaller, and I think that shows that managers have not wanted to upsize their transactions regardless of the increased demand that we’ve seen most recently, and there is a desire to keep credit quality as high as they can and term out these pre-COVID-19 warehouses.
GlobalCapital: James, are you are you seeing anything in terms of changes to deal documentation or anything on the legal side to allow for more flexibility among managers in this period?
James Smallwood, Allen & Overy: Yes, I think we are, and I think that’s part and parcel of the natural progression of how the now mature market is dealing with this unprecedented set of months that we’ve been through. I think from our perspective, we can really see the lockdown period in the UK being split into a first and second half - the first half really being March and April and the second half being May through June.
In the first half, from our perspective, our focus was really on working with our arranger and manager clients to ensure that the deals that were priced pre-COVID-19, but were closing during the lockdown, went as smoothly as could at closing and settlement. Because obviously, this was a situation where no one had envisaged that entire financial centers would be locked down and the practicalities of closing, let alone working with the clearing systems, the rating agencies etc. So, we moved from that to the practical points of how do you get documents signed when signatories are not in the office and perhaps don’t have a printer or a scanning machine. Thankfully, all the closings that we were on and the rest of the closings in the market went off smoothly and there was no missed settlement, which is fantastic.
Moving on to the second half of the lockdown period, through May and then into this month, we really have seen a progression on the number of deals coming through. And I would agree with Marcus that almost everything that we’re seeing is arrangers and managers working together to get a warehouse that is at the stage where it can be marketed as a new kind post-COVID-19 deal, which is basically a CLO 2.0 but with particular features that enable the deal to get to get priced at this moment. In terms of how that works with the legal documents, for the most part it is really just small amendments that we’re making that come from the commercial decisions that are decided between the various players and investors.
We are moving to smaller deal sizes, increased credit enhancement for top classes, shorter reinvestment period and a shorter non-call period. All of those points together, they are working to ensure that deals can get over the line. From our perspective, the biggest change really has been the timelines involved on getting deals done in the COVID-19 era. Whereas before, I’m sure everyone is aware that you could go from picking up a first draft document through to pricing in six weeks or even longer. Now we’re looking at a fortnight, maybe even less, and the settlement period between pricing and closing is coming down as well, which leads to a requirement that everyone works together very well.
GlobalCapital: Do you expect to see any so-called enhanced CLOs with a higher allocation to triple-C?
Smallwood, Allen & Overy: I think that could be on the radar. There’s certainly a lot of chatter about that in the market. We haven’t seen that yet in any of the deals that I’ve worked on, but that’s a conversation that many managers will be having with the rating agencies, and I think that’s part and parcel with how European CLOs deal with the post COVID-19 world, so I am sure that’s a conversation that’s being had across the city right now.
Roger Coyle, Fair Oaks Capital: Through the end of April and May, we’ve been surprised at how quickly the market has rallied and how quickly primary reopened. 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.
GlobalCapital: Paul, coming back to you, can you talk a bit about some of the key functions of the trustee in this period and how BNY Mellon is making sure the needs of the market are met and your clients have access to speedy and efficient data?
Murphy, BNY Mellon: Regarding the needs of the market, it’s been commented by some of the contributors already, that speed of response has been of the essence with deals moving through the process quickly, pricing to close to instant effective date.
That has been a definite change that has required us as a trustee to work closely and efficiently with our clients and with all other parties in the market, everyone getting lined up and working off the same page, especially in a market where everyone has been displaced from the office as well.
As James said, coming into April, the pre-COVID-19 pricings moving to closing was the first hurdle to overcome. In that period, we were involved in the closings of eight deals, which all went well due to the close coordination, responsiveness and open communication channels from all parties.
Regarding data, well before COVID-19, the CLO market has been moving towards a requirement for more readily available and usable data for managers and other users. This has been a big focus for us and we’ve been actively engaged with our clients in assessing those requirements and to that end, we made a decision just about a year and a half ago to change our loan platform and to use the opportunity to build out a more automated and streamlined operating model.
We are currently in the midst of our transitioning to the new loan administration platform. It is a significant project that has been fully staffed to help prevent any impact to our clients’ business as usual requirements.. The transition process will help ensure that parallel processing and reporting is overseen by the transition teams before sharing parallel reporting with clients in advance of switch over.
The system move has also given us an opportunity to build a much more integrated technology solution which enhances process automation and allows real time client access via LoanArcSM .
GlobalCapital: In the US, there’s been some innovation in terms of deal structures and formats. Could we talk about what everyone is seeing in terms of innovation in CLOs right now, either from the investor or manager perspective? Are we entering CLO 3.0?
Coyle, Fair Oaks: I think it’s difficult to be innovative in a tougher market. It’s really more a case of adapting to the market environment with smaller transactions, shorter reinvestment periods, and more overcollateralization, and that’s driven by caution on the side of investors and rating agencies, frankly.
Now, I think you see what you could call maybe innovations around the edges, such as delayed draw tranches we’ve seen in the US, and actually, we did one of them in Europe as well. But, you know, they’re not fundamentally very different to the equity retaining a single-B or a double-B tranche. So I really think it’s more a case of adapting and in some ways taking a step backwards rather than really innovating.
I think it’s like it is in the loan market in the bond market, where you get more pushback on documentation and structure in a wider spread environment where the supply demand balance is shifting. So, I don’t really think we’re entering CLO 3.0. Now, if the market continues to normalize, as it has been over the last few weeks, I think we’ll just go back to five year reinvestment in US and four years in Europe, as well as the same documentation as we had before.
If the market continues to improve and we don’t go through a second round of COVID -19 outbreaks, I think it is likely we’ll be back to the same documentation we had six months ago.
GlobalCapital: Marcus, what are your thoughts on innovation in the market?
White, Prytania: I completely agree that we’ve not seen anything shatteringly innovative. Where we have seen a few tweaks, it has generally been tough to find some investor demand. So like Roger mentioned, you’re seeing some delay draw junior tranches, you’re seeing some adaptations to the discount obligation definition, etc.
A couple of things that I have seen which may be more innovative is in some senior and junior triple-Bs and double-Bs. It was kind of a dynamic where arrangers were struggling to place the junior mezz late last year, so they were splitting the triple-Bs and double-Bs into senior and junior tranches as a way to find some demand. So that was a slight innovation that we’ve certainly found interesting. And the only other small innovation that I’ve seen, come out post-COVID-19 has been in the US on one deal where the equity was simply going to reinvest their proceeds to buy additional collateral
Those are really the only slight differences that I’ve seen. I agree with Roger that I’m not convinced this is the beginning of the 3.0 era. I don’t think structures have changed to the degree that you can say they’re very different. Sure, you’re seeing most deals come with more credit enhancement and shorter reinvestment periods, but they’re only slight changes.
I think the fact that the market only really actually shut down for a couple of weeks – from the last pre-COVID-19 deal on 12 March to the first post COVID-19 CLO on 2 April - makes it a bit harder to draw a distinct line between 2.0 and 3.0.
GlobalCapital: Paul, do you agree that the CLO market in Europe is going through more of an evolution rather than revolution in the asset class?
Murphy, BNY Mellon: I would tend to concur with what the others are saying. The changes seen in respect of new deals, size off about 35%, lower leverage, one year non call have been very consistent to date but are all driven by market conditions so every chance we will see a return to norm when the market does.
GlobalCapital: James is there anything from a legal or documentation perspective that you are seeing that is different in this time?
Smallwood, Allen & Overy: I concur with what the other participants have said. When you look at CLO 1.0 to 2.0, there were enormous changes and we’re just not seeing that now.
We we’re seeing is necessity causing a tinkering around the edges. I think as I said before, the interplay between the debt, the equity and the managers - all of those tinkerings can revert back if the market situation allows. I’d agree that we haven’t really seen anything that would win a prize for innovation.
Coming back to the timelines, I think it would be okay if the turbo timelines stayed and there are particular reasons why that works. Not least as you know, the less time required to ramp given we are dealing with COVID-19 warehouses, but if the quicker timeline were to stay, I think that that would be sustainable. But Likewise, if we did move back to allowing the more traditional month, two months for additional ramping for managers then that would be fine for all of us as well.
GlobalCapital: With regard to leveraged loan sectors, what are you observing on a sector by sector basis in Europe? What sectors are showing resilience in this time versus others?
Coyle, Fair Oaks: I don’t think we’ve seen very large shifts in industry exposure. I think the obvious problem sectors are well known – travel and leisure related was the first to feel the impact of COVID-19 and I think the prices dropped too quickly in March for managers to actually manage down that exposure without taking too much pain. So I think for most managers in the US and Europe, there was a bit of trading around the edges to manage triple-C balances.
I think as for sectors people like, there are few credits that have benefited from COVID-19, some lab testing businesses, for example, but actually I think the benefits have often been largely outweighed by the kind of regular non-COVID-19 testing that was interrupted. So I think you could arguably say healthcare is kind of a safe haven to some extent.
I can’t really think of any other particular favorite sectors, but I think it’s more case by case kind at the moment.
White, Prytania: Roger I think identified that the sectors most impacted are hotel, gaming, leisure, energy, automotive, transport, aerospace and consumer discretionary spending sectors such as retail. It is well documented that they’re going to feel the most pain and I think it speaks to the value of having a well diversified portfolio in CLOs, and that is something investors should take away from this and make sure they are monitoring how managers may be overweight in certain sectors.
But essentially, I think most sectors are going to take an extreme amount of pain, but it is still a case by case basis and doing your work on the individual underlying credits will be of real value in a crisis like this.
GlobalCapital: Paul, how prepared do you think the market is for the disclosure requirements coming into force under Article 7 of the new Securitisation Regulation?
Murphy, BNY Mellon: Beginning in March of 2019, the industry came together and got around the table to start painstakingly working their way through the disclosure templates to ensure there was a common level of understanding on approach. Thankfully there was a very broad representation of managers in the region, legal firms, trustees and corporate administrators.
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. 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 the very detailed level of oversight required, it has brought us to a good place for when the templates go live.
GlobalCapital: There was a very sudden shift to remote working across all markets at the start of the pandemic. How has this period been for you all from a market functionality standpoint? Was there any disruption or has the market made a more or less seamless transition?
Murphy, BNY Mellon: From the perspective of BNY Mellon, like all organizations, we’ve put a lot of time and effort into contingency planning and looking at alternative sites and combinations of working from home. But I think also like all organizations, the requirement that was imposed whereby everyone needed to work from home at a very short take up of within a week to 10 days, was a huge challenge.
But thankfully, across our organization we got to almost all teams working from home successfully within a very short period of time, and the technology has worked really well, which is of course critical.
As already mentioned, the onset of heightened downgrade activity, April payment dates and the pre-COVID 19 transactions closing meant there was a lot of moving parts requiring a lot of oversight, coordination and communication internally and externally. Thankfully we settled quickly into a process of good communication channels including to our clients, who were also being displaced, and who are also adapting.
Across the board, while the experience has been challenging, I think it has proved itself to work very well, overall. And I think that in a heightened sense, some of those challenges, such as getting reports out, producing numbers and payment dates, especially with all of the rating downgrades occurring in April, was a big test of our systems and a big test of our people. The tech worked great but the staff proved exceptionally flexible and was able to work in a very strong partnership manner with our clients. That flexibility combined with detailed transaction knowledge proved critically important. I think all in all, while definitely challenging it’s gone far better than we could have expected.
White, Prytania: In the first couple of weeks, everybody was experiencing the same shock factor and was having a lot of the same teething problems in terms of getting set up to work from home efficiently. We’re a smaller organization so maybe it was slightly easier for us than others but being able to have daily calls on Zoom or Teams, the dialogue was continued. We’ve been able to talk with managers really easily as well. I think actually they’ve been easier to contact in this time than they are normally, because I think maybe they’re not in as many meetings internally. So our contact with CLO managers has been the same or I’d say even slightly higher.
Every CLO manager has told me basically the same thing. They’ve been surprised and extremely happy with how efficient they’ve been able to be. There aren’t a lot of things that can’t be done in this environment. Perhaps there is not the same trading floor environment, but for us at Prytania, we’re largely a buy-and-hold investor and we’re doing work on these CLOs for a decent period of time. It isn’t as if we’re putting in bids for every single line item on a BWIC, so for our analysis and for us to get comfortable, we don’t necessarily need that trading floor environment.
So I think it has been fine, and to be honest, I’m not in a huge rush to get back on that train into London. I’m more than happy with the current set up. Once it is definitely safe and we get the green light that would be fine. But so far, there are no problems working from home.
GlobalCapital: Prior to the pandemic, were CLOs mostly marketed in a physical road show or had they already been moving toward digital marketing?
White, Prytania: Definitely still a physical road showing scenario, though I suppose where that might not be needed is if you are comfortable with the manager already and it’s just a case of calling them for an update. I think it would be difficult for us to invest in a manager we didn’t know through a digital road show. We like to have meetings in our offices but also like to go visit the manager’s office as well and see their set up and have a feel for how these guys do their day to day work. Investing in a new manager would be difficult for us right now, but we also don’t expect the current set up to continue forever and there also aren’t a whole lot of new managers to consider right now anyway.
Coyle, Fair Oaks: Its been similarly painless for us. I think the fact that we’re a relatively small organization, we already had tested these systems and had done the planning. We have London and New York offices, so we are used to having a lot of video conferences and making sure everyone is included. The transition was relatively easy, with some minor IT teething problems in the first week or two.
We expected this to last for a while, so we made sure everyone had the set up at home, the multiple screens and whatever they needed, which was important. Overall, I have been pleasantly surprised at how well the market transitioned. In March we were a little concerned that liquidity might dry up as bank trading teams were suddenly being split up and working from different locations. We were concerned that might make them reluctant to make markets if they felt they weren’t in the flow as much and that coincided really with the bottom of the market. But as it happened, it turned out liquidity was sufficient even through mid to late March. As mentioned earlier, we’ve gone from CLO pricing to closing in two month down to two weeks. To do that when everyone is suddenly working a different way is quite impressive and a function of having already moved to digital signatures and electronic communications. I agree with Marcus that over time, you eventually may need face to face meetings with managers, but I think the immediate challenge we face, bigger than moving out of the office, will be moving back in. 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.
Smallwood, Allen & Overy: I would echo what everyone has said, that is has largely been absolutely fine working in this environment. From our perspective at A&O, we happened to go live on a completely new IT system the day of the London lock down, so that was a unique challenge, but even with that, it has been basically fine.
From a legal perspective, by chance the industry had done all of the work needed in terms of analyzing how e-signing would work under English law. All of that analysis at an industry level in the City of London had been done in the last few years. So when the lock down came, and all of a sudden it was literally physically impossible for documents to be signed by various parties, we were all completely ready and set up to go down that route.
So probably our biggest job was convincing various stakeholders to ensure their internal regulations are being complied with and helping our clients over those hurdles internally. There are few people at home with a scanner and printer at home and you don’t need that anymore, to be honest. Using platforms like Docusign get the job done.
Murphy, BNY Mellon: As proven through a very turbulent period in the last few months, what we have works very well. Also as mentioned, we’re transitioning to a new technology platform, so a number of the CLOs which issued in the last six to eight weeks have gone directly onto our new platform. That’s been in conjunction with running the existing system, so all the balls are in the air but we are managing it all relatively comfortably I’d say. So the tech has worked well, which is great, but you still need very clear communication channels with all parties internally and externally. We’re working very much in partnership with our clients and being very engaged to know what their issues are and being proactive. All of those things, when you piece them all together, have worked well. To what everyone else is saying, people working at home have proved to be very flexible and at times it is challenging, especially with children at home and home schooling. But there is a lot of flexibility built into how we are approaching it.