Dreaming of new CLOs is no bad thing
Talk of attempts at new CLO issuance in Europe is likely to remain just talk for a while yet. But such aspirations are a healthy sign that the leveraged loan market has realised its future is at risk.
Most leveraged finance market participants are puzzled by rumours that some fund managers are trying their hardest to bring a new European CLO to market.
It's not hard to see why. Even if a CLO manager can stump up the 5% of the deal from its own funds — as new regulations dictate — and even if they can somehow find an equity investor friendly enough to make the arbitrage work, there is still a major issue.
What on earth would a new CLO buy?
The key is in the name. A collateralised loan obligation requires collateral. The rate of new European leveraged loan issuance is struggling to reach a deal a month, let alone the few deals a week required for a new European CLO to make sense. Furthermore, the pre-crisis generation of CLOs snaps up any paper going free, conscious of the impending expiration of their reinvestment periods.
Let the fearless fund managers dream. While leveraged financiers confidently instruct their M&A colleagues not to worry about the debt markets, they ignore the fact that the leveraged loan market remains in a precarious state.
It is true — up to a point — that lack of debt is not to blame for the drought in LBO supply, as buyers and sellers of companies struggle to agree on price. Indeed, the reverse flexes that buyout loans for Wood Mackenzie and Bartec have been able to pull off are proof that there is strong demand for leveraged loans. And potential deals for Base, Birds Eye Iglo and Schenck would have probably had a good reception had their auctions not been aborted.
But this will not be the case for long. It cannot be far from the minds of any private equity practitioner that without new fundraising for loans, a couple of big deals can change the supply-demand dynamic rapidly in the favour of investors — leading to higher costs and greater volatility for sponsors.
Moreover, by 2014 the CLO bid will not be there at all, meaning it could well be high yield or nothing for large LBOs. Attempts to raise new money from managed accounts or listed vehicles are positive developments, but will not bring the scale required to replace CLOs.
That may be the moment when dreams become reality. Without the CLO bid, pricing on leveraged loans will almost certainly have to rise — potentially lessening the challenge of the arbitrage.
Secondary loans may also widen, and new LBOs will have to look entirely to new money for debt, rather than rely on legacy CLOs. That means more of that magic ingredient — collateral — will be available.
It will not be easy, but it is refreshing to know that the leveraged loan market has not given up on CLOs. By 2014, the market could find itself very grateful to those battling against difficult odds to make these much maligned — but very useful — vehicles work.