European CLO managers should take a long summer holiday

While many capital markets participants are enjoying a well earned break over the summer, European CLO managers are still churning out deals.

In the last two weeks of July alone, managers priced 18 deals, including new issue, reset and refinancing transactions.

More deals are in the works. Research from P&G Alternative Investments shows that 13 are in the immediate pipeline, including nine resets and four new issue deals.

Resets will likely outnumber new issue deals, because leveraged loan supply typically slows in August. Managers rely more on primary loan issuance to print new issue deals than they do price resets, making resets more attractive.

Beyond this slight tilt in favour of resets, managers are unlikely to slacken their pace later in the summer. Most market sources expect only a modest slowdown in issuance.

Investors are increasingly available during August and demand for CLO paper is such that managers rarely struggle to print deals.

The fact that managers can continue to price deals throughout the year is a sign of the CLO product’s health. But managers might actually benefit from pausing issuance over part of the summer.

CLO equity returns are exceptionally weak at the moment. According to data from Bank of America, median cash-on-cash returns for CLOs within their reinvestment periods were just 2.4% in July. This is the lowest level since European CLOs were reborn after the 2008 financial crisis.

A crucial part of why equity returns are so lacklustre is the volume of CLO issuance. Managers keep printing deals, keeping demand for leveraged loans high and squashing loan spreads.

Tight loan pricing leads to a wafer-thin arbitrage between loan spreads and liability spreads for CLO equity investors. Demand from CLOs for loans has also allowed for seemingly endless repricings in recent months.

In a repricing, borrowers approach lenders with a request to tighten loan spreads. Lenders that choose not to participate are repaid at par.

CLO managers often agree to repricings, as the alternative is usually underwriting new, unknown credits at only slightly higher spreads. Over €80bn of repricings have taken place so far this year and the average equity arbitrage has flattened as a consequence.

Reducing CLO issuance over an extended summer holiday would be one way managers could help equity returns in the long term. Fewer CLOs would lead to less demand for loans and wider loan spreads.

CLOs and their warehouses hold a substantial majority of European leveraged loans, giving them considerable sway over loan pricing.

Tight loan spreads are a result of a supply and demand mismatch between CLOs and leveraged loans. Managers cannot control the volume of loans available, but they can curb CLO creation.

Slowing CLO issuance over the summer and into September would likely widen loan spreads, increasing the arbitrage and raising CLO equity returns.

The only other way to improve the arbitrage is to tighten liability spreads. However, most CLO mezzanine tranches are pricing at historically tight spreads in the primary market.

CLO triple-As are pricing wider, but the spreads on these notes remain sticky because of a shallow investor base and a large volume of CLO issuance. Fewer CLOs could lead to more demand for triple-As and tighter spreads, revitalising the arbitrage.

Scaling back CLO issuance over the summer could also lower loan prices, helping managers unable to better equity returns by building par.

Figures from Barclays show that 42% of loans are trading above par. A large portion of leveraged loans have traded above par for much of this year.

This gives managers few opportunities to build par in their portfolios by buying loans cheaply, selling them at higher prices and using the proceeds to buy loans with larger par balances. Building par increases the value of CLO collateral pools for equity investors at liquidation.

The proceeds from selling loans above their purchase price can also be flushed through to equity investors, boosting returns.

Consistent demand for loans from CLOs pushes up loan prices. Managers purchase loans to fill new issue deal portfolios and as part of portfolio cleaning during resets.

Less CLO deal flow would allow loan prices to soften, offering chances for managers to build par and improve the outlook for equity investors.

Taking a break from printing CLOs can be more complicated for managers than it sounds.

Many managers now use captive equity funds to buy some or all of the equity in their deals. These funds combine managers’ capital with outside money and have to be fully deployed within a specific time frame.

Waiting too long to price deals risks having to issue too many transactions in a short period of time, potentially causing market indigestion.

Managers therefore sometimes use their captive equity funds to price deals even when initial equity returns are less appealing.

The number of CLO managers has also shot up in recent years. S&P now rates 69 CLO managers, compared with 45 in June 2020.

New managers are under pressure to establish themselves and often feel a need to print a certain number of deals each year, even when market conditions are less favourable.

But investors in captive equity funds and in new managers’ deals will not thank managers if low equity returns persist over time.

The number of CLOs remains slightly unnatural relative to the supply of loans. In the absence of a blaze of leveraged buyout (LBO) activity in Europe, paring back CLO issuance is one of the only ways to correct this imbalance.

It is time for CLO managers to recline on sun loungers for a little while, if only to nudge up those equity returns.