CLOs sound death knell for “London approach”

Specialist credit funds have revolutionised the leveraged loan market. But could this mean trouble for the private equity industry when things start to go wrong? James Taylor reports.

The rise and rise of specialist debt investors has been a driving force behind the current private equity boom, but it could cause serious problems in the event of a downturn, according to a new report.

The report, by independent leveraged debt specialists Blenheim Advisors, highlights the growing influence of CLOs (collateralised loan obligation funds), dedicated vehicles that invest in debt markets. The huge increase in the number of these funds and their subsequent demand for assets has created massive liquidity in the leveraged loan market, and thus allowed private equity sponsors to take on bigger and more daring transactions.

However, because many of these funds are primarily return-focused rather than relationship-driven, private equity sponsors could find themselves in trouble if portfolio companies go into default or are forced to restructure.

At this week’s European Venture Capital Association investor conference in Geneva, many delegates were expressing concern about the increasing levels of leverage currently being employed in buyout deals.

In previous years, before the explosion in the CLO market, investment banks would provide private equity firms with these leveraged loans and then keep the debt on their balance sheet. Nowadays, the emergence of dedicated credit funds has allowed banks to parcel these loans up and syndicate them on, reducing their balance sheet risk.

One difficulty this creates is that it is much harder for sponsors to know where all the debt is, and to manage relationships with their investors. Blenheim is trying to obviate this by implementing a system that tracks every tranche of a syndicated loan, whenever it is sold on to a third party. This will theoretically make it easier for sponsors to manage their debtor base, although the firm accepts that not all funds will be willing to disclose full details of a sale – particularly the price paid.

However, Blenheim believes the major difficulty will come when a private equity backed company goes into default on its loan covenants, or requires a restructuring of its debt. The sheer number of debtors will make this negotiation process complicated enough in practical terms, particularly since funds can trade in and out of positions from week-to-week. Indeed, most CLOs can only invest a certain proportion of their funds in distressed debt, so they are often forced to do so.

But the key issue is that whereas before the debt was held by relationship-driven investment banks, in most cases it will now be held by return-driven credit funds – who are more likely to take an aggressive approach to the negotiation. Blenheim managing director William Allen says the days of “The London Approach” – a relatively civilised process whereby sponsors would sit down with bankers and work out an amicable debt restructuring without relinquishing control of their companies – may be a thing of the past.

Allen says: “In today’s market syndicates are heavily weighted towards institutional investors, a large majority of whom have taken loan positions on the basis of return rather than relationship and therefore we believe there will be a much more aggressive position taken by lenders in future restructurings.”