News Analysis: CLOs – the transatlantic divide

The contrast between the thriving CLO industry in the US and its ailing     European counterpart could not be more stark. Yet the appearance of a handful of new-issue European CLOs suggests a tentative resurgence is taking hold.

In the US, January was the busiest month for CLO issuance since November 2007, with $9.9 billion of funds issued, according to JPMorgan data. And in Europe? Virtually nothing. It’s been a similar story since the credit crisis, with only a two new European CLOs formed in the post-Lehman era – one from European Capital marketed by Deutsche Bank in 2011, and the second by ICG Group in 2012, according to Bloomberg.

In Europe, around €70 billion of CLOs were used to underpin many private equity deals prior to the financial crisis, but most are now coming to the end of their five to seven year lives. The departure of those CLOs from the market will leave a big hole in the continent’s credit supply, given the lack of new issuance.

All that could be set to change, however. UK-based credit asset manager Cairn Capital, for instance, is poised to launch a new CLO in partnership with Credit Suisse. Many in Europe will be watching eagerly to see both how it is received by the market, and how it is structured.

But why the disparity between the US and European CLO markets?

“CLOs have offered investors strong relative value. The market has been resilient, providing investors with 17 percent cash returns on average,” explains Steven Miller, analyst at S&P Capital IQ. “In 2012, $55 billion of new CLOs were issued in the US, more than the total combined issuances between 2008 and 2011. The market could top $90 billion if the fourth quarter run-rate holds up [this year].”

In Europe, however, there are significant structural and economic reasons for the withering of the CLO industry.

First, there is the regulatory environment. Many cite the onerous ‘skin in the game’ requirements for European CLOs, which requires mandating managers (the originator, sponsor or original lender) of CLOs to hold an economic interest equivalent to five percent of the total value of the fund or securitisation. Cairn is getting round this cleverly, holding the five percent in a managed credit fund which will act as counterparty to the total return swap with Credit Suisse, someone with knowledge of the deal told Private Debt Investor.

Some are confronting the issue head-on, lobbying regulators for a removal of stringent risk retention rules.

Nicholas Voisey, director at the Loan Market Association (LMA), tells Private Debt Investor: “There are two main reasons why there has been virtually no issuance of CLOs in Europe. Firstly, market conditions have been unfavourable and secondly, regulatory risk retention requirements arising from the European Capital Requirements Directive 2 are largely prohibitive.”

“If CLO managers were able to raise cheap money, they would do it,” explains Simon Gleeson, partner at law firm Clifford Chance.

Voisey adds: “Most CLO managers do not have the capacity to hold the retention required however. The LMA has been in talks with regulators, seeking ways to solve the regulatory requirement so that this important source of funds, particularly to the sub-investment part of the market, can function effectively”, he says.

A spokesman for the European Banking Authority responds:  “The CRDIV/CRR proposal currently discussed at EU level includes a mandate for the EBA to draft regulatory technical standards (RTS) on securitisation retention rules. The discussions are still ongoing and a public consultation on the RTS will be organised later this year. In this respect, it is too early to draw conclusions on what the final text will look like.”

Some, like S&P Capital IQ director Sucheet Gupte, feel regulation isn’t to blame however. “Regulation is a hurdle that most people get around. I don’t see it as a hindrance for the market,” Gupte says. “Most of the large CLOs would have no problems with the risk retention rate. There just aren’t enough deals to get the CLO market moving,” he says.

In order for investors to make any substantial returns from CLOs, managers are typically required to buy at least 100 loans and subsequently package them into one pool. Institutional investors buy portions of this pool, offering different payouts depending on the level of risk the investor takes.

“The biggest problem is supply,” believes Gupte. “There aren’t enough deals to get a CLO running – and asset spreads have tightened for the underlying loans, so the economics are not attractive either.”

Romain Cattet, partner at debt advisory group Marlborough Partners, agrees: “Though there are some encouraging signs of CLOs making a comeback, the European market is incomparable with the US market. Primarily, there isn’t yet the breadth and depth of assets in the market to allow for CLOs to ramp up quickly.”

“Then, there are still issues with available leverage quantum and pricing for new vehicles. It is a mathematic exercise. A CLO’s cost of liabilities needs to be lower than the yield of the assets acquired in order for it to be profitable. Unlike in the US, the arbitrage doesn’t work quite as well as it used to in Europe.”

Investors are still wary after many were burnt by the crisis. “Normally CLO debt tranches are reasonably liquid, but when you really need to get out, it’s like trying to get out of a burning house,” says James Newsome, managing partner at placement agent and consultancy Avebury Capital Partners. “At the moment, a European market with active CLO issuance is either two to three years away, or never coming back. In the US, it’s an artificial market created by massive intervention by the Fed. We might be seeing good deals and it might be gaining momentum but it has been falsely created. Having been through the cycles in the credit markets I am concerned that this is what securitisation of private debt through CLOs will do – provide too much funding now, distort incentives and ultimately deteriorate performance,” Newsome adds.

“In the US, they’ve breathed life into the CLO model but over here it’s a different story,” says Nick Fenn, founding partner of London-based mezzanine firm Beechbrook Capital.  “The obvious providers of AAA credit have disappeared, so you can’t get the leverage at the fund level you used to.  It’s unclear whether there will be a new generation of CLO, though institutional fund managers are working hard to develop alternative debt structures.”

That uncertainty is one reason all eyes will be on Cairn’s new vehicle. Whilst it would be overstating things to say the fate of the European CLO industry rests on the fortunes of one manager, a successful launch will certainly prove a shot in the arm to an industry that has lagged behind its US sibling for several years now.

“In Europe it will be interesting to see if the new CLOs that people like Cairn are starting to market will get off the ground or not,” says a financing specialist at a large UK-based private equity firm. “A new wave of those would be good for the European market but it’s still early days and we may be a while off from heavy new CLO issuance on this side of the Atlantic.”