Adding strings to the bow

Following hard on heels of the global economic crisis, the wave of maturing collateralised loan obligations (CLOs) sweeping through the European market has buffeted the region’s credit industry. Despite a recent uptick in issuance – some $2 billion of CLOs have been raised in Europe in the last six months – a yawning hole estimated at $70 billion is set to appear in the continent’s credit supply once reinvestment periods come to an end over the next 12 months.

Regulatory edicts from the European Banking Authority last month added to the turbulent environment for the issuance of CLOs. Market participants are beginning to accept that a lack of arbitrage and collateral, coupled with stringent regulatory pressures, will put managers in danger of dying out unless they diversify their credit offering.

A tentative post-crisis resurgence was suggested six months ago, with the appearance of a handful of new-issue European CLOs. In February, Cairn Capital launched the first new European CLO since the financial crisis, raising €300 million. It was followed by fund managers Pramerica and Apollo Global Management, who raised €325 million vehicles in February. Since then, activity has been muted. Opinions are divided as to whether or not a true recovery of the CLO market will ever take place.

“You’ve got this ongoing asset reduction that CLO managers are currently facing as reinvestment periods end and assets amortise, and the problem is it’s being replaced by very little new CLO issuance,” explains David Parker, a partner at Marlborough Partners. “It’s quite tough for the CLO managers and their investors – you are trying to convince yourself of [the benefits of] issuing when the returns are really tight. You’ve had a few people dipping their feet into the water; but the big change will come when the legal environment is more conducive and it becomes really economically compelling again,” explains Parker.

For now, the chances of CLOs taking advantage of the market, like they did in 2006/7 are very slim with the current economics, he believes. “You have to make some heroic default assumptions when you are modelling it out, you’re going to have to say we are going to continue living in a benign credit environment with very low default rates,” adds Parker.

According to figures released by JPMorgan, roughly 30 percent of European CLOs are already at the end of their reinvestment period. This figure will continue to rise until it hits 97 percent by the end of 2014.

“All of this is going to drastically affect the number of CLO managers operating in the credit market,” one London-based CLO manager told Private Debt Investor.

He believes that there are a couple of natural brakes to the growth of the CLO market, at least relative to its peak.

One is the lack of ability to manage a CLO programme warehoused by a bank. “That game is over – at least where we sit today,” commented one debt market participant.

“This is a very quiet market,” believes Marlborough’s Cattet. “Until there is more legislative change, pricing goes up on the asset side, or prices come down on the liabilities side, we are not anticipating significant volumes of CLO issuance in the medium term.”

He believes that the cost of the capital stack still does not produce arbitrage as attractive as it did in the peak of a market. “The liability cost hasn’t moved back to where it was in the mid 2000s – on the asset side, recent pricing has been lower than initially anticipated – so it has made the whole process a lot harder,” he adds.

One thing is beyond doubt: the number of CLO managers diversifying into other credit streams in the region has risen significantly.  Parker and Cattet both believe the departure of those CLOs will mean only one thing for the industry: a convergence between  CLO managers and alternative debt fund managers.

“The credit skill set is relatively similar, it’s just your cost of capital and the structure of your funds are different.  Ultimately the managers, (big or small) will go where the opportunities lie,” explains Cattet. “The gap will likely be filled – and CLOs may become a small segment of what credit managers once used to specialise in doing; the market will become more diversified and managers will follow the money”

Some traditional CLO managers have already adjusted to changes in the credit landscape. Europe’s oldest CLO manager, Intermediate Capital Group (ICG), is emblematic. For five years, the firm has been biding its time with regard to new CLO issuance, but has been robustly developing its teams of credit specialists, and launching real estate debt vehicles, high yield bond and mezzanine funds.

The market is also experiencing a strange situation, whereby for the first time in the history of loans and high yield bonds, “high yield issuance is greater than leveraged loan issuance,” believes Dagmar Kent-Kershaw, head of ICG’s credit fund management business.

“There are a range of credit strategies available,” she argues. “Many of the largest CLO managers are taking a tactical approach – by broadening their fund ranges and not being overly dependent on any one fund offering, particularly CLOs,” believes Kent-Kershaw.

She notes: “It’s clear that the lending capacity has shrunk, and new sources of capital are moving in; be it direct lending, high yields bonds or new investors such as pension funds.”

One other CLO-specialist that has been robustly developing its debt management business beyond just CLOs is 3i. The firm has adopted fund strategies across leveraged syndications, mezzanine finance and senior loans.

“We are still far away from a properly functioning primary market in Europe and that together with the new retention rules will dictate new CLO volumes,” explains Jeremy Ghose, chief executive of 3i Debt Management.

There is a general consensus that the CLO managers who have been able to sustain growth have predominantly been those who have diversified into innovative debt fund offerings including real estate debt, distressed debt, high yield bonds and others focusing on infrastructure debt, locking in cheap financing for years to come.

Charles Noel-Johnson, managing director in Moelis & Company’s restructuring group, reckons larger managers are in a good position to negotiate extensions with their investors.

“It won’t be a hard stop for the bigger managers who have the flexibility to extend their funds even further. Some CLOs will have to be repaid of course, and some managers will be able to raise new funds. CLO issuance will start to come back – maybe not to ’06 levels, but their variable rates of return make them attractive to investors.”

Kent-Kershaw agrees.  “CLO structures have operated as they should through the crisis, with in-built mechanisms to protect investors in a downturn. Economically, they can offer attractive returns now as the underlying loans offer compelling risk-adjusted credit spreads in today’s yield-hungry market,” she says.

So the prognosis appears to be that CLOs are too attractive an instrument – given the right conditions – to disappear altogether from the market. But if they’re the only string to your bow, then you’d better hope those conditions improve soon. Canny managers have explored other options so as to avoid being left a hostage to fortune.