Market equilibrium – CLOs and leveraged loans

Supply and demand – the two fundamental pillars of markets. In the leveraged loan markets of Europe and the US, both have fallen. And the fallout has pushed the two markets in interesting directions.

Leveraged loan volumes are €16 billion behind where they were at end of September last year, while in the US the equivalent shortfall is $114 billion, according to S&P Capital IQ data. 

On the CLO side, $78 billion of issuance in the US in the first three quarters puts the running total well behind earlier projections for the year that suggested it would be close to 2014’s $124 billion. In Europe, the gap is not as wide, but the €10 billion of CLOs issued to the end of September is also short of expectations. 

Reduced leveraged loan issuance does not automatically translate into fewer CLOs, says 3i Debt Management managing director and partner Andrew Bellis. That explanation is a little too pat. He points to the fact that in the first six months of this year, CLO volumes in the US were a little down but roughly flat with last year’s total for the equivalent period. A sharp fall in issuance in the third quarter – $18.94 billion compared with $30.77 billion in Q1 and $28.58 billion in Q2, according to S&P – threw the pattern out of sync. 

In fact, in the US, reduced CLO capital is more likely to translate into fewer loans, argues Monroe Capital’s Jeremy VanDerMeid. 

“CLOs account for roughly 60 percent of all loans in terms of buyers, so when you have that engine slowing down, combined with what’s happening with other buyers in the market … it really creates a slowdown in [loan] issuance,” says VanDerMeid who is a managing director and portfolio manager for CLOs and loan trading with the Chicago-based mid-market lender.
The other buyers exiting the market referenced by VanDerMeid are retail loan funds. Leveraged loan funds recorded their 11th successive week of outflows for the week ending 7 October, according to Lipper. Net outflows from US loan funds over the year had reached $10 billion by the same date. 

It is those outflows that have amplified the impact of CLOs on the US market, says Bellis. 

VanDerMeid says the US loan market slowdown is unrelated to merger activity as the forward projections remain stable with around $30 billion-$35 billion of deals coming down the line. 

Nobody in financial markets likes the word slowdown – bar distressed investors but they are a breed apart. In this scenario, though, it has been a boon for buyers, VanDerMeid says. With fewer buyers and the same pressure to successfully syndicate deals, arrangers are producing more investor-friendly packages with enhanced cash flow sweeps, real financial maintenance covenants and tighter language around restricted payments and fewer add-ons to EBITDA definitions. 

“We’re seeing better structures, higher spreads and I think you’re seeing some rationality in the market,” says VanDerMeid. “It’s good for guys who have capital available and it’s certainly something we’re taking advantage of as a firm.”

To illustrate his point, VanDerMeid mentions that a couple of mid-market deals have had to sweeten pricing or add financial covenants to deals that were initially structured as covenant-lite. In September, a $245 million loan backing Lone Star’s acquisition of Foundation Building Materials was forced to insert a covenant and was offered at a 95 OID. 

And September is when the pushback by loan buyers began in earnest, VanDerMeid says. No one factor has prompted the slower rate of securitisation, he adds, but the impending CLO risk retention rules are putting pressure on a number of managers while Chinese stock market volatility and worries over energy and metals as well as mining credits also contributed.

Bellis agrees that it is a general sense of increased global volatility that is contributing to investor wariness. The link between the primary loan market and CLOs is, on balance, closer in Europe where managers have more of a reliance on new loan flows, he notes. 

It is this link that has one advisor who directs client capital into direct lending funds worried. 

CLOs are essentially passive money with managers less engaged in negotiating the terms of the loans from which they take a narrow slice. This, the advisor says, creates a trickle-down effect where the broadly syndicated market exports terms that CLOs are comfortable with into the lower end of the market. 

Legal intelligence research firm DebtXplained has some data which certainly confirm that looser term structures are making greater inroads into the mid-market. The firm analysed deals of under €250 million which showed that the proportion of cov-loose deals rose from around 50 percent in 2014 to 75 percent as of 20 October. 

Bellis, however, disagrees that this can be blamed on the influence of CLOs on the larger-cap market putting pressure on mid-cap deals. “The mid-market in Europe includes direct lending businesses which are contributing to the weaker terms,” says Bellis, noting that direct lending firms actively pitch themselves as more flexible than the banks. 

With plenty and growing competition in the European market as well as reduced influence of retail flows, there does not appear to be the same pushback on terms in Europe. And trying to apportion blame for weak terms by asking either direct lenders or CLO managers who is responsible isn’t going to produce a reliable answer. 

On the outlook for loan issuance as the market runs down to the end of the year, both Bellis and VanDerMeid are positive. 

“I think the general view is that the primary market is picking up both in the US and Europe and certainly the primary market is more active than it was a month ago, but CLO issuance is a hard one to call. It has slowed down substantially compared to last year,” says Bellis. 

Being the more complex product, it’s hardly a surprise that the influencing factors on CLOs are that bit more complicated too. The impact of impending risk retention rules for US CLOs should not be discounted but Bellis points out that factors completely separate from the supply of loans should be taken into account. European ABS has widened so much that UK non-conforming mortgage triple A was trading above CLO triple A tranches, he says.

Whatever the external or internal market factors, CLO issuance on both sides of the Atlantic will not reach last year’s strong totals and will also fall short of analysts' predictions for 2015. And that in turn will continue to influence loan market size, terms and structures.