When cash isn't king

Nowhere is the old adage “cash is king” more appropriate than in the world of leveraged loans. Great effort is expended on analysing target businesses and figuring out ways of squeezing the maximum level of debt into them within the limits of the expected cash flows. Yet to certain members of the buy side community, this doesn't necessarily appeal.

One of the oddities of arranging leveraged loans is that there is a presumption that a structure only works, i.e. is acceptable to the market, if the repayment of the bulk of the advances is clearly supported by forecast performance. This is logical, but actually does nothing to promote the participation of institutional money managers in the loans market.

Because for fund managers, repayments are a problem. The performance of a fund relies on the success of its investments. If a fund remains less than fully invested, returns will be diluted. So if an underlying investment begins to return cash almost as soon as the initial capital has been deployed, such as with an amortising term loan, the appeal to institutional investors will be limited.

The need to accommodate institutional buyers has of course led to the development of “institutional” tranches in capital structures, otherwise known as B and C term loans, which do not amortise over their life but are repaid at maturity. This isn't new; in fact, Europe is now beginning to witness a move towards layered structures that have been standard in the US for some time, for larger transactions at any rate.

As a result, institutional tranches now constitute a larger proportion of the loan capital being provided to the European market. The growth is in part driven by strong appetite from managers of collateralised debt and loan obligations (CDOs and CLOs) such as London-listed Intermediate Capital Group, Duke Street Capital Debt Management (now owned by David L Babson & Co.), M&G Investment Management (part of the UK insurer Prudential) and Alcentra (owned by Alchemy Partners).

HEAT IN THE MARKET
Thanks to strong private equity backed buyout activity, 2004 looks set to become a bumper year for leveraged loan issuance. Already CLO managers are salivating at this prospect, and CLO fund formation continues apace. “Raising liabilities is more straightforward in 2004,” says David Forbes- Nixon, chief investment officer for Europe at Alcentra. However, he also says this: “The challenge is to invest in high quality credits at the right price.”

Part of this challenge brings us back to the issue of repayment. According to Standard & Poor's LCD, European prepayment levels are rising. The data shows that quarterly prepayment levels jumped from an average of less than 5 percent in the first six months of 2002 to over 8 percent during the first half of 2004. Even though this is not as high as the 11.4 percent average seen in the US over the same period, the increase is significant. On an annualised basis, it implies that substantially in excess of one-third of leveraged loans outstanding at the beginning of the year will be prepaid by the year end, assuming that the market as a whole continues to grow at current run rates.

For managers of CLOs this has even greater importance than for proprietors of other types of fund. The reason is that CLOs are leveraged vehicles. Investors in the lower mezzanine and equity classes of a CLO structure benefit from a high degree of gearing, hence the attractive returns offered: triple-B rated notes issued by such vehicles are typically priced with spreads in excess of 250 basis points, and equity classes have been marketed with target IRRs in at least the mid teens.

But gearing also means that if a CLO pool remains underinvested, returns to the lower classes of capital could seriously suffer, because the “excess spread” generated by the vehicle, i.e. the difference between the yield on investment and the cost of the rated liabilities, is lower than expected.

MANAGER PAIN
Because strong secondary and refinancing activity in the buyout market continues to drive cash back to loan investors, life is likely to remain difficult for CLO managers. They will need to work harder in order to generate their target levels of return as they continually need to seek reinvestment opportunities of similar quality and yield. “Raising funds is one thing, but we have to work harder now to keep them filled,” says Ian Hazelton, chief executive of Duke Street Capital Management.

Rising interest rates will not necessarily ameliorate the situation either: most CLOs issue floating rate liabilities to match the interest rate basis of their investments, though equity tranches (which generally pay “dividends” rather than offering a yield) should benefit if rates rise significantly, as looks the case in the UK at least.

Not that CLO managers are strangers to strong headwinds, coming to think of it. As another ([A-z]+)-based CLO specialist fund manager puts it rather more colourfully: “Any time there are difficulties in the credit markets, it immediately puts pressure on CDOs as they are highly leveraged, structured vehicles. They're pretty crap to manage, actually.”

General woes aside, how are managers and their advisers reacting to this particular headache of cash coming back too soon? Such is the sensitivity of a CDO structure to underinvestment that in earlier structures a manager was contractually required to “ramp up”, or fully invest, the proceeds from fundraisings within a short period of time, typically six months.

But this essentially meant that managers found themselves between a rock and a hard place. If investments weren't made quickly enough, they faced the prospect of diluted returns, yet if the need to invest fast led to hasty investment selection, the end result was the same. A number of earlier transactions disappointed partly as a result of this Catch-22.

Today, CLO structures generally employ a longer ramp-up period: nine months to a year has become the norm. Other tools being used are so-called Variable Funding Notes (VFNs), i.e. notes where the drawdown of capital can be deferred, as well as the provision of third party funding sources in order to increase flexibility in the investment process and reduce the pressure on the manager. With both measures, however, lower expected returns have been the result.

GETTING THE HIT RATE RIGHT
In any event, if the speedy recycling of loan capital continues, managers will have their work cut out. This may lead to greater staffing needs, put upward pressure on management fees and prompt managers to simplify their investment strategy.

To illustrate the latter scenario, a manager controlling three or more CLOs (as some now do) might choose to adopt the same strategy for each so as to reduce the amount of management effort required and to improve cost efficiency given a fixed amount of fee income.

There is nothing necessarily wrong with such an approach, as long as the fund manager continues to make successful investment decisions. But one or two mistakes would lead to the underperformance of not just one fund, but the whole stable of funds. This further implies that, from an investor perspective, it becomes more important to focus on the individual manager's track record, and so prospects for newer entrants, or those with patchy past performance, are worsening.

So far, managers have been arguing forcefully that they are maintaining their focus on quality. “There's a wider standard deviation in the quality of assets this year – our hit rate is lower than a year ago,” says Forbes-Nixon.

The need to put plenty of capital to work relatively speedily has to be good news for leveraged financiers seeking to push further the boundaries of what can be done in terms of deal size and structure. But potential CLO investors should beware. In a hot market, where transaction prices are stretched and new structures are being tested, CLO managers will always have to try to find the middle ground between two potential negatives: not being able to pay a dividend to their equity investors because some of capital hasn't been put to work; and ending up with the wrong deals in the portfolio because capital had to be deployed quickly. The margin for error is limited.