Two recent developments could kick off another round of ratings shopping in Europe’s CLO market as managers look again to ensure they have the most flexible criteria to manage their CLO transactions.
The first is the latest update by Standard & Poor’s to its CLO methodology, which managers say, along with its revised recovery ratings in February, could tempt some of them back to the rater they deserted in droves last year.
The second is the arrival of a fresh rating firm to the market, Kroll Bond Rating Agency, which is working with The Carlyle Group on its latest European new issue CLO, Carlyle Euro CLO 2019-2 via arranger Citi.
These changes come against a backdrop of frustration among CLO managers with the more restrictive nature of Moody’s Investors Service’s collateral and transaction tests. A wave of loan downgrades by the rating firm and increased pressure on a particular test that governs the way a firm can manage its CLOs -- called the weighted average ratings factor test (WARF) -- have made managing a CLO challenging, and more importantly, can impede the equity performance of the vehicle.
That could leave the door open for CLO managers in Europe to revisit once again which raters they work with, potentially challenging the current dominance of Moody’s as the first choice for most managers.
CLO Managers May Revisit S&P After Recovery Ratings Review
Three rating agencies have dominated the European CLO ratings space since 2013: Fitch Ratings, Moody’s and S&P.
The arrival of Kroll could shake things up if the U.S.-based company can build on the leg-up provided by the Carlyle transaction. The rating firm has established itself across other structured finance asset classes, including CMBS, RMBS and ABS, and has been steadily building its presence in the U.S. CLO market. It has rated four broadly syndicated U.S. CLOs this year, and has provided CRE CLO ratings in the U.S. since 2016.
“Our issuer clients want competition in the ratings market, especially the more frequent issuers, and we want to put the cat among the pigeons and help issuers reduce their reliance on one or two agencies," said Mauricio Noé, senior managing director and head of Europe at Kroll.
But breaking into the market has proved hard for others. That’s despite efforts by regulators to increase the competitive rating landscape in Europe after the financial crisis, by requiring CLO managers to secure two sets of ratings for their transactions under CRA III rules.
The rating firm will have to work to win over not only issuers, but also the investor base, who have proved tough to leave incumbents in the past.
Kroll does not rate the underlying loan assets. Instead it can use what is available in the form of outstanding public ratings from other agencies, as well as its own work to provide ratings analysis.
“We live and die by investor acceptance,” said Noé. “We approach investors before the issuers and are actively working with some of the largest investors in the market to ensure we are providing them with a valuable service. You have to get your way on to deals to start with and build from there. We have now achieved this on all the major asset classes in Europe.”
Carlyle has replaced Moody’s with an S&P/Fitch/KBRA combination, using Fitch to appease investors in the top-rated triple-A tranche, and KBRA to allow for greater leverage through the structure compared with Fitch, but especially in the mezzanine tranches, a person familiar with the transaction said.
Whether other managers consider this option may depend on how investors react to Carlyle’s deal, but it wouldn’t be the first time that managers have switched allegiances to improve their ability to manage transaction tests.
CLO Managers Seeking More Flexibility Go Ratings Shopping, Again
S&P will also be looking to bring back managers after losing significant market share to Fitch over the past year. Managers found the low recovery ratings assigned to the loans rated by S&P too restrictive, at the same time that Fitch embarked on a strong drive to win loan and CLO ratings business.
Just four managers have used S&P to rate their new issues in Europe this year – out of a total of 32 new issues. Carlyle represents the fifth as it returns to S&P having worked with Moody’s and Fitch on its past two new issues.
Other managers say they will also take another look at S&P to understand the impact of its updated ratings methodology, in relation to its recovery ratings, and whether it offers another option away from Moody’s for their next vehicles.
