Europe’s CLO printing machine enters a negative feedback loop

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Collateralized loan obligations in Europe are running low on fuel, prompting some investors to seek greater protection that may slow the market even further.

Just two new vehicles have priced since the end of July as the volume of leveraged loans, which a CLO manager repackages into debt and equity tranches for investors, trails last year’s tally by more than a fifth.

CLO managers chasing too few assets have driven down borrowing costs on newly-minted loans this year while also stoking demand in the secondary market -- and as prices rise in that market so they too become less economical for a manager to buy for a new CLO.

This uncertain outlook for asset gathering hasn’t gone unnoticed by investors in a CLO’s equity tranche, who receive income from what is left after the interest on a CLO’s rated debt tranches, and management fees, has been paid.

“The first distribution has always been really important to equity investors,” said Gauthier Reymondier, a portfolio manager at Bain Capital Credit.

Some equity investors are now looking to see CLO warehouses that are filled with a higher percentage of loan assets ahead of pricing--preferably more than 50% of the final deal size--to mitigate the reduced visibility over loan supply.

“If they are not sure about primary market flow, and the secondary market is high, an investor may prefer the certainty of knowing what is going to be in the portfolio than risk the uncertainty that a manager might not be able to buy an asset more cheaply in the next two months,” Reymondier said.

With the time taken to get CLO deals to market in Europe now taking as much as six to 12 months, this negative feedback loop could stymie new issuance in the final quarter of the year.

Captive Market

Managers have done what they can to get to the required ‘ramp’ level ahead of pricing, even if doing so has taken longer. They say they can take advantage of better loan supply, including add-ons, when it has materialized, while also relying more heavily on secondary market purchases this year.

There is also a chance that an expected flow of M&A related loan supply after the summer slowdown will provide fresh assets for managers to feed into warehouses. That could enable a revival in CLO issuance in October ahead of the Oct. 31 Brexit deadline, and as managers look to take advantage of strong demand for triple-A debt.

Managers were not buying assets into their portfolios with any urgency in April and May due to the weak CLO arbitrage, according to one London-based manager. They will be looking for loan issuance in the coming weeks to reach a critical mass before launching the marketing process.

However, a good chunk of the loan pipeline includes take-private transactions that can take time coming to market, if they do so at all -- and there’s little visibility beyond this current batch of loan supply. Rather than grapple with these loan issuance and arbitrage hurdles, some managers have opted not to open another warehouse after pricing their latest deal.

That could leave it up to managers with who don’t need to sell their equity to third party investors to prop up supply in these final months.

“Those managers that have captive equity investors may price more deals this year, but the newer managers or managers who need to syndicate most of their equity, are unlikely to issue again, said Jihan Saeed, an investment director at Permira Debt Managers. “This could result in second half of 2019 seeing less supply than the first half.”

Bloomberg News