There's little doubt among market participants that in the tainted universe of structured finance, the collateralized loan obligation has the greatest chance of survival. The CLO structure is sound and robust, they said, and CLOs are composed of straightforward assets whose origin is easy to determine. Yet, in a market where these products have to contend with forces stronger than their managers ever imagined, experts are forecasting a tough year for European CLOs-one in which the asset class overall will remain in hibernation, and some individual structures will become extinct.
A serious lack of collateral, impending corporate defaults and a secondary market that for months has offered better deals than the primary are all serving to dampen the CLO market in Europe.
"There will be no new CLOs until those dynamics play themselves out, and what's going to happen is that all the existing CLOs in Europe are going to be in a lot of trouble," a European CLO manager said.
Perhaps the greatest concern for European CLOs is the growing prospect of corporate defaults and increases in triple-C rated assets, said David Quirolo, counsel in the securities and structured finance group in the London office of law firm Ashurst. "We still have not seen significant defaults in Europe," he said. "But they're likely to come given the economic outlook, and this may put some structures under stress."
To be sure, CLOs are subject to what's happening in the broader economy, since the downturn in numerous industries will impact corporate loans. Loan issuers are working with their bankers to stave off bankruptcy, but there's no denying that the outlook is dire, and defaults and downgrades are coming en masse. The pressure on CLOs will therefore be great, because if more than 7.5% of a CLO's collateral is rated triple-C-and experts believe that will be the case this year-the vehicle could run into trouble. The fees CLOs generate, which have already plummeted, could drop even more, so much so that for many managers even paying salaries and rent could become a real issue. And this could force them to go under.
"People who have only one or two deals under management must be really suffering already, particularly since the new guys didn't get the best collateral, and had to scramble and get whatever was available," the CLO manager said. "The question is going to be whether a manager can survive with limited fees and very low income during 2009 and, perhaps, 2010 as well."
During the leveraged buyout boom, CLOs steadily became the premier buyer of leveraged loans in Europe. More and more CLOs came into existence, a fair number of them put together by managers who had never been in the business before and for whom Europe was an entirely new market. Sources believe that these newer players are having a really tough time now, and some are expecting to see consolidation in the European CLO space this year, with start-ups selling out to the established managers.
"You would expect to see some degree of consolidation, but whether it happens on a widespread basis will depend on what sort of fees the collateral managers are generating. And that again will depend on the underlying portfolio of loans," said Michael Smith, a partner in Ashurt's international finance department.
Although in this down market, relationships, experience and track record are not helping as much as they have at other times, sound market knowledge is still important for any CLO that wants to survive, said Joachim Keller, who works in the financial stability department of the National Bank of Belgium in Brussels. As such, long-standing managers in the European CLO space, such as Babson Capital and Harbourmaster, will have an easier time than others, since they have not only been in the business for many years, but also have more than one CLO running.
"You have to have between two and four CLOs to become profitable, and in this market, the younger managers that have only one or two vehicles are likely to go away," Keller said.
While no one expects the demise of the CLO, its survival is nonetheless going to be tricky. Certainly, new issuance is on hold for a long while. And any CLOs that are issued this year are likely to be structured to take advantage of a move by the European Central Bank, which allows banks to use the loans they have on their books to structure a CLO then use the proceeds to fund operating activities. "There have been a number of these deals, and we will see more of them," Smith said.
Not Your Father's CLOs
However, these deals are purely for funding purposes and not a way to transfer risk, which CLOs were used for in the old days, said Paul Kerlogue, vice president and senior credit officer at Moody's Investors Service in London. If a CLO is structured in the traditional manner, then it will focus on a specific area where an investor has expressed interest, he said, and be composed of collateral that investors believe sound, such as loans for infrastructure finance.
"Deals that are structured for the needs of particular investors are likely to be done, but they'll be put together with the characteristics the investor wants and with exposure to industries of the investor's choosing," Kerlogue said. "CLOs are quite a useful tool, and they could continue to be useful. However, their usefulness is subject to economic circumstances, which is the greatest risk to the future of CLOs. So while many people are positive in the long term, it will be very unlikely that there will be a return to structured finance as we used to see it in the short term."
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