Babson Capital Europe announced the close of the 500 million Duchess VII CLO last week, a regally named fund arranged appropriately enough by Royal Bank of Scotland. Duchess VII ancestry dates back to 2001, when the series began as a sister business to Duke Street Capital. It was acquired and renamed by Babson Capital Management in May 2004.

The fund's current allocations are set at 85% senior loans and 15% mezzanine loans, with investments in debt packages from 100 million to 10 billion, a range that obviously includes some of the megadeals that have flooded both the U.S. and European credit markets.

Smaller debt packages are left up to Babson's mezzanine fund. "We think that if you are dealing with smaller companies you should have a more flexible fund than a cash-flow CLO," said Ian Hazelton, chief executive of Babson Capital Europe. And though Babson does not necessarily dislike smaller debt packages, the rating agencies don't always look kindly on them, Hazelton noted.

The concern in Europe is that a smaller deal means the company's Ebitda will be at a lower level than that of some of the larger pan-European companies, which have more room for diversification, explained Michelle De Angelis, analyst at Fitch Ratings.

Show me the sterling

At its close, the fund was approximately 75% invested. It also has a 30% British pound sterling bucket, flexibly funded through a multicurrency revolver. Quite a lot of European issuance still comes from the U.K. - from about a quarter to a third - so for the firm to invest in sterling with efficient hedging costs, Babson used a hedging program within the vehicle rather than asset-by-asset swaps in a side vehicle. For instance, there are drawdowns in sterling on the revolving credit facility, Hazelton said. The firm must hedge everything back to euros for rating agency purposes since it is a euro fund. "It is the most efficient structure we have come across yet to allow us to buy sterling assets within a euro capital structure," Hazelton said.

Debt fit for a king

Though the Duchess VII is Babson's most recent CLO, it is not the firm's biggest fund under management. The first CLO in the series, which was closed in 2001, was $1 billion. Subsequent funds have weighed in at around half a billion. "We wanted to do a big deal first off to make sure we were in the market as significant buyers. Once you have multiple funds, the actual size of each fund does not matter that much because you do orders for several funds at the same time," said Hazelton, who has been with the firm since the first days of Duke Street Capital in 2000. The funds are a good size to manage given the allocations of European leveraged loan deals, he said. "We are comfortable with that size and can get the ramp-up done efficiently."

Duchess VII ranks as the European CLO with the lowest overall cost of capital to have priced to date, according to a JPMorgan Securities research report (see the graph on this page). The fund's average cost of debt - arrived at by calculating the weighted average costs of all CLO debt, from the highest rated to the lowest - came in at 45.57%, with debt ranging from AAA to BB-/Ba3.

By comparison, the Wood Street VI fund clocked in at 45.85% on Dec. 15, 2006 and Skellig Rock I recently came in at 45.86%.

"The name of the game for us is to lend money out at a certain spread, which is greater than the cost ... to us," Hazelton said. "The profit you make on that deal goes into the equity returns of the CLO."

CLOs in Europe tend to be around 10 times levered, so the fund has an equity strip of about 10% on the capital structure, Hazelton said. While the structure is pretty standard across the industry, Babson said it was able to keep the cost of capital down because of investor demand. "It is the price that the buyers of the rated paper are prepared to pay coming from us as the managers," Hazelton said.

And with lots of investors chasing leveraged loans for the performance, the low default rates and the high quality of leveraged buyouts in the European market, margins have been compressed, though somewhat slower than in other credit markets. Babson has been able to take advantage of these reasonably attractive spreads. The firm's weighted average spread, including cash pay on Babson's mezzanine loans and senior secured loans across all of the firm's funds, is somewhere between 280 bps and 300 bps.

Investors in Duchess VII included mostly European and Asian banks and asset managers, though the fund has drawn a few U.S. investors.

Babson Capital Europe, headquartered in London, currently has 4.5 billion under management in eight CLO funds, one mezzanine fund, one credit opportunities fund, one managed account and two warehouses.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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