First-time collateralized loan obligation (CLO) managers entered the game in droves in 2013, and participants expect this tend to continue in 2014, even if risk-retention regulation will make it more difficult for smaller firms to keep playing.
In fact, managers considering a shot at the market have just as much incentive as existing managers to pull issuance forward before the regulation—which requires sponsors to retain a 5% stake in CLOs—takes effect in 2016.
“Smaller firms are disadvantaged if risk retention shapes up as it is currently understood, but several smaller managers we are reviewing have existing hedge fund platforms, existing assets under management,” said Yvonne Fu, a managing director in Moody’s Investors Service’s structured group. “In the future, doing another CLO may not be profitable, but they won’t have to close up shop; they just won’t do as many CLOs. They can keep the ones they have as a source of revenue.”
Min Xu, a senior credit officer in Moody’s structured group, added, “Maybe the trend will actually pick up, and these managers will come to the market and pick up assets under management [while they can]. It’s certainly a profitable platform, and it’s a natural extension of what they’re doing already. They’re already doing the credit work.”
While a number of managers closed up shop following the following the financial crisis, theentry of new CLO managers over the last two years has more than offset the consolidation that took place between 2009 and 2011, according to research published by Moody’s in October. By the rating agency’s count, 18 new players entered the market between January 2012 and June 2013, bringing the totalnumber at midyear to 131. The newbies, which have teams with varying amounts of previous CLO management experience, control $13 billion of the $82 billion in assets backing the 180 deals Moody’s rated in 2012 and the first half of 2013.
The number of entrants in the second half of 2013 is less clear; however it appears that we’re seeing a shift in the type of player taking a crack at the CLO market. “My impression is that it’s a little more geared toward independent firms at this point. They have existing assets under management but not a large private equity firm backing them,” Fu said.
In December alone, at least two firms jumped into the game, and both illustrate this trend. Credit Value Partners, LP priced the $400 million fund CVP Cascade CLO-1, via Credit Suisse, and Hildene Leveraged Credit, LLC issued the $300 million Hildene CLO I, via Bank of America Merrill Lynch.
Credit Value Partners was established in 2008 within Credit Suisse Asset Management, then spun out in mid-2010. As of Sept. 30, 2013, CVP had roughly $758 million in assets under management. The firm’s senior managers have 20 years of corporate loan and distressed debt experience, and loan market veteran Joe Matteo joined this past summer to build out the CLO platform.
Hildene Leveraged Credit is part ofHildene Capital Management, a New York-based firm focused on structured finance investments with more than $1.5 billion in assets under management. Although HLC’s portfolio management team has prior experience in evaluating corporate credits and investing in CLOs, they had not previously managed a CLO as a team.
Notably, in both cases Babson Capital Management LLC, an experienced CLO manager and investor in the funds, agreed to act as the designated replacement manager, an arrangement that served to mitigate risk and assuage any trepidation investors might have.
Moreover, CLOs run by less experienced managers appear to pay investors a premium. For example, the triple-A tranches of the CVP and Hildene deals priced at 145 basis points and 150 basis points over Libor, respectively, while fourth quarter transactions from seasoned managers such as Ares Management, Pinebridge Investments and Symphony Asset Management priced in the range of 125-135 basis points.
It’s a testament to the strength of the market’s recovery that so many veteran and first-time managers alike can get deals done. Issuance for 2013 reached the $80 billion mark, the highest level since 2007. And the steady stream of transactions looks poised to continue, with the New Year getting off to a strong start: predictions for 2014 range from a conservative $60 billion all the way up to $85 billion. Most market players we spoke to think it will land somewhere in the middle.
This downside to this heavy volume is that there is a limited supply of investors in triple-A tranche, which has kept senior tranches of these deals in general comparatively cheap, relative to similarly rated tranches of other asset-backeds.
"That’s in part why we’ve seen triple-A spreads widen, it’s simple supply and demand,” said John Clements, a managing director in the CLO unit at Citi. “I think there’s a lot of equity capital out there to drive deals. So the limiting constraint is really triple-A capacity. That’s why we’ve seen some widening in that tranche. I think for the other tranches, double-As down through double-Bs or single-Bs, the spreads have held up pretty well if not tightened."
The triple-A widening is expected to reverse, at least to some extent, in the coming months, partly because of the asset class’ attractiveness relative to other structured products. Wells Fargo analysts expect CLO spread contraction to lag other assets in 2014, with triple-As possibly tightening to the area of 135 basis points in the first quarter. And with competing products offering less bang for the buck, demand for triple-A tranches of CLOs will likely climb as relative value increases.
“On a pure economic basis, there’s no reason triple-As shouldn’t be inside 100 basis points,” said Josh Terry, head of structured products and trading at Highland Capital. “Obviously, you have FDIC charges on bank portfolios, in addition to their cost of capital, and that keeps CLO spreads wide. And the Volker Rule could slightly impact how they’re structured. But we do think they’re historically attractive and wide, which should increase demand.”
Of course, the triple-A demand equation relies on a broader base, something the market has been talking about and hoping for since volume began to pick up two years ago. Now, an increasing number of asset managers have begun to take a look.
“We have definitely seen that over the course of this year,” Sajid Zaidi, head of CLO structuring at Morgan Stanley. “I think the relative value keeps changing depending upon what happens with the interest rate curve, but we have definitely seen more interest from pensions and asset managers in 2013 than we have ever in the past.”