While one could hardly call the CLO market healthy, the rumors of its demise may be slightly exaggerated. It's not impossible to get a CLO transaction done, though a significantly easier time will be had by all if arrangers stay realistic about pricing and forget going the market value route, sources said. This market is going for cash.
With the recent news of vast restructurings to rescue total-rate-of-return market-value CLOs from liquidation (BLR, Feb. 18, 2008), on top of deflated loan prices and a dearth of investors, the CLO market has certainly seen better days. But activity has not stopped; CLO dealers have quietly priced four cash-flow CLOs since the beginning of the year -the $750 million ECP CLO 2008-1, managed by Silvermine Capital Management and arranged by Citigroup; the $350 million Galaxy X CLO Ltd. managed by AIG and arranged by Lehman Brothers, and two Morgan Stanley-arranged funds, one for Camulos Capital and one for Babson Capital Management - and sources say others are in the works. So while it may not be the massive party of the golden 2005 to mid-2007 era, it's not a wake either.
"A number of dealers, including us, are actively working on one deal at a time right now," one CLO investment banker said. "There's a pretty popular misconception that the market is dead and nothing can work right now. But despite all the other C-blank-Os' that are having challenges in the marketplace, vehicles backed by senior-secured bank loans on a cash-flow basis have pretty much always worked out."
He added that the volume the market is seeing now is consistent with 2002 or 2003, the last challenging period the market saw. "For those of us with a little bit of seasoning, this is been there done that,'" he said.
Morgan Stanley on Feb. 22 priced the $550 million Babson Loan Opportunity Fund at Libor plus 135 bps for the class A senior notes; Libor plus 300 bps for the class B senior notes; Libor plus 450 bps to 550 bps for the mezzanine tranches; and Libor plus 750 basis points for a class E deferrable junior note tranche. The fund also contains a tranche of subordinate unrated notes whose holders receive a residual coupon.
The investment bank earlier in the month also priced the $731.3 million Camulos Loan Vehicle 1, with the class A senior notes at Libor plus 85 basis points; the class B senior notes at Libor plus 250 basis points; mezzanine tranches from Libor plus 300 basis points to 800 basis points; and a subordinated note tranche with a residual coupon.
In both vehicles, the class A senior note tranches make up roughly 75% of the fund.
"We were realistic about the levels on the triple-As," said Zach Buchwald, head of U.S. CDO banking and origination at Morgan Stanley. "I still see dealers out there trying to get these trades done at much tighter financing spreads, and that just doesn't make sense right now. It's not where the market is.
"There's limited depth in the triple-A market right now, that's really the bottleneck for us," he added, "though the deals that we've printed have been distributed to several different buyers. Given where loans are trading, as well as both fundamentals and technicals, I think Libor plus 135 is a reasonable level."
Now that the monolines and conduits have gone away, the buyers at the top of the capital structure at this point are generally banks and insurance companies, while the junior tranches are going largely to hedge funds, according to sources, who expect this to continue.
"Morgan Stanley is not retaining the risk tranches in any of our deals," Buchwald said. "There are third-party investors who want to participate throughout the capital structure."
The CLO investment banker said that the investors who are buying broadly now are the same ones who bought five years ago. "These are investors who, when triple-As were at 20 basis points a year ago, they were like See ya later,'" he said. "Now the market has come to them."
Buchwald agrees. "They were priced out of the market," he said. "In the past, the monolines worked for thin fees on CLOs, and as a result the triple-A tranche priced so tightly that it didn't make sense for a cash buyer to participate. At Libor plus 135, it makes a lot of sense for cash buyers to participate."
Generally, the market is seeing vehicles come with the equity tranches already committed to, sources said. "There's not a huge road show effort on the equity pieces," one CLO manager said. "You'd expect new CLOs to be strategic or partner-oriented type investments, with a lot of upfront, behind-the-scenes work done."
Buchwald calls these "financing transactions," in which an investor who is looking to invest in loans gets financing through a CLO issuance rather than a total return swaps program, a prime brokerage or another short-term provider. These deals are driven by the equity investor, often the same institution as the asset manager, which wants to put risk capital to work.
Meanwhile, investors have gotten pickier. "Some investors are trying to tighten up some of the buckets for things other than first-lien senior secured loans," the CLO investment banker said. "Towards the end, eight or nine months ago, things got a little leaky in terms of what you could put in." He noted that the percentage of assets other than first-lien loans that were going into funds didn't qualify as an egregious overstepping of the limits, instead of 10% maybe it got up to 12.5%. "But now the investors are clamping down and saying let's keep it at the standard 10," he said.
Another challenge is educating investors about the difference between CLOs and ABS CDOs, which has been a significant hurdle, sources said. Backed by mortgages, ABS CDOs are a completely different product with different fundamentals, though there were some crossover investors who got burned, and whom the corporate credit CLO market is trying to lure back.
"The market is still very tentative," Buchwald said. "I don't think that [Camulos and Babson] signify a new day in the CLO space. I think that they show some light on the horizon, but I don't believe that we're going to be in a place even six months from now where the CLO market can support the same kind of leverage loan issuance that we saw in 2006 or early 2007."
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