A collective sigh must have fallen across weathered European collateralized loan obligation (CLO) managers when news emerged about H.J. Heinz Co.’s decision to forgo selling a European portion of its $12 billion LBO financing in mid-March.

The financing to support the U.S. ketchup company’s $28 billion buyout by Warren Buffet’s Berkshire Hathaway and 3G Capital was originally slated to include $12 billion in mostly term debt, including up to $1.4 billion in euros and $600 million in sterling. Managers of the three European CLOs completed so far this year as well as those prepping offerings currently in the pipeline were likely eyeing the loan hungrily.

At the last minute, however, greater demand on the other side of the Atlantic prompted bankers to sell all of the Ba2/BB-rated financing package in dollars.

After a five-year hiatus, the European CLO market has revived, as deal economics have improved, and three leveraged-loan CLOs have priced so far this year, for a total of approximately $1 billion.

A fourth CLO from the Carlyle Group is currently in the market, and a reported seven or eight more are in the pipeline. J.P. Morgan forecasts $3 billion and perhaps as much as $4 billion in new European CLO volume by year-end. Cairn Capital closed the first CLO since the financial crisis in late March, and Apollo Asset Management and Pramerica priced deals in April.

Even if J.P. Morgan’s forecast is doubled, that’s still a drop in the bucket, considering that nearly $29 billion in CLOs were issued in the U.S. alone through mid-April. Even so, there remain nagging concerns about whether the European CLO market may be jumping ahead of itself, given the paltry origination of leveraged loans in Europe and lenders’ unwillingness to sell those already on their books.

New regulations and evolving market dynamics are also likely to effect whether the European CLO market sputters out, yet again. However, the shortage of leveraged loans is clearly the primary issue, pushing managers to consider fundamentally changing the CLO structure by including greater allocations to alternative assets such as fixed-income and loans denominated in non-euro currencies. Such changes would give managers a greater selection of potentially high quality assets to choose from, but they may unnerve investors.

“The looser the criteria, the less comfortable we are giving money to the manager,” said Herman Slooijer, head of European credit at APG Asset Management, the investment arm of the Dutch pension fund provider that manages €330 billion in assets. He added that most CLOs buy more than half their full allotment of loans after deals are inked, and investors must rely on managers’ discretion to choose those credits, as long as portfolio eligibility criteria and portfolio quality tests are being met, rather than their own credit analysis.

Europe’s Institutional Loan Parsimony

The U.S. dollar denominated institutional leveraged loan market, reaching $632 billion in 2012 according to Credit Suisse, is more mature and much larger than Europe’s, which relied heavily on CLOs for liquidity in the years before the financial crisis. Without those CLOs, the leveraged loan market there has shriveled, and borrowers have instead turned to the bond market. At the end of 2008, the institutional term loan market in Europe reached €230 billion outstanding and the high-yield bond market was a mere €80 billion; at the end of 2012, the bond market had grown to €300 billion and the loan market was just under €150 billion.

S&P Capital IQ’s LCD recorded fewer than nine senior leveraged loans issued monthly, on average, in Europe last year, and while the number of deals in January jumped to 18, February and March each recorded 10.  Considering that a European CLO is viewed as sufficiently diverse when it pools 60 to 80 loans, unless leveraged loan volume increases CLO managers will continue to scramble for assets.

“It would certainly take many months for a CLO to ramp up completely on ‘brand new’ assets,” said Rishad Ahluwalia, head of global CLO research at J.P. Morgan, adding, “Hence, 25%, 50% or even more of the portfolio would have to come from the secondary loan market, other portfolios, or existing CLO holdings.”
So far, however, finding those existing assets has also been challenging. With the disappearance of the European CLO market after 2008, APG has instead become a direct lender. Slooijer said leveraged loan prices rarely rise much above par, even if the coupon level suggests they should, because borrowers can call them at any time and lenders would end up taking a loss.

Lenders might be more apt to sell the loans if prices rose above par, but instead they tend to hold on to them. “Loans are typically much stickier; if you have a loan, you stay on it,” Slooijer said, adding, “It’s difficult to buy paper because nobody wants to sell it to you.”

Banks Holding Out for Higher Prices

Plus, banks often prefer to hold impaired loans to maturity than sell them and take a big a haircut. A bank may hypothetically be holding a distressed loan at par on its books, but its actual value has dropped to 80 cents on the dollar. The bank may be willing to take a haircut at 90 cents, but until there’s sufficient demand to push up the price to that level, it will hold on to the loan.

“If spreads in the [loan] market tighten, and 80 becomes closer to 90, then the bond may come out,” Slooijer said. “It’s a chicken or egg situation.”

In terms of new leveraged loans, Ahluwalia noted that, unlike in the U.S., where leveraged lending is often used as a corporate financing tool, in Europe leveraged loans have typically supported M&A, LBOs and similar one-off transactions.  Consequently, he sees the chicken-or-egg causality conundrum extending more broadly, requiring growth in CLOs and the liquidity they provide in order for leveraged lending to increase and support those deals, even while CLO managers need new loans to grow.

So far there’s little change in sight to resolve that conundrum and open the leveraged loan spigot. John Brynjolfsson, who oversees investment activity at Armored Wolf, an investment manager that provides advisory services to mutual funds and hedge funds, said the flow of loans may be muted for awhile. He said the Eurozone is built on a structure of cooperation that doesn’t have strong political backing from local populations in either the core or periphery countries, and the resulting tension has created “a hostile environment for capital” flowing into Europe that could spur more leveraged lending.

In addition, he said, wages in the periphery countries have caught up to more expensive core countries such as Germany, but productivity to support that increasing cost structure has not. “Nobody wants to make adjustments, either to reduce wages or devalue currencies, and as a result there’s very high unemployment or stagnation,” further damping corporate borrowing, Brynjolfsson said.

Changing Market Dynamics and the Virtuous Cycle

Although Europe’s politics and economy present a less-than-rosy picture, given today’s historically low interest rates, more CLOs may be in the wings, if only the financing becomes available. No one seems to think there will be a vibrant leveraged loan market anytime soon. However, European Central Bank (ECB) President Mario Draghi’s speech last July, in which he vowed that the ECB would support the euro, has resulted in a more risk-friendly environment, said Clayton Perry, chief operating officer of Avoca Capital, a CLO manager since 2002.  Perry added that tightening spreads on leveraged loans in the U.S. over the last 15 months have made returns on dollar-denominated CLOs less attractive, while spreads on securities issued by European CLOs have tightened, reducing their liability costs and improving returns.

“The economics available to the investors in European CLO equity have improved relative to those in the U.S., so there’s a healthy number of U.S. investors looking to get involved,” said Perry, noting the U.S. pension fund that purchased the equity portion of Cairn Capital’s Cairn CLO III offering, the first European CLO since the crisis.

Perry declined to say whether Avoca is currently working on a CLO.

Tightening CLO spreads may spark investor interest in higher-rated tranches of these deals.  The 40% credit enhancement and relatively short maturities of the new CLO structures, dubbed CLO 2.0 for U.S. offerings and as well as for similarly structured European ones, are additionally attractive features.

“From a technical view of the AAA-rated tranches, you may be able to argue there’s going to be more demand, and that could be an interesting space to be positioned in,” said Chris Kruthoffer, senior portfolio manager and structured finance manager at APG.

There is hope that successful new CLOs will feed a virtuous cycle, spurring demand for loans that encourages banks to originate more new loans and sell existing ones.

“In our talks with managers, they’ve said that if the first three or four deals successfully close, that could spur significant issuance by year-end,” said Matthew Jones, senior analyst for structured credit, Standard & Poor’s.

Similar hopes, however, were dashed only a few years ago. Leveraged loan spreads began tightening in 2011 and banks underwrote a number of new loans, but an upset in the macro environment reversed the trend, and banks took a beating.

“Banks’ appetite to underwrite new loans dried up and pushed people further into the bond market,” said an investment banker who declined attribution.

Even if origination of new loans fails to increase significantly, Ahluwalia said, there should be enough collateral available from the secondary market or other loan funds to support the volume he foresees. In addition, he said, existing CLOs are exiting their reinvestment periods—J.P. Morgan estimates 80% of CLOs this year and 95% by the end of 2014—and that will lessen demand for leveraged loans and widen their spreads.

“This helps the new issue CLO market, because it will make new loans more economical in terms of spreads for new CLOs that now have wider funding costs,” Ahluwalia said.

New Types of Assets

Another solution to the European CLO dilemma may be to broaden the types of assets that can be included in CLOs. Most pre-crisis European CLOs have buckets of 10% or less for fixed-income assets, assuaging the rating agencies’ concerns about basis risk when matching assets and liabilities. By contrast, the recently priced CLO from Pramerica, the European affiliate of Prudential Financial, can allocate up to 40% of its assets to high-yield fixed-income.

Jonathan Butler, head of the European leveraged finance team at Pramerica, said his firm has identified upward of 50 “liquid, clean loans with attractive yields that we like in Europe,” even though the firm is tracking more than 250, many of which it already owns in CLO portfolios it has acquired over the last several years.

“If you believe you should have 60 to 80 names in a European CLO, then you’re obviously caught short,” Butler said.

Pramerica’s solution is to allocate up to four times the volume of fixed-income typically found in existing CLOs. Another solution may be to permit assets denominated in other currencies, such as British sterling. No deals priced this year have allocated non-euro assets yet, but the issue was addressed at an Information Management Network conference in early April, where concerns raised about the high cost of swap currency conversions were countered by greater selection of sterling loans that CLO managers could choose from.

Credit Enhancement Stronger Than  Legacy Deals

The market for new-issue European CLOs literally disappeared in the wake of the financial crisis, and the first batch of 2.0 offerings has been fortified with stronger credit enhancement and other risk-adverse features. Nevertheless, the 1.0 generation of CLOs has performed as anticipated, through thick and thin.

Ian Perrin, a senior credit officer at Moody’s Investors Service, noted that there have been downgrades but was unaware of any European CLOs that actually experienced losses at the AAA level, although there have been bumps, as one would expect. For example, higher quality loans may have been prepaid or refinanced in some CLOs, he said, and so they now hold fewer better rated names, putting pressure on the bottom of the capital structure. However, he said, the vast majority of existing CLOs will soon be amortizing, resulting in a deleveraging of the overall transaction and consequently senior-note upgrades.

Investors in subordinated tranches may have seen their cash flow diverted for a period to support higher rated tranches, but long-term equity value in traditional cashflow CLOs has remained intact, said Dagmar Kent-Kershaw, head of credit fund management at Intermediate Capital Group, which launched the first European CLO in 1999 and currently manages 13 billion euros in assets. “There are very few European cashflow CLOs where equity investors have crystallized losses to date on a buy-and-hold basis,” she said.

In fact, the dearth of European CLOs in recent years appears to have been something of an overreaction, perhaps because the deals were associated with highly problematic securitizations, such as the residential mortgage-backed securities issued in the U.S., and because of economic and financial uncertainties. “One of the things that slowed down recovery in this market is a lot of potential investors were worried about what would happen with the Eurozone, and they still want to see limited exposures to Southern countries,” Perrin said.

Risk Retention: Friend or Foe?

New European risk-retention rules may present an obstacle for some CLO managers, especially the lightly capitalized ones, because they must retain a material net exposure to the transaction of not less than 5% or find a third-party subordinated investor to fill that role.
The rule’s intent is to align equity investors’ interests with those of note holders. Slooijer at APG, which in 2007 had CLO investments tilting toward senior tranches that totaled 10% of the pension fund’s total European ABS exposure, said the pension fund now sees more value in lending directly, though it could find highly rated CLO tranches interesting.

He added, however, that the fund has hesitated because of the “buy-to-distribute” nature of the CLO market prior to the crisis. Although APG approves of the new risk retention rules’ general thrust, Slooijer said, it has concerns about managers selling their “skin in the game” to third parties.

James Warbey, a partner at Milbank, Tweed, Hadley & McCloy, which advised on two of the first three European CLOs, said that a third-party equity investor can be compliant with risk retention rules’ Article 122a, which requires that a party with an alignment of interest hold a 5% net economic interest, but does not require that party to be the CLO manager.

CLO managers are incentivized to manage a deal’s assets properly if they want to stay in the business, but many European managers left the business when their assets hit hard times and had to be sold to stronger players. For APG, the notion of third-party risk retainers resembles the buy-to-distribute model, when managers buy the assets to distribute them to investors but may not monitor their performance as if they still held the risk.

“That may be the biggest problem we have with CLOs,” Slooijer said. “We think it’s bending the rules.”

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