While even a couple of weeks ago European loan market participants were hoping for their market (which has barely seen a drop in the way of primary issuance over the past month) to get going in September, the word is now that it will take longer, much longer than that for new loans to be structured and priced. And when fresh transactions do come, sources say they will be vastly different from the funky stuff that Europe has so recently been witness to.
"New deals, when they come, will be quite unadventurous," said Michelle de Angelis, senior director in Fitch Ratings' London-based leveraged finance unit. "It's no secret that everyone in the market is cautious, so future deals are likely to come with lower leverage, tighter covenants and amortizing A tranches, among others, similar to deals we saw in 2003."
These are the kinds of issues that dedicated loan investors such as CLOs, among others, would be interested in buying. CLOs were either prohibited from or not keen on investing in the more avant-garde deal structures that were marketed earlier this year. But now, with the hedge funds virtually gone from the loan market, arrangers need to lean more heavily on CLOs. And it's anyone's guess just when the CLO market will get up and going again, sources say.
The vibrancy of the loan market earlier this year had resulted in a flurry of new CLO vehicles, but now, as a result of the change in market conditions, there are very few warehouses being organized in Europe and no new CLOs. Because of this, CLO demand for loan paper has substantially declined, said Christine Vanden Beukel, senior managing director of European structured products for investment firm GSC Group. Still, bankers and CLO managers themselves say that CLOs are interested in deals, but for them to return to the market, a few things need to happen first.
"In order for old CLOs to invest again in the loan market, they need to see some deals being repaid in order to free up some cash," Vanden Beukel said. "Before the market changed, CLOs could expect between a third and half of the portfolio to get repaid every year, but now repayments are slow because there are few buyouts in Europe and virtually no recaps. One could also sell CLO collateral in the market to free up cash, but the prices are low, and the quality relativelyhigh, so no one wants to sell right now and crystallize a loss."
According to Daniel Scharpenack, managing director at German investment management firm CIS Asset Management, which specializes in the management of structured finance products, some old collateral CLO deals will be priced and brought to market in the coming months. However, these have to be priced at relatively large discounts.
Even if this does happen, second-tier managers will have a harder time pricing CLOs, since only the premium, well-regarded managers with strong track records are currently able to bring deals to market, Scharpenack said.
New CLOs could happen again if banks are willing to enter into a new warehouse or deal with their existing warehouses, Vanden Beukel said. Also, investors need to take stock of things on the liability side: "I hear it's relatively easy to place a triple-A tranche, even if it is relatively expensive, but it is hard to place mezzanine tranches. As a result of the subprime problem, many CLOs are also being questioned, even though they are not directly related to that market," she said.
Right now, triple-A-rated paper is trading at a price of 95, "so your arbitrage opportunities are very low at the moment," Scharpenack said. "You would need to be in an environment where there is fresh collateral with high priced spreads to successfully price a CLO."
Many believe that if one person is brave enough to strike out and price a CLO in the current market, things could get going again. But who will take the step remains to be seen, since most investors believe that loan prices might continue to cheapen, and no one wants to buy now if prices are to fall further.
"People are in a waiting period. There is demand for paper out there, but everyone is waiting to see who will be the first one to take a step forward, and if someone does, others will follow suit," Vanden Beukel said.
All in all, though, no one really expects the leveraged finance market - be that CLOs or the collateral itself - to get going before the end of this year. And there is an overhang of underwritten deals that still need to get done at some point. However, getting these done doesn't necessarily mean simply cutting the issue price or raising margins: "They may also need to be restructured, since the level of leverage on most is likely to be unacceptable in the current market," de Angelis said.
For sure, many dedicated loan investors felt that credit standards were just not high enough at the beginning of the year, and Scharpenack believes it will take at least two quarters for banks to clear the current deal overhang.
"We have been cautious about the loan market since last December, when managers and banks did not take us seriously when we asked for a 12-month ramp-up period for a CLO, saying they could do five CLOs in five-months time," Scharpenack said. "This was, for us, a bad sign, so we stopped investing in new deals and bought our last transaction in the market in early spring."
While many of Scharpenack's clients were willing to invest contrary to the market cycle in the summer and transfer new money his way, he told them to wait until the fall. Now that fall is coming, though, "my feeling is that we will not see any new CLOs with newly priced underlying loans ramping up before January 2008, because right now there are only a few professionals that are willing and able to take the current market risk."
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