Duke Street Capital Debt Management's closing of Duchess II, the second-largest leveraged loan collateralized debt obligation (CDO) to close in Europe this year, proved that despite increasingly difficult market conditions, it is still possible to raise new CDOs. But even Duke Street, whose sizeable Duchess I transaction enjoyed a solid investor base, had a much harder time structuring some of the debt tranches this time around.

Over the past 18 months, the number of new CDOs launching into the European market has tailed off significantly. Only 19 transactions originated in Europe, amounting to e3.7 billion, have launched so far this year, compared to e4.1 billion in the same period last year. Duchess II closed at e550 million, making Duke Street one of the largest CDO managers in Europe with a total of e1.55 billion under management.

Once again, Duke Street drew the underlying collateral for Duchess II from the leveraged loan market (Duchess I had a 75% minimum senior debt requirement,). But unlike Duchess I, which could include high yield bonds up to a 10% limit, Duchess II has no mandate for high yield, as senior debt accounts for 75% of the collateral and mezzanine makes up the balance.

"The choice of collateral was driven by investor demand. Sentiment is currently focused on leveraged loans as opposed to high yield," said David Wilmot, director at Duke Street.

High demand for mezzanine

Over the past six months, the mezzanine market has heated up considerably. Private equity houses have made it clear that they prefer mezzanine over high yield as a means of funding leveraged buyout transactions. This has led to increased supply, which in turn has resulted in an increase in the number of mezzanine funds operating in the market. Several high yield funds have also jumped onto the mezzanine bandwagon, and this has driven the institutional bid for mezzanine significantly higher. "Mezzanine has become much more adaptable to larger ticket transactions over the past 12 to 18 months as arranger banks have become more comfortable in taking large positions. On the buyside, investment capacity of both traditional mezzanine players and institutional investors has strengthened," Wilmot said.

On the leveraged loan side, credit facilities have increasingly been structured for the institutional market, and the general quality of deals has been very strong. Leveraged loans have thus become a popular form of collateral for European CDOs.

"The general quality of businesses banks are bringing to the senior debt market is very good, and this matches our need to build a diverse CDO fund based around strong credits," Wilmot said.

Based on these factors, the ramping-up period for Duchess II was very successful, especially during the final quarter of 2002, when leveraged loan issuance gained momentum. Duchess II's dual currency (euro/sterling) capability also helped maximize the choice of assets.

But it was not all smooth sailing, and Wilmot admits that some of the components within the debt structure have been harder to fund in the current market.

"In a reversal of past experience, we found that the equity book was fully subscribed in advance of the completion of the debt-placement process," he said.

The e52 million equity portion of the fund was oversubscribed, with support coming from the traditional investors involved in Duchess I. Duke Street also broadened its net as new institutional buyers and high-net-worth buyers also bought into the new CDO. The fund is already 80% invested.

A Tough Business These Days

Duke Street was successful, but most European CDO pros agree that it is getting harder and harder to put these deals together for several reasons.

One problem is investment banks' reduced appetite for warehousing, said Sara Halbard, portfolio manager at Intermediate Capital Group. Also, the loan market is still light on supply, and "at this stage there doesn't look to be a great deal of new supply this side of the summer," she said.

As a result, it is getting tricky for all but the larger fund managers such as Duke Street - who benefit from being able to place large ticket orders - to raise debt for a CDO.

"Raising money for the asset class has become impossible for newcomers, while existing investors are finding themselves with too much exposure to established fund managers, or that there is too much collateral overlap with other fund managers," Halbard said. "CLO portfolios in Europe look very similar and this is a real problem."

The market is also fickle, and as market participants eschewed high yield in favor of leveraged loans as collateral, it seems the new trend is to favor ABS as collateral, said one CDO analyst at a large bank.

But more ominous is the increasing number of professionals turning away from CDOs altogether.

"A significant number of people have left the structured side of the business to raise hedge funds and get involved in other types of alternative fund raising," said another credit derivatives specialist.

As such, few expect the 10 or 12 new CDOs rumored to be in the works to get done this year.

"I am skeptical as to the ability of all these funds to issue this year," said Wilmot, "although, of course, a thriving market is better for all involved."

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