CLOs remain a hot commodity in Europe, as both veteran and first-time managers have launched or are gearing up new vehicles for this year. This is in large part due to the positive credit risk profile and strong availability of leveraged loans in the European market. Also, the reasonably stable spreads offered by CLOs are attractive to fund managers, notes a recent report by Standard & Poor's.
But for existing CLO fund managers, today's bullish capital market conditions can be a double-edged sword. S&P reported that a whopping 16.5% of the institutional loans in its European leveraged loan index were prepaid during the second quarter of 2005 - up from about 8.2% in the first quarter.
These high prepayment levels are leaving fund managers with extra cash on the sidelines. And for managers of older funds - which may be unable to invest in new credits with longer maturities - it is not always as simple as just investing in a new deal.
"It's something that European managers are all aware of and discussing...particularly with the wave of recapitalization transactions that came to market in the first half of the year," said Rachel Hardee, head of European leveraged finance for Fitch Ratings. She added that managers of CLOs with mezzanine buckets also have to grapple with high prepayments of mezzanine loans. The amount of mezzanine loans prepaid in the second quarter outpaced the amount of new issuance, according to a recent Fitch report.
The market took notice of the problems European CLO managers face with respect to high prepayment levels when Babson Capital Europe Ltd. announced late last month that it had extended the maturity of its 1 billion Duchess I CLO by four years. While some of the newer CLOs have longer maturities, a "first generation" transaction such as Duchess I, which closed in June 2001, was slated to mature in 2013, 12 years after it was issued. In turn, the firm decided to ask investors for a maturity extension of the fund to 2017 instead of allowing the equity investors to call the transaction or let it amortize before the end of its reinvestment period.
"In an environment where you expect high prepayment rates and you only have seven-to-10-year assets...a structure with a 12-year maturity doesn't quite work," said Oliver Burgel, a director at Babson Europe. "The prepayment rates have turned out to be substantially higher than when we first started," he added, noting that about 15% to 20% of credits were prepaid annually in 2001, but that figure has since crept up to roughly 35%.
Extending the maturity of a CLO is, of course, not the only option to help deal with high prepayment rates. Kevin De Baere, an associate director at S&P in London, said that how managers address prepayments to some extent depends on how the transaction is structured and how its weighted average life covenant is defined.
He noted that some CLOs have a small bucket allowing the fund to buy paper with a longer maturity than the CLO. "Some managers just sit on more cash," he added, pointing to S&P data that show that CLO transactions, on average, had cash balances of about 6.66% in the second quarter 2005 - up nearly 40% from the 4.78% in the first quarter.
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