When the leveraged loan market starts to see defaults you better.
It seems easy to get caught up in the leveraged finance bonanza of late, and CLO managers have done just that. According to figures reported by Derivative Fitch, cash CLOs made up 69% of total European cash CDO issuance in 2006. This phenomenal growth is expected to continue into 2007. But as the market grows to accommodate a larger investor base, market analysts warn that the signs for an impending downturn are already there and managers should be taking steps to make sure their investments are safeguarded today from the defaults of tomorrow.
Standard & Poor's said it expects European corporate balance sheets and profitability to stay strong overall and low borrowing costs to continue to spur leverage. S&P estimated loan issuance for the year to reach 130 billion ($169 billion) to 150 billon in 2007, driven by private-equity led LBOs and rising corporate leveraging. "The stable leveraged credit market and low default rates continue to drive strong returns for managers but how well managers are able to deal with default rates is crucial to the markets performance going forward," said Michelle De Angelis, senior director of European leveraged finance at Fitch. De Angelis warned that the increased liquidity driving both growth in volumes and higher leveraged buyout multiples, could be masking the risks that lie ahead. "A lot of the deals done over 2006 were a result of refinancing of loans that might have otherwise encountered problems," she said.
European CLO issuance has increased with the expansion of the leverage loan market. According to Moody's Investors Service, 23 billion ($30 billion) was issued in 2006, representing an 80% increase in volumes registered for 2005. This growth has primarily been driven by the arrival of new managers - 35% of deals in 2006 were managed by new names. In terms of market participation, there are now more CLO managers in Europe than ever before, including U.S. managers setting up operations in Europe and managers of other asset classes establishing CLO businesses.
But there is a minimal pricing differentiation within CLO rating classes that mirrors the relative lack of tiering between established and new managers. As the market evolves, analysts expect to see greater tiering of managers, which should provide opportunities for investors who look beyond first-time labels to the underlying experience in the European market and ability to source quality credits. "This differentiation will be even more heightened in a less benign credit environment expected over 2007," Dresdner Kleinwort Wasserstein analysts said in a report. "In addition, we believe demand for CLOs with a greater ability to alter the size of their CLO buckets may increase, as a manager can then position themselves to better benefit from any market swings."
The best performing managers will be those that are already established in the European CLO market. These managers benefit from stronger relationships with arrangers and sponsors, giving them first dibs on the higher quality paper and their larger ticket size. The more established managers will increasingly be sought after and, consequently, will benefit from lower funding costs resulting from their CLO issues pricing at relatively tighter spreads, Dresdner analysts said. Manuel Arrive, a director at Derivative Fitch, said the market is already beginning to see polarization between the more established managers and the newer players.
(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.