European CLO Managers' Lament: No Market for Sterling Tranches

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Once the stewards of a market declared all but dead, CLO managers in Europe have plenty to be thankful for today. Regulations many deemed as fatal to European collateralized loan obligations have failed to live up to the hype—in fact, euro-denominated CLO volume has steadily increased over the past few years and is expected to continue upwards, fueled by a resurging leveraged loan market, which hit a post-crisis high in 2014.

Still, there’s something more that Europe’s CLO managers would like to have, sort of an icing on the cake that has, for the most part, proved difficult to attain: the sterling liability tranche.

“We would love to see more multi-currency deals; we ourselves would love to issue multi-currency deals, because that just opens things up in terms of asset sourcing,” said David Ford, director of credit fund management at Intermediate Capital Group in London.

“Anything that widens out the universe of investable assets is a good thing from our perspective, particularly when you think about sterling buyout loans, which typically price 50 to 75 basis points wider than their euro equivalent, so you potentially have the ability to capture value.”

ICG is far from the only one; interest in issuing CLOs that include a tranche of sterling notes, or less so U.S. dollars, is widespread among managers in Europe, participants say. That’s partly because the alternative—buying sterling assets and then swapping out the currency to issue euro liabilities, called a perfect asset swap—is cumbersome and expensive. Indeed, it can cost as much as 75 basisi points to 100 basis points, Ford said.

“If there were a better way to be able to buy, particularly sterling, because there is a pick up, and potentially dollars when the market is wider in the U.S., then I think most managers would be interested in having some form of multi-currency structure,” said Andrew Bellis, managing director of 3i Debt Management in London. “Unfortunately, [issuing notes in sterling] is not as easy as it looks.”

The main obstacle, according to market participants, is finding end investors for sterling CLO paper. Not only is the sterling investor base somewhat small, but there probably aren’t many natural sterling-only buyers of CLO paper. In other words, even CLO investors happy to invest in British pounds are normally equally as happy to invest in euros. This limited buyer base presents a liquidity problem, which can not only causes trepidation with the potential sterling investors, but also with structuring banks and other parties participating in a deal.

ICG, for example, has completed two European CLO 2.0 transactions in the last year, and the firm had initial discussions with the structuring banks about the possibility of including sterling or dollar tranches in those CLOs, Ford said.

“But if you think about the way it’s structured, you’ve got the large triple-A piece and inserting at the triple-A level sterling or dollar tranches reduces the overall size of the euro piece, so it potentially reduces the liquidity there,” he said.

“And end investors buying a small sterling or dollar tranche are potentially buying a very illiquid bit of paper. In addition to that, there’s the question of pricing. Would the different currency tranches be priced the same as the euro tranches, or would they be priced wide of the euro tranches to take into account that this is an illiquid piece of paper? That has an impact on the economics of the overall structure.”

Likewise, 3i Debt Management is currently shopping a €414.7 million deal, the Harvest CLO XI, which can invest as much as 30 percent in non-euro assets but will use the perfect asset swap method rather than issue non-euro notes.

Another reason that the market has not seen more multi-currency CLOs is that these structures do have their risks.

In a January report, Fitch Ratings warned that liability currency hedges in European CLOs are less effective than perfect asset swaps because of the exposure to foreign exchange risk. This could come from asset defaults or different repayment profiles between euro and non-euro assets. Fitch analysts looked at pre-crisis multi-currency deals and determined that the risk is exacerbated following the end of the reinvestment period, when certain strategies for foreign exchange imbalances become unavailable.

To date, there have only been two post-crisis CLOs in Europe with sterling tranches, both in 2013. The Hayfin Ruby II Luxembourg CLO, managed by London-based Haymarket Financial and arranged by Paris-based Natixis, has a rather large sterling tranche—it comprises €173.64 million senior secured floating-rate notes; £148.77 million of senior secured floating-rate notes; and €50 million in variable funding notes, according to a Standard & Poor’s. The CLO, which invests primarily in senior secured loans to European middle-market companies, was effectively a balance sheet vehicle that refinanced Hayfin Ruby I, also a balance sheet CLO that priced in 2011 via Deutsche Bank, according to press reports.

The other 2013 deal was the GoldenTree Credit Opportunities European CLO, managed by GoldenTree Asset Management and arranged by Morgan Stanley. It comprised €285 million in floating-rate, fixed-rate, and subordinated notes, along with a £15.32 million tranche. In a ratings report, S&P noted that the transaction benefited from a natural hedge since, at closing, the amount of sterling-denominated liabilities equaled the amount of sterling-denominated assets.

One likely reason these deals got done in 2013 and there haven’t been any since is the shortage of euro-denominated collateral the market was experiencing at the time. Since then, leveraged loan issuance has picked up substantially, alleviating the hurt for assets. Loan issuance hit €78.4 billion in 2014, up 17% from the previous year. Not only is this the highest reading since 2007, the results of a year-end survey done by Europe’s Loan Market Association indicate renewed optimism among loan market professionals. Nearly one half (45%) of participants believe leveraged loan issuance will increase by 10% to 25% in 2015, while 41% expect more or less the status quo.

One of the main drivers behind the increase in loan volume is a rise in M&A activity, also a trend that is expected to continue this year. This is good news for a market that had been subsiding subsisting largely on refinancings.

This increase won’t entirely alleviated the scarcity of collateral, however. “Asset availability will always be an issue in Europe, more so than in the U.S.,” said Matthew Jones, a CLO analyst at S&P. “I think managers are always looking to diversify in Europe outside of euro-denominated, publicly rated leverage loans.”
So we can expect the desire among CLO managers to issue sterling notes to continue, while the deals will likely only come on an opportunistic basis, perhaps by reverse inquiry. 

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