Fitch Ratings said last week that the number of CLO managers is likely to decline by about 20% over the next three years as a result of managers being replaced or withdrawing from the market.
At the moment, the European market consists of 62 managers, half of which have only one or two CLOs under management. Fitch said that 60% of these CLO managers entered the European market opportunistically over the 2006-2007 period and that 50% of these were U.S. managers.
"The European CLO management industry is entering a new phase in its development; the long-awaited manager shakeout has begun," said Manuel Arrive, a director in Fitch's fund and asset management rating group.
Fitch said that managers need at least two CLOs to break even in a benign environment, but at least three to break even in a more challenging environment. As defaults and distressed debt exchanges increase in frequency, the break-even point is expected to move to four or more CLOs, depending on the reduction in subordinated fees, which represent two-thirds of a manager's compensation.
Most European managers have only two CLOs or less than Ã1 billion ($1.5 billion) under management, which means that to survive, these managers would have to turn to other income sources.
As the challenging conditions for the industry intensify, the European leveraged loan market is likely to see consolidation in the CLO asset management industry. Fitch expects greater divergence in European leveraged loan credit performance that will reveal differences in managers' capabilities and, ultimately, business viability.
"Their performance will distinguish between those who were better prepared with more defensive portfolios as opposed to those who were concerned with just pumping new volume," Arrive said. He added that the industry favored established managers because the necessary survival factors required critical mass, a proven track record across the cycle and a solid and recurrent investor base.
For managers who had not achieved critical mass, withdrawing from the market seemed the likely choice. Arrive said that opting for manager replacement could be used to execute growth strategy, but it also had its limitations because the process is cumbersome and could take up to six months. He also saw limited potential for a merger-and-acquisition option because the M&A pool in Europe is very small, with less than five fully independent managers operating in Europe.
Fitch expects value to erode for all creditors (including senior secured), even if defaults are slow to materialize due to covenant headroom and the early life of most loan deals. The real test for the leveraged loan market will be felt through refinancing risk from 2012, when bullet structures fall due. Consolidation among CLO managers, along with the departure of CLOs as principal syndication targets for leveraged loans, will pose a threat to the refinancing of such loans in 2010 and beyond. This is when substantial debt amortization requirements will arise.
"The dice have largely been rolled," Arrive said. "It's before the peak of the market that you begin to prepare for a downturn."
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