A new rule in Europe—Article 122a of the Capital Requirements Directive, which calls for originators, sponsors or original lenders in an arbitrage CLO to retain at least 5% of the vehicle’s equity on their balance sheet—has European loan market participants worried about the future of these funds, and places a kink in a market that, after two years of inactivity, is just starting up again.
The rule, which was introduced at the beginning of the year, will make creating CLOs — the primary buyers of institutional loans in Europe prior to the financial crisis — more expensive and risky than in the past, when originators could pass along any and all of the risk to secondary investors.
“We are trying to figure out how to work within the [regulatory] guidelines, and to wait and see whether the regulators will soften their stance. But clearly, in this new context, it will be very tough for the first-time, small mangers we saw in Europe in 2006 and 2007 to issue a new deal,” said Shawn Cooper, vice president of ABS and CDO trading at Deutsche Bank in London.
According to Cooper, recruiting investors for a new CLO is not a problem. With the European loan market improving, investors are once again expressing interest in CLOs, he said, and they are actively trading existing CLO paper on the secondary market.
Moreover, because recent loan deals have been of higher quality and have come with less leverage and wider spreads, they make for attractive CLO collateral, Cooper said. But working within the parameters of the new regulation is going to be tough even for experienced CLO managers.
“Before the crisis, the biggest concerns with respect to CLOs were either that the collateral was too expensive or that CLO liabilities were too wide for the arbitrage to work,” Cooper said. “Now, the difficulty in setting up new deals has to do with the regulatory hurdle.”
The new regulation has put a damper on the CLO market, not least because most European CLOs have come through a very tough financial crisis in far better shape than most people had expected, and there is still a great deal of interest in the structure, said Alastair Sewell, associate director at Fitch Ratings in London.
“The CLO structure proved itself, and although some CLOs might have stopped making interest payments in equity and junior note tranches during the downturn, improved performance of the European CLO market in general means they can now make up the missed payments as cash flows have been coming into them,” he said.
However, making the arbitrage work on a CLO — one of the biggest challenges for CLO managers before the crisis — is still tricky, Sewell said, since new issue collateral is expensive and the cost of CLO funding is high.
“But we can see that people are thinking about structures and ways to address arbitrage and make it work, so that bodes well for sentiment, even as the market deals with the regulatory issue,” he said.
Additionally, some market participants feel that banks might be reluctant to underwrite new loans if, in the absence of CLOs, those loans are going to get stuck on their books.
There is a limit to how many assets banks can hold on their balance sheet, said Grant Buerstetta, partner with the law firm of Blank Rome. And with Basel 3 on the horizon, banks won’t be able to retain that many lower-rated credits either, so the situation becomes more constrained for the issuance of new CLOs, he said.
While loan deals like a $2 billion loan for the buyout of RBS WordPay, which would not even have considered the loan market a year ago, have been successfully syndicated, and there is interest both from issuers and investors in leveraged loans, high yield bonds, including senior secured notes, are still extremely popular as a source of funding, added Chris Brils, high yield fund manager at F&C Management in London.
“I think that looking ahead, the combination deals of bonds and loans are what make sense and what we’ll see,” Brils said. “Banks are more than willing to underwrite loans for the right type of company.
Companies seem to prefer doing a bond because they can lock in an attractive fixed rate now, and some investors prefer senior secured notes, so split deals are more likely to happen. And syndicates with large deals will likely tread the water to find the balance between leveraged loans and senior secured notes.”
But despite the uncertainty over the future of the CLO market in Europe, there is nevertheless a pipeline of new CLO deals — a modest pipeline when compared to the buyout boom days, of course, but a pipeline nonetheless, Sewell said. Even if there isn’t a significant increase in new CLOs in the near-term, some existing structures can continue to reinvest, and they will be able to invest in new loans, he said.
And like their U.S. counterparts, European loan funds are enjoying strong inflows, and there is an increased interest in Europe in mutual funds that focus specifically on leveraged loans or can hold leveraged loans, Sewell said. “These funds can be expected to act as a source of demand for loans in both the primary and secondary markets,” he said.