The CDO business in Europe has been booming, and sources say a new structure is announced almost every week.
European market players believe the CDO business will continue growing, given the high level of cash still floating about in Europe. However, many are also beginning to think about the potential problems such a rapid rise in the number of CDOs might engender, and how these would impact the future of the CDO business in Europe.
Aside from the scramble for assets and the tight spreads managers - both old and new - are having to deal with, one issue European investors are increasingly aware of is that of "key-man risk." This is the potential risk posed to a CDO or CLO if the individual (or individuals) perceived as "key" to the transaction should leave.
Many investors put their money into a CDO or CLO because of the manager's reputation and track record, a CLO manager in Europe said, and if that person should leave, investors - whose money is usually tied in for a long period of time - are wont to think that the CDO or CLO is at risk.
The proliferation of CDOs and CLOs in Europe has highlighted the importance of key-man risk provisions, the manager said. In addition to a few high-profile departures that have taken place in the industry, there has been some shifting around of teams in the CDO/CLO world, and this is likely to continue as the market grows. (Simon Hood left ING Capital Management's Copernicus CLOs, a move sources say investors didn't like too much, even though ING later sold the business to Highland Capital Management. And Mike Ramsey left Prudential M&G to go to The Carlyle Group.)
But although there are more opportunities out there for CDO/CLO managers now, investors are still more likely to be concerned about people leaving smaller management firms, said Ian Hazelton, chief executive of Babson Capital Europe, responsible for the management of the firm's Duchess CDOs.
"I have been careful to ensure that there is a strong business culture [at Babson Europe]," Hazelton said. "But at smaller shops that might have only a fund or two, and where one person is key to these, the temptation for a manager to move elsewhere is probably more than it is at a larger, more established house."
For investors in Europe, the key-man clause is important in that "we are committing large sums of money to a CDO for a long period of time, and we want to be sure of the commitment level of a manager to a structure," said Daniel Scharpenack, head of global credit arbitrage products at Deutsche Asset Management in Europe. "The key-man clause is one way of ensuring that there is higher alignment of interests, but it is not the only criteria. Giving a manager a substantial share in the business, for instance, is another way to ensure that there is a high level of attachment to a structure and the lifetime of a deal, as it ensures a greater commitment level to the structure and to not cashing out before the reinvestment period ends."
That said, the European CDO market is still growing, and it is still nowhere near as big as that in the US (where investors are quite concerned about key-man risk, given the amount of moving around that has taken place recently, a US CLO manager said).
While the European marketplace is growing to increasingly resemble its US counterpart, there are still numerous differences between the U.S. and Europe that are important to bear in mind, Scharpenack said, not least the fact that in Europe, CDO managers have a much greater attachment to the vehicle than in the U.S. "They are more bound to stay, by contract and behavior of having a long-term view on things than their US counterparts," he said. "However, seeing as the market is developing so rapidly, we could see this change in the coming years."
In Europe, too, there are more meaningful carry structures than in the US, where even bigger managers typically operate under a basic fee income, Hazelton said. As such, incentivization should serve more as a long-term hook in Europe than in the US, he said.
For large investors like Deutsche Asset Management, however, the bigger concern for the European CDO business is liquidity. "While there have been many new deals, there are still not enough, and the institutional investor base in Europe needs to really broaden out," Scharpenack said. "Thus far, Europe is still made up mainly of par loan managers, but we need managers who can deal with a range of other asset classes, including distressed credits - and that too, before there is a market downturn."
A number of CDO managers are thinking along the same lines. Babson, for one, is looking at putting together funds that would look to manage assets a step down the credit curve, Hazelton said. "We are going to see the market develop in this way, he said."
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