The current shutdown of the European leveraged loan market, after a glimpse of better times earlier this year, has prompted some to fret, once again, about a barrage of loan maturities coming due just as many of Europe's CLOs come to the end of their reinvestment period.
"In 2014 and 2015 there is a concentration of leveraged loans maturing at a time when a significant batch of existing CLOs are-according to their governing documents-unlikely to be able to offer fresh finance," Standard & Poor's analysts wrote in a recent report. "We expect the potential concerns surrounding refinancing are likely to be further exacerbated by other pressures in the CLO market and by the general refinancing difficulties currently existing in the global capital markets."
In all, from 2011 to 2015, as much as $87 billion (â‚¬61 billion) of European leveraged loans held within CLO portfolios will need to be refinanced; while at the same time $98.5 billion (â‚¬69 billion) of European CLOs by par amount will have ended their reinvestment periods, the S&P report says. The problem reaches its peak in 2015, when about â‚¬23.3 billion of leveraged loans held by CLOs will require refinancing, according to the report, which was authored by analysts Emanuele Tamburrano, Sandeep Chana and Paul Watters, all based in London.
While it's nowhere near the size of the infamous U.S. maturity wall - which at its peak portended $800 billion in debt owed by subinvestment-grade companies - Europe's potential refinancing troubles are exacerbated by technical and regulatory issues to a greater extent than in the U.S.
The technical issues, aka restrictions on CLOs, exist here as well, however, in Europe CLOs make up the bulk of the institutional investor base, providing as much as 63% of overall institutional loan funding in 2007. In the U.S., the investor base is more diverse, with mutual funds and even hedge funds playing a role.
The limitations on CLOs, S&P points out, include governing documents that restrict, in some cases, reinvestment following a downgrade of the CLO's notes; other restrictive reinvestment guidelines that limit CLOs from reinvesting in leveraged loans; and the fact that many subordinated CLO note holders have the option to redeem their notes under certain conditions, which could - if those circumstances arise - hasten the end of the CLO even before its reinvestment period ends.
Moreover, there has been a fall-off in new CLO creation in recent years in Europe, meaning that there would need to be a steep rise in new CLO issuance to plug the potential gap left by the restrictions on existing CLOs.
And that's not likely to happen, sources say, at least not anytime soon.
"The way it looks right now, for the foreseeable future and definitely for the rest of this year, a syndicated, arbitrage, cash-flow CLO is not something I would expect in Europe," said Shawn Cooper, head of European CLO trading at Deutsche Bank. "You need to have loan prices and CLO debt prices so that the arbitrage works. And right now, if you want to do a new deal, assuming that you can get past all of the regulatory hurdles, returns to your equity holders would be much lower to what people can get on the secondary market. So there's not a lot of incentive there."
Which brings us to the regulatory hurdles, the first being Article 122a of the Capital Requirements Directive, passed early this year, 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. (The Loan Syndications and Trading Association is still fighting the U.S. version of this regulation.)
Then there are the UCITS III fund requirements, which determine eligibility for retail investment and prohibit retail funds from investing in leveraged loans. This brings us full circle, as it is a big part of the reason the institutional market relies so heavily on CLO buying power.
Still, a long stretch exists between now and 2014, and a lot can happen in the interim. "Even if we assume zero issuance for the next few years, and assume a low prepayment rate, the European CLO market - based on prepayments and the assumption of some manager trading in the portfolios - has buying power of up to â‚¬30 billion for the next three years," said Rishad Ahluwalia, global head of CDO Research at JPMorgan. "That would take out about half of what is due before 2015. And that's with little or no CLO issuance."
Moreover, Rishad says additional debt could be eliminated by high yield bond refinancings, possibly some buying from the banks, and pay downs from companies themselves, as some do have decent cash flow.
Indeed, the European junk bond market has almost doubled in size during the past two years to roughly â‚¬200 billion, according to Thomson Reuters, and this has been driven predominantly by the refinancing of leveraged loans.
According to S&P, at least 30% of new European high yield issuance during the first half of 2011, or almost â‚¬9 billion, was raised to refinance leveraged loans.
Still, if the regulatory environment doesn't improve for CLOs, any comeback will fall short of meaningful. And if the mutual fund market can't step in to pick up the slack, it leads one to wonder: Who is the European institutional loan market of the future?