With economic hardships still throwing punches at the high-yield market, more European market players are turning a keen eye to leveraged loans. As a result, CDO managers say that there has been an increase in appetite as well as opportunity over the past year for these types of CDOs.
Last year Standard & Poor's rated a total of six CDOs backed by leveraged loans. Among those, the leverage loan component for each transaction represented anywhere from 63% to 100% of the total portfolio, with a weighted average proportion of leveraged loans of about 88%. In the fourth quarter 2002, these transactions continued to perform satisfactorily, with Intercontinental CDO S.A. and Ecureuil Credit Plus CDO B.V. both ramping up and becoming effective.
According to S&P, a typical leveraged loan has likely earmarked 80% to 90% of the assets in a CLO structure as senior secured leveraged loans, but these structures allow the flexibility of incorporating a mezzanine loan component of up to 20% of total assets. As this market matures and more tailored structures emerge, there will be a growing interest in structuring transactions that offer a higher mezzanine loan component.
Mezzanine loans tend to be clumped together with leveraged loan CLO targeted assets, as these financings are increasingly structured with a mezzanine tranche, reported S&P. The collateral managers have the expertise in leveraged loans and will already have a clear credit opinion on the underlying business being financed. "With equity market volatility and low interest rates, institutional investors must go down the credit curve," said one manager at RMF Investment Products. "There will be growing demand from the institutional market for yield in the form of loans, bonds and mezzanine loans."
Small boutique and big ole' banks
Leveraged loans in Europe are still very much a growing asset class, and are largely limited to a handful of managers and investors. Royal Bank of Scotland, which, according to bank sources, has the largest leveraged loan portfolio of any bank in Europe, tapped the market last year with the first CDO sporting a 100% leveraged loan pool, dubbed Cairngorm Ltd. The bank expects to bring at least one transaction later this year.
"We obviously expect to draw on [our leveraged loan] portfolio as a source of loans for our securitizations, but the structure we are contemplating will not preclude the addition of loans from other sources," said one bank spokesman. "We think there is a lot of investor interest, especially as an alternative to the European high yield bond market where high default levels have drastically reduced the new issuance market and the attractiveness of the product overall."
Because it's relatively new, the European leveraged loan market has seen a limited number of Euro transactions completed. Most banks have only been actively involved in the market for the past four years, but market evolution paired with growing loan volumes means that there should be more product to securitize going forward. "The relative lack of product is also one of several reasons why there is still a lack of liquidity for leveraged loans," said one spokesman at RBOS. "This creates some issues for their securitization in CDOs, as their illiquidity and lack of historical track record make recoveries less certain. Nevertheless, we believe investors are generally comfortable with these issues because the loans are usually well secured and banks such as RBS employ a very disciplined approach to the workout and recovery process. Certainly, we perceive that investors are interested in the product as a means of diversifying their portfolio's risk profile."
Still, the figure of the big bank manager seems less imposing in the future. Banks can no longer afford to ignore the capital requirements outlined in the upcoming Basel II, and will likely focus on return on capital. Traditionally banks lend money cheaply, but when Basel II comes into effect, these banks will find that lending money at these rates just doesn't make sense - likely forcing some to reduce their cheap funding for mid-size corporate borrowers. "However, it's important not to forget that banks will always take risks; there will just be a shift of this acceptance from banks to institutionals," said the CDO manager at RMF. "Institutionals will purchase the term loan Bs and Cs, and banks will continue to fund revolvers and term loan As."
Weaker vintages keep investors away?
As the market shows its potential, managers are finding that placing the equity pieces of these tranches still remains a challenge. In its past deal RBS counted on two investors, but since then those players have either moved on to gain direct exposure to the market or have left the market altogether.
Such is the case for Centre Solutions, which early last year counted on the promising environment for this asset class and planned to position itself in a leading role going forward. Things were not to be (see ASR 1/14/02). Early this year, Centre's parent company Zurich Financial Services announced that Centre would no longer write new credit enhancement business. The London-based CDO team is consequently no longer together, but sources said that the team intend to stay in the market and is looking into building an independent asset management company focusing on managing CDO Equity Funds and managed accounts.
RMF Investment Products launched an in-house transaction last October and is in the process of completing the ramp. "For the transaction we completed in October, the investor appetite was there," said the spokesman. "But it is difficult to judge the size of appetite."
Because some of the older vintages have not performed well, it has become more difficult to place the equity. From an equity investor point of view, due diligence and the manager have become more important.
Because the market in Europe is relatively new, sources believe there is potential for growth - both on the manager and investor sides. "Europe is behind the U.S. in terms of the number of high yield loan/bond managers. First-time managers with quality personnel should still be able to get deals done," said one source. "It will not be easy, but it is doable with the right support; there is a solid European equity investor base which will continue to grow with underlying cash markets."
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