Consolidation among CLO managers, underway since the financial crisis, shows no signs of slowing even as issuance of these structured investment vehicles starts to recover.
While some of the early deals took place because managers or their parent companies were in financial distress, these days CLO managers are acquiring other shops in order to achieve economies of scale.
Earlier this month, Apollo Global Management said it had agreed to acquire Gulf Stream Asset Management, which runs 10 CLOs totaling over $3 billion. Once the transaction closes, Apollo expects its senior loan business to exceed $14 billion.
In a statement announcing the deal, James Zelter, managing director of Apollo’s capital markets business, said the firm believes that “scale is essential in our industry.”
In March, GSO Capital Partners, the credit investment arm of Blackstone Group, announced the acquisition of AIB Capital Markets’ CLO business, which consists of four deals worth more than $2.1 billion.
In February, Resource Capital agreed to purchase Churchill Pacific Asset Management, which had four CLOs totaling $1.9 billion.
Even before this year’s deals, consolidation had thinned the ranks of CLO managers considerably. In 2006, the number of managers of CLOs rated by Moody’s Investors Service stood at 134; by December 2010, there were just 100. The trend is similar, if less pronounced, in Europe, where the number of managers of Moody’s-rated CLOs dropped from 59 to 54 over the same time period.
In the U.S., about one in five Moody’s-rated CLOs had experienced a collateral manager change during its life cycle as of late last year, and in Europe manager change had affected one in 20.
A big driver of consolidation is the fact that CLOs are more profitable to run during the early part of their life cycle, while they are still investing.
“A lot of the assets that were issued pre-crisis... are gradually getting past their investment periods,” said Nicolas Gakwaya, a structured finance analyst at Bank of America Merrill Lynch. “Sometime it’s still possible to reinvest principal proceeds, but generally you’d expect the outstanding balance to start to decline.” That means “fee streams are under pressure.”
While it’s becoming easier for managers to issue new CLOs or refinance existing ones, thereby boosting their fee income, this still isn’t an option for everyone.
Through June of this year, just over $4 billion of CLOs were issued, and the general consensus is for issuance to reach between $10 billion and $15 billion by year’s end. That’s nowhere near the nearly $100 billion issued in both 2006 and 2007.
“There is not enough room for all of the players that there were pre-crisis,” Gakwaya said.
He said two types of managers have been most successful in bringing new deals to market: those with significant assets under management and those with strong performance records.
“Size is a definite factor; we have seen a lot of market share accrue at the top. But it’s not the only factor. There are smaller shops that have had tremendous performance that are still able to come to market or have deals in the pipeline.”
Proposed risk retention rules that would require sponsors of securitizations to retain 5% of the credit risk of the assets in the underlying securities could drive still more consolidation, since few CLOs are expected to qualify for exemptions. They would also be unable to hedge or transfer the risk.
“If the proposed rules do not change, it would create the need for many managers to consolidate,” said Cindy Williams, a partner in the structured finance and securitization practice at law firm Dechert. She noted that the requirement for holding 5% of the par amount of securities issued “is significantly in excess of 5% of the real credit risk in the deal... Many managers are simply not able to put up this capital.”
“The thought is that [the proposed rules] would limit the market to very well capitalized entities such as large PE firms,” said John Timperio, another partner in Dechert’s structured finance and securitization practice.
Timperio said some of the consolidation occurring now is “in anticipation of the proposed rules,” which would go into effect in 2013, two years after publication of the final rules.
Williams said the risk retention rules are unnecessary. “Because managers typically have some subordinated fees or incentive fees that don’t get paid until debt issued is paid, managers’ interests are aligned with investors’ even if managers don’t put up 5% of the risk retention capital,” she said.
The deadline to submit comments on the proposed rule was originally in June but has been extended to Aug. 2, and industry groups are still lobbying.
Also driving consolidation is the fact that managers are still unable to find buyers for all of the equity in new CLOs, meaning they are already retaining much of the credit risk. “In all but the last couple of deals that came to market last year, all of the equity was retained by managers,” Timperio said.
In some of the more recent deals Dechert has worked on, as much as 40% to 50% of the equity has been sold to third parties, “but there’s still a significant portion retained by managers or funds advised by managers. Back in the heyday, you could get 70% or 80% sold... we’re not up to those levels yet.”
A lot of the investors in the equity tranches are business development companies, Timperio said.
While CLO managers are increasingly seeking economies of scale, not all of the consolidation consists of large players swallowing smaller ones. Yu Sun, a senior credit officer at Moody’s, said some small to medium-sized managers are also seeking opportunities to grow their CLO management business, either by acquiring an entire shop or an individual CLO.
Still, in both the U.S. and in Europe, the 10 largest CLO managers (in terms of the number of CLOs managed) are in charge of more than 40% of total transactions, according to Moody’s research, while about 30% of managers have only one deal under management.
A change in CLO management may have consequences for investors in these deals, since the new management may have a different investment philosophy or goals; it may want to align the underlying loan portfolio with assets held by other CLOs it manages, for example.
Gakwaya said a management change “is something that can have a positive consequence for investors... We’ve seen a couple of examples of deals that were underperforming being purchased by an upper-tier manager and having their performance increase over time.”
Another potential upside for investors: manager consolidation may remove obstacles to restructuring debt held by CLOs. Sun said that since many CLO managers invest in the same loans, consolidation may ease the process of achieving consensus on workouts
