With European loan volume so far in 2004 at an all-time high - 35.4 billion for the first half of this year - the pipeline for European collateralized loan obligation (CLO) issuance is stronger than ever. Four European CLOs were completed in the second quarter of 2004 alone, adding to the three completed in the first quarter. And CLO activity is expected to remain just as busy or even busier through year's end, with at least eight to 10 more funds expected to emerge before 2005, said Standard & Poor's in a report on European structured finance for the second quarter of 2004.
Although CLO activity in the European market still takes place on a much smaller scale than in the U.S., this current surge in CLO issuance indicates the developing landscape of the European loan market, where institutional investors are increasingly moving into the mainstay of a market traditionally dominated by relationship banking.
Indeed, institutional lending capacity in the European debt arena is growing like wildfire, with CLOs comprising the majority of that capacity. About 18.1% of the 20% of institutional investors making up the European lending community comprise collateralized debt obligation (CDO) managers. And these figures could grow even higher, as about 2.58 billion in CLO volume has been racked up through the first half of 2004, compared with about 4.46 billion for all of 2003, according to S&P data on S&P-rated CLOs.
The European loan market's record 2004 volumes support this influx in CLO issuance, as 2003's 48.1 billion total volume is expected to be well surpassed in 2004, S&P said in the report. "Records have already been set - leveraged loan volume in the first half of 2004 was a substantial 35.4 billion, the highest ever for any half year since Standard & Poor's LCD started tracking this data in 1999," S&P said.
That said, there are still obstacles to overcome for European CLOs, as they must tackle a continued high level of loan prepayments from issuers. Since 2002, Europe's loan prepayment levels have averaged about 4.6% per quarter of what was outstanding at the beginning of the quarter, S&P said. However, the repayment rate shot up considerably to 8.3% in the first quarter 2004 and 8.6% in the second quarter.
"Loan prepayments continue to remain high, with CLOs typically experiencing 25% to 30% annualized prepayment levels," S&P said, adding, "This has resulted in managers holding cash balances in the range of 4% to 12%."
"What this means is that [CLO managers] have extra cash to reinvest," said S&P analyst James Cuby. He explained that if you assume the average life of a loan is seven years, a manager might not be able to find a shorter-tenored loan to reinvest prepaid cash that would match the remaining maturity on the CLO. And if a CLO has a weighted-average life (WAL) covenant, it is restricted from extending the maturity of the CLO. Therefore, managers may be forced to deleverage their CLOs by prepaying notes in order to stay below their WAL covenant, Cuby said.
In response to the prepayment problem, S&P said that some CDO managers have reportedly considered including a distressed bucket in their next funds so that they can better ensure returns for their investors (see ASR 6/21).
Also, European CLOs are including bond buckets in their structures to soften the prepayment blow - both Leopard CLO III and RMF Euro CDO II, which were completed this past quarter, included bond buckets in their deal structures. M&G Investment Management and RMF Investment Management manage the two funds, respectively.
CLO tenors also augment the dilemmas that arise from high prepayment levels. CLOs normally have a 10-year maturity, but that usually limits the assets a manager can buy during its reinvestment period - typically five years for European CLOs. For example, a manager loses the ability to purchase a loan with a seven-year term after year three if the CLO's legal final maturity is 10 years. As a result, many deals are beginning to be structured with 12 years or longer final maturities, in part, to reflect the longer maturities of European loans. This is particularly the case for mezzanine collateral, which European managers have increasingly turned to as a way to capture increased yield.
Nevertheless, the potential hurdles facing European CLO managers haven't deterred market players from setting up more funds. S&P said it has already published presale reports on Natexis Banques Populaires' Vallauris CLO, Duke Street Capital Management's Duchess III CDO and Alcentra's Jubilee CDO IV, all of which are expected to close in the third quarter 2004.
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