GREY SKIES AHEAD: "This time, when the default cycle does arrive, it will be for a prolonged period and the recovery rates will be much lower," says 3i Debt Management's Jeremy Ghose

The European Central Bank’s announcement last month of expanded economic stimulus has provided some welcome relief for the region’s CLO managers, allowing several to complete deals that had been in the works for months.  After a slow start to the year, five collateralized loan obligations worth a combined €1.8 billion priced during the month of March, bringing the 2016 total to seven.

3i Debt Management was one of those managers; it priced the €413 Harvest CLO XV last week, some two months after the deal was launched.  Jeremy Ghose, the firm’s managing partner and CEO, still has a cautious outlook for the remainder of the year, however. In a telephone interview with Asset Securitization Report, he warned that the current rally in European credit markets is likely to run out of gas, and the ensuing volatility will continue to make it difficult to securitize below-investment grade corporate loans and bonds.

And if 3i, one of the biggest European CLO managers, struggled to price a deal in these conditions, where does that leave other smaller, less experienced players? 

Ghose, an industry veteran, founded the London-based leveraged finance business of The Mizuho Corporate Bank in 1988. He became one the first non-Japanese board members for Mizuho, joining 3i in 2010 when private equity firm 3i Group acquired Mizuho's investment management business.

How do you see the European CLO market shaping up for the second quarter, as well as for the remainder of the year?

JEREMY GHOSE: My view is that it’s going to be an up and down year for all in the CLO market, not least in Europe but also the U.S. As you know, in 2015 the total issuance globally was around $100 million to $110 billion. My sense is that it’s going to be approximately half of that this year. Our expectation is for approximately $50 billion to $60 billion globally. My sense is that in Europe we’re going to see circa $15 billion in total issuance, which will make Europe a much bigger percentage of the global pot.

Why is that the case? One, Europe is a significantly smaller market than the U.S. The risk retention rules mean that the number of players with the capability of issuing CLOs is about 20, so by default the larger players – we were ranked second last year in European CLO issuance – face an implied ceiling on the number of CLOs they can issue because the investor base is not endless.

The investor base is in fact very concentrated. Investors want to diversify and they don’t typically want to double up or triple up on the same managers or on the same collateral. If you take all of that into account, it means we will continue to see a somewhat constrained CLO market in Europe. However, more positively, a couple of newcomers have printed CLOs and there may be one or two more newcomers to the European market.

Another factor is deal flow. The private equity houses have a lot of dry powder. So that’s good news. But what we typically still see is that in volatile times, there is often a substantial gap in price expectation between what a seller wants for his assets and what a buyer is prepared to pay. We expect that trend to continue for the remainder of 2016.

What impact will the European Central Bank’s expanded stimulus have?

Clearly, Mr. [Mario] Draghi’s quantitative easing program is overall good news for the credit markets. l think with the ECB increasing it from 60 billion to 80 billion [euros] per month, and extending it to corporate investment grade bond purchasing, this gives the overall markets a big boost. What that also does is delay the credit cycle, which is good news for the CLO market because if defaults are rising on the portfolio side and CLO equity is trading at a very low price in the secondary market, often investors are better off buying that discounted secondary paper as opposed to buying primary new CLO equity. This is clearly what we have seen in the U.S. market over the last several months.

How would you contrast your outlook with those of other forecasts and projections?

My projection for 2016 is that it’s going to continue to be a volatile year. Our sense is that we’ve already seen a huge amount of volatility so far. We’ve had a bit of respite thanks to Mr. Draghi’s actions. However, my view is that the rally won’t continue for long and it will run out of gas. That goes hand in glove with where we are in the credit cycle. We’ve had blue skies in the credit cycle over the last five to seven years, which can’t continue forever. This time when the default cycle does arrive it will be for a prolonged period and the recovery rates will be much lower.

Does 3i plans to issue additional CLOs this year?

We just priced Harvest XV, which we were hoping to do in January. We were ready to go then, however it took us until the end of March to price the deal, so that shows how tough the current market is. We will continue with our issuance levels, with the next one projected around June/July and, all things being equal, we usually print one in the autumn. That becomes our three CLOs in a calendar year this side of the ocean, and we also have plans to do the same in the U.S. It remains difficult to issue more than three CLOs in Europe in a calendar year.

This is caveated by what we see on the deal flows side. If there are no deals and the M&A market and PE firms are not active, then there are no loans to invest in. Investors don’t want to see us always investing in the same loans. They want to see new primary deals in the marketplace.

What is the likelihood of European CLOs including more distressed-level and Caa-level debt in their portfolios?

Knowing the investor base as we do, I think there will be reluctance amongst investors for distressed names to be included in European CLO portfolios, due to investors’ risk tolerance levels. It happens in the U.S., you’re right, but frankly the European market makes up just 10% or 15% of the global market. Both the liquidity levels and the investor base are much smaller here. In our experience, we don’t see investors agreeing to that in Europe.

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