The CLO market got off to a rocky start this year, as defaults on leveraged loans started to multiply, sending prices of these assets down sharply and putting many deals at risk of tripping coverage tests. The resulting selloff in collateralized loan obligations themselves, combined with a dearth of new loans, has made it difficult to bring new CLOs to market.
But one of the biggest challenges in putting new deals together, according to Justin Plouffe, managing director of U.S. and European CLOs at The Carlyle Group, has been the decline in the number of buyers of CLO debt. Plouffe says that this has resulted in “clubbier” transactions that are distributed among a much smaller group of investors than has been the case in recent years. And these investors individually have more power to negotiate deal terms than they would have otherwise.
Just $15.1 billion of CLOs (in 37 deals) were issued through May 2, down 66% from the same period of 2015. The Carlyle Group completed two of them totaling $901 million in April, following what Plouffe described as a deliberative and measured ramp-up of senior-loan assets over first three months of the year
Plouffe, an attorney and former partner at Ropes & Gray who joined Carlyle in 2007, spoke with Asset Securitization Report following the launch of the deal about the loss of liquidity in CLO trading, opportunities for bargain hunting in the secondary loan market, and the firm’s efforts to navigate impending rules requiring managers to retain a share of the risk in their deals. An edited transcript follows.
[Carlyle GMS CLO 2016-1 on April 22] was Carlyle’s first CLO for 2016. Can you walk us through the market’s trends and challenges, such as spread volatility, that Carlyle faced in putting together this deal?
JUSTIN PLOUFFE: In the first quarter of the year there have been fewer participants in the debt tranches of CLOs. That means that it takes longer to put a transaction together. Transactions tend to be less broadly distributed and more bilaterally negotiated. We’ve seen this in the market before. The market comes and goes as in terms of the number of participants. That’s probably that largest challenge, that there have been fewer participants in the market.
How do you view the market conditions right now for new deals – can the market recover enough to still reach the forecasted 2016 issuance levels of $75-$90 billion or so?
I think issuance will pick up for the remainder of the year, but I doubt it will be at the level that gets us above $75 billion.
Is the secondary market becoming a growing resource for CLO issuance out of necessity to fill the pipeline, or because of sell-off pricing opportunities?
Both. One of the challenges on the asset side is lack of consistent new issuance in the loan market. That means collateral managers have no choice except to turn to the secondary market. But I think volatility in the secondary market also offers some attractive opportunities. Many managers like the value they can purchase in the secondary market so turn to the secondary as a means of ramping up a portfolio.
How much of an issue has liquidity been for CLO paper this year?
Liquidity has been inconsistent. Earlier in the quarter, when we saw significant widening of spreads in the junior part of the capital structure, that widening did not seem to be based on a significant amount of volume, and when trades picked up we saw spreads contract.
Are CLOs adapting to new ways of monitoring or reacting to underlying asset performance because of default/downgrade trends?
This is what we have seen in past credit cycles. CLO managers have to pay very close attention to the triple-C assets, to their WARF scores, to defaulted assets and assets likely to default because all of those things can make it very difficult to trade within the CLO and they can result in cutting off equity cash flows. The last three or four years have been a very benign default and downgrade environment, but we’re seeing that change. But it’s not a surprise. This is what happened in the last two credit cycles, and experienced CLO managers should be ready for it.
Will energy exposure continue to stress CLO overcollateralization and Ca-rated asset limits, or do you think CLO managers have that issue contained?
I think that’s highly dependent on the CLO manager and specific portfolios. We see certain transactions that are in very good shape in terms of their energy exposure. We see other transactions that we think will continue to have problems throughout the rest of the year. I think that is a question that has to be decided deal by deal.
Has Carlyle made any changes related to energy exposure?
We were relatively underweight in energy starting in 2014, so we felt we were well positioned. We have not made any significant changes recently to our energy exposure because we had already underweighted the industry.
Are there sectors or pockets of the loan industry that may provide good pricing opportunities for CLO managers this year?
There are definitely credits we see that we think are underpriced and areas to add value. I would not say there is one particular sector. It’s more of a credit-by-credit analysis. We are looking to find value in companies that we think have traded off unfairly maybe due to the overall market sentiment and not anything that is fundamentally wrong with their credit profile.
How has Carlyle prepared for the upcoming U.S. risk retention standards, particularly in the way you will warehouse or finance the retention stake?
We are prepared to comply with risk retention rules in the U.S. We’re starting to see the market require that even though the rules don’t technically come into effect until December. We currently comply with risk retention rules for European CLOs as well. We’ve been preparing for this for some time. It’s an expected market development, and we expect to continue to be in the CLO market in size despite the new regulations.
We take a very straight forward approach: the collateral manager purchases the retention notes. We are interested to see how the market views new types of structures, and we are aware they are out there.
Are you focused on dual European and U.S. retention compliance?
Right now, we are not seeking dual compliance for transactions. We have not seen the market demand for that. There are some complexities to achieving dual compliance. So I think it will be interesting to see over the course of the next 12-24 months whether or not the market moves to require dual compliance.
One of the panels in May will talk about the “real cost” of implementation for risk retention. What do you think have been the “real costs” that were perhaps unanticipated by regulators and examiners?
Risk retention certainly makes management of CLOs a more capital-intensive business. It is likely to be dominated by managers that have access to more capital, whereas prior to risk retention, managers could be relatively asset lite and balance-sheet lite and still carry on a business. It will change the capitalization of managers in favor of the more heavily capitalized.
I think the other cost is the cost of financing of companies that come to the loan market to be funded. There is a theory that risk retention will reduce the number of CLOs issued – CLOs are a large portion of the loan market – and that could result in increased cost of financing for companies coming to the loan market. I’m not sure that we’ve had enough time to see if in fact that has happened, or if the demand for loans will be filled by other sources, but it’s definitely something to keep an eye on in the coming years.