While not an immediate concern, the diminishing returns on CLO equity are not going unnoticed in Europe.
For some leveraged loan bankers, they're a barometer for the future health and performance of the leveraged loan marketplace. As the European loan market continues to remain skewed in favor of issuers and as loan prices continue to rise, it is getting harder for investors to get decent returns on CLO equity, they say.
The question is when investors in that equity will say "no more." If this happens, it might lead to a slowdown in the CLO market and, by extension, the issuance of new loan paper as well, since CLOs have been the biggest loan buyers.
The European leveraged loan space has undeniably experienced one of
the highest growth rate in recent financial market history - one that has been going on for a long while and that shows no signs of abating. Loan issuance has reached record volumes, driven in large part by the buying frenzy of European CLOs, the number of which has also increased significantly. Derivative Fitch counted 70 new European CLOs in 2006, and a further 20 were created in the first quarter of 2007.
Those close to the CLO business see no reason why things should change, even if returns on equity have been falling. Indeed, selling European CLOs has become substantially easier, and the equity - traditionally the hardest part of the deal to place - has been acquired by a whole range of investors.
"It's true that these transactions have been targeting lower returns than before and spreads have tightened a great deal, but investors still want to be in CLOs to participate in European credit markets," said Richard Reilly, co-head of law firm White & Case's global securitization practice, which was involved in more than 50% of the European CLOs rated by Standard & Poor's in 2006, primarily as deal counsel. "We've seen this market growing significantly, and we believe it will continue to grow."
Both the leveraged loan market and the CLO market in Europe are still on course for positive growth, agreed Stefan Bund, managing director at Derivative Fitch in
London, and so long as they can benefit from the credit-friendly environment that continues to prevail in Europe, there is no real reason for this to change. Indeed, "CLOs are being put together very quickly and sold very quickly," Bund said, "but even more interesting than that is the number of these deals that have been increased in size due to high demand, which means that their equity tranches are also being increased."
Indeed, marketing equity is no longer the challenge it might have once been, Reilly said, and all collateral managers have a solid plan in place when it comes to selling it.
But planning, execution and investor willingness aside - is the market in Europe going to reach a level at which the base spread on CLO equity will no longer clear, at which CLOs might not be as much of a good thing as they still seem to be?
It is difficult to say, but there are some signs that some of the heat may be subsiding in the European CLO space, and some sources say that the number of vehicles being added to the forward calendar has slowed down.
According to Oliver Burgel, managing director at Babson Capital in London, there has been a noticeable flight to quality in European CLOs, meaning that investors are tending toward more experienced, seasoned managers who are entrenched in the business. It is harder these days for newcomers to place equity, Burgel said, than it is for the more tried and tested managers, which might mean fewer deals being done by new arrivals going forward.
Earlier this month, Babson - one of the pioneers in the European CLO business - priced another CLO via Goldman Sachs, a 500 million ($682.73 million) structure that is the company's ninth CLO so far.
Because of the stiff competition for leveraged loan paper in Europe from such a huge range of investors, it is also increasingly hard for CLOs to get their hands on collateral, a European manager said. Primary market loan prices are sky high, and in the secondary market, too, there has been little or no letup. Even if there are opportunities for CLO managers to put together new deals, and even if there is interest still for these deals, it's getting so that only the established managers are able to access loan paper, he said, so they will be the ones doing the deals going ahead.
If tight spreads persist, managers might also tend toward putting together other kinds of structured deals that are better suited to this kind of tight spread environment, such as total return swap-based structures or market value funds, Burgel said, and this might also eventually serve to bring about a decrease in the number of CLOs in Europe.
For now, though, there are still new CLO deals coming to market, and overall, the newer CLOs have been structured to better operate in a tighter spread environment than their predecessors, Burgel said. But what's mainly driving investor interest in CLOs is the overriding desire to get returns. Even if CLO equity returns stand at 10% - substantially decline from some time ago - this might still be better than what can be had in any other asset class, Burgel said, so some investors are still ready to get involved in these deals.
Indeed, everything is relative, said Thomas Siebens, a London-based partner in the capital markets practice of law firm Millbank Tweed. "People are always looking for higher yield and taking it where they can get it," he said. "With respect to CLOs, the bottom line is whether the returns they offer are greater than what you can find elsewhere, or not."
As for the loan market, it does not look as though issuance is likely to stop anytime soon, what with private equity houses still flush with cash and many LBO deals still in the cards. Even if the European CLO market cools off, there are other investors - institutional funds and hedge funds - that remain interested in leveraged loans. However, banks that have been reliant upon CLOs as the main buyers for their product might still want to be careful, sources say, so as not to be left holding stacks of paper on their own books.
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