European CLOs continue to perform well, despite regulatory actions serving to constrain the market. Steady issuance is expected even in the face of a number of hurdles, with changes such as risk retention requirements forcing investors to reconsider manager selection and issuance expectations.
“From a manager’s perspective, CLOs are an attractive way to raise AUM. For some investors, the product became perceived in the same negative way as CDOs, but CLOs have actually done well,” says Andrew Bellis, partner, 3i Debt Management.
He adds: “The CLO product has delivered what it said it would deliver. The challenge is getting the regulators on side.”
The regulatory issue is one factor differentiating the European market from the healthier US market. Another CLO manager suggests that European issuance is around three year behind the US precisely because the latter market does not yet have to work around regulatory obstacles. Another significant difference is collateral liquidity in the US market.
“Deals can be done in the US without warehouses, but in Europe warehousing is absolutely necessary. There is no retail money in the European loan market and less twoway flows; it is more difficult to trade than the US loan market,” says Bellis.
As well as issues around regulation and loan supply, another factor that was holding the European market back was the lack of arbitrage. When the arb returned around Q2, the second manager suggests, the market was able to work around the other difficulties.
“In the US, there were Libor floors and those created arbitrage. Now we are seeing those floors reducing and interest rates look set to go up, so the key consideration becomes liability costs,” says the manager.
He continues: “US CLO triple-As are fantastic relative value at the moment and spreads are going to come in. Triple-A spreads are currently around 145bp-150bp, but they could move as tight as 120bp in 2014.”
Peter Nowell, head of ABS trading at BNP Paribas, points out that European CLO spreads have already narrowed versus US CLO spreads – with the additional subordination compensating for a lack of liquidity. He believes that this is a fair trade-off, but notes that Europe has a long way to go in terms of improving transparency and supply of the underlying loans.
Nevertheless, loan supply was better than expected this year and is only expected to grow as the market seeks risk and returns. “Loan supply in 2013 has been an improvement on the previous year and 2014 will see more robust issuance. One thing we are nervous about is if triple-A spreads don’t tighten, the arbitrage could disappear,” says Bellis.
Nowell indicates that European CLO issuance volume of 15-20 deals a year is sustainable at present, given the reduced number of senior investors involved in the sector. He suggests that an expansion of the investor base would serve to bring spreads in further. Where those deals will come from, however, is not entirely clear. Risk retention has become a key concern and while 14 different managers issued CLOs in 2013, with limits on capital, questions are being asked as to how many of those managers will issue a second deal next year.
That makes risk retention one of the most important considerations for an investor when it comes to selecting the right manager. An investor does not want to invest in a deal where the manager’s business is in run-off two years down the line. Draft risk retention rules in Europe have just been finalised, with signs that the EBA may be softening its stance slightly (SCI 18 December). Meanwhile, the Loan Syndications and Trading Association warns that risk retention requirements in the US could “severely limit the availability of CLOs” (SCI 19 December). So far, managers have been taking down the retention piece and that will continue until the regulations are nailed down. However, not many investment advisors have the capital to continue doing that and so risk retention remains a challenge.
“I don’t think investors want a market where only one or two managers can do deals, but for most fund managers, capital is client not manager capital. There needs to be a way to address regulation, so that the burden for managers to hold the retention piece is reduced, because at the moment it looks like a burden that will reduce the size of the whole market,” says Bellis.
He continues: “One option for CLO managers is to take a vertical strip and to finance that strip. The financing has to be full recourse to the manager and so can lessen the capital burden for the manager, but it is probably not an ideal solution for the market.”
Risk retention was introduced to ensure the interests of managers are aligned with investors, but those were largely already aligned through features such as incentive fees. It is also inescapable that a vertical strip will align a manager with debt investors in a way that holding 5% of the equity would not.
“A manager can help debt or can help equity, but I find it hard to understand how they can do something to help all investors,” says Chandrajit Chakraborty, cio and managingpartner, Pearl Diver Capital. He notes that when looking at new structures, it is important for an investor to look at both the manager profile and the documentation.
“You can look at a manager’s history and previous trading patterns and, depending on which level you are investing at, you can look for managers who take actions which are beneficial to you,” says Chakraborty. “Also, CLOs are quite granular, so you can look at the loans and look at the companies and know how likely those loans are to default based on how those companies are performing.”
The importance of reading documentation carefully is underlined by Greg Branch, cio, SCIO Capital. “For example, we bought an RBS arranged synthetic CLO back in 2009, which at first blush seemed like a disaster. But, after scrutinising the docs, it became apparent that the deal effectively could not reinvest throughout the crisis and actually it turned out to be fantastic investment,” he says. Branch continues: “There is a significant lack of standardisation in the market and documentation does take a lot of time to go through. Unlike RMBS, whose analysis is quite statistical in nature, for CLOs portfolio manager behaviours prove difficult to model.”
This is where another difference with the US market becomes apparent. The highly bespoke nature of European CLOs makes standardisation of documentation challenging. “One thing the US does well is transparency and standardisation. Having deal shelves means that once you get up to speed with a deal from one shelf, then you can handle others from that shelf. In Europe it is so much more bespoke across all asset classes,” says Branch.
Every investor wants a different return profile and Chakraborty suggests the fact that the European CLO market has not yet been standardised implies standardisation is unlikely in the near future. CLOs are, he notes, ultimately negotiated transactions.
“Sometimes equity will give away rights and obligations to triple-A and sometimes it will not. That is why there is so little standardisation,” says Chakraborty. While standardisation appears some way off, the ability to refinance European CLOs also remains constrained. “Refi risk is prevalent in CLO 1.0 deals, many of which have been extended and are probably still too weak to repay the principal in certain cases,” notes Matthias Neugebauer, md, Fitch.
He suggests that one possible way of boosting leveraged loan supply is through banks delevering their balance sheets. “If these non-core assets were sold into CLOs, it would have the benefit of freeing up regulatory capital.”
CLOs suffer from not having ECB repo eligibility, as well as from the fact that they can’t be counted under the liquidity coverage ratio, Neugebauer observes. “However, CLOs are still one of the few triple-A rated assets remaining. The success of the new issuance market hinges on how the retention rules play out and equity take-up by managers.