INSIGHTS

SCI – Euro CLO – Entrants Encouraged

More managers could benefit European CLO market The European CLO market is smaller than its US counterpart, but arguably provides greater scope for a good manager to outperform. With the pool of European managers currently limited, equity investors are among those who would welcome new entrants

The CLO market has learnt many lessons from its 1.0 days, not least that in Europe there
were too few assets. Vivarte provides one well-publicised example of a single loan used
in many transactions (SCI passim). In the US, by contrast, there is far greater asset
diversity.

“The US is a deep, liquid market, where managers are able to build par and ramp up
quickly. The average first coupon for a CLO in the US in 2014 was around 24%, but in
Europe it was more like 16%,” says Chandrajit Chakraborty, principal, Pearl Diver
Capital.

A US manager can choose from a few hundred different names in a liquid market, but in
Europe the pool is limited to closer to 50 assets. Of those, maybe 20% are non-starters.

While the pool of available assets remains smaller than market participants would like, so
too does the pool of available managers. “Our CLO exposure is to about 20 different
managers in Europe. There are only about 25 active managers in total and we would
definitely welcome new managers coming in,” says Benoit Pellegrini, portfolio manager,
Chenavari Credit Partners.

He adds that a new manager could provide a different perspective and that, rather than
buying the market, they could be more selective. That would provide a better alignment
of interests and would be healthy.

Like current managers, any new manager would still face challenges, such as working
with a limited pool of assets. However, this is where the good managers are able to stand
out.
“A CLO is not a static pool being leveraged up. The pool is dynamic and changes, so
investing in equity is taking a view of the overall credit cycle. We have also seen that two
similar starting portfolios in the hands of two different managers can perform very
differently,” says Chakraborty.

Size alone is not enough to guarantee a manager’s success. While there are advantages to
having a large credit team, a manager will succeed or fail on several other factors.
“For any new manager entering the market, you want to know that they have the right
credit skills and sourcing. It is also important that any European manager has to be based
here in Europe, rather than trying to manage European loans from the US,” says Graham
Rainbow, managing partner, Alcentra.

He adds: “A manager has to pick the right credits for the right price and proactively sell
them early at the first sign of major problems. Around the edges, there are questions like
how much sub debt and how much peripheral debt are acceptable and how triple-Cs are
managed. But generally if a manager is doing a good job in avoiding defaults, then they
are doing a good job for all their noteholders.”

While different investor classes typically have different priorities, all are interested in
managers who can maximise returns. European CLO 2.0 equity has been generating
returns in the mid-teens and one equity investor expects that to continue.

Chakraborty currently sees an average cash-on-cash return in Europe in the mid-teens and
in the US in the high-teens. Although that might not be as high as some investors hoped
for, it only represents an average.

“CLO equity has not performed as well as expected. But some managers have
outperformed and generated attractive returns,” says Pellegrini.
He continues: “CLO 2.0 is the cheapest credit product out there. The widest asset the
ECB is buying is only circa 100bp, double-A/single-A split-rated and over eight years
WAL.”

As a cheap product, many investors have long waited for CLO paper to rally. However,
there are compelling reasons for the status quo to remain.
“The reason it has not rallied and CLO triple-As remain wider than ABS is because these
are different products. There is extension risk and a dynamic pool. It is a different
product,” says Chakraborty.

Meanwhile, creating alpha – whether for an incumbent or a new manager – remains all
about due diligence. Rainbow concludes: “If you are a good manager, then it is easier to
outperform in Europe than it is in the US, but how you play peripheral Europe is very
important. If you know what you are doing, you can outperform – and, if you do that with
lower European liability costs, you can generate a decent return versus the US.”

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