CLO Revival

A collective sigh must have fallen across weathered European collateralized loan obligation (CLO) managers when news emerged about H.J. Heinz Co.’s decision to forgo selling a European portion of its $12 billion LBO financing in mid-March.

The financing to support the U.S. ketchup company’s $28 billion buyout by Warren Buffet’s Berkshire Hathaway and 3G Capital was originally slated to include $12 billion in mostly term debt, including up to $1.4 billion in euros and $600 million in sterling. Managers of the three European CLOs completed so far this year as well as those prepping offerings currently in the pipeline were likely eyeing the loan hungrily.

At the last minute, however, greater demand on the other side of the Atlantic prompted bankers to sell all of the Ba2/BB-rated financing package in dollars.

After a five-year hiatus, the European CLO market has revived, as deal economics have improved, and three leveraged-loan CLOs have priced so far this year, for a total of approximately $1 billion.

A fourth CLO from the Carlyle Group is currently in the market, and a reported seven or eight more are in the pipeline. J.P. Morgan forecasts $3 billion and perhaps as much as $4 billion in new European CLO volume by year-end. Cairn Capital closed the first CLO since the financial crisis in late March, and Apollo Asset Management and Pramerica priced deals in April.

Even if J.P. Morgan’s forecast is doubled, that’s still a drop in the bucket, considering that nearly $29 billion in CLOs were issued in the U.S. alone through mid-April. Even so, there remain nagging concerns about whether the European CLO market may be jumping ahead of itself, given the paltry origination of leveraged loans in Europe and lenders’ unwillingness to sell those already on their books.

New regulations and evolving market dynamics are also likely to effect whether the European CLO market sputters out, yet again. However, the shortage of leveraged loans is clearly the primary issue, pushing managers to consider fundamentally changing the CLO structure by including greater allocations to alternative assets such as fixed-income and loans denominated in non-euro currencies. Such changes would give managers a greater selection of potentially high quality assets to choose from, but they may unnerve investors.

“The looser the criteria, the less comfortable we are giving money to the manager,” said Herman Slooijer, head of European credit at APG Asset Management, the investment arm of the Dutch pension fund provider that manages €330 billion in assets. He added that most CLOs buy more than half their full allotment of loans after deals are inked, and investors must rely on managers’ discretion to choose those credits, as long as portfolio eligibility criteria and portfolio quality tests are being met, rather than their own credit analysis.

Europe’s Institutional Loan Parsimony

The U.S. dollar denominated institutional leveraged loan market, reaching $632 billion in 2012 according to Credit Suisse, is more mature and much larger than Europe’s, which relied heavily on CLOs for liquidity in the years before the financial crisis. Without those CLOs, the leveraged loan market there has shriveled, and borrowers have instead turned to the bond market. At the end of 2008, the institutional term loan market in Europe reached €230 billion outstanding and the high-yield bond market was a mere €80 billion; at the end of 2012, the bond market had grown to €300 billion and the loan market was just under €150 billion.

S&P Capital IQ’s LCD recorded fewer than nine senior leveraged loans issued monthly, on average, in Europe last year, and while the number of deals in January jumped to 18, February and March each recorded 10.  Considering that a European CLO is viewed as sufficiently diverse when it pools 60 to 80 loans, unless leveraged loan volume increases CLO managers will continue to scramble for assets.

“It would certainly take many months for a CLO to ramp up completely on ‘brand new’ assets,” said Rishad Ahluwalia, head of global CLO research at J.P. Morgan, adding, “Hence, 25%, 50% or even more of the portfolio would have to come from the secondary loan market, other portfolios, or existing CLO holdings.”
So far, however, finding those existing assets has also been challenging. With the disappearance of the European CLO market after 2008, APG has instead become a direct lender. Slooijer said leveraged loan prices rarely rise much above par, even if the coupon level suggests they should, because borrowers can call them at any time and lenders would end up taking a loss.