CLO Market Attracts Private-Equity Funds
May 7, 2010
Large private-equity firms are buying up CLOs to generate higher returns for their investors, and the purchases have helped resuscitate a market that was in severe distress just a year ago.
Washington's Carlyle Group and the New York buyout groups Apollo Global Management, Blackstone Group and Welsh Carson Anderson & Stowe are among the names that have been active in this corner of the structured finance market.
Carlyle purchased $4.2 billion of CLOs and $950 million in managed accounts last week from the New York fixed-income manager Stanfield Capital Partners.
"There's a significant trend to consolidate CLO managers, because many of them are relatively small and lack sufficient scale to adequately perform the increasingly complex role for CLO managers," said Paul Forrester, a partner at Mayer Brown, which advised Carlyle on its transaction with Stanfield Capital.
Market participants said heightened interest by sponsors is tied to falling default rates, steady gains in loan prices in the senior debt market and a rising economy.
On Thursday, Moody's Investors Service reported that an April gauge of global defaults fell from March, though it rose slightly from a year earlier, to 9%. Moody's said the global default rate will fall to 2.7% this year. A year from now, the rate should be at 2%, according to the rating agency.
Moody's also said its April U.S. default rate fell roughly 1.5 percentage points from March and 30 basis points from a year earlier, to 9.5%.
As the credit crisis took hold in late 2008 and 2009, rating agencies issued downgrades for many CLOs. The impact on the structured investment market was significant; by some estimates, firms issued $100 billion of CLOs in 2006 and another $100 billion in 2007. As a result of the downgrades, investors vacated the market, and no new CLOs were launched last year.
The vast majority of market-value CLOs, though, avoided defaults, according to a report Moody's issued Wednesday. "During the credit crisis, only six out of approximately 40 market value CLOs monitored by Moody's experienced events of default," the report said. Moreover, for the CLOs that did experience a default, none were required to liquidate "quickly" and absorb major losses, according to Moody's.
The market-value CLOs are different from cash-flow ones, because their rated notes are over-collateralized. Today's CLOs are different from the highly leveraged investment vehicles that flourished from 2005 to 2007. Market participants say a lower risk profile is helping the vehicles come back into fashion, particularly among private-equity firms that have debt capital market platforms.
"The major plank of triple-A buyers [insurance companies] is not there, but we've seen alternative buyers come into the market," said Ratul Roy, head of structured credit strategy in fixed-income research at Citigroup. "Equity buyers have set up platforms to invest in debt and build separate asset-management franchises. They've got money to put to work in leveraged companies."
Citigroup, for example, is marketing ALM Loan Funding 2010-1, a $300 million CLO with triple-A and single-A tranches sponsored by Apollo and scheduled to price in the next two weeks.
Last month, Citi marketed a similar $525 million CLO called Fraser Sullivan for an investment affiliate of buyout group Welsh Carson.
Forrester said the vehicles that will come to market over the next few years stand to play an important role as loans mature in the coming years. "Frankly, we need CLOs back, because we have a strong refinancing need as large amounts of syndicated corporate debt comes due over 2012, 2013 and 2014," he said.
Roy said he was "cautiously optimistic" about CLO's prospects this year.
In February, Blackstone acquired management agreements for nine CLO and collateralized debt obligation funds valued at $3.1 billion from Callidus Capital Management, a portfolio company of the Washington investment firm Allied Capital Corp. (which Ares Capital Corp. bought last month).
One month earlier, the Guernsey hedge fund Tetragon Financial Group bought Lyon Capital Management of Pittsford, N.Y., and six CLOs worth $2.5 billion from Credit Agricole Group for $10 million.
"Leading private-equity firms are uniquely complementary to credit-management firms. By buying these firms, they can help fund new products and sponsor CLOs," said Ted Gooden, a managing director at the New York investment bank Berkshire Capital Securities, which advised Stanfield on its sale of CLOs to Carlyle.
Spreads have tightened in the CLO market over the past year. In the 12 months through late April, triple-A issuances commanded spreads of 205 basis points, as compared with 600 basis points in the previous 12 months, according to the Springfield, Mass., firm Babson Capital Management.
If a Babson report released late last month on the CLO market offers any indication, the outlook for the structured vehicle business is improving.
"We believe the 'fear factor' that permeated the CLO market has decreased significantly," the report said. "Also, with the revamping of the rating agencies' criteria for CLO ratings now complete, we see greater ratings stability."
Babson, which oversees $129.4 billion of assets, also said in its report that the new CLOs could prove to be a good draw for the type of investor seeking less risky investments. "Given the lower-risk environment, investment-grade CLO bonds offer attractive investment opportunities for investors who have typically been buyers of high-quality credit securities such as investment-grade debt," the report said.
Also, ratings agencies are issuing fewer downgrades for the debt vehicles, helping bolster their appeal among investors.
According to industry participants, the new CLOs will likely produce returns from 10% to 12%, as compared with the high-teen, mezzanine-fund-type returns generated by structured funds during the 2005-2007 boom period for mergers and acquisitions.