Collateral damage

The European collateralised loan obligation market is experiencing unprecedented growth, with established and first-time managers pricing deals. Despite this enthusiasm, concerns surrounding overlap in collateral pools and the ability to source assets are mounting. By Rachel Wolcott

With issuance so far this year at EUR14.18 billion, the European collateralised loan obligation (CLO) market has already surpassed last year's total of EUR10.55 billion. A confluence of factors - a large supply of assets coming from private equity and bank sponsors, hedge funds setting up CLO operations and US asset managers launching European deals - is driving growth. But as quickly as this market is growing, so are the questions about its sustainability and deal quality.

Demand from CLO managers and other institutional investors is driving up loan prices in the secondary market, and has led to fierce competition for primary market assets. The competitive bid for loans has sparked concern among CLO investors that, in the hurry to ramp up deals, managers are being forced to buy assets they may not otherwise have purchased. And while managers publicise their relationships with private equity and bank sponsors as assurance that they have access to the cream of the crop of loans, there is considerable overlap between deals - meaning investors are exposed to similar names in each of the CLOs they invest in.

One reason the European loan market has grown so quickly is the entry of non-bank investors into the asset class. Those investors that had been waiting in the wings for increased deal flow and liquidity are now scrambling for allocations.

"Non-banks represent 60% plus of the market, particularly when you include the secondary market, and I think that percentage will go up," says Paul Sennett, managing director and head of European loan sales at Deutsche Bank in London. "Three years ago, non-bank investors represented 30% of the market, so it's been a radical change."

CLO managers aren't the only buyers of European loans. Hedge funds, as well as specialist credit funds and insurance companies, are now active in the market. "Three years ago, we covered about 40 non-bank investors, two years ago we covered 60, and by the middle of last year we covered around 90," says Sennett. "Now we cover 163 clients. The volume of counterparties has gone up dramatically."

This widening of the investor base hasn't been great news for CLO managers, who had previously dominated the institutional market. "Three years ago, CLO managers represented roughly 90% of the buyers of institutional loans," says Domenico Picone, head of structured credit research at Dresdner Kleinwort in London. "Now they have lost this power, because roughly 70% of the market has been taken up by credit funds, insurance companies and banks."

Nonetheless, new managers continue to enter the CLO market. Firms such as Elgin Capital and CQS Management have launched deals, while several US managers are transacting their first European CLOs, including Halycon Structured Asset Management, Oak Hill Advisors and Sankaty Advisors.

CQS, a London-based hedge fund manager with EUR4.5 billion under management, EUR1.2 billion of which is dedicated to credit, launched its first CLO in May. Called Grosvenor Place I, the EUR366 million deal includes a £27.5 million tranche.

"We've always been involved in the loan market through our credit fund since its inception in 2002," says Mark Benson, head of fixed-income trading at CQS in London. "Within our existing fund there is a limit to the amount of capital you can deploy in any one product, and loans are a fast-growing asset class where there are some interesting changes going on in the market that we want to take part in."

CQS, like other managers, is touting its long-standing relationships with sponsors, and believes its ability to buy any part of the capital structure also makes it an attractive partner to sponsors. But it is not depending solely on its connections to make its CLOs a success - CQS has added some features that enable it to buy sterling assets along with other non-euro deals.

"It was a multi-currency structure with a revolver and a sterling tranche," explains Benson. "We were trying to exploit the fact that a substantial part of the market is not always euro-denominated. We put in a revolver with seven currencies to access deals that other managers typically can't buy, and as a consequence tend to trade a bit cheaper."

Multi-currency revolvers are a feature other managers are using as a way to differentiate themselves from the ever-growing pack. Sankaty Advisors, a Boston-based CLO manager, is one of the latest US managers to launch in the European market, and its Nash Point CLO is also able to buy loans in a number of currencies. Like other US managers, Sankaty now considers the European market mature enough to launch a CLO.

"If we go back a few years, the European market was primarily a telecom market, in terms of what was offered to institutional investors," says Diane Exter, a managing director at Sankaty. "Now we can have a balanced portfolio of various industries. And there is now secondary trading that, while not as robust as the US, allows us to buy and sell loans to rebalance a portfolio."

While sponsor relationships and flexible CLO structures are important factors in building diversified portfolios, they do not necessarily solve the overlap issue. While overlap may not be a concern for investors at the AAA level, it certainly is for those buying the equity tranche. The default of one or two popular names that appear in multiple underlying portfolios could spell disaster for an equity investor with several CLO investments.

"Some CLOs are trying to ramp up quickly, and to do that they need to buy assets they're not terribly keen on," says London-based Richard Munn, co-head of Oak Hill Advisors' European effort. "Some end up being buyers of the market - they don't have the time or the ability to pick and choose. That's where the larger players and ones with stronger track records can take their time. In this market, that's important." Oak Hill Advisors, a New York-based manager, recently launched its first European CLO deal, details of which were not available as Risk went to press.

Overlap is not a new phenomenon in the CLO market. However, with more managers competing for a limited number of loans, the issue could become more acute.

"In any asset-backed deal, you suffer from what's called the vintage effect - people buy assets at the same time, and there's a limited amount of assets to be bought. If you take 10 CLOs from the US and 10 from Europe, you'll see a natural overlap," says Jonathan Laredo, partner at London-based Solent Capital, a specialist credit manager that invests in CLO equity as well as senior tranches.

In these cases, Laredo says there is a premium in understanding how managers buy assets, how they select and manage them, and their history and track record. "Can they do more than manage a structure?" asks Laredo.

It's the classic credit conundrum: managers tend to get into the same trades at the same time. Investors must understand that they're entering a crowded market, and if the market goes sour, it's going to be just as crowded on the way out, says Laredo.

"In Europe, the level of overlap we're seeing in CLOs is significant," says Miguel Ramos, managing partner at London-based Washington Square Investment Management, also a CLO equity investor. "In specific cases, I've seen close to 70% overlap. That means for most of the capital structure, and especially for the equity, the portfolio risk is concentrated in certain names, and you're not really exposed to a significantly wider portfolio of single risks.A fewdefaults in widely held credits andyou're going to be affected significantly."

In five recent transactions Ramos has seen, four names were common in all the deals and 60 names were in at least three deals. Another two transactions Washington Square has turned down recently had 13 assets in common.

"I think manymanagers are underestimatingaccess to the market. That's partly why we're seeing this overlap in broadly syndicated, liquid names," says Ramos. "The European market is still not as developed as the US in terms of secondary trading and institutional investors having access to transactions."

As primarily an equity investor, Washington Square turns down deals if there is too much overlap. Some investors, however, are snapping up CLO tranches without really considering the impact of any overlap in the underlying portfolios. "There are many investors who don't really look in detail at the underlying portfolio," adds Ramos. "They are accumulating some transactions and think they're diversified and they're not."

CLO managers and underwriters point out that portfolio overlap is not easy to address - with only a limited number of loans coming to market every year, CLOs to some extent have to buy the same credits. And deals that are able to invest in other currencies in an attempt to mitigate that overlap are just tinkering around the edges, say investors.

"It's true that the investor has to decide what to do," concedes Ramos. "We have had the situation several times where we see a transaction that on a standalone basis that looks good, but we will not buy it because it will take our exposure to a particular credit above a threshold."

The extra yield to be gained on CLOs versus more commoditised asset-backed securities such as residential mortgages is attracting new investors to the sector. But too much overlap in portfolios could cause problems down the road for managers looking to get new deals off the ground, say investors. "Equity investors do look at the portfolios and see which managers can differentiate themselves from the pack in terms of generating investment opportunities," says Oak Hill's Munn. "Overlap could be CLO managers' problem because they might have a hard time raising equity."

For the time being, at least, the European CLO market appears to be steaming ahead with EUR3.3 billion in new deals coming to market in June, a slight tick down from the EUR4.29 billion issued in May - a record month for issuance. Demand seems strong, with little spread differentiation between experienced managers and neophytes - 2-3 basis points at most on AAA, with most priced at around 25bp. However, with some investors looking ahead to a possible downturn in the credit cycle - global credit quality was reported to have deteriorated sharply in June, according to Hawaii-based market risk management firm Kamakura Corporation - some participants are asking whether European CLOs merit the current tight pricing.

"A lot of AAA CLOs trading at 25bp aren't such a good trade," says Solent's Laredo. "If the markets get wider, which they will, and defaults get higher, it's hard to see why these transactions would be trading there rather than in the 40bp area where they were trading a few a years ago."

Experienced managers are already looking beyond CLOs for other ways to invest in European loans. Specialised loan investment managers have been part of the fabric of the US syndicated loan market for years, but there are only a few of these entities in Europe. Investment vehicles with lower leverage and market value funds are being considered.

"We're looking at options for lower-leveraged and market-value funds," says Peter Firth, London-based managing director and portfolio manager for specialist credit manager GSC Partners' European CLO business. "At this point in the cycle, there are some investor concerns about the amount of leverage of the funds and the amount of leverage on the underlying assets."

These newer vehicles will not replace CLOs, but could be a way for loan managers to buy a broader array of assets. It could also attract new investors who like leveraged loans as an asset class, but want more liquidity and less leverage than that on a traditional CLO, which are typically nine to 10 times leveraged.

"There will be a place for less-leveraged loan funds," says CQS's Benson. "Right now, the net returns to investors are better in a CLO format than through the use of on-balance-sheet leverage. However, in certain circumstances the restrictions of a CLO format can negate some of the positive aspects of the structure."

For now, CLO managers are driving ahead with new issuance. With roughly EUR2 billion of cash CLOs in the pipeline in the next few weeks and new deals being priced at record tight levels, the market appears unfazed by the possibility of a credit downturn. But that doesn't mean all the new entrants to the market are going to get past their first deal.

"Some of the new entities setting up will not survive," predicts Oak Hill's Munn. "We are in a liquid market with low default rates at the moment, and those managers that have invested through the credit cycle and have experience will survive, but others will not."

Harbourmaster Capital brings pro-rata CLO

While newcomers are falling over themselves to issue European collateralised loan obligations (CLOs), managers who have been in the market for years are honing their structures to create innovative deals.

Dublin-based Harbourmaster Capital is one such manager. In May, the firm priced Harbourmaster Pro-Rata CLO, a EUR850 million, seven tranche deal, believed to be the first CLO to allow the manager to enter into the bank pro-rata syndicate for primary European leveraged loans. This means Harbourmaster, as an institutional investor, can buy loans usually reserved for bank buyers, such as the pro-rata strips - revolving credit facilities and term loans A (TLA). Institutional investors normally have access to longer-dated term loans B and C only.

"There's a lot of demand for institutional tranches. They're over-subscribed and managers are getting under-allocated," says Mark Moffat, head of European CDOs at Bear Stearns in London, which underwrote the deal with ABN Amro. "Whereas the pro-rata strips are under-allocated and under-bid because institutions cannot deal with revolving credit or the fact that they're multi-currency."

Harbourmaster created a structure that allows it to deal with shorter-dated revolvers and TLAs in European currencies, as well as some others. Harbourmaster can then take advantage of the relative value in the pro-rata strips versus the institutional tranches and deliver that onto its investors. Currently, pro-rata strips are priced at par with the fees, which means Harbourmaster buys them at a discount of between 98% and 99%. All in, the manager is getting a similar yield to the institutional tranches, especially if the 30-40% prepayment rate prevalent in the market is factored in.

"The structure helps Harbourmaster get more access to collateral, but they're also getting similar risk cheaper because of the fees that flow through the deal," says Moffat. "The key is, will that pricing benefit stay there? It may be that as other people do similar deals they may be a victim of their own success."

If that happens, the deal is structured so they can go back to buying the B and C tranches. Apart from that, the deal shows Harbourmaster's willingness to explore new ways of delivering value to investors, which can mean a lot in this crowded market.