Issuer: EuroCredit CDO 1
Amount: €416.5 million
Type of issue: European high-yield collateralized debt obligation
Date: August 11, 1999
Bookrunner: Morgan Stanley Dean Witter
A sure sign that the European high-yield debt market is expanding and maturing is the appearance of wider and more sophisticated investment products. The increasingly diverse range of new issues and a more reliable and regular flow of deals have opened up the market, and are attracting new investors. To capitalize on this, in August, Morgan Stanley Dean Witter and UK mezzanine finance specialist Intermediate Capital Group (ICG) introduced high-yield collateralized debt obligations (CDOs) to Europe.
High-yield CDOs are a staple of the US debt market, accounting for approximately 20% of all high-yield investments. In the first eight months of this year, $25 billion of US CDOs have been issued. They are special purpose vehicles that invest in a portfolio of assets and are funded through securitization. In this case the portfolio will consist of non-investment grade bonds, loans and mezzanine positions including many from large European MBOs for which ICG arranged and provided mezzanine financing, and ICG will act as investment adviser for the CDO. Several classes of securities are typically issued, carrying differing levels of risk and return. CDOs allow investors who might not want to take the credit risk of a specific high-yield issuer to acquire diverse portfolios of high-yield assets. In addition, high-yield investors that buy into the lowest-rated tranches can achieve returns that are in excess of normal high-yield bonds and closer to equity.
CDOs are one of the fastest-growing sections of the asset-backed securities market. The product is already popular with some European investors who have bought into the US market. This deal, called EuroCredit CDO 1, has now given them the chance to buy CDOs in euros.
The deal was launched on August 12. "We had a good sense that there was institutional investor interest in the deal," says Edward Ocampo, head of the structured products group at Morgan Stanley Dean Witter. It consisted of five tranches with yields ranging from 60 basis points over Euribor for the senior notes, to over 600 bp over 10-year Bunds for the bottom tranche of unrated paper.
All tranches, which are rated by Moody's, were oversubscribed and the deal raised a total of €416.5 million. The senior notes attracted mainly financial institutions, while the riskier tranches were bought by insurance companies and pension funds. More than 30 investors bought into the deal. "We were pleased by the amount of interest shown in the junior tranches," says Ocampo.
Morgan Stanley, which has experience in the CDO market in the US, had been considering introducing the product to the European market for more than a year. "We had wanted to bring this idea to the European high-yield market for some time, we were just waiting for the right opportunity," says Ocampo. But in the aftermath of the Russian crisis at the end of last year, demand for high yield had virtually dried up and new issues were scarce.
When issuance began to pick up in the second quarter of 1999, the bank looked around for an adviser that could manage a CDO. After talking to several possible partners, Morgan Stanley started working with ICG in March. The company, which is listed on the London Stock Exchange, has a market capitalization of £266 million and balance sheet resources of around £500 million. ICG made an investment of e15 million in a tranche of the subordinated notes.
After a decade as a leading mezzanine finance provider, ICG was keen to diversify its business and move into the growth market of high-yield bonds. The deal was an important strategic move, and ICG's first foray into fund management. "We want to demonstrate that we are serious buyers of all types of sub-investment grade assets," says Andrew Phillips, director of Intermediate Capital Managers, part of ICG. "We need to grow our business continually," says Phillips. He sees high-yield debt as a logical extension to mezzanine fund management.
Morgan Stanley approached ICG with the idea of a CDO after ICG had had held talks with several investment banks about ways into the high-yield market. A year ago ICG made preparations for a collateralized bond obligation, but was not convinced that the flow of deals or market conditions at the time could support such a deal. "The market was still young and fragile," says Phillips, and he didn't want to have to invest in a range of currencies or enter the US market in order to get sufficient diversity.
The bank went for diversity through a mixture of bond, mezzanine and senior debt investments, enabling ICG to focus on euro assets. "It's very difficult to do a CDO in euros, but it's impossible if you just invest in high-yield bonds," says Phillips. "There was a concerted effort between March and August to get the transaction done," says Ocampo. "To do the first deal of this kind in Europe took a significant amount of work, working with the rating agencies and ironing out legal issues."
Phillips admits that completing the first high-yield CDO in Europe has been tricky, but thinks that ICG has the expertise in the leveraged market and the European corporate contacts to be successful. "We have lots of experience in intermediate capital, and we can get diversity in a single currency which you can't get just in high-yield bonds."
This deal is a sign of the growing sophistication of the high-yield debt and leverage finance markets. "It is a positive step in the development of the high-yield market in Europe, bringing in securitization technology, and it expands the universe of high-yield investors," says Ocampo. The transaction has attracted existing securitization and high-yield bond investors, plus those who don't have the credit research infrastructure to invest directly in high-yield. CDOs can also help bring stability to the European high-yield market because they are closed-ended. Investors cannot just pull out of the market when conditions become more volatile, as they did last September.