Leveraged loans: Arb windfall for cash CLOs

by Louise Bowman

Repricing in the leveraged loan market means that some CLO managers have been having a field day.

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There were not many people in the debt markets with smiles on their faces at the end of August but a few CLO managers were managing to raise a grin. Having long lamented the spread compression in the leveraged loan market that was destroying their arbitrage, Christmas came early for some asset managers in July when spreads on senior loans blew out from around 225 basis points to 300bp. When you have locked in term funding at historically tight levels but not yet invested and asset margins suddenly blow out by 30% it must be hard to stop grinning.

The speed with which leveraged loans have changed from a seller’s to a buyer’s market is quite breathtaking – it seems just a matter of weeks since buyers were grumbling about covenant-lite documentation, and they can now practically write their own terms.

Those managers that had launched relatively recently and were still sitting on reasonable cash balances in August were best positioned to take advantage of the situation. According to Deutsche Bank, some European CLOs had sizeable percentages of assets still to be purchased at the time: Wood Street (40%), Cordatus II (35%) and Avoca VIII and Gresham Capital with 30%. “If we had sufficient cash now, then yes, we would be buying,” commented one CLO manager at the end of August. “We have been waiting for spreads to widen – but perhaps not by quite this much!” According to Standard & Poor’s LCD, 26.7% of leveraged loan transactions in Europe flexed higher during the three months to August, with the average upward flex being 38.3bp.

Not only have the events of the summer provided a loan margin windfall for certain CLO managers, they have also taken care of another of their recent headaches – prepayments. The fevered loan market of recent years resulted in very high prepayment levels – necessitating constant replenishment of asset pools in an increasingly competitive marketplace. With the jumbo LBO market now at a standstill and activity elsewhere far reduced, the pressure to constantly replace assets has abated.

European institutional loan average

Primary spreads

Source: S&P LCD

Any grins on the faces of bankers holding warehouse collateral for CLOs will, however, be considerably more forced. According to Reuters LPC, US leveraged loan issuance was a record $215 billion in the second quarter of 2007 – with $65 billion lending to the LBO market alone. Hedge funds, mutual funds and CLOs bought $142 billion of those loans, but the third-quarter totals will likely tell a very different story. There was a global pipeline of $15.9 billion US CLOs and $2.9 billion European CLOs at the beginning of September – but the European CLO market dried up after July, with no issuance at all. Deals have continued to come to market in the US ($2 billion during the last week of August) for managers such as Lightpoint Capital, Gulf Stream Asset Management and Tall Tree Investment Management. But whether or not the pipeline keeps going depends not only on how much pressure there is on warehousing banks from their own balance sheets and from equity holders to ditch loans rather than hang on for a (perhaps increasingly expensive) CLO exit. On the liability side, there are substantial doubts about how much CLO paper might be dumped into the secondary market as a result of any further forced unwinds of investment vehicles – and the resultant impact on spread levels.

Shuffling deckchairs

When cracks started to appear in the leveraged loan market in late June, the forward calendar was already above $200 billion. Many of these loans are now on hold. According to RBS there was €80 billion of “currently unsaleable” paper in the European leveraged loan market alone at the end of August, so the prospect of any wholesale reopening of bank warehousing lines for CLOs would be “shuffling the deckchairs on the Titanic”. For banks holding the existing warehouses it becomes a delicate balance to keep as much on balance sheet as possible, but inevitably assets are being sold at a discount, putting pressure on secondary spreads. This lack of clarity as to just how many assets might end up being dumped amounts to a very real risk for CLOs that launch in the current environment.

The fact that both asset costs and liability costs have blown out suggests that the CLO arb should still be there – although many question whether equity returns will be sufficient. Figures from JPMorgan in late August suggested that the all-in cost of launching a European CLO had shot up from around 50bp to between 140bp and 150bp while asset spreads had reached 300bp for a four-year maturity – up 75bp from where they were in May. But any new launch is locking in financing at what could be a cripplingly high rate.

“The risk that new CLOs run is that the loan market returns to more reasonable levels quite quickly,” says a CLO manager. “Then you are left with the real risk that you will not be able to generate sufficient arbitrage to provide an equity return.” However, at the beginning of September details emerged of a new €350 million primary CLO for Invesco in the works, via Lehman.

Although the main difficulty faced by CLO managers in recent years (the challenge of sourcing good assets) has rapidly reversed into a situation where there is a surfeit of good assets at firesale prices, the predicted outcome could still be the same: consolidation. It was the established players that held the upper hand before as they had better access to the LBO sponsors and could therefore get their hands on assets. They have the upper hand now as they have committed long-term funding locked in at very low spreads and can buy up loans at far higher yields than they could possibly have expected just months ago. Times will therefore continue to be tough for the newer entrants and some will inevitably disappear.

The priority of the banks is to clear the debt backlog – there is a huge amount of paper still to be syndicated and banks will want to shift as much as possible off their balance sheets by year-end. This, together with the stalled LBO market, means that while primary issuance might be paying a lot more, there might not be very much of it.

Sovereign wealth funds on euromoney.com

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Leveraged loans: Arb windfall for cash CLOs

Repricing in the leveraged loan market means that some CLO managers have been having a field day.

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