The near disappearance of triple-A investors is making CLO issuance impossible for all but the top tier of managers and will likely contribute to the demise of smaller players.
In Europe, CLO issuance has declined more dramatically than in the US. That said, US volumes are flattered by restructuring activity. In the first half of 2008, fewer than 10 deals priced for less than €5 billion. Compare that with 2007, when approximately 85 European CLOs worth more than €30 billion priced. The reduction in CLO production poses a direct threat to managers that lack scale. This is why Fitch Ratings is predicting a 20% contraction in the number of European CLO managers over the next three years. It says that managers with fewer than two or three CLOs under management are vulnerable to any substantial erosion to their fee base. Over half of European CLO managers have only one or two deals – and nearly 80% of those were launched in 2006 and 2007. Subordinated fees are worth – according to the rating agency – on average 0.42% per annum. The incentive collateral management fee is paid depending on the internal rate of return on the equity tranche. Managers also typically invest in this first-loss tranche to align their interests with those of investors.
According to Fitch, the fees paid on two CLOs or fewer are not enough to allow a manager to make a profit, although there might be cross-subsidies from other revenues such as managing leveraged loans portfolios. As credit conditions deteriorate for leveraged companies (newcomers were not well placed to get allocations to better credits when the market was hot) and affect CLO performance, coverage test triggers will divert payments to senior liabilities. Under these circumstances, all junior liabilities are affected – including the aforementioned subordinated fee and equity notes.
Subordinated fees are some two-thirds of total manager fee income. Fitch states that if the subordinated fee income is cut by a quarter, managers need to have four CLO deals in order to break even – assuming no revenues from other activities.
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Safety in numbers |
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Impact of a 25% reduction to subordinated fee, by CLO |
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Source: Fitch Ratings |
Fitch lists AIB Capital Markets, BNP Paribas (leveraged funds group), Pimco Europe, Blackstone Debt Advisors, Investec Bank (UK), Caja Madrid, Mezzvest, Axa Investment Managers, Elgin Capital, IKB Fund Management, Halcyon Structured Asset Management, Prudential America Management, Invesco Senior Secured Management, CQS Management, NIB, Cyne Capital Management, NAC Management and Morgan Stanley Investment Management as having four or fewer deals under management.
The Americans are going
Fitch also predicts that many of the US managers that set up shop in London and launched CLO businesses at the height of the market (after 2006) will either repatriate their businesses or unwind them completely, as nearly 60% manage two or fewer CLOs.
On the face of it, US activity looks a lot more buoyant than that in Europe. Of the 28 US CLOs to have priced, according to Moody’s Investors Service, only a handful constitute true new issuance, the rest being restructurings of total rate of return swap structures.
Total rate of return swap structures are aggressively leveraged cashflow deals with market-value triggers. These structures are not as flexible as traditional market value deals and cannot move into cash when market conditions deteriorate. In addition, total rate of return swap structures have net-worth tests, whereby if the equity value drops below a certain level, the deal liquidates.
"These look like market-value CDOs, because they have market-value triggers," says Richard Parkus, director, head of CMBS research and head of CDO and ABS synthetics research at Deutsche Bank in New York. "These were aggressive and bad structures that now require restructuring."
When the US loan market was falling off a cliff in late February and early March, there was a scramble to restructure deals into cashflow transactions. Deals such as Vinacasa CLO, Bushnell Loan Fund II and Stedman Loan Fund II all originally managed by Hartford Investment Management, and Hudson Canyon II, managed by Invesco, are examples of transactions born from the need to salvage total rate of return swap structures deals spiralling towards liquidation.
Quick thinking helped Babson Capital Management step in to help Hartford save its $644 million Vinacasa deal. "It was a fluid situation," says Russ Morrison, managing director and co-head of Babson’s US loan team. "There were fewer investors than a historical cashflow deal and we were able to work together and restructure the vehicle to recover a substantial amount of capital."
Not all the deals transacted in the first half were restructurings, however. These deals have something else in common: most of them were issued by large, brand-name managers with loyal investor bases, such as Babson Capital, GSO Capital Partners and Carlyle Investment Management. New deals took advantage of bargain prices in the US secondary loan market and were backed by high-quality assets.
"One thing they have in common is how conservative they are," says Bill May, managing director, structured finance, at Moody’s in New York. "Second liens, covenant lites and large bond buckets are out."