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Hotly anticipated Cairn CLO might not be yearned for market blueprint

There's a lack of clarity over the ultimate driver behind the new - and hotly-anticipated - transaction, seen as a landmark for the European collateralized loan obligation market.

The first newly originated CLO in Europe since the financial crisis could be inked in the next few weeks in what would be another milestone in the rehabilitation of securitization in Europe. In the worst kept secret in the loan market, Cairn Capital is now marketing a €300 million deal – Cairn CLO III – to investors, and Barclays is working on a new transaction for US manager Pramerica.

The Cairn deal incorporates a €181.5 million Class A senior tranche rated triple-A, a €28 million Class B tranche rated double-A, a €20 million class C tranche rated single-A, an €11 million class D tranche rated triple-B and a €60 million unrated tranche. It has been in the market for some time but is now understood to be close to a mid-March completion.

A CLO is a very rare thing in Europe. The market collapsed in 2007 and ballooning spreads killed the arbitrage. However, renewed interest in the structure in Europe is now being driven by the record low yields available elsewhere.

The US market saw $55 billion of CLO issuance in 2012, while there were no deals in Europe. This is partly due to Article 122 of the CRD, which requires the manager to retain a 5% stake in the structure. This will prove a serious impediment to smaller independent managers but should not prove too much of a hurdle for the larger firms.

And returns on offer might soon attract more investors to new vehicles. For example, a European open-ended loan fund with monthly liquidity will probably offer a yield of around 8%, while CLO equity could yield 11% – but for locked up capital. This might start to attract interest away from other parts of the market.

“What do private equity firms realistically think that they can get out of corporate earnings?” muses one investor. “Not much. Most are looking at 10% to 15% yields from locked up capital. CLO equity is now comparable to this.”

US CLOs generated returns of 40% last year, according to Citi, but they might struggle to maintain that performance.

“The US market overinflated issuance so some have struggled to get ramped,” reckons one CLO manager. “The general feeling is that there was too much issuance last year and we expect spreads to widen again as the market takes a breather.” Certainly, while a US CLO would have offered a better return than a European deal 12 months ago, that is not automatically the case now with senior triple-A rated CLO debt in Europe trading at around 150 basis points over Euribor.

While equity returns have improved, the latest deals might not, however, be the blueprint that the market is looking for.

Some investors with knowledge of the deal claim that investors in the equity of Cairn CLO III have a specific reason for wanting the deal done. They reckon that the deal is being driven by one or more shareholders that can afford to take sub-optimal returns in order to rebuild their credit businesses. The CLO is certainly lightly levered and as such is unlikely to be an arbitrage play. If this is the case it will not be a structure that other equity investors who are not in the same position can duplicate. A spokesman for Cairn Capital declined to comment when asked by Euromoney about this assertion.

Consensus on the Pramerica deal, which is being arranged by Barclays, is that it could be structured more along the lines of a classic CLO. It is understood to be a euro structure, due to currency hedging issues, and the pool is thought to include infrastructure-like assets. Barclays declined to comment.

For any new European CLO, ramp-up will be the ultimate challenge – indeed even after months of preparation the Cairn deal might be only partially ramped.

“The trick will be having the confidence that pricing will remain stable during the ramping period,” muses one credit manager.

In credit markets as skittish as these, that could be quite an ask.

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