Battle lines drawn in European CDO market

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The European market for collateralized debt obligations is set to grow significantly this year. This promises to be an area of intense interest for US and UK structured finance lawyers.

In March, three high-profile capital markets partners left Weil, Gotshal&Manges' London office to join Ashurst Morris Crisp. One of them, Erica Handling, has a strong reputation for expertise in collateralized debt obligations (CDOs), acting for Morgan Stanley, Merrill Lynch, Deutsche Bank and Nomura, among other clients.

This development underlines the escalating competition between the London offices of the big US securitization law firms and their UK peers. Structured finance in Europe - and in Asia - may have some way yet to go before it begins to rival the enormous US market, but euro-denominated and/or European-based deals are on the increase and the deal pipeline is, by all accounts, well stocked, especially with CDO transactions.

CDOs, in their purest form, are vehicles that invest in high-yield bonds and loans with low credit ratings, spreading the risk of potentially low-performing individual investments across a highly-diversified portfolio. This enables the CDOs to issue highly rated bonds, to be repaid by their investments.

Worldwide, according to Moody's Investors Service, over $120 billion of CDOs were issued during 2000 and volumes are expected to keep growing. The US CDO market has already come of age, utilizing the complex securitization techniques first developed to help resolve the savings&loan crisis of the 1980s.

In Europe, however, the potential for breathtaking growth has only recently become apparent. European CDO issuance rocketed 500% to $15.2 billion in the first quarter of 2001, compared with $2.3 billion in the same quarter last year, according to Standard&Poor's.

Volumes in Europe have increased mainly because of banks' and fund managers' willingness to use CDO technology as a balance-sheet management tool, removing unwanted assets, and also for arbitrage purposes.

The market for these products has evolved substantially in recent years. CDO structures are now also being applied to non-traditional collateral, including resecuritizations, trust-preferred CDOs and CDOs of investment-grade corporate obligations. Synthetic structures, in the US and Europe, are becoming increasingly important because, as Moody's recently pointed out, these deals carry lower execution costs than traditional CDOs, allow banks to hedge exposures without notifying borrowers, and can achieve highly tailored credit positions. There were 48 synthetic CDO deals last year, compared with 22 in 1999.

Moody's predicts that rapid growth will continue in Europe, with Asia beginning to follow suit. It predicts that arbitrage transactions will increase markedly. These are designed to exploit the spread between the yields on the illiquid assets that constitute the collateral pools and the most highly rated liabilities issued by CDOs. In the US, conventional arbitrage deals are mature. In Europe, they are just beginning to take off.

As so often in the capital markets, structures developed by the US banks for the US market have found their way to Europe and will ultimately flow through to Asia. This is good news for the banks - and good news for their legal advisers. Although, in the short term, the availability and diversity of underlying high-yield bonds could prove to be a constraint, longer-term sustained growth in the European CDO market looks assured, driven by strong investor demand.

This is a godsend for the handful of US law firms that advised Schroder Salomon Smith Barney, Morgan Stanley and Goldman Sachs through the US CDO market boom. Since last summer these banks, and their competitors, have been aggressively increasing the staff of their European CDO teams. When they need legal advice, their first port of call has tended to be the London offices of their stateside advisers.

This was underlined recently when the London office of US law firm Milbank, Tweed, Hadley&McCloy advised on two landmark European CDO transactions. In the first of these, Milbank advised Merrill Lynch as arranger and lead underwriter on a e262.7 million balance sheet CDO for Banco Comercial Português. This was the first CDO in the Portuguese market, and was rated triple-A by both Moody's and Standard&Poor's.

In the second deal, Milbank advised Goldman Sachs as arranger and lead underwriter on the e500 million CDO for Blue Eagle CDO I SA. The issuer offered e500 million of notes divided into eight different tranches, with the senior notes rated triple-A by Fitch IBCA, Moody's and Standard&Poor's.

John Walker, the partner in Milbank's London office leading both deals, points to the significance of Blue Eagle for the growing European CDO market: "This was, at the time, the largest ever arbitrage CDO in Europe, and it is certainly one of the most complex to have been completed so far. It was also the first CDO to be rated by all three rating agencies."

Looking ahead, Walker hopes to see more headline CDOs coming through, although perhaps not at the same level of volume as the US. "The US and euroland are increasingly the subject of statistical compare/contrast exercises," he says. "In the context of an economic analysis this approach may be valid - but rather less so in a legal context. Unlike the US, euroland comprises a large number of separate legal jurisdictions resulting in CDO transactions encountering and needing to resolve multi-jurisdictional issues relating to tax efficiency, asset transfers and effective security."

Aside from their long-standing institutional relationships, the US law firms have another important headstart on their UK competitors, as Walker goes on to explain: "In Europe, most securitizations are listed, making the basic tenets of each deal public knowledge. In the US however, because the disclosure requirements are more onerous, few deals are listed and, as a consequence, deal structures remain private. One could argue that this places US firms in an advantageous position."

There are few other areas where the London offices of US law firms can claim much competitive advantage over the UK firms' European networks. But certainly, where Milbank is concerned, its strong relationships with Goldman Sachs and Merrill Lynch, alongside the firm's longstanding US CDO experience, should stand it in good stead.

The defections from Weil, Gotshal&Manges to Ashurst Morris Crisp have served the English firm well. Ashurst was already one of the stronger UK players in the CDO market. It advised fund manager Intermediate Capital Group on Europe's first CDO deal and the arrival of Withey, Handling and Lamburn should give a boost to one of the City's fastest-growing banking/finance teams. And, as the competition heats up for market share in this sector, there will inevitably be more such defections, as UK firms target their US rivals in a bid to build instant CDO capability.

That being said, Ashurst faces stiff competition, both from the Wall Street camp, and from the top-end city finance practices.

This competition may become especially intense in the arbitrage CDO arena, as Morgan Stanley and Goldman Sachs find their supremacy challenged by key competitors including other American investment banks and several of the leading European firms. Deutsche Bank, CSFB, Merrill Lynch, UBS Warburg and Schroder Salomon Smith Barney are all strong contenders in this specalized area of the debt capital markets.

The City firms which traditionally service these institutions - notably Clifford Chance, Allen&Overy and Linklaters - have already developed expertise in the collateralized debt obligation sector and this, coupled with their sizeable and growing New York law capabilities, will make them hard to beat.