Appleby Partner Julian Black and Appleby Senior Associate James Kinsley outline the differences between the European and U.S. CLO markets and what the future holds in the light of increasing regulation and economic recovery in the Western World.
Confidence slipping in Europe
The first half of 2013 saw optimism in the European CLO market, as the market showed signs of revival. The nascent recovery was embraced by banks and managers and helped reduce the fear that weaker markets and tough financial regulation would lead to a regional credit-crunch, whereby a lack of CLO investors would increase the cost of corporate deal-making for sub-investment grade companies.
Unfortunately, this positive sentiment has been undermined to a degree by proposed financial regulation that threatens to shake the recovery in the European CLO market.
Existing financial regulation requires managers to retain an interest in the CLO (the so-called “skin in the game” rule) by holding a slice of the equity tranche of the CLO. Managers have so far been able to absorb this financial burden by off-loading their share to a larger, third party investor.
The recovery premised on such strategy has been disrupted by a new European Banking Authority proposal that would limit the ability to carry out such off-loading. The full consequences of this change remains to be seen, but many commentators argue that it is likely that the small CLO managers will be the most impacted, because they won’t have the financial resources to hold millions of Euro on their balance sheets.
Before this regulatory uncertainty emerged, analysts had expected €5 billion of new CLO issuance this year and €7 billion next year. It is now expected to be significantly less, although uncertainty in the final form of the new regulations makes it very difficult to predict to what degree.
One thing that is clear, however, is that the proposed new regulation is unlikely to affect the larger managers, such as ICG, which recently raised one of the biggest CLOs in Europe since the financial crisis. But the story for the smaller CLO managers could be very different: there is already speculation that some may try to join forces with hedge funds specializing in credit strategies, who would consider partnering with a CLO manager as a key-stone investor, by taking a large proportion of the equity tranche in return for having an active role in the portfolio selection. Whether this strategy takes hold remains to be seen, but most commentators agree that in any event the number of CLO managers who are able to launch deals in Europe will start to contract.
The United States
The market in the U.S. could not be more different. The deal pipeline is healthy and investors are clamoring for CLO paper.
The European and the U.S. CLO markets were never equally matched rivals. Historically, the European banks were more pre-disposed towards arranging leveraged loans and keeping them on their balance sheets, rather than distributing them to investors. The U.S. model, however, was markedly different, with U.S. bankers treating it as axiomatic that similarly structured leveraged loans would be distributed to institutional investors.
As reported in our recent report on the CLO market (‘Appleby’s CLO Insider’), the first half of 2013 saw US$47 billion of issuance including $7 billion in June, compared with $53 billion for the whole of 2012. Pundits speculate that issuance for 2013 could exceed $75 billion, with nearly $29 billion raised in the first quarter of 2013 alone. (See Figure 1)
The hunt for yield as monetary policy begins the long road back to normality
It is not just size and volume that is undiminished in the U.S. CLO market. The Financial Times estimates that in the second quarter, the debt financing raised for new CLO issuances was approximately nine times the value of the underlying equity, which is up from approximately eight times in the average deal in 2012. It is interesting to note that whereas approximately 15 percent of deals in 2012 had a single B-rated lower tranche of debt, 45 percent of deals in 2013 so far have added a single B, where the CLOs pay a higher interest rate to compensate for the increased risk.
This increase in leverage in the CLO is driven by a number of factors, including investors’ hunger for higher yields in a low interest rate environment and the fact that the spread between the yields on leverage loans and CLOs remains tight. Some commentators argue that this is a strong indication that incidences of increased leverage are not isolated occurrences. Furthermore, it is clear from recent U.S. Federal Reserve minutes that financial policy-makers are actively debating how to take the first step in reducing quantitative easing, which many think will be swiftly followed by a rise in interest rates.
As monetary policy in the U.S. starts its long road back to normality, the markets are preparing for yields to rise and this suggests that the hunt for higher returns will continue undiminished.
Who is buying the CLOs?
Some commentators have expressed surprise that the demand for CLO paper is so high, particularly in the U.S. market. CLOs offer investors diversification as well as predominantly floating interest rates, which means that they are a better hedge against future rising interest rates than fixed rate bonds.
Also, unlike the CLO’s distant cousin the collateralized debt obligation (which is one of the pariahs of the financial crisis), CLOs have largely made it through the financial crisis unscathed (despite the prices of the bonds falling sharply during the crisis).
Our view is that at least for the foreseeable future CLOs are here to stay, and continue to be a staple of a U.S. institutional investor’s portfolio.
The Cayman Islands’ role
Cayman remains the legal jurisdiction of choice for U.S. CLO issuers, based on its time zone proximity to New York and its provision of quality professional services and infrastructure, which are attractive features to underwriters, collateral managers and their counsel. There will be Cayman counsel for the issuer, the issuer’s independent Cayman directors and corporate administrator.
The CLO is not a tax driven transaction, but the use of Cayman enables the transaction to proceed without adverse tax consequences, and consequently they attract many non-U.S. investors. Some of the world’s largest asset and investment management groups actively partake in the CLO market, whether as collateral managers or their private equity and fund businesses investing in the bonds. While such groups might be seeing other areas of their business generating smaller profits, they are seeing impressive returns from CLO management fees and returns in some cases of up to 10-15 percent on the subordinated tranche.
2013 and beyond
The continuing strength in the U.S. CLO market has clear benefits. U.S. banks are well on their way to financial recovery from the crisis and are providing liquidity to the corporate borrowers whilst at the same time stimulating the demand from institutional investors, who enjoy returns from their CLO investment that are well above traditional asset classes favored by European institutional investors.
Only time will tell how the European market reacts to new financial regulations and how quickly European banks’ damaged balance sheets will be repaired. As Greece heads for a third rescue package and analysts estimate that European banks need to shrink their balance sheet by nearly €5 trillion over the next five years to meet capital adequacy requirements, the story of CLOs in Europe and the U.S. remains very much a tale of two markets.