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January 29, 2013 7:20 pm
The race is on. Two investment groups are vying to be the first in Europe to put together a type of structured product many thought had been killed off by the financial crisis, and which could hold the key to averting a regional funding crunch.
Pramerica and Cairn Capital are both looking for the glory of arranging the first new collateralised loan obligation since 2007, attempting to drum up support from investors ahead of the official launch of the €300m-€400m deals as early as next month, according to sources close to the deals.
CLOs bundle corporate loans taken out primarily to fund leveraged buyouts into a single investable package. They were the main source of funding for the once €220bn European leveraged loan market for mainly pre-crisis corporate buyouts.
Since 2007, regulation and weak markets have proven a disincentive for new deals. The ones that exist today, holding around €70bn in loans, are mostly reaching the end of their five to seven-year investment lives this year and next.
This raises the prospect of a major funding gap opening in the coming years. From now until 2015, existing CLOs will be winding up at the same time as €40bn of pre-crisis loans reach maturity and will need refinancing, according to S&P LCD.
Unless, that is, either Cairn or Pramerica is able to prove that new CLO deals can be done, kickstarting the market to some semblance of its pre-crisis glory.
Hopes of such a revival have been sparked in recent months by a huge shift in market sentiment towards riskier but higher yielding assets after central bank action last year helped remove the threat of a eurozone break-up.
The price of all European credit, including CLOs traded in the secondary market, rose sharply as a result. Perhaps, some now believe, sharply enough to make the investment vehicle an economically viable product for the first time since the crisis.
“The revival in the CLO market is long overdue,” says Krishna Prasad, head of asset-backed strategy at RBS. “Europe needs new investment vehicles that will buy leveraged loans or companies will struggle to refinance over the coming years.”
If someone proves that the economics once again works, there could be as much as €3bn-€5bn worth of new European CLO issuance this year and €5bn-€7bn in 2014, according to RBS: enough to refinance a meaningful amount of soon-maturing leveraged loans.
Ratul Roy, a structured finance analyst at Citi, says demand for the CLOs has grown in recent months. “There is appetite for European CLOs from investors, as it is increasingly hard to find a strong risk-adjusted yield elsewhere in fixed income at the moment.”
But despite creeping optimism there are still major hurdles preventing the return of the European CLO market to any meaningful state, even if the Pramerica and Cairn deals are successful in the coming weeks and months. Both groups declined to comment.
The biggest issue holding back the market is European regulation covering structured products that requires CLO managers to keep some “skin in the game” by holding a slice of equity in the deal themselves.
This is hard for the smaller CLO managers, and has made deals uneconomic for the larger groups. It is expected that, for any new European deals this year, the equity slice is likely to be farmed out to a parent company or bigger group.
The second major problem is simply finding enough leveraged loans in Europe to buy with the CLO. With mergers and acquisition activity sluggish since the crisis, the size of the institutional loan market has fallen from €220bn in 2007 to €150bn last year, according to Credit Suisse.
“The risk retention is one issue, but it is also very difficult to get a portfolio together as there are not really enough primary loans out there at the moment,” says David Quirolo, an international finance partner at Ashurst, the law firm.
In the US, the CLO market is already going strong. After a tentative $4.5bn worth of issuance in 2010, there was $10bn in 2011 and $55bn last year. But the US market has a more liquid leveraged loan market, and there are no “risk retention” rules yet in place.
Because of this, the European market is unlikely to replicate its success.
“There seems to be some evidence of life returning to the European CLO market, but for it to operate effectively we will need to get some flexibility from the regulators on the retention rules,” says Nicholas Voisey, a director of the Loan Market Association, the industry trade body for the loan market.
But at the very least the prospect for at least one new European CLO getting done this year is looking increasingly likely.
“If you just take the amount of visits we have had from investment banks about new CLOs, there is a definite sense that we are significantly closer to getting the pricing dynamic that works than six months ago,” says Martin Horne, managing director at Babson Capital.
And even one deal would be a historic moment for a complex financial product many wrote off as extinct in Europe.
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