GBP GSSF08 142 148 DB EU CLO - Global Securitisation

1 22 Profiling European leveraged loan CLO managers Conor O Toole and Ganesh Rajendra Deutsche Bank142 Global Securitisation and Structured Finance 2008 Deutsche BankDespite the credit market turbulence, 2007 was yet another record year forEuropean leveraged loan collateralised loan obligation (CLO) issuance. Thischapter looks at the development of the European leveraged loan CLOmarket from the perspective of CLO Global high-yield CLO market continues to be dominated by USproduct, with the European market share standing at 18 per cent of Global CLO volumes in 2007. However, growth of the European CLO markethas been more spectacular in recent years the market grew by 193 per cent in 2006 (some 34 billion, as a case in point, moderating only slightlyin the credit-crisis dominated 2007 (to 27 billion, still some 135 per cent ahead on 2005 volumes).)

2 Indeed, the CLO market in Europe has grown appreciably since the very first deal in 1999, brought by IntermediateCapital Group. Growth of the European CLO market has mirrored thedevelopment of the underlying market in leveraged loans, which itself has grown from just 35 billion in 1999 to 165 billion by the end of 2007, according to Standard & Poor's leveraged Commentary & Data. (Inrecent years at least, the growth of the leveraged loan market has been fuelled by the private equity-driven LBO boom.) Unlike the UnitedStates, where collateralised debt obligations (CDOs) of asset-backedsecurities (ABS) dominate, the European CDO market is heavily biasedtowards leveraged loan product, which accounts for 82 per cent ofoutstanding cash CDO volumes, with CDOs of ABS and commercial realestate CDOs making up the balance.

3 Amid the credit crisis, volumes in the fourth quarter of 2007 dropped dramatically, with issuance limited tolegacy warehouse European leveraged loan CLO managers IGlobal Securitisation and Structured Finance 2008 Global Securitisation and Structured Finance 2008143 Deutsche BankRecent trends in the CLO manager marketTestament to the recent remarkable growth ofEuropean CLOs, the bulk of the market outstanding (85per cent ) comprises post-2005 vintages. On our count,there are currently 84 billion of European leveragedloan CLO volumes outstanding, based on 203 dealsmanaged by 58 loan investors. Of these managers, weconsider 52 to be programmatic CLO issuers that is,Figure 1: Global cash managed CDO volumesSource:Deutsche Bank Global Markets Research 250200150100500 bn199920002001200220032004200520062007 USEuropeanEuropeUSFigure 2: CLO share of leveraged loan marketsSource:S&P LCD 100%80%60%40%20%0%% share19992000200120022003200420052006200 7those that have come to market at least once since thebeginning of 2006.

4 The top 10 managers in theEuropean CLO market account for 43 billion (or 52 percent) of volumes line with the growth of the European CLOmarket, CLO managers have become a very importantinvestor constituency in the underlying leveraged loanmarket. Banks still dominate the European leveragedloan lending market (with a circa 50 per cent marketshare, according to Standard & Poor s), but CLOmanagers have muscled a steadily increasing marketshare in recent years and currently account for circa 38per cent of the European leveraged loan investor recent market turmoil has seen loan price declinesfollow on the heels of CLO spread widening, thusevidencing the pricing relationship between the assetand funding markets which in turn underpins, webelieve, the importance of CLOs as lenders in theEuropean loan of the most defining trends in the Europeanleveraged loan market in recent years has been theproliferation of managers.

5 From a more fundamentalperspective, the significant increase in the number ofCLO managers in recent years has been underpinned bythe attractive risk-reward opportunities in the leveragedloan market, coupled with the efficiency of using CLOs asa means to finance and grow assets under managementwhile leveraging equity returns. Indeed, the ready, cost-effective liquidity provided by the structured financemarket in recent years has arguably been the key factorbehind the proliferation of the CLO manager the market s inception in 1999 until 2004,managers were relatively few in number, with repeatissuance from established platforms such asIntermediate Capital Group, Alcentra, Duke StreetCapital (acquired by Babson), M&G Investment andAvoca Capital accounting for the bulk of deal flow.

6 Themost significant influx of debut managers occurred in2006, as 27 inaugural CLO programmes came to marketvia billion of volumes, compared with just in new CLO manager issuance over 2005. Thedepth of the CLO manager base almost doubled in2006, bringing the total number of managers that havetapped the European CLO market to 58 Securitisation and Structured Finance 2008I Profiling European leveraged loan CLO managers 144 Global Securitisation and Structured Finance 2008 Deutsche Debut managersFigure 3: European CLO primary market volumes debut v established managersSource:Deutsche Bank4035302520151050 bn20022003200420052006200760%50%40%30%20 %10%0%Looking through the recent proliferation of theEuropean CLO manager base, a number of noteworthytrends are observable.

7 The first is the greater diversity ofmanager types in recent years. Once the preserve ofloan market boutiques, the market has evolved toencompass a broader base of CLO managers, includingbanks, traditional asset managers, private equity-relatedloan platforms and credit funds. The second notabletrend has been the significant influx of US managers,most of which are established US loan and/or high-yield specialists looking to build out their businesses ona more Global scale. Oakhill, Sankaty Advisors, EatonProfiling European leveraged loan CLO managers IGlobal Securitisation and Structured Finance 2008 Global Securitisation and Structured Finance 2008145 Deutsche Bank4356627945912202811101 DebutEstablishedFigure 4: European CLO primary market manager count debut v established Source:Deutsche Bank50454035302520151050 Number of managers199920002001 200220032004200520062007 Boutique private equity relatedBankAsset managerCredit fundFigure 5: European CLO primary volumes by manager typeSource.

8 Deutsche Bank100%80%60%40%20%0%199920002001200220 032004200520062007 Vance and Ares Management count among such US-domiciled CLO managers venturing into the Europeanloan market in the past year or so. The other trend inrecent years that we would highlight is the emergenceof loan investors or CLO managers that we would deemto be the more opportunistic issuers. By this we meanthe few CLO platforms that have surfaced since2005/2006 primarily to exploit the asset-liabilityarbitrage that is, the yield gap between leveragedloans and CLO bonds. Identifying such opportunisticissuers is not straightforward, but almost by definitionsuch CLO managers would typically be newly initiatedplatforms rather than established loan market businessmodels, and are also likely to be heavily reliant on theCLO market for funding.

9 The potential lack oftechnical/credit expertise and experience, and a lessdemonstrable commitment to the loan market amongsuch managers, are key risk considerations for CLOinvestors, in our view. Indeed, some of these smallerplatforms (particularly those with three CLOs or less)are likely to face significant business model challengesin a more difficult CLO issuance the different manager typesThe preceding credit bull run has made it difficult tocompare and contrast manager skill-set and abilities alpha generation has not been particularly observable,given the recent broad-based rally in both the loan andCLO markets, which in all likelihood has also served tobail out any weak asset selection practices.

10 Still, CLOmanager business models and operating structures varysomewhat, as does the degree of access to primarycollateral. However, from what we can tell, investmentand credit processes seem less distinguishable, at least inthe current market. (We emphasise again that weakcredit management is likely to become more apparentonly in a downturn.) Generally, analysts conduct theinitial research on loan deals shown by syndicates andpresent the underlying credit assessments (which wouldnormally cover operating, financial and structuralanalysis of the loan borrower) to the portfolio analysis usually also incorporates corporate cash-flow stress runs in order to size the borrower s ability torepay debt in various scenarios.