Debt market liquidity threatens European CLO sustainability

The increasing competitive power of direct lending funds in the leveraged finance market, which Euromoney explored in April, is now being keenly felt in the region’s collateralized loan obligation sector. 

The size of tickets that funds can now write means that they are in direct competition with CLO managers warehousing deals – and are contributing to record tight pricing for these structures. Borrowers are exploiting terms available for bilateral loans to argue that more liquid and shadow-rated CLO paper should offer a yield differential to direct lending assets. This could drive the market to unsustainable levels.

“We are now in an environment where funds can compete head on with high-yield or CLO-driven options, with an increasing number of direct lenders able to take and hold loans of up to £250 million ($322 million),” says Fenton Burgin, head of the UK debt advisory team at Deloitte in London. 

“The markets are certainly now highly competitive and arguably exuberantly so, exceeding the innovation that we saw pre-Lehman’s collapse. It is worth remembering that up to 30% of the deals written immediately prior to Lehman’s collapse in 2007 ultimately ended in default. We’ve seen this film before and it didn’t end well for some parties.” 

Burgin explains that CLO pricing continues to chase downwards towards a Libor-plus-300 basis point resistance level and the best credits may get there in the next six months. “It’s difficult to see pricing falling below these levels,” he says. If it does, the economics of the CLO structure will be called into question.

According to S&P Global Market Intelligence, European CLO issuance was €2.8 billion in the first quarter of this year. However, the supply shortage in the institutional market means that on average there has been a €390 million shortfall over the last 12 months. There are just not enough loans to go around to feed both CLO warehousing appetite and the growing institutional bid. 

Despite the perceived tail risk posed by the French election, euro investment grade CLO paper was still at its post-crisis spread tights at the end of April. S&P cites the Unilabs Diagnostics, Cerba and Versure deals, which all priced single-B rated loans at 300bp over Euribor with a 0% floor and are the lowest yield to maturity (for non-cross border facilities) since it started tracking the market in 2010. “The flow names are up above 101 in the secondary market and we are nearing the 275bp spread level from 2007,” one investor told the rating agency. “We’ve come a long way in the last seven to eight months – too quickly for our liking.”  

Burgin attributes much of the pricing pressure in the market to the shift by borrowers away from unitranche structures, which has seen traditional mezz and unitranche investors move into second lien. “In 2015, we worked on a lot of unitranche structures, he says, “but while our private equity clients liked the flexibility provided, these facilities were seen as expensive. Today, banks and funds are increasingly collaborating, and the structure of choice is a combination of up to 1.5 times ebitda first-lien bank debt and fund-provided second lien through to total leverage of 5.5 times ebitda. The combination of fund and bank finance has significantly lowered the cost of capital from where we were in 2015.” 

Alix Partners recently published its mid-market debt survey that showed European unitranche fell from 120 deals in 2015 to 93 in 2016, with borrowers trading leverage for increasingly competitive senior terms. 

“Where do the unitranche players now play?” asks Tom Cox, director at Alix Partners. “With material capital to deploy the larger funds are now writing larger bilateral tickets, which is likely to continue. At the same time, with defined hurdle return requirements, funds may become more active in second lien alongside the banks.”

An interesting finding from the Alix Partners survey is that the dominance of the larger funds is growing, which is bad news for the smaller players and gives concrete evidence of a trend that has been widely anticipated. 

“The top 10 non-bank lenders accounted for 60% of activity last year, up from 51%,” Cox tells Euromoney. “One can only speculate about the root cause but this may have been driven by the fact that a number of funds were busy fundraising last year and some took a more selective and cautious approach to lending across certain sectors. The larger, more mature funds, with scale origination platforms and more experience simply have more capital to deploy, which is likely to have supported activity levels. It will be interesting to see if this trend continues in 2017. It may be increasingly difficult for funds in the mid-market to compete with larger funds – particularly as the larger platforms can attract fund leverage themselves and we may see more specialization amongst the smaller funds.”

Larger, more leveraged funds throwing money at leveraged buy-outs has happened before. “Arguably, we are right back to where we were pre-Lehman,” warns Burgin. “Volumes of cov-lite loans are at record highs and we are seeing sponsors capitalize on market conditions to secure high levels of covenant headroom often off ‘pan flat’ banking base case projections,” he warns.