CDOs Roundtable 2007: Part 1
IFR: I would like kick off with a look at the corporate landscape. Ian, could you start us off with an overview of corporate defaults. What is your reading for the next couple of years?
Ian Perrin (Moody’s): I think the key characteristic of the market over the last couple of years is that there has really been a negligible default rate which has really been helpful for growth of the CLO business and the leveraged finance business overall. There has been more pressure recently both because of higher interest rates and some market signals suggesting things will become tougher.
We are in a wait and see situation. We are still confident the leveraged loan market will develop, though probably at a slower pace than over the last eighteen months.
IFR: Vincent, we had one period last year when there were zero defaults – it was almost unnaturally low, so was a turn for the worse inevitable?
Vincent Dahinden (RBOS): Every key professional will have forecast a turn in the market. We knew we were at the top of the credit cycle but as to the timing, no-one could have predicted it.
Asset spreads have been compressing over the last two years due to massive liquidity so to achieve expected returns people had to leverage more and more.
IFR: Increasing risk?
Dahinden: Yes, taking more risk. But at the same time the cost of debt was very cheap. The credit environment is still very solid, so all you are seeing now is a repricing in line with supply and demand. The markets are shot right now, but I think most people expect them to reopen in the next three or four weeks.
I think fundamentally the markets are still good. We will see defaults but this is normal. We are seeing a repricing of the market and, in that context, we are searching for the balance between supply and demand.
Phillipe Tromp (FSA): It is important to stress the fact that the corporate story is actually good at present. We are facing a liquidity crunch with the consequence that spreads widen in the credit markets. Unless there is some impact to the real economy, which is possible, I would expect the collateral performance of CLOs to remain good.
If the higher costs of borrowing that we are now witnessing lasts for a while, that would affect the performance of corporates; particularly the more highly-leveraged entities, which would hit the performance of CLO collateral.
IFR: Oliver do you think there is a danger that some of the weaker corporates might not be able to roll their financing, is there a risk that a protracted liquidity crisis will cause default to rise above their historic average?
Oliver Burgel (Babson Capital): It’s more likely in the United States because the US leveraged loan market is structured differently from Europe. In the United States 60% is LBO-driven and 40% is levered corporates. Levered corporates tend to be bullet facilities and they would run very close to their maturity before refinancing.
On the LBO side, however, these facilities never really run to their maturity date. They are always refinanced much earlier because a private equity house typically has an exit horizon of between two and four years.
What is so interesting about the European leveraged loan market is that 95% of the leveraged loan issuance in CLOs is actually LBO-driven – there are very few levered corporates.
What people often overlook is that leveraged loans are a dynamically improving asset class. Almost all of those facilities actually have amortising debts, though in 2007 for the first time we saw a few loans that had bullet debt. But the overwhelming majority feature amortising debt and they have cash sweeps where whatever’s left after the financial year has to be used to repay debt. That is something that you typically will very often not see in a levered corporate.
Refinancing activity hasn’t declined dramatically. This is a reflection of the liquidity. But low refinancing is not bad news. High refinancing has meant we have had to actually work hard just to stand still. If the level of refinancing falls we will have to work a lot less to keep our funds fully invested. At the same time have collateral that, with some exceptions, is going to improve over time.
Rob Marshall (M&G): I think there is an issue that many market commentators and most CLO managers would acknowledge, which is that leveraged multiples had become stretched over the last four or five years.
I think the difficult part for me is that the liquidity crisis we are in came out left field and was, to a large extent, unrelated to credit issues and credit quality. There must be a risk that the correction, which people felt was necessary from the perspective of getting leveraged multiples and covenants back to their market levels, will be accelerated by the situation we are in now.
Burgel: That is true, but you also have to see this in context: every major European economy is seeing growth of somewhere of between 2% and 3-1/2%. The US is actually sort of halfway in the doldrums but preventing Europe from overheating. This is the most benign macroeconomic scenario that corporates have seen for a very long time.
You take that and you add on top the fact LBO sponsors in the last two or three years have increasingly started to buy larger and larger companies, where the rating agencies themselves say the business risk is clearly investment grade, but by virtue of the acquisition finance structure they become sub-investment. But you end up backing companies of a vastly superior quality than was the case when we first started the European CLO market about seven years ago, when your average LBO would have been a manufacturing business somewhere in the north-east of England.
Ian Kilcullen (Key Capital): But we have been operating in a negligible default environment and I think it is fair to say that that cannot continue. In a normal market you do see defaults and that has not been the case recently so when you see that increase in defaults, the market should not be taken aback.
Peter Combe (Permira): There is going to be an increase in defaults because from zero there kind of has to be. But I think it is all relative. I think it is really, important to look at what has happened over the last few weeks in the context of the last 25 years history of the European LBO market. What really does matter is that this market is stable for the next 20 years.
What I see as being good about this liquidity crisis right now is that it is ultimately a very orderly re-pricing of risk and an orderly repositioning of credit, completely unlike the Asian crisis of 1998 or the default-driven crisis of the early 1990s. Unusually this crisis is caused by extraneous non-credit factors which have done us all a favour.
Alan Packman (Lloyds TSB): We have been in a zero default situation but it is not that the market has been without anything that would on other occasions have been actual defaults; there have been forced refinancings and stressed refinancings.
Those marginal borrowers of the past 12 to 18 months are now going to potentially become the defaults that we will see come through, even in a benign macro environment.
In terms of the repricing, I think it depends on your perspective. If you are in the market owning the risk, then to a degree you can say it has been orderly. But it has not been quite fair in the sense that because the flow of liquidity was pretty much pulled out from under investors’ feet, many simply didn’t have much in the way of a chance to react to the changes in spreads.
At the end of the day, most investors tend to find out what the impact has been over the past month at the end of the month and don’t get much information in the meantime.
So orderly, perhaps, from one perspective, but viewed from another’s it certainly has not felt orderly.
Dahinden: While there has been no corporate default, we have started to see defaults of funds that are forced to liquidate based on market value triggers. Because the whole trigger has been the US sub-prime market, the first reaction is in funds that invested in those assets.
The pain today is not taken through default but through forced liquidations, either from poor financing or a combination of that and poor market valuation.
IFR: Peter how will private equity change going forward?
Combe: If you look at the liquidity crunch from the point of view of private equity it confirms that there were a lot of people playing in this market who should not have been. We believe that it is going to get rid of all of the tourists in the market; I mean principally people who are funded short.
Private equity funds are structured as long-term funds, and the debt lent to leveraged buyouts is always structured as long-term debt. I have always believed that people investing in that debt should have long-term structured funding as well; ergo, the CLO is the perfect vehicle for investing in leveraged loans and leveraged buyouts.
The problem in the market, and we were the beneficiaries of it in one sense, was that there were an awful lot of people who were funding short to enable themselves to be more aggressive, particularly hedge funds. Those people have now been burnt and that is a good thing because they should not have been in this market.
As every bank that has ever gone bust knows, rule number one of lending is: fund your liabilities the same length as your assets. We believe there is going to be a huge flight to quality and established CLO players, like Babson and M&G, are going to be the beneficiaries.
Private equity firms, to the extent they run debt operations, will be the beneficiaries of that. When this market does reopen, we are very optimistic that it is going to be a much more orderly stable market.
That is going to flow through to acquisition prices being lower and more sensible.
IFR: So presumably with a section of the managers taken out, that will have an effect on loan repricing?
Dahinden: I think it goes back to the point on supply and demand. What we have seen in Europe is increased demand on the B and C tranches from institutional investors, those mainly being CLO managers. If there is less demand for those assets, there will be less CLO funds being raised, and they will be done by the best managers, and that will flow through to lower demand on the leveraged loan side.
Marshall: But before CLOs can really turn up in a big way, I think the loan market itself needs to find its feet. That almost certainly has to be driven by bank credit houses. The guys who were buying 80% of the market five years ago, those people have to come back and establish what the clearing price is for the pipeline.
Dahinden: I am not sure banks will be coming back to the market and have the market share that they used to have in leveraged loans. I believe institutional investors will be the ones that will actually set the pricing and demand, because banks now are being forced to slowly mark to market their loan position, which they never had to do before. They will look to institutional investors for guidance as to what the value is.
Marshall: My point is that the one market which is more dislocated than the loan market is the ABS market. You can only establish a CLO-like vehicle once you have pricing points for both your assets and liabilities, and we are not even close to getting a pricing point for the liabilities.
Kilcullen: Stepping back and looking at the role of private equity in sponsoring CLO transactions, I think you are going to see a situation where private equity and that core group of established and leading managers work together to identify the clearing levels for loan assets.
I think the broad-based syndication process for leveraged loans that we have seen over the last few years will be replaced by a more interactive discussion between those private equity sponsors, and a core group of large managers with the buying power to be able to determine the clearing level for assets.
This market will settle down – there is a demand/supply imbalance at the moment (supply outstripping demand) but I think it is important to remember that we have been operating in an imbalance for the last couple of years with demand massively outstripping supply.
The market will settle down and find equilibrium, and it will be private equity sponsors using their relationships with that inner group of managers that will help to facilitate that.
IFR: Surely they cannot work in a vacuum without investors, who will in the end determine the liability clearing level. There has to be a final exit. That level will need to be comparable with where ABS is.
Combe: I think you are absolutely right. When we are talking about breaking this log-jam, some people say the banks will break it, some believe it will be private equity but I actually think it is the ultimate CLO investors.
That requires them to go back the credit fundamentals. Defaults, albeit that they are going to increase from zero, are still going to remain very, very low in European leveraged buyouts. Even the state of deals that were done post-Easter, which did ramp up very high leverage levels, even those still have 20/25 per cent equity checks in them.
So there is a huge margin for error in even some of those very late, highly-geared deals. I am a big believer, and I think we all are at Permira, that ultimately CLO investors will recognise the credit fundamentals, which is that we are in a fundamentally low default environment with regard to European sponsored LBOs.
Burgel: But we have a bridging problem here, because it is harder to open a warehouse. It is actually harder to place the liabilities for a CLO and we have to bridge that.
I think that in the short-term this is not going to be driven by banks but to a large extent by institutional fund managers. We will work on more creative solutions. How, for example, can we start longer-term warehouses?
For example, we could have funds which are total returns-based using modeled leverage with bigger equity checks. These funds would build attractive collateral points which in the next 12 months could be securitised.
I don’t think that is going to happen in two or three months, but it is going to happen. That is why the correction, in terms of leveraged loans, has already happened. You talk to arrangers of leveraged loans and private equity houses right now and they have fully woken up to the fact that the times of covenant cures, dividend recaps, upgrades and amendments, are over.
Quite frankly, what has happened is we had arranging banks and private equity sponsors abusing the institutional investor community over the last month. A spread of 25bp has almost no impact on the ultimate IRR of private equity investment. But it makes a huge difference to your institutional investor base, which basically needs spread.
Tromp: There has clearly been a shift in the balance of bargaining power between issuer, arranger and investor – back to the investors. That generally is good news for the long-term viability of the market.
At the same time there is this gap at the moment which is hard to bridge. We find that a number of arrangers and some of the providers of warehouse lines, the people that need to price the debt, are still a bit in denial about what is the new, true level of the cost of the liability structure, as well as the price of the loans.
Those with warehouse lines have to digest what is now in the warehouse line. They must realise it has to be marked down dramatically to clear at what is now the new market level.
Likewise, when you look at the capital structure of CLOs, there has been an entire repricing. There are still many parties that are doing their best to say it is still at 35bp on Triple As when actually it looks more like 55bp.
When you step back and look at where we were just four years ago, the market has re-priced back to then. Why is it so shocking that all of a sudden you are back to where spreads were four years ago?
What is shocking is the abruptness of the re-pricing.
Packman: The simply fact is a lot of the banks right now are too busy worrying about whether they are going to have to consolidate massive SIVs, or how they are going to deal with their own funding needs in the inter-bank market to bring themselves to worry about whether or not they are going to bother giving a new warehouse line to another CLO manager.
That is why I believe you have to go back to who the buyers of this risk before the structured finance markets were around to find the solution. So you have to go back to the traditional investors to find the bottom.
Now the reality is the market will recover and those guys will probably pick up the bargains. But the market will take time to get back to any sense of normality.
Kilcullen: I actually think banks will be willing to provide warehouse lines for the leading managers, those who they believe can execute transactions.
There will be innovation and people will look at structures that will operate in the new environment.
I think it is important that arrangers do not provide warehouse lines to lure managers that aren’t fundamentally core to this marketplace. But I do think they will provide lines for leading managers.
Packman: I agree going forward, but I am talking about where we are right here, right now.
Dahinden: People forgot the value and the risk associated with the warehouse. It has been looked at from a lot of people as being necessary to give warehouse on very aggressive terms otherwise they would not get the deal.
Obviously those days are gone. People have misunderstood the value or the risk of warehouses by saying: “none of those assets will default in the next six months, so therefore it is free money”. But the risk is not default. If you have half a decent manager buying primary assets, the actual risk of default during the warehouse period is very limited.
The risk is not being able to securitise, and the mark to market risk as the result. If you cannot securitise, this is the risk of the warehouse. And I think people are really only just starting to realise the magnitude and the consequences of that.
We have had many calls from people saying: “I will sell protection on default in your warehouse but we never transacted on that basis; that has never offered any value to us”.
Click here for Part two of the Roundtable.