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Monday, 20 November 2017

CDOs Roundtable 2007: Part 3

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Burgel: Mezzanine debt was actually starting to get priced wider from March/April onwards, before there were any sort of underlying issues. In May nothing priced above 225 – it didn’t work anymore. It came to the stage where we are saying: hang on, what do we do?

We sold only one CLO in the last ten months because we could not see how we could get those things to work. Therefore, actually before all of this shock happened, pretty much by the time we actually hit June and another pricing flex came along, we pulled our orders, because we didn’t have room for this kind of paper anymore.

So had the sub-prime crisis not happened I think the re-pricing would still have happened and we would have seen a correction also of underwriting standards because there were, other than the really fast money from some very large hedge funds, there were no more homes for these assets.

Those are actually the people who ended up buying the leveraged loans and when they had unrelated problems in another part of their portfolio, then the question was: okay, what do I sell, the stuff where I take a 20 point hit, or the stuff where I take a two point hit?

That is suddenly how we actually had all of that contagion – something like 70% of financing provided to hedge funds comes from the same eight prime brokers.

Combe: And all those TRS funds were pulled at once.

Burgel: So basically we had a huge community of people actually investing not with cash they had raised, but on credit. The risk guys were those same people who are also now sitting on all these stuck warehouses and stuck LBO deals, especially in the States.

I have no idea what that is going to mean for those eight banks in the next three to four years.

Tromp: And I think there are institutions that hold tens of billions of basically stranded leveraged loans. A single institution holds tens of billions. So you are saying that the entire syndication that is stranded in Europe is €70bn.

Dahinden: I think possibly one of the key things that might change in the leveraged loan market going forward as a result of what has happened in the last few years is recoveries. One of the fundamental values of a CLO is, regardless of the expected default, your expected loss historically has actually been very low. Is it your sense that, because of the leverage and the covenant-lite package we have seen, when we do see default, the recoveries are likely to be lower than was historically the case?

Packman: We believe future of recoveries will be lower.

Combe: Why do you think that?

Packman: You can argue that the loosening of covenants could actually be potentially a good thing for certain borrowers in that they may have had a financing package that was more appropriate for them, that would not have stressed them to the same degree as more historical-type covenanted packages would have done.

But the simple reality is that with looser covenants you can take a company to a greater degree of stress before you fall over their form. Fundamentally the intrinsic value must be lower.

Combe: In the 20 years I have been doing leveraged loans, I have never, ever seen a lender enforce against a financial covenant breach. You only ever enforce against non-payment of interest or principal. To that extent, covenant-lite is all a bit of a red herring. It was a symptom of an overheated market and that is why we didn’t like it.

With regard to recoveries, you are looking at it in a sort of top down sense. Broadly speaking, you ought to be right. It is a bit like Ian’s comments on defaults, if they are zero they only have one way to go really.

I have to say, if you work specifically in the market and you look at these loan agreements, yes, leverage had got too high in the last two years; yes, pricing was too low; yes, there were some horrible structural features, not so much covenant-lites, actually, but on subordinated debt, which perversely made the senior debt safer – like toggles on mezzanines, but it made the mezzanine absolutely horrible to invest in.

But there are two things that I have not seen a massive compromising on, even in this overheated market. The first thing is due diligence; which as usual, with all sponsored LBOs, is incredibly thorough. Accountants’ reports, a vendor report, a buyer report, always a market report. That is the huge difference between sponsored loans and non-sponsored loans and, as Oliver said at the beginning, it is the huge difference between the European market and the US market. You don’t take that kind of execution risk on European LBOs.

The second thing where I have not seen a massive compromise is in security documentation. Banks are still insisting on all these loans being secured. UK deal securities are all absolutely full security packages.

Kilcullen: From the perspective of our investment strategy we have always sought to identify the managers with that experience and with access to assets. Access to assets may become less of a problem in the medium term, but with that access to assets, the leading managers had the ability to be selective.

But if you were aligned with a manager that had the opportunity to see all the transactions, they had the ability to be selective. The approval rates for new investments for leading managers I know have decreased massively over the last 12 months. They have been selective and avoided those deals that have been overleveraged and overstretched.

Burgel: That is exactly why you ought to be in a much safer position with the large managers. By that I mean those managers that have the proper infrastructure, as opposed to two or three guys and a Bloomberg. I mean, the proverbial guys who set up a shop in Mayfair, who unfortunately do exist and got funds away at liability costs not much wider than ours.

Combe: Credit adjustment is about two things. One, it is about whether you “have it” or not, which is a question of experience, training, infrastructure.

The second thing it is about is your ability to exercise it. You can be the best credit guy in the world, but if you are not seeing 100%of the market you don’t have the ability to turn down the 75%, and that is why I think Oliver is absolutely right.

Going back to what I said about a flight to quality, you have to believe that those fund managers who have the ability to turn deals down probably have safe portfolios.

Marshall: If you assume that those good managers have been perfectly selective and ranked the deals from good to bad, then you just have to hope that the bad stuff just does not creep above the bottom.

Kilcullen: We would expect even good managers to experience defaults in a normal default environment, but I think it is important to remember that the structure is built from an equity returns perspective to absorb those defaults and you will get massive differentiation between managers.

Dahinden: I think one of the structures that will change with the new environment is good managers will not have to turn down 75% of what they see, and it will not take them 12 months to ramp up.

Burgel: The ramp up for the larger manager, has never really been an issue, because when you get access to close to 100% of the market as a larger manager you get better allocations.

I think from an arranger’s perspective, what will be much better is you ought to be able to ramp up in six months and actually bring deals to the market.

We pretty much only played in the primary market. We were net sellers of assets in the secondary market. Now, having the ability to tactically play again in secondary markets – sell some positions, buy others – that is actually improving flexibility in managing our vehicles.

On the point of recovery there is one thing I want to say. I would probably be a bit more on Alan’s side with expecting lower recoveries because, while it is true we have also never seen a situation where you had the enforcement of a covenant breach, it has actually gone once or twice pretty close to the brink in actually forcing the private equity house to put more money in.

Covenants are an early warning mechanism to catch underperforming assets and to basically force everybody to get around the table and say, “What are we doing about it?” But it is true, nobody ever enforces on a covenant breach.

Where we probably see the risk is with distressed players, people who have a completely different agenda than traditional lenders.

Back in the old days you had tighter covenants, you had a tighter covenant breach, and the bankers would all get in a room together with the private equity house and say, “OK guys, what are we doing about this?” And by and large there would be a bit of shouting as usual, but people would actually come to an agreement and sort it out.

Right now we have people who have emerged who are not interested in that, they actually want the keys to the companies and they actually buy the debt in the secondary market with that objective.

I think you will have a few rather odd outcomes which are driven by one or two investors who have a completely different agenda than traditional lenders.

I think that is unfortunately something that we have to learn to live with and actually, in some cases, where we might not like it, sell out early before it gets to that. The skills of bringing superb recoveries, even on your troubled cases, will not be sufficient anymore.

Dahinden: Experienced investors in CLOs have in reality never accepted the standard default parameters, timing and so on. They have always had their own scenarios and stressed the transactions in their own way.

IFR: Presumably that is the more sophisticated investors, but one would assume there is a whole batch of investors who have come into the market recently who are not that sophisticated and just want exposure to the underlying, or just bought exposure into the CLO because of the high-yield.

Marshall: People like to joke about that.

Packman: I think a handful of years ago we used to say the same thing about people, general fund managers, moving into the RMBS markets; they were not necessarily experts, but the reality is that in a relatively benign environment they could get away with it. The testing time will come when the corporate credit cycle really changes.

Dahinden: There is a view amongst people who are not as involved in the CLO market as we are here that there are investors who have no idea what they are buying but that is not our experience at all.

We have not met investors who say: “I am just buying these things and have no idea what I am buying”.

Tromp: But they would not say that.

Dahinden: In your view do you think there are a fair amount of investors involved in this product that don’t understand it?

Tromp: There are investors that buy without fully understanding the structure. Maybe it is the right thing for them to do. We are a player that buys big tickets. We like to do the entire Triple As. Where we do big tickets and we keep the risk, we ask a lot of questions. So our threshold is naturally higher than an investor that has a diversified fund.

Kilcullen: But there is no substitute for doing your own analysis and having a thorough understanding of the risk that you get involved in. We invest at the equity level and our due diligence process involves drilling down to the underlying assets and understanding the credit process of the manager, to understand how the manager originates business.

Packman: That may be true on the equity. But debt has a set return: they buy it at par, it redeems at par, it pays them a coupon and unless the actual tranche defaults, then you don’t take a loss.

Combe: You clearly have massive protection from that structure. But nevertheless, going forward, everybody, whether they are Triple A or equity investors, have to distinguish much harder between good and bad.

Marshall: The issue is not that people are not able to discriminate; the point is that people have been forced buyers – the credit guys have been sidelined.

Combe: it has been noticeable in the last nine months that there have been new CLO managers who have set up with incredibly limited experience at the top. Not everyone has to have 20 years of European LBOs, we are not saying that. But at least they should have worked in leveraged finance, for goodness sake, or credit of some kind.

Packman: I think the reality is the banks will not provide warehouse lines now to those guys. The banks will be far more choosy because of the fact that they know it is more of a challenge to place these deals, so they will play safe.

Will we see a round of consolidation in the market? Will the likes of Babson and the larger players start taking over some of the newcomers?

Dahinden: It has always been our view to only work with people that we genuinely believe will be there in 17 years when the deal matures. Whether they were first time managers, they were starting the business earlier or later, that did not matter to us.

I don’t want to put them all in the same bag because being a hedge fund means a lot of things these days. Golden Tree is perceived to be a hedge fund – we think of them as being a quality manager – but there are hedge funds where we would not want to have a conversation with.

IFR: I would be interested to hear people’s views on future deal flow.

Dahinden: I think it will be reduced for sure, as it should be. You will not have the deals that get done basically by the skin of their teeth. I think that is fair to say. It is still an open question as to how many will get done in the current format. We like low leveraged fund, we like TRS, we like certain things, that if they are done properly, have some value.

So I think the shape of the structure will have to be evolved based on the arbitrage which will exist between the cost of debt and the spread on the assets. That is still debatable and it is hard to tell today where it is going to be.

But if I had to give a number, I would most probably have said it will be half of what the running rate would have been otherwise. I thought that rate was silly and nonsensical anyway.

I do believe that the investor base will have shrunk. We know, for instance, investors who said: “well, I bought Triple As, I started to buy Double As and I never thought I would have any mark to market issues, but now I do. So I am not going to buy anything for the next three months.” So there will be people that will be sidelined for a while and you will have a change of investors, like you always do every two or three years when there is a hiccup. Some people get out of the market and some people come in.

I would like to say that we have had a large number of conversations with investors which historically have never been involved in CLOs and are starting to say: We think there is value here. We are going to do more work to learn about this asset class because we think it is a good one.

So you will have new participants as well as people exiting. We are at this stage and I think there will be less deals initially. I think you will have new transactions and new structures coming out as well. I think the credit opportunity funds will most probably be a lot harder to sell going forward. They were difficult to sell in the first place.

IFR: What types of managers will inspire confidence?

Dahinden: A perfect example is Permira. We have no doubt they will become large participants in that market. They originate most paper in Europe.

IFR: Are you expecting deals to be brought by managers who retain the lower rated debt?

Burgel: There are structures that don’t have Double Bs. The leveraging is reduced to the extent that, if you eliminate the Triple Bs, it starts making little sense. We are the largest equity investors in our whole fund.

Marshall: At some point if spreads are wide enough then less leverage can create an attractive return.

Burgel: It depends on many factors. One deal at the beginning of 2003, when tanks were rolling into Iraq, we priced the Triple As at 65bp. It still worked and the IRR to equity was over 18%. Now we are at the point where warrants will come back into mezzanine to make transactions work. About 40% of what we manage is outside global CLOs so we will only choose them if it is appropriate.

Combe: Regarding future issuance, the one thing that is certain is the European leveraged loan market is not going to be as big. I’m afraid we have had the best five years that our market is going to see for quite some time.

IFR: A question for the investors: what are the two or three most important services you expect from arranging banks?

Marshall: Upfront transparency in sources and uses for the transaction being put together. There are often items that aren’t disclosed in the offer memorandum. A classic one would be arranging banks fee swaps, when upfront fees are deferred, here is an item coming out of the waterfall which is unquantifiable based on the documentation provided.

Packman: Investors have lost out on interest in the first period of the deal because of late changes that were not initially specified. Late change need to be detailed and specified.

Tromp: If it is an enhancement we may not need to complain, but that is not always the case.

Kilcullen: We are investing at the equity level and have found information has been forthcoming.

Packman: Moving to the secondary side it is liquidity and consistent valuation methodologies. I think some banks and syndicate desks have been incredibly naive as to the long-term implications of the events that have happened this year with their relations with their investors. I think there should be some form of discussion going forward in terms of standardisation of valuation methodologies.

You read the disclaimers from different banks and it is from the sublime to the ridiculous in terms of the disclaimer and the valuation methodology that comes through. I think it is something that the market needs to get to grips with; it will be a large part of the healing process.

Kilcullen: Some banks have not behaved properly in the recent market turmoil but that will impact their business franchise, the impact it has had on investors has been significant.

Burgel: We have to factor in our due diligence when we choose our long-term partners because some outrageous things have been brought to our attention as well.

Tromp: The part that we struggle with has been late structural changes, and the really short time given to get a full credit approval. I think investors will be given more time.

Kilcullen: I think it is important to finish on a note that this market has developed very rapidly and as is often the way it tends to snap back very quickly. We are in an adjustment phase trying to find equilibrium, but this market has come too far to go backwards.

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