Investors struggling to find the terms they want on public leveraged loan vehicles are increasingly turning to an old markets trick: going private.
As the economics of arranging collateralised loan obligations have become strained, a growing number of funds have moved towards private, unrated deals. That has given CLO investors a fast and flexible way to get leveraged exposure to risky loans, while providing a useful revenue stream for investment banks arranging the deals. But it also raises questions about the direction of travel in an already hot part of capital markets, which has caught the attention of regulators following its precipitous growth in recent years.
Banks’ financing activities related to CLOs grew roughly 30% last year to around US$500m in revenues across the industry, according to estimates from industry executives, comfortably outstripping growth in the traditional CLO underwriting business, albeit from a smaller base. Those financing activities comprise arranging private CLOs and providing investors with leverage on tranches of public CLOs - another growth business for banks of late.
BNP Paribas, Citigroup, Deutsche Bank, Goldman Sachs and JP Morgan are understood to be among the banks that are prominent in arranging these deals, which typically involve offering investors leveraged exposure to a portfolio of risky loans through a type of credit derivative called a total return swap.
“There is certainly an increased or heightened focus away from the more traditional CLO product [towards one] which may be less liquid,” said a senior CLO banker.
The CLO market - where portfolios of leveraged loans are sliced into tranches with varying rates of return and exposure to losses - weathered the financial crisis well, with the most senior slices of debt not incurring any defaults.
That record has helped fuel interest from yield-hungry investors. In the US, the CLO market has more than doubled in size over the past few years to $616bn, according to trade body Sifma, even as other crisis-era acronyms such as synthetic CDOs remain firmly outside the mainstream.
In recent months, however, bankers and investors have struggled to keep the CLO machine running at full throttle and the pace of new deals has slowed as their economics have come under strain.
The average gap between what CLOs earn on investing in loans and their own cost of capital declined to 172bp in the US and 240bp in Europe at the end of 2018, according to strategists at Barclays, down by 147bp and 111bp since the end of 2015, respectively.
QUICK AND EASY
Step forward privately arranged CLOs, where investors can get the same kind of leveraged exposure to loans without spending months gathering the paper or having to comply with the ratings agency guidelines necessary in public deals.
A typical transaction would see a bank pool together some leveraged loans on its balance sheet or stick them in a special-purpose vehicle, tailoring the portfolio and structure to the investor’s needs. The investor will then enter into a total return swap with the bank to receive the cashflows from the portfolio, usually leveraged several times over.
“Banks are very keen to win financing mandates from CLO managers. They want to provide TRS facilities, they want to provide leverage facilities, and they are all fighting with each other, making the terms very flexible,” said one European CLO manager. “And, as a CLO manager, you have to pay almost nothing for it. From that standpoint, they are certainly risk-on.”
As well as representing an efficient way to get exposure to the loans, the total return swap has another advantage: leverage. Depending on the risk of the underlying portfolio, investors could juice their potential returns up to five times on shorter deals, or two to three times on deals that don’t come due for up to five years or more.
That’s far less than the roughly 10 times leverage investors in equity tranches of CLOs can achieve. But what private deals may lose in leverage, they can make up for in ease of execution and flexibility, bankers say.
“The CLO market is mainly driven by rating agencies … there are guidelines you need to deal with,” said another senior structured credit banker.
Doing a loan TRS with a bank is “much more efficient from a timing standpoint to get leverage - and much more flexible,” the banker said.
ALARM BELLS
The shift towards private, un-rated deals may be a cause for concern among regulators, who have already sounded alarm bells over the rapid growth of the CLO market and deteriorating standards in leveraged loans.
Bankers point out that leverage levels are much lower than the pre-crisis period, and that trades are structured appropriately with built-in protections such as daily margin - the amount of capital banks have to hold against such positions acts as a limit on how much leverage they can offer.
That protection also holds for the other engine of growth in banks’ CLO financing businesses: offering funds leverage on tranches of public CLOs through total return swaps.
Still, at a time when primary CLO volumes are slowing, and underwriting fees are under pressure from increased competition, the financing business is an obvious target for growth among investment banks this year.
“We’ve definitely seen more banks offering warehouse financing for a CLO take-out and longer-term fund leverage – the increase has been noticeable,” said Benjamin Edgar, a portfolio manager at Intermediate Capital Group. “However, it is very different from the leverage that was being offered in 2006 and 2007.”
Additional reporting by Gareth Gore
