CLO Managers Tempt Investors With Sweeteners as Market Revives

(Bloomberg) — Europe’s market for collateralized loan obligations is readying for a rapid pick-up in activity in September, as managers seize on the cheaper cost of capital to refinance or reset their vehicles after years of high interest rates. 

Around 240 active European CLOs — bundles of leveraged loans repackaged as bonds — have already exited their reinvestment period, according to data compiled by Bloomberg, meaning that they’re no longer permitted to trade their underlying assets and are eligible for a refinancing or reset. Managers with active CLOs include Apollo Credit Management, Blackstone Credit and CVC Credit Partners.

While only a fraction of these are expected to actually launch by the end of the year, market participants are anticipating a flurry of activity. Such expectations are fueling competition among managers to enhance their offerings. That may take the form of selling out of riskier loans, marking-to-market assets trading at a deep discount, retaining equity distributions to juice up cash reserves, or even waiving fees. 

Portfolio tail risk — the exposure to riskier loans — will be a key focus for CLO refinancing and resets in September, according to Jacob Walton, co-head of European CLOs at Sona Asset Management.

“Underperforming names haven’t rallied like the rest of the market and managers will have to be cautious of the impact on the liability pricing,” he said.

Issuance Soars

Since September 2023, refinancing and resets have skyrocketed to €12.3 billion ($13.6 billion) after a lull that lasted almost two years. The cheaper capital available drove total issuance this year — including new vehicles — to €41 billion as of July 2024, a 46% increase compared with the whole of 2023, according to data compiled by Bloomberg. 

That wave of refinancings and resets saw funds launched in 2022 succeed in slashing the cost of capital across debt tranches by about 100 basis points, according to data compiled by Bloomberg. This trend is set to continue with 2023 funds that also priced during the subsequent period of high interest rates, according to three CLO investors surveyed by Bloomberg.

While September is typically a busy month in leveraged finance markets, this year is set to see even more CLO paper than usual as managers seek to come early to avoid any market volatility around the US election in November.

And it’s not just US politics that’s likely to weigh on the European CLO market. Some portfolio manager strategies that are more common in the larger US CLO market are starting to appear in Europe, with more expected before the end of the year.

Beauty Contest

With a larger pool of funds to choose from, CLO managers will be eager to stand out. Investors, on the other hand, will be wary of the quality of the underlying assets on which the CLOs are based, particularly given the number of rating downgrades for leveraged loans has consistently outpaced the number of upgrades across CLO asset pools since 2022.

Managers whose portfolios include a higher proportion of riskier assets may want to sell out of some to ensure they have a comfortable cushion ahead of their internal quality tests. This was the case for Partners Group, which decided to cross-sell its remaining exposure to French telecom group Altice ahead of both the resets of its Penta 2022-12 and Penta 2022-11 funds in April and July 2024, according to a person familiar with the matter, who wasn’t authorized to speak publicly. 

Meanwhile, Capital Four — in a bid to highlight its transparency to investors — decided to mark-to-market one outstanding loan that was trading at a deep discount, when its documentation would have allowed it to mark the loan at par for the reset of the fourth fund, according to two people familiar with the matter. This created some buffer for the manager to create further value for investors from the gap between the marketed value and the par value.

Among the other tools at managers’ disposal is the willingness to waive their fees — at least temporarily — or to retain the first equity distribution due at the first or second payment date. Such a move helps to boost the cash reserves available and to manage upcoming portfolio quality tests. The retention of a first equity distribution has already happened in Europe this year with Voya’s reset of its sixth vehicle in March, as well as Hayfin’s 10th vehicle in May, according to two other people familiar with the matter, who were not authorized to speak publicly.

Credit Quality

The use of these strategies looks set to become more popular in Europe, narrowing the gap with the US. Managers’ focus on credit quality across their portfolio will remain key and could lead to higher volatility on low-quality loans and bonds toward the end of the year.

Portfolio credit risk remains historically high, according to Fitch Ratings. The average triple-C rated bucket in Europe was at 3.8%, following rises in March and June 2024 due to the downgrades of Altice France Holding S.A. to ‘CCC’ and Altice International S.a.r.l. to ‘CCC+’. This compares with the 2023 average of 2.5%, according to the ratings agency.

Fitch also expects both European leveraged loan and bond default rates to reach 4% by year-end, from 3.5% for loans and 1.7% for bonds in the first half of 2024. These are then expected to stay at 4% throughout 2025.

The average recovery rate for assets in CLO portfolios hovered around 63% in Europe from October 2020 to July 2024. However, for assets in default, such rates dropped to 41% on average. This has motivated CLO investors to require clean portfolios from managers.

“The portfolio credit quality of European collateralised loan obligations being reset in 1H24 improved compared to the original transactions,” said Fitch analysts Apeksha Mantri and Matthias Neugebauer, pointing to almost no defaults after the resets and average triple-C exposure declining from 2.8% to 1.7%.

–With assistance from Molly Price.

©2024 Bloomberg L.P.