* Sourcing assets will be biggest challenge
* European market cannot grow without primary lev-loans
* Rally in liabilities makes arbitrage work again
By Owen Sanderson
LONDON, Feb 15 (IFR) - Cairn Capital is about to win the race to become the first manager to sell a European arbitrage CLO since the onset of the financial crisis, but a true recovery in the market is being blocked by a lack of loan supply.
Without new loans to buy, CLO managers hoping to bring new deals - or to stay invested with their outstanding deals at decent spreads - will have to hunt around in the secondary market to get hold of small size in a dwindling, ever-more-concentrated pool of European leveraged loans.
In the last 12 months, appetite for European CLO liabilities has grown, and spreads have raced tighter still in the first six weeks of 2013.
"All the big arranging banks could sell a full CLO capital structure tomorrow," said a European CLO market veteran. "We'll see more deals this year purely on that basis, but it will be held back by [lack of] loan supply."
A UK-based CLO manager said that liquidity in the European loan market was a huge challenge for CLO arrangers.
"In the US, you can go out to the market for USD500m of leveraged loans. You can buy them in a day, more or less at the offer price. In Europe, the same thing would take six weeks at least."
HOW CAIRN WILL DO IT
Cairn's EUR300.5m deal Cairn CLO III can be seen as a bet on the recovery of the primary market - the new deal will only be 50% ramped at close - giving Cairn six months to invest the rest of the money, during which time it will be receiving "negative carry" - paying more to borrow the money than it receives from holding the assets.
Exposures already in the pool are also said to be short-dated, meaning Cairn will not only have to find another EUR150m of loans, but also maintain asset coverage as existing loans roll off.
One market participant reported that a hung warehouse, possibly from a previously aborted Cairn deal, may have provided some of the underlying assets, though two sources said at least 40% of underlying came via sole arranger Credit Suisse's secondary loan trading desk.
A recovery in the loan market will allow Cairn to get more spread in the deal because it will ease the supply-demand imbalance in loans and give Cairn a greater variety of assets to purchase. This should give a better return to the equity holder, which is a US pension fund with more than USD6bn of assets under management.
Cairn receives a 10% performance fee for any equity IRR above 12%, suggesting this is its minimum case for equity returns. Cairn takes a 50bp management fee regardless, 15bp at a senior level and 35bp subordinated.
In its last pre-crisis deal, Cairn received a variable fee from 50bp to 65bp, and 20% of performance over 12%.
Cairn's structure incorporates innovations from the revival of the US market. The equity gets coupon reset language, allowing a majority of equity holders to refinance the liabilities at tighter spreads without collapsing the structure. This limits the upside for the debt - but makes for a stronger structure.
For their part, debt investors get better security, with drastically lower leverage than with pre-crisis deals, and a cleaner collateral pool. Instead of the 10 times leverage usual in the pre-crisis market, Cairn CLO III is five times leveraged, with no Double B debt tranche. It also specifies 90% senior secured loans - limiting possible exposure to second lien loans, bonds, or other collateral. This was included in Cairn II, but was not standard across European CLOs before the crisis. Structured finance and synthetic collateral is excluded and currency rules have been tightened.
The next CLO in the pipeline, arranged by Barclays with Pramerica as manager, may adopt a different approach to the problem of finding assets, with a larger bucket for bond collateral, said to be up to 40%. To maintain credit quality, this will need to exclude unsecured holding company bonds in favour of senior secured FRNs, close to loans in credit quality.
Another obstacle to the resurgence of European CLOs has been Europe's skin-in-the-game rules. Thinly capitalised CLO managers cannot necessarily hold the required 5% of deal size from their own funds. For Cairn CLO III, the equity holder has committed to permanently holding 5% of the deal in the form of an M2 tranche, which comes with control rights not attached to the other equity notes.
Execution on the Cairn deal seems to be running ahead of market expectations, with spreads on offer appreciably inside secondary levels for comparable deals.
Guidance on the Triple As - said to have been largely placed to UK and Japanese banks - has been revised to 140bp area from 140bp-145bp, while there has been reverse enquiry interest in the Triple B tranche from three accounts. The latest word from Credit Suisse sales coverage to CLO investors was that they were seeing good interest up and down the capital stack.
CAIRN AS SYMBOL
Given the "anaemic" state of the European primary loan market, according to one CLO manager, a full recovery in CLO issuance seems unlikely, even if Credit Suisse manage truly spectacular execution on the new deal. USD55bn of CLOs were issued in the US market last year.
As well as the Barclays/Pramerica deal, two major CLO managers reported Citigroup and Bank of America Merrill Lynch approaching them about European deals, while JP Morgan and Deutsche Bank have also been named as prominent arrangers hoping to do a deal.
The fee structure pre-crisis was typically 1.5% of deal size - equivalent to EUR4.5m on the Cairn trade - with another EUR1m each on rating agency and lawyer fees. Arranging banks can also expect to earn some carry warehousing leveraged loans ahead of a deal, though this has become increasingly costly in capital terms.
One CLO manager said that the parlous leveraged loan market in London was, in part, a function of the dormant CLO market.
"It's a chicken and egg situation," he said. "Banks are reluctant to syndicate without a reliable CLO bid, while arranging new CLOs is hard without a reliable leveraged loan pipeline."
Positive market sentiment across credit also may not help, though it buoys demand for CLO liabilities.
"CLOs can be seen as a bear market trade," said the CLO manager. "Lock in your cheap debt while you can, then use the reinvestment period to pick up assets when loan prices fall."
Without a CLO market recovery - which depends on new primary supply - leveraged investment will gradually drain away from the whole leveraged loan space - limiting options for LBOs and refinancing of existing deals.
CLO managers, including 3i, Alcentra and ICG, have been diversifying into unlevered loan funds, or other forms of sector leverage include using total return swaps - which effectively means buying loans on margin. These are easier to arrange than CLOs, but vulnerable to margin calls and mark-to-market declines - CLOs lock in debt for the long term. (Reporting By Owen Sanderson, editing by Anil Mayre and Matthew Davies)