Alcentra The whys and wherefores of European CDOs


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Alcentra The whys and wherefores of European CDOs

  1. 1. The whys and wherefores of European CDOs Faith Bartlett Global Head of Marketing & Structuring and CDO Portfolio Manager Alcentra Limited
  2. 2. This presentation has been prepared by Alcentra Limited (Alcentra). Alcentra has compiled the Information contained herein from public sources which it believes to be accurate. However, no representation is made as to the accuracy or completeness of those sources or this information and no responsibility is assumed for any error or omission which may have been made in the compilation of this information. Any views reflected herein are those of Alcentra and are subject to change without notice. The Information is provided for reference purposes only and does not constitute an offer or solicitation of any offer to enter into investment business of any description based on the Information provided herein. Neither Alcentra nor any of its officers or employees shall be liable for any loses or expenses arising directly or indirectly out of the use of or reliance on the Information set out herein. The Information contained herein is for your private use only and may not be reproduced, distributed or published (in the case of the information contained herein, insofar as reference is made to the fact that Alcentra has produced the Information) without the prior written consent of Alcentra, unless you are required to do so by law or your Regulatory Authority. Alcentra Limited is regulated by the Financial Services Authority (FSA). Alcentra does not provide services to Private Customers (as defined in the rules of the FSA). Registered in England number: 4324531. Registered office: 88 Wood Street, London EC2V 7RS.
  3. 3. What is a CDO? <ul><li>A Collateralised Debt Obligation (‘CDO’) fund is a pool of assets held by a bankruptcy remote special purpose vehicle, which finances itself by issuing rated bonds </li></ul><ul><li>The underlying pool of assets can be actively managed or static </li></ul><ul><li>CDOs can be used to take assets off a bank’s balance sheet (Balance Sheet CDOs) or bought in the market for the purpose of yielding groups of investors a return (Arbitrage CDOs) </li></ul><ul><li>The underlying assets in the portfolio can be bonds, loans, CDS, ABS (including other CDOs), private equity </li></ul><ul><li>The amount of leverage on each fund depends on the underlying collateral e..g loans 10-11x levered, HYBs 8-9x levered. </li></ul>
  4. 4. Growth of CDO market <ul><li>CDOs originated in the US in late 1980s as a way to manage bank’s balance sheet for regulatory capital relief </li></ul><ul><li>With the Savings and Loans crisis in the early 1990s and bank consolidation in the US, banks started to pull back from the leveraged loan asset class and managed CDOs started to take up some of the slack </li></ul><ul><li>Bank loans were bought by the CDO asset managers who then started to require structural adjustments to better suit their vehicles </li></ul><ul><li>Institutional investors in the US, of which the majority are CDOs, now buy almost 60% of a loan on primary issuance </li></ul>
  5. 5. US Primary Market for Leveraged Loans by Investor Type (Source: S&P/PMD) Excludes hybrids as well as all left and right agent commitments (including administrative, syndication and documentation agent as well as arranger) Foreign Banks Institutional Investors Domestic Banks Securities Firms Finance Cos
  6. 6. US Primary Market for Institutional Loans by Investor Type Excludes the $900 million Berkshire Hathaway commitment for CenterPoint Source: S&P/PMD To provide a more realistic view of institutional buying habits in today’s market, we add to the CLO tally the institutional commitments held by the arranger at close. For tax purposes, of course, CLOs tend to participate as primary assignees and therefore are often left off the “at close” allocation list. Starting in 2002, we have made a better effort to track hedge funds and other investors in this analysis. As a result, we only provide a single point for this year. Prime Funds CLO/CDO/Synthetic CLO Insurance companies High-Yield Funds, Hedge Funds & Distressed Funds
  7. 7. European CDO market <ul><li>NatWest was the first European bank to complete a balance sheet CDO with ROSE, now most banks have a CLO programme. </li></ul><ul><li>The first European arbitrage CDO was ICG with Eurocredit in mid-1999, this had underlying collateral of senior loans, mezz and HYBs </li></ul><ul><li>At least 27 European arbitrage CDOs predominantly based on sub-investment grade credit have been issued to date </li></ul><ul><li>The size of these funds typically range from €300 – 1,000m and most are managed by specialist asset managers </li></ul><ul><li>Institutional investors, mainly CDOs, now account for c 20% of primary loan issuance </li></ul>
  8. 8. Primary Market for European Leveraged Loans by Investor Type Source: S&P/PMD Non-European Banks European Banks Institutional Investors Securities Firms
  9. 9. Primary Market for 1999 – 2002 European Leveraged Loans by Investor Type ( Excludes U.S. Dollar Tranches) Source: S&P/PMD Based on 76 allocation lists Institutional Investors: 20.2% (note the rounding error) Based on 82 allocation lists Institutional Investors: 13.9%
  10. 10. Typical CDO Structure <ul><li>Jubilee II, closed June 2002, underlying collateral senior loans (min 80%) and mezz (max 20%) </li></ul><ul><li>Class A Senior AAA €303.5m </li></ul><ul><li>Class AX Junior AAA €36m </li></ul><ul><li>Class B A €53.3m </li></ul><ul><li>Class C BBB €31.25m </li></ul><ul><li>Class D BB €6.55m </li></ul><ul><li>Equity N/R €40.5m </li></ul>
  11. 11. CDO Investors <ul><li>The CDO issues rated debt which allows it to have an average cost of funds lower than the spread on the underlying collateral </li></ul><ul><li>The excess spread above the average cost of funds and after asset management fees is distributed to the equity holders. </li></ul><ul><li>A performing CDO should return c. 15% p.a. to equity holders </li></ul><ul><li>The asset managers are usually required to hold 20-30% of the equity in the CDO to ensure alignment of interests </li></ul><ul><li>CDO equity is typically bought by pension funds, insurance companies and some banks as part of their alternative asset allocation </li></ul><ul><li>For many investors this a method of getting access to asset classes, like leveraged loans, which they don’t have the ability to manage or source internally </li></ul>
  12. 12. Overview of Structural features of CDOs <ul><li>Issue long dated bullet paper, 12-13 years </li></ul><ul><li>Are rated by 1 or more agencies </li></ul><ul><li>Debt tranches range from AAA down to BBB or BB </li></ul><ul><li>To date in Europe the majority have been issued in Euros and any other currency exposure has to be fully hedged out </li></ul><ul><li>Underlying focused on loans and mezz (needs to have cash element) </li></ul><ul><li>Have limits on amount invested in single obligors </li></ul><ul><li>Have buckets for countries and industries </li></ul><ul><li>Are sensitive to rating of underlying assets and to recovery rates on these assets, as well as spread </li></ul><ul><li>Able to trade assets </li></ul>
  13. 13. Impact of CDOs on Loan Structures <ul><li>The structure of each CDO is slightly different but there are some common themes across CDOs of what they look for in loans </li></ul><ul><li>Longer dated paper – to match their liability structure, hence focus on TLB and TLC e.g. Panzani - institutions only took TLC </li></ul><ul><li>Bullet tranches – CDOs are financed by bullet debt and it is difficult to re-invest small amortisations/prepayments in new assets. Any cash that CDOs carry affects their performance as they are carrying a cost of funds c 100-120bps </li></ul><ul><li>Minimum spread levels – need to hold assets that yield more than their cost of funds and also cover costs and provide a return on equity. Therefore, CDOs typically have a yield hurdle rate of c. 250bps </li></ul>
  14. 14. Impact of CDOs on Loan Structures <ul><li>Currency – majority of CDOs are funded in Euros and therefore prefer Euro assets. They can usually take £ or $ assets but these need to be fully hedged, which costs 75-100bps off the spread each year </li></ul><ul><li>Rated assets – most CDOs need to have each asset they own rated by the agencies that rate the CDO. If the loan is not publicly rated then each CDO will have to pay for shadow ratings. These are based on the agencies’ desk-top review and therefore tend to be lower than public ratings. </li></ul><ul><ul><li>Most CDOs are targeting assets with at least a B rating, most loans will need to be B+/BB- rated. </li></ul></ul><ul><ul><li>The rating agencies also assign a recovery rate to each asset based on security and jurisdiction </li></ul></ul><ul><li>Country – CDOs are often limited to the countries in which they can have exposure e.g. no emerging markets, limits on US for European deals. The country is also determined by the rating agencies. </li></ul>
  15. 15. Impact of CDOs on Loan Structures <ul><li>Industry – CDOs are required to have a certain level of diversity. This is measured by the rating agencies (Moodys diversity score, S&P/Fitch industry buckets) who determine which industry the asset is in. This is usually based on the location of the majority of employees/EBITDA/Assets. </li></ul><ul><li>Minimum hold amounts – CDOs aim to have very diversified portfolios say 70 names and therefore need the ability to hold relatively small pieces </li></ul><ul><li>Transferability – CDOs like the ability to sell assets (for credit and portfolio reasons) and transfer assets between funds without needing the delay of borrower consent or the cost of transfer fees (esp for intra-fund trades) </li></ul>
  16. 16. Major European CDO managers <ul><li>AIB (Tara Hill, Clare Island) </li></ul><ul><li>Alcentra (Blue Eagle, Jubilee I and II) </li></ul><ul><li>AXA (Concerto I and II, Ecureil) </li></ul><ul><li>Duke Street Capital Debt Management (Duchess I) </li></ul><ul><li>Harbourmaster (Harbourmaster I, II and III) </li></ul><ul><li>ICG (Eurocredit I and II, Promus I and II) </li></ul><ul><li>ING Capital (Copernicus) </li></ul><ul><li>Prudential (Life Fund and Leopard) </li></ul>
  17. 17. Characteristics of European CDO asset managers <ul><li>Most are non-bank e.g pension funds, life companies, private equity-owned </li></ul><ul><li>Mainly staffed by experienced long-standing professionals in the European leveraged loan market </li></ul><ul><li>Smaller teams, 5-10 people </li></ul><ul><li>Shorter lines of communication – quicker decisions </li></ul><ul><li>Very credit and relative value focused, less relationship driven </li></ul><ul><li>Ability to commit significant orders – 5 managers can commit orders in the €30-50m range </li></ul>