Collateralised loan obligations, the specialised vehicles that were a mainstay of private equity deals funding, have a finite lifespan. Many will start to wind down in the coming decade, yet the creation of new CLOs has been stymied by post-crisis regulatory reforms and limp investor interest.
Banks, meanwhile, are shying away from long-term lending to private equity firms. Fees for providing M&A advice, short-term loans and debt underwriting are still enticing, but regulation is limiting long-term lending to riskier companies. Industry participants are asking what could fill the gap left by CLOs and banks.
“With CLOs effectively in rundown mode in Europe, and banks constrained, we have to find new sources of debt for deals,” says Simon Begg, European head of capital markets at Warburg Pincus, the private equity firm.
Some hope that “mezzanine” funds will be able to fill part of the funding gap. These specialist funds generally finance the riskiest, and most lucrative, parts of private equity transactions, and became more active when most other markets froze last year.
Some CLO fund managers are also reinventing themselves as broader credit investors and starting up a new breed of loan funds that can provide financing for private equity deals.
Clayton Perry, chief operating officer at Avoca Capital, a European credit fund manager with 10 CLOs under management, expects pension funds and insurers to increase allocations to the loan market in the coming years. “In a few years these institutions should make up a significant portion of the loan market in Europe,” he predicts.
However, the mezzanine industry is tiny compared to the size of the CLO market, and fund raising for new loan funds remains sluggish.
One plausible answer is therefore the high yield – or “junk” – bond market.
Although it effectively shut down in the second half of last year, bankers widely expect that investors’ need for higher returns will propel more money into Europe’s newly-resurgent junk bond market. We like European high yield,” says Howard Cunningham, fund manager at Newton, part of BNY Mellon. “The [European Central Bank’s] LTRO money stopped the potential for a cataclysmic banking system failure, and even in a low growth environment, most of these companies will still generate enough money to pay coupons.”
Indeed, the European junk bond market has provided about 50 per cent of total financing to non-investment grade companies over the past two years, compared with 14 per cent in 2007, Standard & Poor’s said in December, before the market’s first-quarter rally. “The market has already started to evolve,” says Matt Naber, co-head of European leveraged finance at Morgan Stanley.
Still, many bankers doubt that the European high-yield market will grow quickly enough to allow companies to repay the estimated €250bn of private equity loans due by 2017, let alone finance fresh deals.
“As CLOs start disappearing and as bank liquidity remains constrained, the depth of the high yield market is likely to be tested,” says Arnaud Tresca, head of high yield capital markets at BNP Paribas. “The extent of refinancings looming is much larger than the European high yield market is currently able to swallow.”
Some help may be found across the Atlantic. When European appetite for leveraged finance shrivelled late last year, US investors remained receptive, and many larger deals this year have been sold in the US. Industry insiders hope US investors will continue to supplement – and at times supplant – Europe’s buyers of private equity loans and bonds.
“Luckily, the US market has really stepped up to the plate to finance European deals, and European markets are looking much better now as well,” Mr Begg says.
Bankers and fund managers say that the next few years should go relatively well, given that the refinancings are manageable, sentiment is improving, and the fact that many CLOs still have plenty of cash and life in them. Mr Perry points out that most CLOs will be allowed to amend and extend existing loans, within the constraints of their lifespan, and argues that Europe could once again see the creation of new vehicles once financial tensions ease.
“We’ve seen the CLO market return strongly in the US, and I don’t think the European regulatory hurdle will be insurmountable once the cost of funding drops,” he says.
However, for now there have been no new European CLOs since the crisis, and existing vehicles will not be able to finance new acquisitions. Bankers pinpoint 2014 as the time when repayments – and stresses – will peak. Chetan Modi, head of European leveraged finance at Moody’s, says the CLO restrictions on reinvestments are “going to start to bite this year”, and predicts this will lead to an increase in corporate defaults in the coming years.
“Unless a new source of capital magically appears, we think the funding gap for much of the leveraged loan market will be solved by a combination of the high-yield market, and debt restructurings,” he says.
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