Ever-Shrinking CLOs Leave Market Permanently Changed

As collateralized loan obligations become a smaller factor in the market, dealmaking increasingly must rely on other sources of funds, such as high-yield mutual funds and loan funds.

But in contrast to the relatively stable source of institutional capital, mutual funds are daily-redemption vehicles, which magnifies the impact of changing expectations for inflation and interest rates, market watchers say.

Taken together with pending regulatory changes imposing risk retention requirements on CLO managers, the new environment could mean a more volatile market for private equity dealmaking.

In the near term, the shortfall in new CLO issuance is likely to mean wider spreads for issuers, said Steven Oh, managing director and co-head of PineBridge Leveraged Finance, which closed a new $400 million vehicle, Galaxy XI, in August. “It’s going to make it more difficult for leveraged buyouts to get financed.”

And in the intermediate term, Ben Bernanke, the head of the U.S. Federal Reserve, has promised to keep interest rates low through at least 2013, which could also dampen enthusiasm for floating rate loans like CLOs, Oh noted. “The asset class outperforms when interest rates are rising.”

There are indications that the change may be structural rather than simply cyclical. Prior to the financial crisis, CLOs represented funding for 70 percent of new leveraged loans originated, according to the mid-market investment bank Lincoln International. Today, these instruments fund only 40 percent to 50 percent of the market.

At the same time, the role of mutual funds has grown. Pre-crisis, such funds accounted for a near-negligible 5 percent of the market, estimated Michael Zupon, a partner and chief investment officer at Sound Harbor Partners, a New York private equity firm that invests in both debt and equity. Today, he said, they are a much more significant 15 percent or so.

All of which makes mutual fund flows more important in the financing of deals. As of mid-October, retail bank loan mutual funds funds pulled out $26.3 million from the leveraged loan market, in their the 12th straight week of outflows, sister service Thomson Reuters LPC reported, citing Lipper FMI.

At the same time, however, retail investors pumped $2.27 billion into high-yield bonds, on top of a $634.9 million inflow into high-yield bond funds, according to Lipper FMI. That could indicate a tilt toward larger credits, which have access to the bond market, rather than mid-market borrowers, which depend more on bank loans.

To be sure, CLO issuance has rebounded from 2009, when the financial crisis virtually crushed new issuance. But about 50 percent of CLOs will hit their reinvestment expiration periods in 2012 while nearly all CLOs will be beyond their reinvestment periods by 2014, LPC reported, citing Wells Fargo. And new CLO creation has not been robust enough to make up for the CLOs going static.

On top of that, the U.S. Securities and Exchange Commission has asked for comment on a rule that would require CLO managers to keep “skin in the game” under risk retention rules that prohibit them from selling all of the ownership of the instruments to third parties. CLO managers have complained that such rules, if adopted, could drive all but the largest managers from the market.

“We do know that the European risk retention rules have had a chilling effect on issuing CLO notes into Europe, so if the U.S. rules follow the European rules, it would be problematic. This is unfortunate because CLOs have, in fact, performed very well,” Meredith Coffey, the executive vice president of research and analysis at the New York based trade group Loan Syndication and Trading Association, wrote in an e-mail to Buyouts. “I think people believe there will be more reliance on loan funds, HY funds, etc, in the future. Ultimately, this may make loan prices and loan availability somewhat more volatile, and will likely also have the effect of raising loan spreads and the cost of loans for borrowers.”