CDO/CLO sales slowing down, LBOs becoming more difficult?

KKR, Homeowners Face Funding Drain as CDO Sales Slow (Update2)
By Neil Unmack and Kabir Chibber

July 24 (Bloomberg) -- The Wall Street money-machine known as collateralized debt obligations is grinding to a halt, imperiling $8.6 billion in annual underwriting fees and reducing credit for everyone from buyout king Henry Kravis to homeowners.

Sales of the securities -- used to pool bonds, loans and their derivatives into new debt -- dwindled to $9.1 billion in the U.S. this month from $42 billion in all of June, analysts at New York-based JPMorgan Chase & Co. said in a report yesterday. The market, which was ``virtually shut'' earlier this month, is showing ``signs of life,'' the bank said.

Investors are shunning CDOs after the near-collapse of two hedge funds run by Bear Stearns Cos. that owned the securities. Standard & Poor's downgraded bonds from 75 CDOs as mortgages to people with poor credit defaulted at record rates. Concern about losses on home loans are rattling investors across the credit spectrum.

``We're walking on thin ice,'' said Alexander Baskov, a fund manager who helps oversee $25 billion of high-yield debt for Pictet Asset Management SA in Geneva. ``People are trying to find value and the right price and right now nobody knows what it is. Pretty much everyone is in the dark.''

Investors are demanding yields 15 percentage points higher than benchmark rates to compensate for the risk of losses on some of the lower investment-grade rated parts of CDOs, up from 5.5 percentage points in February, according to data compiled by JPMorgan.
Deals Pulled

The shakeout is leading firms from Maxim Capital Management in New York to Paris-based Axa Investment Managers to delay or scrap planned CDO sales.

Maxim began buying mortgage bonds for a new CDO after completing its second deal in March. Chief Investment Officer Doug Jones in New York said he slowed the purchases, having acquired only a third of the assets planned, partly because the bank underwriting the deal grew concerned it could lose money as volatility increased. He declined to name the underwriter.

``We don't want to get too far along and create something that's not sellable,'' said Jones, who manages $4 billion of CDOs.

Banks are becoming more skittish about providing credit lines, called warehouse financing, managers use to buy assets that go into CDOs in the months before the securities are issued, said James Finkel, chief executive officer of Dynamic Credit Partners. The New York-based company manages $7 billion in 10 CDOs and a hedge fund.

New Warehouses
``There are just very few, if any, bankers opening new warehouses,'' said Finkel.

Axa, which manages 4.7 billion euros ($6.5 billion) of high- yield loans, abandoned plans to sell a collateralized loan obligation, a type of CDO that's mostly backed by corporate loans. High-yield, or junk, securities are rated below Baa3 by Moody's Investors Service and BBB- at S&P.

``CLOs are not that appropriate an instrument to offer investors given the current credit cycle,'' said Nathalie Savey, Axa's head of leveraged finance in Paris. ``There is so much uncertainty regarding spreads.''

The slowdown comes as private equity firms such as Kravis' Kohlberg Kravis Roberts & Co. and Blackstone Group LP, both based in New York, need to borrow at least $300 billion in coming months to finance acquisitions, according to Baring Asset Management in London.
Buyout groups rely on CDOs for 60 percent of the loans to finance U.S. acquisitions, according to JPMorgan.

More Bailouts?
``CLOs have been instrumental in funding the surge in LBOs and pushing down loan spreads,'' said Gunnar Stangl, the Frankfurt-based head of index and bond strategy at Dresdner Kleinwort, a unit of Allianz SE, Europe's biggest insurer. ``They provide constant institutional demand for leveraged loans.''

CDOs also financed growth in lending to home owners with poor credit or high debt, known as subprime mortgages. About $50 billion of home loan debt rated BBB and BBB- went into CDOs in 2006, almost the same as the total sales of mortgage backed securities with identical ratings, Citigroup Inc. analysts estimated in a report in April.

``For the last 18 months the majority of subprime ABS was bought by another securitization vehicle that issued further bonds,'' the Citigroup analysts said.

The five biggest managers of U.S. CDOs include New York-based Bear Stearns and Zurich-based Credit Suisse Group, according to S&P. Their annual fees range between 0.04 percentage points to 0.75 percentage points of the amount of underlying collateral, depending on the type of the CDO and its performance.

Merrill Leads
New York-based Merrill Lynch & Co., the world's third-largest investment bank by market value, is the biggest underwriter of CDOs, selling $55 billion last year, said a report this month by Charlotte, North Carolina-based Bank of America Corp., which cited Dealogic Holdings Plc data.

Citigroup of New York is the biggest underwriter of CLOs, managing $16.6 billion of sales, and the second-largest bank underwriter of CDOs. Bank of America Securities LLC, Wachovia Corp. of Charlotte and Goldman Sachs Group Inc. in New York are the next-biggest CDO underwriters.

On top of management fees, banks underwriting CDO sales charge underwriting fees as high as 1.75 percent, compared with an average of 0.4 percent for selling regular investment-grade bonds, according to data compiled by Bloomberg. Banks collected $8.6 billion underwriting CDOs last year, according to a report last month by JPMorgan analyst Kian Abouhossein in London. They took in another $3.8 billion from related trading, investing and other activities, the report said.

Drexel Creation
Collateralized debt obligations were created in 1987 by bankers at Drexel Burnham Lambert Inc. Sales of the securities surged to $503 billion last year from $84 billion five years ago, according to Morgan Stanley. Sales reached $251 billion in the first quarter, the Bank for International Settlements in Basel said last month.

CDOs pool assets ranging from investment-grade asset-backed debt to high-yield loans, and repackage them into bonds. The securities are split into portions with ratings as high as AAA to no ratings, known as the equity portion.

Any losses on the underlying collateral are first assigned to the equity portion of a CDO. These are mainly bought by hedge funds, banks, pension funds and managers of the CDOs, according to a JPMorgan report last week. In return for the higher risk, buyers received annual returns as high as 98 percent, according to a report this month by Morgan Stanley, citing Moody's data. The median return for CLOs was 8.55 percent, based on securities that have been liquidated, Morgan Stanley said.

Steering Clear
At the opposite end, insurers, banks and other CDOs tend to buy the less risky portions with AAA credit ratings that pay 23 basis points to 150 basis points more than benchmark interbank lending rates, according to Morgan Stanley. Governments selling AAA bonds typically pay interest at the interbank rate or less.

Buyers of the least risky portion of a CDO underwritten by Credit Suisse this month were offered annual interest 22 basis points above benchmark rates. The CDO, called Avoca CLO VIII Ltd., managed by Avoca Capital in Dublin, pooled 508 million euros of high-yield loans. About 69 percent of the deal was rated AAA. A basis point is 0.01 percentage point.

Investors are steering clear of new CDOs following the Bear Stearns debacle. Ralph Cioffi, the 22-year Bear Stearns veteran who managed the two money-losing hedge funds, tried to minimize risk by buying the top-rated portions of CDOs.

`Unprecedented Declines'
The funds were wiped out by ``unprecedented declines'' in the value of AA and AAA rated securities, Bear Stearns wrote to clients last week. The losses triggered a selloff across credit markets because of concerns that a fire sale of CDOs would mean losses for holders of even the least risky debt and that fewer sales of new CDOs would reduce demand for bonds and loans.

``If the experts are getting it wrong that says something,'' said Kevin Lyne-Smith, who helps oversee $100 billion as managing director at Julius Baer Holding AG's private banking division in Zurich.

Even with the widening in CDO spreads, the funding cost remains at around the average over the past five years for deals backed by leveraged loans. Defaults by speculative-grade companies slid to a 25-year low of 1.12 percent worldwide in June, Standard & Poor's said.
Weathering Disruptions
CDOs were booming until the Bear Stearns funds collapsed. New funded deals are up 31 percent this year to $315 billion, according to JPMorgan.

Sales of U.S. funded CDOs, which include only CDOs sold to investors as bonds, were $6.1 billion in the U.S. this month, down from $36.7 billion for all of June, according to JPMorgan.

Deals are still being completed. London-based Elgin Capital, a fund manager co-founded by Michael Clancy, who formerly helped run Merrill Lynch's credit trading operation, sold 400 million euros of CLOs in July. BNP Paribas SA, based in Paris, underwrote the sale, offering yields for the BB-rated portion at 425 basis points over interbank rates, less than the spread of 480 basis points on similarly rated securities it sold in May 2006.

The CDO market has weathered disruptions in the past. In 2002, bond defaults by telecommunications companies including WorldCom Inc., now Ashburn, Virginia-based MCI Inc., caused junk- bond CDO sales to drop by 19 percent from the previous year as rating companies downgraded the securities. In 2003, CDO sales increased 18 percent to $99 billion, according to Morgan Stanley data.
Better Terms

M&G Plc, the fund-management arm of London-based insurer Prudential Plc, is considering a new CLO fund when the market stabilizes.

``We don't know when it will come back, but it should,'' said Dagmar Kent Kershaw, who helps manage 6.5 billion euros of CDOs at M&G. ``We believe now is a good time to get into the market, as some of these assets are cheaper than they have been for a while and offer excess value to the savvy investor.''

Frankfurt-based Deutsche Bank AG is leading banks attempting to sell 9 billion pounds ($18.5 billion) of loans to finance KKR's 11.1 billion-pound takeover of U.K. pharmacy chain Alliance Boots Plc with billionaire Stefano Pessina. KKR partner Dominic Murphy in London declined to comment.

``Before, you could structure an aggressive loan, and knew that a CLO would buy it,'' says Miguel Ramos Fuentenebro, managing partner at Washington Square Investment Management in London. ``Now you can't be so sure.''

Cerberus Capital Management LP, based in New York, increased the interest margins on $12 billion of loans to finance its buyout of Chrysler in Auburn Hills, Michigan, to 300 basis points over Libor for five years on the biggest portion of the debt, up from the 275 basis points it initially proposed.

``It's dangerous to call the end of a market, but there are concerns,'' said Jeroen Van den Broek, credit strategist at ING Groep NV in Amsterdam. ``Private equity firms are going to have to pay up. The cost of debt is significantly higher than it was two years ago.''

Introduction to Collateralized Loan Obligation

Risky Collateralized Loan Obligations Spark Boom
From BizDevDigest http://www.bizdevdigest.com/ialt/bdd/issue.aspx?id=106

By now everyone knows that an estimated $1 trillion in global liquidity is mostly fueling the recent LBO boom. Question is what caused it? In part, the rise of so-called collateralized loans obligations (CLO), and the overall collateralized debt obligation (CDO) industry, have provided institutional investors funds for their illiquid fixed-income assets. The special purpose vehicles (SPV, usually sponsored by banks) that manage CLOs arrange their purchased loans into a portfolio made up of varying tranches. The SPV then issues unrated securities that are securitized by the SPV’s assets, which are the loan payments the CLO manager maintains. CLO managers covet the loans’ high yield while investors can choose a tranch that fits their risk profile. In addition to mutual funds and hedge funds, CLOs bought a record $157 billion of leveraged loans in the first quarter of 2007. The volume of CLOs has nearly doubled to a record $97 billion in 2006 from $53 billion in the previous year.

Typically, CLOs have been the domain of investment banks. The banks set up SPVs for the purposes of selling portions of large portfolios of commercial loans (or in some cases, the credit risk associated with such loans) directly into the international capital markets, which would offer banks a means of achieving a broad range of financial objectives, including the reduction of regulatory capital requirements, off-balance sheet accounting treatment, access to an efficient funding source for lending or other activities, and increased liquidity. Bank CLOs would contain a mix of bonds and secured and unsecured commercial loans. Private equity CLOs that first surfaced in 2001 when Capital Dynamics and Deutsche Bank launched Prime Edge (the first ever CDO to be collateralized by private equity investments) contain loans that are tranched into four classes: senior, mezzanine, junior risk, and equity.

“CDOs of private equity would broaden the available investor base and allow portfolio investors a greater opportunity to invest in private equity,” wrote J. Paul Forrester, an attorney with Mayer, Brown, Rowe & Maw, about private equity CDOs. Private equity CDOs also add liquidity, transparency and discipline to this market. Huge demand from CLOs has contributed to low spreads and generally easy credit conditions to the benefit of private equity outfits.

Steven J. Adelkoff, a partner with Kirkpatrick & Lockhart Preston Gates Ellis LLP who practices structured finance and global capital markets, said CLO deals that involve assets held by private equity firms include mostly mezzanine funds or firms that lend second-lien loans. Sponsors of such CLOs (i.e. the private equity firm) may be required to invest in a mezzanine or equity tranche of the CLO to effectively sell the CLO in the market. By using a CLO structure, private equity firms can monetize their portfolios, providing more room in their warehouse lines to originate or purchase additional portfolio loans.

Mr. Adelkoff said he has seen a small number of PE firms sponsoring CLO deals, and he hypothesizes that the reason for the low number is that most PE shops with debt in their portfolios are making loans at the lower end of the credit curve (i.e. B+, BB- credits) . To get an optimal capital structure in a CLO, a significant portion of the underlying debt instruments are most often rated at BBB+ or above. A PE firm wishing to execute a CLO with a portfolio of its debt may need to look for a JV partner or other solution to combine the PE firm’s lower credit rated assets with higher grade paper.

Mr. Adelkoff said he does see room and the potential for PE firms to invest in CLOs, particularly in the lower tranches of the capital structure. He would recommend for interested private equity players to do the following:

• To either buy, hold, or trade an equity note or a BB, BB-, or a B+ rated mezzanine notes.
• To play in the credit-default obligation or credit default swap arena by selling protection for certain pieces in the CLO structure.
• To consider investments in the equity portion of the CLO structure.

Still, the risk-inherent in CLOs may persuade some to stay away from CLO deals. Business Week reported CLO managers encourage companies to take on more floating-rate debt, which cause problems like those now being felt by homeowners who took out adjustable-rate mortgages a few years back. CLOs also encourage companies to put up more of their assets as collateral for lenders, which during hard times could hinder their financial flexibility. At a recent CDO conference in NYC where arrangers, managers and investors discussed how the mortgage market’s sub-prime woes could be linked to the corporate world. They feared bad loans would mean an increase in warehouse risks and a stagnation or possibly even a halt in mezzanine ABS (asset-backed securities) CDO issuance this year.

The CLO market is largely driven by the rating agencies, Mr. Adelkoff notes, because of how managers are able to infuse their product with credit enhancements, which boost the ratings of the lower tranches in the CLO. Investment managers have been able to corral billions of dollars from insurance companies, pension funds, and ultrawealthy individuals around the world who crave AAA-rated investments and nothing less – certainly not loans to fund LBOs. Standard & Poor’s Leveraged Loan and Commentary calculated that about 60% of buyout loans were packaged into CLOs.

Patrick D’agostino, VP of investments at Boenning & Scattergood Inc., said he would not even go near corporate CLOs because of his clients’ investment profile and inherent risk. A lot of the buyout loans shuffled into the CLOs are financing deals that often come with risky business reorganizations. With loans from the same big deals spread throughout CLOs, the chance of LBO defaults is the number-one risk factor to the CLO-fueled boom. “Some people are just chasing yield, which is dangerous,” Mr. D’agostino said. Dangerous, but not surprising. Such prospects have not scared off private equity firms and hedge funds from forming their own CLO/SPVs.

Private equity firms and hedge fund managers are not looking to fund their own deals with their CLO startups, but to use the financial tool as an additional revenue stream. Kohlberg Kravis Roberts & Co., the big LBO house, two and one-half years ago started its own CLO, KKR Financial Corp., which it took public last year with a chief executive recruited from Wells Fargo & Co. Competing buyout giants Bain, The Blackstone Group, and Carlyle Group also have affiliates managing CLOs. Experts said such alternative asset managers can see firsthand the immense capacity of investors to finance loans that in the past were held mostly by banks.

Just a little over a month ago, hedge fund Epirus Capital planned to start parking investments in a series of collateralized debt obligations that managers would eventually issue. The vehicle is set up to invest heavily in CDO equity pieces, and elsewhere in the capital structure of CDOs that either issue credit default swaps or are backed by such instruments. It may also act as a counterparty in swap transactions. HedgeWorld.com reported that hedge funds’ expansion in the CDO and CLO sector is explained through the observation that the loan market has lived up to expectations over the past decade by generating a low alpha (but even lower beta) product. Thus, loans rewarded investors with superior risk-adjusted returns.

Mr. D’agostino and Mr. Adelkoff strongly urge CLO investors to do their due diligence before throwing money into these capital structures, which can range usually from 100 to 200 loans. The two men and other studies suggested:

• When investing in equity or subordinated debt of a CLO look at the legal structure. Investors should see if the loan’s underlying assets are conveyed to the SPV.
• Check to see if the SPV has properly pledged the loans for the benefit of the note holder.
• Look to see if there is a waterfall mechanism and understand how the flow of funds will fall.
• What credit enhancements are being used to boost the CLO rating.
• What kind of financial covenants are in the loan documents.
• Learn who is managing the portfolio and make sure that covenants like concentration levels, geographic risk, allocation of the underlying assets from the ratings perspective is being met.
• Review the tax structure, especially if it’s an offshore investor where one would want to know if he or she is going to get taxed in the U.S.
• Check to see what underlying assets are in the loan pool, who is managing them, what the concentration risk is, what the borrower’s risk is, etc.
• Ensure there is tight underwriting.
• What risk tolerance threshold the investor possesses.
• Review the bank’s (or PE or hedge fund) historical portfolio performance, origination and collection policies and practices.

Call for greater transparency in leveraged loans

Call for greater openness in leveraged loans
By Stacy-Marie Ishmael

(FT June 13) Investors should demand more transparency and accountability from managers of collateralised loan obligations, according to a new report from Standard & Poor’s.

The rating agency said the the rising popularity of so-called covenant-lite loans imposed significant risks on investors in the opaque CLO market.

Demand for CLOs, complex financial instruments which repackage portfolios of loans, has surged recently. The products can offer investors better returns for a given rating than traditional fixed-income assets.

In the first quarter of 2007, global covenant-lite loan volume reached $48bn, compared with $24bn recorded for the whole of last year. The use of these loans to fund buy-outs is already well-established in the US and becoming more accepted in Europe.

But S&P said the absence of the traditional covenants that give creditors early warnings of financial problems diminished recovery prospects for such loans.

“Cumulative credit risk to lenders and players in the risk transfer chain is building as covenant strength is evaporating,” S&P said in its report. The agency said it was adjusting its CLO rating criteria to reflect the increased risk.

Abundant liquidity and the disproportionate power of borrowers, arrangers, and financial sponsors have allowed a growing segment of high-risk companies to issue covenant-lite loans, S&P said. Many of the loans are held in CLOs.

“We suggest that investors ask managers to disclose their cov-lite holdings in their investor letters or reports, and demand more traditional ‘cov-strong’ rather than ‘cov-weak’ protection,” S&P said.

Managers must also be held accountable if they extend credit to borrowers demanding weaker covenants. “We encourage investors to focus in now more than ever on a CLO manager’s ability to differentiate among debt structures, covenant protections, and asset coverage in their asset selection process,” S&P said.

“We feel we should raise awareness before the next cycle turn,” S&P said