Ending the club culture in European CLOs

To say that the European market for leveraged loan CLOs is opaque would be an understatement. Little more than 30% of European leveraged buyout loans are rated, which means that information on the vast majority of the collateral backing European lev loan CLOs is held in very few hands, typically CLO managers and their private equity sponsors.

But this could be set to change as new proposals from Standard & Poor’s may combine with a considerably more risk-averse investor base to force managers and private equity sponsors to become more open.

“It’s not clear that anyone is taking a lead – we want to get the debate going,” said Paul Drake, S&P’s head of European leveraged finance and recovery. “We are at a crossroads between a club market and moving to a more open and transparent capital market.”

S&P put forward six proposals that aim to hugely increase the transparency of CLO loan pools: placing restrictions on the provision of credit estimates for newly originated CLOs; conducting additional analysis on certain underlying assets that are not publicly rated; expanding the sphere of its recovery ratings; assigning ratings throughout the capital structure of rated issuers; providing the option to choose between recovery ratings and average class level recovery assumptions; and finally, requiring arrangers of leveraged synthetic structures to provide more extensive information.

It is an effort that many on the buyside, long frustrated by the dearth of decent information on collateral pools, will welcome whole-heartedly. “Asymmetrical distribution of information leads to insider trading. Insider trading is not allowed in the stock markets and equally it should not be allowed in the loan market,” said Alfred Haslinger, a partner at fund manager Alegra Capital.

And certainly any unequal flow of information naturally leads to market distortions which could hit CLO investors. “If an unrated deal starts to turn sour, what incentive is there for the manager to communicate this to his investors?,” a banking source asked.

Until now, PE players did not need to get LBO loans rated but, thanks to the credit crunch, investors now call the shots and PE shops may no longer have any choice. “So far there has been no need to get loans publicly rated as banks could get the CLOs placed, but the market has changed,” said a CDO syndicate banker at a major European house.

“Banks are likely to make it a condition that loans over, say, €750m are rated, otherwise many CLO investors won’t buy the deal. If they don’t get ratings, their terms of financing will be hit – in a worst case I’m not even sure they will be able to raise debt [in the CLO market].”

Those who think that the PE firms will eventually agree to get the majority of LBO loans rated point to the example of the US, where as much as 80% of LBOs are publicly rated. The private equity firms involved in such deals are, after all, much the same on both sides of the Atlantic.

It is also very much in the rating agencies’ interest for private equity firms to get more LBOs rated – not just because it will earn them more fees, but also because it will improve the accuracy of their CLO ratings, which currently rely on so-called credit estimates for the majority of the portfolios backing such deals. Credit estimates are a rating agencies best guess of the credit quality of a particular asset. They are inherently based on less than perfect information.

“The agencies are being asked to provide these quick and dirty back-of-the-envelope credit estimates with limited access to information, yet they still have to put their head on the block,” said one structured finance specialist.