Download Europe`s bank loan funds – where now?

Citi OpenInvestorsm presents:
Europe’s bank loan funds – where now?
Are new opportunities opening up for bank loan funds? With banks continuing to shrink their balance sheets,
credit managers are keen to fill the growing gap in the market take up some of the slack. The market still faces
a number of challenges.
Europe’s bank loan market is at a point of inflexion. In
contrast to the situation in the US, no new collateralised
loan obligations (CLOs) are being launched in Europe,
while past issues are rapidly moving towards maturity. In
August last year, Standard & Poor’s warned that more
than 98% of all European CLOs would reach the ‘static’
state – where they are prevented from reinvesting in new
loans – by the end of 2014. With banks also shrinking their
balance sheets, that poses a major question-mark over
the market’s ability to refinance an estimated €250 billion
of leveraged loans due to mature in the period up to 2017.
To many observers, this heralds a major opportunity for
credit managers. ‘All the evidence suggests bank loan
funds are set to play a bigger role than in the past’, says
John Reidy, Director, Alternative Investment Services,
Citi Transaction Services - a specialist in the bank loan
sector with long experience of servicing both direct
lending funds and credit managers launching hybrid fund
or note issuance programmes to invest in liquid bank
loans and high yield debt.
Many certainly have a strong case to make to investors.
As an asset class, leveraged loans have performed well.
Annual returns have averaged 6% over the past nine
years, compared with just 1.4% for equities. Strong
performance has continued into 2012 as investors have
made an aggressive push for yield.
At the time of writing, the S&P European Leveraged Loan
Index (ELLI) had returned 5.93% for the first half of 2012
(29 December 2011 – 30 June 2012) – up 3.1% for the same
period the year before (2.83% between 30 December 2010
and 30 June 2011) .
The regulatory challenge
Despite that performance, investment in bank loans in
Europe is largely limited to institutional investors. UCITS
funds can hold CLOs, which qualify as transferable
securities, but they cannot hold bank loans directly. This
contrasts with the situation in the US where retail mutual
funds can buy loans and there are opportunities to place
loans with large retail accounts.
The EU’s regulatory approach – and in particular the
requirement that issuers retain ‘skin in the game’ – is
another bone of contention. In the US, last year’s proposals
by federal agencies to impose a requirement on collateral
managers of CLOs to retain a 5% credit risk are still being
debated. Final rules are not expected until next year. For
CLOs, any risk retention rule would then become effective
two years later.
In Europe, Article 122a of the EU’s Capital Requirements
Directive goes beyond the requirements of the US
Dodd-Frank Act in imposing onerous capital charges on
banks investing in CLOs if the originators, sponsors or
original lenders have not retained a 5% economic interest
in the issue. This has proved a major deterrent to European
banks looking to participate in new issues of CLOs and
complicated their marketing to institutional investors.
The US market also has its challenges. Much hangs on the
final shape of the Volcker Rule, which will limit banks in
engaging in proprietary trading and retaining interests in
hedge funds and private equity funds. If the restrictions on
bank sponsorship and ownership were to apply to CLOs, it
would undermine their construction and operation. Market
participants have been lobbying for exemption for
securitisation vehicles.
Europe and US go separate ways
For all those uncertainties, the US market in CLOs is
humming while its European counterpart remains closed.
According to data provider S&P Capital IQ LCD, the first
quarter of this year saw a jump in US CLO issuance from
$1.22 billion to $5.83 billion. April 2012 then saw a further
upsurge in activity, taking the total for the year to over $10
billion by the end of the month. That compares with a total
of $12.3 billion for the whole of 2011. Over the three months
to end-April 2012, the volume of CLO issuance in the US hit
its highest level since late 2007, shortly before the bottom
fell out of the market.
The roster of issuers features a host of asset managers.
Several deals were expanded in size to meet demand. In a
landmark move in April, ICE Canyon, the Los Angeles-based
emerging markets and credit investor, issued a $600m CLO
made up of US dollar-denominated bank loans to emerging
markets companies. Brought by investment bank Jefferies,
this was the first such deal since 2007.
In the past year, thousands of older CLO classes that had
been downgraded by the ratings agencies were upgraded
again. Evidence suggests that investor appetite has
returned for a wide variety of manager offerings. AAA
spreads have also seen further compression, to a little
more than 130 basis points over Libor. That compares with
an average 225 bps 18 months ago (and 25 bps at the
height of the market in 2007). Market participants report
that there are new equity buyers around and the hedge
funds are back in. For many, the present surge in activity is
all about exploiting a window that the Volcker rule could
slam shut next year.
Opportunities in the wider corporate space
‘While the CLO market remains stagnant in Europe,
opportunities for credit managers to enter the wider
corporate lending market are increasing, although not at
the rate some would like’ says Catherine Brady, Managing
Director, EMEA Head of Fund and Hedge Fund Services at
Citi Transaction Services. Much depends on the willingness
of banks to sell off more of their leveraged loans and give
credit managers access to their small and medium-sized
enterprise (SME) clients.
half the financing. They are Alcentra, Ares, Cairn Capital,
Haymarket Financial, M&G Investment Management, Palio
Capital Partners and Pricoa Capital.
Some banks are certainly ready to grasp the nettle. At least
two of Europe’s bigger names have been linked with moves
to farm out a percentage of their SME loans to specialised
loan funds. Whether the banks and the funds can agree on
the level of fees the banks would charge for bundling up
the loans and providing credit assessments remains to be
seen. ‘Direct access to the SME borrowers is seen as vital if
credit managers are to take on these loans – something
that is likely to restrict involvement to the biggest and best
resourced funds,’ says Brady.
Ironically, moves of this kind could open credit funds up to
the accusation they are part of the so-called ‘shadow
banking’ system. In November 2010, the G20 mandated the
Financial Stability Board to come up with recommendations
for strengthening oversight of the shadow banking system,
but there is continuing debate over what actually
constitutes a shadow bank.
In the UK, the government is keen to get bank loan funds
engaged in a new scheme to boost lending to SMEs. The
Business Finance Partnership (BFP), due to launch later
this year, is designed to provide an initial £700m of loans to
small and medium-sized UK companies with turnover of up
to £500m. It is loosely based on the M&G UK Companies
Funding Fund, which has commitments of close on £1.5
billion and has so far loaned £830m.
Seven funds have been short-listed to partner the
government in the new scheme and are expected to raise
Six ways to bolster Europe’s bank loan market
Broadening and deepening the market in loans requires
action on several fronts:
Deeper liquidity: This is urgently needed if Europe’s CLO
market is to revive. The US is a more mature capital market
with deeper liquidity. As such, it has obvious attractions for
European issuers – despite the swap costs for borrowers of
US dollar loans serviced by predominantly euro cash flows.
The bank loan market is especially illiquid. Traders say it can
take several days to work a trade in the majority of loans.
Tighter spreads: Spreads in bank loans are significantly
wider than in the bond markets, at two to three
percentage points.
In a recent paper, the Alternative Investment Management
Association (AIMA) argued forcefully that credit hedge
funds (which account for somewhere between a quarter
and a third of global hedge fund assets) were in no way
shadow banks. Andrew Baker, AIMA CEO, says: ‘Credit
hedge funds – and hedge funds in general – do not operate
in the shadows. Managers are extensively regulated, are
subject to reporting requirements and do not engage in
any significant sense in credit, liquidity or maturity
transformation, so their activity is not ‘bank-like’. Credit
hedge funds do not belong in the same category as banks,
let alone ‘shadow banks’.’
Faster settlement: While US bank loans tend to settle
within a reasonable timeframe (T+7 is not unusual),
European loans can take anything from 20 to 60 days.
Lower transfer fees: Transfer fees vary but one bank
prominent in the market charges €3,000 per transaction.
This also impacts liquidity.
Standardisation: Pricing is standardised in the US, but not
in Europe. Standardised pricing around LIBOR would be a
helpful move, say credit managers.
A consistent line from the regulators: The impact of Solvency
II may be helpful in driving demand from insurers. However,
each insurance company has to seek approval from its own
regulator. Different messages appear to be coming back.
New vehicles, new ideas
Citi a leader in bank loan fund servicing
In the past year, two fund management groups have
launched listed funds to invest in the asset class.
Neuberger Berman raised a total of $694m in two offerings
in 2011 for a Guernsey-based closed-ended fund to invest
mainly in floating rate senior secured loans. The fund, the
NB Floating Rate Income Fund, is listed on the London
Stock Exchange. Alcentra took a similar route in raising
£80m for its European Floating Rate Income Fund, which
also listed on the London Stock Exchange. The fund is
investing in a mix of leveraged loans and high yield bonds.
Babson Capital Management came close to launching its
own fund in October, but deferred the issue because of
conditions in the loan markets.
With a 30-strong dedicated loan team, Citi services more than
$82 billion of loan assets across 70 portfolios, maintaining
more than 4,200 loan facilities. ‘We are an industry leader
from a scale, product and service perspective,’ says John
Reidy: ‘Funds need a service provider with European
structuring and financing expertise. They also need hybrid
fund accounting and private equity partnership accounting
expertise and a depth of middle office servicing expertise. We
bring state-of-the-art bank loan and high yield debt
technology and reporting skills to the party – and our
complex pricing group can support valuations.’
More recently, AnaCap announced it had closed its new
Credit Opportunities Fund II after raising a targeted
£350m inside six months. The fund will invest in
performing, semi-performing or non-performing
consumer and SME debt in Europe. AnaCap’s success
suggests there is mounting appetite for credit funds
among institutional investors.
The question is whether this is the start of something
bigger. John Reidy says Citi is talking to a number of clients
that would have managed CLOs and are now considering
fund-type structures: ‘Some are looking to invest in a pool
of syndicated loans, while others are looking at club loans
or bilateral loans. New types of vehicle are emerging –
open-ended, closed-ended, managed accounts – and many
will be complex multi-tiered structures spanning a common
asset pool. As structures become more complex, so more
operational horsepower is needed.’
With banks continuing to retrench and the CLO market in
Europe effectively closed, the bank loan fund universe
looks set for a major expansion in the coming years. Citi is
ready to play its part in helping clients to seize the
opportunities on offer.
For more information contact:
John Reidy
t: +44 (20) 7508 0220
e: [email protected]
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