The whys and wherefores of European CDOs

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The whys and wherefores of European CDOs

• Faith Bartlett
• Global Head of Marketing Structuring and CDO
  Portfolio Manager
• Alcentra Limited

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This presentation has been prepared by Alcentra
Limited (Alcentra). Alcentra has compiled the
Information contained herein from public sources
which it believes to be accurate. However, no
representation is made as to the accuracy or
completeness of those sources or this information
and no responsibility is assumed for any error or
omission which may have been made in the
compilation of this information. Any views
reflected herein are those of Alcentra and are
subject to change without notice. The
Information is provided for reference purposes
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does not provide services to Private Customers
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What is a CDO?

• A Collateralised Debt Obligation (CDO) fund is
  a pool of assets held by a bankruptcy remote
  special purpose vehicle, which finances itself by
  issuing rated bonds
• The underlying pool of assets can be actively
  managed or static
• CDOs can be used to take assets off a banks
  balance sheet (Balance Sheet CDOs) or bought in
  the market for the purpose of yielding groups of
  investors a return (Arbitrage CDOs)
• The underlying assets in the portfolio can be
  bonds, loans, CDS, ABS (including other CDOs),
  private equity
• The amount of leverage on each fund depends on
  the underlying collateral e..g loans 10-11x
  levered, HYBs 8-9x levered.

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Growth of CDO market

• CDOs originated in the US in late 1980s as a way
  to manage banks balance sheet for regulatory
  capital relief
• With the Savings and Loans crisis in the early
  1990s and bank consolidation in the US, banks
  started to pull back from the leveraged loan
  asset class and managed CDOs started to take up
  some of the slack
• Bank loans were bought by the CDO asset managers
  who then started to require structural
  adjustments to better suit their vehicles
• Institutional investors in the US, of which the
  majority are CDOs, now buy almost 60 of a loan
  on primary issuance

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US Primary Market for Leveraged Loans by Investor
Type (Source SP/PMD)
Institutional Investors
Domestic Banks
Foreign Banks
Finance Cos
Securities Firms
Excludes hybrids as well as all left and right
agent commitments (including administrative,
syndication and documentation agent as well as
arranger)
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US Primary Market for Institutional Loans by
Investor TypeExcludes the 900 million Berkshire
Hathaway commitment for CenterPointSource
SP/PMD
CLO/CDO/Synthetic CLO
High-Yield Funds, Hedge Funds Distressed Funds
Prime Funds
Insurance companies
To provide a more realistic view of institutional
buying habits in todays market, we add to the
CLO tally the institutional commitments held by
the arranger at close. For tax purposes, of
course, CLOs tend to participate as primary
assignees and therefore are often left off the
at close allocation list. Starting in 2002,
we have made a better effort to track hedge funds
and other investors in this analysis. As a
result, we only provide a single point for this
year.
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European CDO market

• NatWest was the first European bank to complete a
  balance sheet CDO with ROSE, now most banks have
  a CLO programme.
• The first European arbitrage CDO was ICG with
  Eurocredit in mid-1999, this had underlying
  collateral of senior loans, mezz and HYBs
• At least 27 European arbitrage CDOs predominantly
  based on sub-investment grade credit have been
  issued to date
• The size of these funds typically range from 300
  1,000m and most are managed by specialist asset
  managers
• Institutional investors, mainly CDOs, now account
  for c 20 of primary loan issuance

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Primary Market for European Leveraged Loans by
Investor Type Source SP/PMD
European Banks
Institutional Investors
Non-European Banks
Securities Firms
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Primary Market for 1999 2002 European Leveraged
Loans by Investor Type(Excludes U.S. Dollar
Tranches) Source SP/PMD
Institutional Investors 20.2 (note the rounding
error)
Institutional Investors 13.9
Based on 76 allocation lists
Based on 82 allocation lists
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Typical CDO Structure

• Jubilee II, closed June 2002, underlying
  collateral senior loans (min 80) and mezz (max
  20)
• Class A Senior AAA 303.5m
• Class AX Junior AAA 36m
• Class B A 53.3m
• Class C BBB 31.25m
• Class D BB 6.55m
• Equity N/R 40.5m

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CDO Investors

• The CDO issues rated debt which allows it to have
  an average cost of funds lower than the spread on
  the underlying collateral
• The excess spread above the average cost of funds
  and after asset management fees is distributed to
  the equity holders.
• A performing CDO should return c. 15 p.a. to
  equity holders
• The asset managers are usually required to hold
  20-30 of the equity in the CDO to ensure
  alignment of interests
• CDO equity is typically bought by pension funds,
  insurance companies and some banks as part of
  their alternative asset allocation
• For many investors this a method of getting
  access to asset classes, like leveraged loans,
  which they dont have the ability to manage or
  source internally

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Overview of Structural features of CDOs

• Issue long dated bullet paper, 12-13 years
• Are rated by 1 or more agencies
• Debt tranches range from AAA down to BBB or BB
• To date in Europe the majority have been issued
  in Euros and any other currency exposure has to
  be fully hedged out
• Underlying focused on loans and mezz (needs to
  have cash element)
• Have limits on amount invested in single obligors
• Have buckets for countries and industries
• Are sensitive to rating of underlying assets and
  to recovery rates on these assets, as well as
  spread
• Able to trade assets

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Impact of CDOs on Loan Structures

• The structure of each CDO is slightly different
  but there are some common themes across CDOs of
  what they look for in loans
• Longer dated paper to match their liability
  structure, hence focus on TLB and TLC e.g.
  Panzani - institutions only took TLC
• Bullet tranches CDOs are financed by bullet
  debt and it is difficult to re-invest small
  amortisations/prepayments in new assets. Any
  cash that CDOs carry affects their performance as
  they are carrying a cost of funds c 100-120bps
• Minimum spread levels need to hold assets that
  yield more than their cost of funds and also
  cover costs and provide a return on equity.
  Therefore, CDOs typically have a yield hurdle
  rate of c. 250bps

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Impact of CDOs on Loan Structures

• Currency majority of CDOs are funded in Euros
  and therefore prefer Euro assets. They can
  usually take or assets but these need to be
  fully hedged, which costs 75-100bps off the
  spread each year
• Rated assets most CDOs need to have each asset
  they own rated by the agencies that rate the CDO.
  If the loan is not publicly rated then each CDO
  will have to pay for shadow ratings. These are
  based on the agencies desk-top review and
  therefore tend to be lower than public ratings.
• Most CDOs are targeting assets with at least a B
  rating, most loans will need to be B/BB- rated.
• The rating agencies also assign a recovery rate
  to each asset based on security and jurisdiction
• Country CDOs are often limited to the countries
  in which they can have exposure e.g. no emerging
  markets, limits on US for European deals. The
  country is also determined by the rating agencies.

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Impact of CDOs on Loan Structures

• Industry CDOs are required to have a certain
  level of diversity. This is measured by the
  rating agencies (Moodys diversity score,
  SP/Fitch industry buckets) who determine which
  industry the asset is in. This is usually based
  on the location of the majority of
  employees/EBITDA/Assets.
• Minimum hold amounts CDOs aim to have very
  diversified portfolios say 70 names and therefore
  need the ability to hold relatively small pieces
• Transferability CDOs like the ability to sell
  assets (for credit and portfolio reasons) and
  transfer assets between funds without needing the
  delay of borrower consent or the cost of transfer
  fees (esp for intra-fund trades)

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Major European CDO managers

• AIB (Tara Hill, Clare Island)
• Alcentra (Blue Eagle, Jubilee I and II)
• AXA (Concerto I and II, Ecureil)
• Duke Street Capital Debt Management (Duchess I)
• Harbourmaster (Harbourmaster I, II and III)
• ICG (Eurocredit I and II, Promus I and II)
• ING Capital (Copernicus)
• Prudential (Life Fund and Leopard)

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Characteristics of European CDO asset managers

• Most are non-bank e.g pension funds, life
  companies, private equity-owned
• Mainly staffed by experienced long-standing
  professionals in the European leveraged loan
  market
• Smaller teams, 5-10 people
• Shorter lines of communication quicker
  decisions
• Very credit and relative value focused, less
  relationship driven
• Ability to commit significant orders 5 managers
  can commit orders in the 30-50m range