Goldman, Morgan Stanley are backstopping riskiest slices of CLOs

GOLDMAN Sachs Group and Morgan Stanley are more and more keen to briefly maintain onto among the riskiest elements of recent collateralized mortgage obligations (CLOs), in a bid to win extra market share within the as soon as once more booming enterprise of serving to companies bundle leveraged loans into bonds.

The Wall Street banks have in current months been selectively providing to underwrite the so-called fairness parts of CLOs as a part of a push to win offers, in keeping with sources with data of the matter. CLOs bundle leveraged loans into slices of various threat and return. The fairness piece, whereas providing probably juicy earnings, is the final to be repaid, usually making it troublesome for companies that run the constructions, often known as collateral managers, to drum up demand.

It is the most recent try by banks to realize an edge within the profitable trade of arranging CLOs. In years previous, they emphasised their potential to supply mortgage provide and guarantee managers the most effective allotments, would provide extra enticing phrases on the credit score traces which can be used to step by step construct a portfolio, and provide to purchase up the most important, most secure slices of the offers.

But as competitors has ramped up and extra banks search to muscle into the fee-rich enterprise of arranging offers, some are going to larger lengths to draw or retain purchasers. The threat with backstopping CLO fairness, in fact, is that if banks can’t shortly discover a purchaser, they are going to be pressured to carry it on their steadiness sheet – incurring vital capital expenses within the course of – or promote at fire-sale costs.

Deutsche Bank, Mizuho Financial Group and Jefferies Financial Group are additionally underwriting CLO fairness, the sources stated, asking to not be named as a result of they don’t seem to be authorised to talk publicly.

“It’s one of the creative techniques we see arrangers deploying to entice managers,” stated James Warbey, a London-based companion at legislation agency Milbank who heads its various investments group. “We’re seeing an increasing number of arrangers prepared to make significant commitments to managers, in some cases long-term commitments, by underwriting equity issuance.”

Representatives for Goldman Sachs, Morgan Stanley and Mizuho declined to remark, whereas Deutsche Bank and Jefferies didn’t reply to requests searching for remark.

Central financial institution charge hikes and fears of an impending recession stored the CLO market within the doldrums for a lot of the previous two years, with indicators of therapeutic solely rising in direction of the tip of 2023.

This 12 months has been marked by a pointy enchancment in sentiment. Key buyers have returned or ramped up exercise, and United States managers are creating new offers at a frenzied tempo – US$30 billion to date, over US$10 billion greater than this time final 12 months, in keeping with information compiled by Bloomberg.

“There’s definitely more demand for CLO equity than we’ve seen in a long time. It’s a decent environment right now for minority equity,” stated Jihan Saeed, a managing director at Permira Credit.

Despite the rise in demand, discovering patrons for CLO fairness, which isn’t really fairness in any respect however fairly extra akin to deeply subordinated debt, stays one of many greatest hurdles collateral managers face when attempting to launch new constructions.

That’s very true for companies that aren’t in a position to depend on captive investor money raised through separate CLO fairness funds, or people who lack established reputations, given any struggles might be felt most closely by the fairness holders.

“There are definitely a few managers on the sidelines that we know want to come and haven’t launched officially,” Saeed stated.

That’s the place the banks are beginning to step in.

Those underwriting CLO fairness (which makes up solely about 10 per cent of any given deal, in comparison with roughly 60 per cent for the most secure AAA slices) are usually providing to backstop about US$10 million, roughly a fifth to 1 / 4 of the entire, in keeping with the sources acquainted. They are focusing on “key clients”, usually managers issuing their first CLOs and trying to construct a franchise.

“It’s still an emerging dynamic,” stated David Kim, head of US leveraged credit score at Polus Capital Management. “What it shows more than anything else is banks wanting to solve for the most difficult part of the capital structure.”

‘Competitive advantage’

For the banks, it offers them a definite “competitive advantage” in securing mandates from CLO managers, in keeping with Kos Vavelidis, a companion at DLA Piper.

“It’s good for everyone. If managers can source more equity, then more CLO deals happen, and then there’s more leveraged loans, which means more money and activity for the economy,” Vavelidis stated.

Of course, market watchers are fast to notice that the transfer shouldn’t be with out threat. Banks have solely lately extricated themselves of tens of billions of US {dollars} of hung buyout loans they underwrote on the peak of the cheap-money period however then struggled to dump.

While the size of CLO fairness underwriting is far smaller, getting caught with it could tie up beneficial steadiness sheet that might be deployed elsewhere, whereas promoting at a steep loss is equally unappealing.

To mitigate the danger, banks are structuring agreements to restrict their draw back. While the charges they cost will not be uniform, usually they’ve come out forward even after promoting the CLO fairness at a reduction, in keeping with sources with data of the conditions.

For Milbank’s Warbey, collateral managers should be cognizant of the disparate funding phrases when contemplating CLO fairness backstops.

“Managers do need to be aware that not all the equity underwrites proliferating are equal,” he stated. “There’s significant variation in how attractive the terms can be.” BLOOMBERG