Global credit funds & CLO's
October 2023 | Issue 258
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October 2023 | Issue 258
Analysis
CLO equity
European CLOs win out against US deals
Poh-Heng Tan
Despite higher interest rates in the US, European CLOs tend to outperform their transatlantic rivals, with the timing of spread compressions and extra resets among the decisive factors
Last month, our analysis explored the performance of US CLOs that were previously reset. We found that they delivered higher distributions than deals which weren’t reset, with the exception of the 2017 and 2018 vintages (Creditflux September 2023 — Do resets help CLOs perform better?). This article expands that analysis to the European market, and compares the performance of US BSL and EU CLO equity tranches.
Non-reset CLO equity tranches
We start by looking at non-reset CLOs from 2017 to 2020. (The exclusion of deals from 2014-2016 in the chart above is due to the preponderance of reset transactions in EU CLOs resulting in an insufficient sample size for non-reset EU deals.)
Table 1 (below) outlines the average annual distributions, net interest margin (NIM) and first distributions across various vintages for non-reset deals in the US and EU. (NIM is defined as the portfolio’s weighted average spread, net of management fees and the weighted average cost of liabilities.)
Average annual distributions since inception by vintage (%)
US CLOs generally enjoy a competitive edge over their EU counterparts in equity distributions, primarily due to the more favourable interest rate environment in the US. Nevertheless, EU CLOs from 2017 and 2018 display notably better NIM and initial distribution metrics than those from the US.
The strong figures from Europe effectively offset the interest rate drawback, as highlighted by the European deals’ robust annual distributions. In contrast, US CLOs issued in 2019 and 2020 surpassed their EU counterparts in terms of average annual distributions, albeit with slightly subdued NIM metrics. It is important to note that the release of par during the refinancing of a select number of deals positively influenced the average annual distribution rates for US CLOs in the 2020 vintage.
“2020 US CLOs were boosted by the release of par in refinancings”
Reset deals: US CLOs versus EU CLOs
Next we turn to reset deals, where we can expand our comparison to earlier vintages, as shown in table 2.
Despite the EU’s lower interest rates, we again observed that EU CLO equity tranches in reset deals exhibited higher median annual distributions than their US counterparts across vintages from 2013 to 2015 and 2017 to 2018. This outperformance can be attributed to better net interest margins on average since inception.
Investigating median deals
All CLOs are distinct, and it would be misleading to try and explain the variations in NIM for an entire vintage. Instead, we will focus more closely on the median deals from 2013 to 2015 as a way to illustrate some of the factors impacting annual distributions.
Chart A (below) depicts the net interest margin trends for median 2013 US BSL and 2013 EU CLO deals. The primary reason for the overall outperformance of the 2013 EU deals was the significantly higher NIM observed between February 2016 and January 2018.
US asset spreads compressed substantially during this period, leading to the underperformance of US CLOs. Conversely, the sharp compression in EU asset spreads began a year later, in March 2017. When examining the leverage ratio, the median US deal was considerably more leveraged at 8.8x, compared to its EU counterpart at 7.0x. However, this was offset by a higher relative quantity of class X tranches.
Chart B (below) illustrates the NIM trends of the median 2014 US BSL and 2014 EU CLOs.
8.8x
Leverage of the median US deal — its EU counterpart was 7.0x leveraged
The US median deal underwent a reset in February 2018, while its EU counterpart experienced resets in April 2017 and March 2020. The rapid compression of US asset spreads, particularly between July 2016 and July 2017, had a significant negative impact on the NIM of the US deal. Conversely, the EU deal benefited from a slower pace of asset spread compression, and its NIM was further boosted by the second reset, which resulted in tighter liabilities and the removal of the single-B tranche.
Chart C (below) illustrates the NIM trends for the median 2015 US BSL and 2015 EU deals.
The NIM metrics for both median deals converged quickly after inception. The 2015 EU CLO deal then underwent a favourable reset in February 2018, which locked in a very tight cost of funding and subsequently boosted its NIM.
Since early 2018, this deal’s collateral-weighted average spread has remained largely stable, even edging higher. In contrast, the US median deal underwent a reset in November 2018 that significantly improved its NIM, but not enough to catch up to its European counterpart. While its NIM has continued to lag behind, its average annual distribution was only slightly lower. This can be attributed to three main factors:
- The absence of a Class X tranche in the US deal.
- A higher leverage ratio of 11.3x for the US deal compared to its EU counterpart’s 9.4x.
- The higher interest rate environment prevalent in the US.
A. Net interest margin trends — 2013 deals
B. Net interest margin trends — 2014 deals
C. Net interest margin trends — 2015 deals
Final equity NAV realisation values
Finally, we examined the final equity NAV realisations that would be required for the upcoming payment date to achieve the standard 12.0% IRR target (see table 3, above).
We again looked at the four individual deals from the reset 2012 to 2015 vintages that had median annual distributions. This analysis assumes a purchase price of 95%. The upcoming distributions scheduled for October 2023 have also been incorporated into these values.
64%
Final equity NAV required by 2014 US deals for them to hit 12% IRR
As the data demonstrates, the median EU CLOs require a lower final equity NAV value to achieve a 12.0% IRR target in all the vintages. This suggests that EU CLOs are less dependent on the final equity NAV value for meeting their IRR objectives compared to their US counterparts.
It’s noteworthy that a portion of these deals still have a significant runway for improvement. As time progresses, the final equity NAV realisation value needed to achieve the target IRR of 12.0% is expected to decrease from its current level.
Methodology
- All data is sourced from CLO Research and Intex.
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