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Hybrid CLO strategy emerges in Europe as investors seek yield and liquidity
by Kathryn Gaw & Shant Fabricatorian
For months, the European CLO market has been abuzz with talk of a new kind of CLO vehicle — a never-before-seen hybrid combining private credit and leveraged loans in one package.
Until recently, these hybrid vehicles have existed only in the hypothetical, hinted at in interviews and posited during panel discussions at industry conferences as the ‘next big thing’ in the European CLO market. They promised to breathe life into the continent’s muted private credit CLO sector that to date had amassed just five deals in total.
But during the mid-August lull, Sona Asset Management issued the first hybrid CLO, titled Aclai CLO I. The deal, valued at just over EUR 400m, was made up of a mix of 70% of broadly syndicated leveraged loans (BSL) and 30% private credit loans.
“One of the real attractions of [hybrid deals] to us as a strategy is that it plays into a fundamental ideology that we have around the fluidity and the convergence of public and private markets, and the ability to play seamlessly across the two,” said Jacob Walton, co-head of European CLOs at Sona.
“It really reflects the changing dynamics that we’ve seen across leveraged finance over the last few years. The blurring of the lines between public and private credit issue is moving between both markets.”
Europe’s CLO market experiments with a new credit compound
Investor demand driver
Investor demand has been instrumental in creating this new class of hybrid CLOs, according to market participants. Frustrated by stubbornly tight spreads and a challenging arb environment, investors have been working with CLO managers to build
new products that can offer attractive yields alongside a certain amount of liquidity, underpinned by high-quality collateral and actively managed by industry veterans.
Sona’s new CLO was structured as a multi-currency deal and priced its euro-denominated triple As at 140bps over Euribor. That compares to an average triple A spread for standard new-issue European BSL CLOs in August of 126bps over the reference rate, according to Creditflux data.
By comparison, the two European private credit CLO transactions to print in recent months — Golub’s new issue and Barings’ reset — cleared their euro-denominated triple A notes at 150bps and 145bps over Euribor, respectively.
We are wary about going into higher yielding, less liquid assets in this part of the credit cycle
Laila Kollmorgen
Global head of CLO tranche investments
MetLife Investment Management
On the Sona deal, two of the mezzanine tranches pay interest semi-annually, while the remainder of the capital structure follows the BSL CLO convention of quarterly payments.
“I think this solution was created to make some of these tranches investable to certain investors that have certain requirements,” said Gabriele Gramazio, a managing director in KBRA’s structured credit ratings group that rated the Sona deal. “These transactions are complex, they are more bespoke, so there is more back and forth between investors and the rating agencies.”
Indeed, Aclai is Latin for ‘flexible’, and this CLO has been designed to adapt to the wider macroeconomic environment. Sona has the ability to change the composition split between its BSL and private credit holdings.
“As attractive private opportunities come along, then that ratio will shift,” said Walton. “But this is intentionally designed with a structure that allows us to be flexible and go where the best opportunities are.”
Blackstone issue plan
Sona has now set the industry standard, but an upcoming Blackstone issue will tweak this blueprint. According to a source familiar, Blackstone will print its first hybrid CLO by October. It will have a higher private credit allocation than the Sona deal on day one and will target companies with an EBITDA of EUR 100m or above. It will be structured as an all-euro transaction.
Several investors told Creditflux that, having now seen the details of the first hybrid print, they would be interested in backing future iterations of these deals. But others have expressed more caution.
Laila Kollmorgen, global head of CLO tranche investments at MetLife Investment Management, said that she is concerned about the consequences of manager drift as a response to the challenging arb environment.
“Recent hybrid CLO issuance in Europe was notable for the illiquid portion of the portfolio,” Kollmorgen said. “We’re really taking a look at how managers are making that arb work and you can only do it by going into higher yielding, less liquid assets, and that’s always something we tend to be quite wary about in this part of the credit cycle.”
Nevertheless, investor interest is robust enough to have multiple CLO managers exploring hybrid issuances of their own. KBRA’s Gramazio told Creditflux that since the Sona pricing he has fielded a number of calls from managers wanting to learn more about the process of structuring a similar deal.
“We’re already working on some other deals,” he said. “That really shows that the growth of this market is continuing — it’s resilient. We’re going to see new managers coming to the market and then managers repeating issuance over the coming months.”
Some market participants have even predicted that hybrid CLOs could overtake the paltry EUR 2bn European private credit CLO market — though, given the deep private credit CLO market in the US, the technology may not have much application across the pond.
Appealing new market
Hybrid deals solve many of purely private credit CLOs’ problems — they can ramp up quickly, deliver competitive yields, and offer some liquidity via the BSL safety blanket. Add in bespoke documentation and investors are discovering an appealing new market that could comfortably co-exist alongside the traditional BSL CLO market and PC CLOs.
Sona’s market-first product took an enormous amount of work and time to come to fruition. According to the manager, the period from idea inception to the final print was around a year, and ratings agency KBRA told Creditflux the deal took approximately eight months to structure.
“We began speaking to institutional investors around different ways that they could access the best of what Sona has to offer,” said Sona’s Walton. “Working with [arranger] Goldman Sachs, we came to the realisation that a CLO structure would allow us to connect with a deeper pool of investors around what we call an ‘all-credit’ CLO strategy.”
And the market should expect to see more. Walton told Creditflux that the firm very much intends to be a repeat issuer of hybrid deals, with no plans to do a private-credit only deal.
Meanwhile, Blackstone is continuing to work on its first purely private credit European CLO, with a view to pricing some time next year.
