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Analysis CLOs
Reset focus shifts to pre-COVID deals
by Shant Fabricatorian, Lisa Lee & Poh-Heng Tan
As spreads tighten, managers are looking to reset CLOs that priced before the onset of the COVID pandemic — even if this slightly increases the deals’ weighted average cost of capital
It seemed unlikely, if not impossible, mere months ago, but such has been the narrowing of triple A spreads over the past quarter that European CLO managers find themselves focusing on their back catalogues, and considering which pre-COVID deals may be ripe for a reset or refinancing.
In recent weeks, credit specialist Alcentra paved the way by printing resets of two 2019-vintage European CLOs. These caught the market’s attention, since with one exception (King Street Capital Management’s short-dated reset of Rockford Tower Europe CLO 2018-1 in March), they marked the first reworkings this year of European transactions outside the 2022 and 2023 vintages.
1: European CLO weighted average cost of debt by vintage (bps)*
* excludes CLOs reset this year Source for all data: CLO-i, CLO Research, Intex
Deals priced over those vintages are noted for their high weighted average cost of capital (WACC), so the rapid tightening of spreads has given managers many viable candidates for resets and refinancings.
According to Ariadna Stefanescu, co-head of Permira Credit, there has been a rapid change in market sentiment about the viability of deals dating back to 2019 and prior. “Everyone was expecting the late 2022 and 2023 vintages to come back to market, but no-one was really talking about anything older,” she said. “If you look at the cost of capital, the WACC at the moment in Europe is around 200bps over Euribor. If it continues to fall towards the 180-190bps range, more 2018 and 2019 deals become viable.”
190
bps
Predicted level of WACC for additional older deal resets to work
On the face of it, Alcentra’s decision to undertake its two resets may still appear puzzling. While triple A spreads had certainly tightened markedly over the first half of this year, the market remains some way from the level that allowed Alcentra’s Jubilee CLO 2019-XXIII to print its triple A coupons at 90bps over Euribor five years ago. Both Alcentra’s resets, in fact, widened spreads on their triple As — and by a substantial 42bps in the case of the first deal.
But according to the manager, the deals made sense for investors across the structures. “Despite the increase in headline WACC, these transactions displayed a number of favourable factors, including a significant amount of par having been built into both CLOs over time, which meant they could be reset and upsized without a need for new equity, an X-note or payment deferral,” a spokesperson said.
If the cost of capital continues to fall, more deals which are amortising will be reset
Ariadna Stefanescu
Co-head
Permira Credit
“Investors also benefited from the ability to reoptimise the portfolios, resulting in more favourable WARF and triple C metrics. Furthermore, given the amortisation schedules, it was likely that cash arbitrage would compress. With current structures, it has been possible to ramp portfolios with attractive arbitrage and improved money multiples and IRRs.”
Similar thinking is underway at other managers. As Creditflux went to press, Onex had begun marketing a reset of its OCP Euro CLO 2017-2, while Oaktree was understood to be considering potential refinancings of Arbour CLO V and VI, dating from 2018 and 2019 respectively.
According to Rebecca Mun, director and lead analyst at S&P Global Ratings, tightening in the mezz could improve the viability of such deals. “Whilst the original triple A coupon looks low, it is possible that tightening lower down the stack means that the new WACC, although wider, still makes economic sense, particularly for the older vintage deals that have come out of their reinvestment period and are starting to amortise.”
Less flexible deals may be reset first
The candidates for a reset include a variety of 2019-vintage deals that have a WACC over 175 (see table, above), including a number that originally priced with triple A spreads tighter than 100bps over Euribor. Managers with less flexible reinvestment-period language may also prove keener to reset deals, along with those that find their deals amortising rapidly.
One investor told Creditflux that even if the WACC increased on some of these prospective deals, the arbitrage remained reasonable. He added that equity holders benefited from an enormous increase in optionality after a reset, along with a further four-odd years of continued cashflow.
Yet even as the market has warmed up to the possibility of a wave of such resets and refis, conditions have shifted to mean such deals could face more headwinds than managers expected.
As August began, global markets took a turn, with the Bank of Japan surprising investors by raising interest rates. That spiked a global equity market sell-off, and raised fears about a US slowdown.
For CLO managers and investors, the effect has been that continued tightening is by no means a given. JP Morgan recently raised its end-of-year triple A spread target for both European and US CLOs to 150bps, up from 130, citing rising US recession risks, higher volatility, and the apparent unwinding of carry trades.
* includes adjustment for fixed-rate tranches
According to JP Morgan’s CLO research team, if worries over US growth result in interest rate cuts, that presents an outlook that “is not conducive to demand for floating-rate CLO products — with or without the much-vaunted technical of amortisation”. Indeed, the bank’s researchers, Rishad Ahluwalia and Noelle Cooke, even foresee a 175-200bps risk case should the economy suffer a hard landing.
Still, while investors may take a pause, there remains plenty of dry powder to deploy. Net triple A issuance remains down for the year, and a huge wave of principal is coming their way from amortisations and called deals.
According to Permira’s Stefanescu, managers will continue to keep an eye on potential restructuring opportunities, given that the market is not far off the levels needed for a range of older resets to make sense. “I think it only takes another 15-20bps of tightening,” she said.
