European CLO 2.

0 Structures Evolve
In Response To Changing Market
Conditions
Primary Credit Analysts:
Sandeep Chana, London (44) 20-7176-3923; sandeep.chana@standardandpoors.com
Aleem I Akhtar, London +44 (0) 207 176 8532; aleem.akhtar@standardandpoors.com
Matthew Jones, London (44) 20-7176-3591; matthew.jones@standardandpoors.com
Table Of Contents
Quarterly Pay CLOs Have New Features To Mitigate Reset Risk
European CLO Portfolios Continue To Include Senior Secured Bonds
Optional Repricing Is Unpopular With CLO Noteholders
Single Currency Transactions Dominate The European CLO Landscape
...However, Multicurrency Transactions Could Become More Popular As
Managers Broaden Their Investor Base
Related Research
STRUCTURED
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European CLO 2.0 Structures Evolve In Response
To Changing Market Conditions
The European leveraged loan collateralized loan obligation (CLO) market continues its revival, building on its
renaissance in 2013. In the year to date, managers have priced 10 transactions for a total issuance volume of 4.3
billion. This is despite the pricing and availability of underlying collateral continuing to be relatively unfavorable,
compared with the U.S. market, for example.
In response to this reemerging market, Standard & Poor's Ratings Services examines some of the evolving structural
features of the new breed of European CLOs issued post-credit crisis ("CLO 2.0"), which are a response to uncertain
collateral conditions and the need for managers to meet equity investors' return expectations. We also consider what
market developments may occur in the remainder of the year and beyond.
Overview
European CLO issuance post-credit crisis has evolved to respond to changing market and regulatory
conditions.
In 2014, we have seen more European CLOs structured with quarterly pay liabilities, rather than traditional
semi-annual pay liabilities.
Some current CLO issuers allow managers to include higher levels of senior secured bonds in their portfolios.
Optional repricing is featuring in fewer transactions, most likely because investors are concerned about early
prepayment risk.
Although single currency transactions dominate the market, multicurrency transactions could become more
popular as managers broaden their investor base.
Quarterly Pay CLOs Have New Features To Mitigate Reset Risk
The structure of more 2014 European CLOs includes quarterly pay liabilities, instead of traditional semi-annual pay
liabilities. We understand that this is an attempt by arrangers and/or collateral managers to bolster equity returns and
help CLO managers handle basis risk. However, given the embedded reset optionality or the ability of the assets to
reset their interest period in European leveraged loans, CLOs with quarterly pay liabilities are potentially exposed to
reset or liquidity risk: The CLO notes are scheduled to pay interest quarterly, while the underlying assets may reset
their interest period from quarterly to semi-annual, potentially exposing the transaction structure to reset risk. If a
significant proportion of assets reset to paying interest semi-annually, the structure may not receive sufficient interest
proceeds from the underlying assets to pay timely quarterly interest on the rated notes.
In order to mitigate the effects of these timing mismatches, most quarterly pay CLOs issued in Europe over the past
year have relied on a liquidity facility. By contrast, some structures have opted for an interest-smoothing account and
embedded triggers to switch the payment frequency on the rated notes to semi-annual under certain conditions.
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Interest-smoothing accounts effectively retain a portion of the interest proceeds received on assets that pay interest
less frequently than quarterly in order to pay quarterly interest on the notes. However, a payment frequency switch
supplements the interest-smoothing account if a significant proportion of assets resets to paying interest semi-annually
in any single quarter.
A payment frequency switch event, evaluated on the determination date (a cut-off date where the agent determines
interest and principal proceeds received since the last determination date) before each quarterly payment date,
permanently switches the payment frequency on the rated notes to semi-annual if:
The proportion of assets that have reset to a semi-annual basis over that quarter exceeds a threshold defined by the
transaction documents;
The ratio of (a) interest and principal proceeds scheduled for the issuer over the immediately following quarter and
(b) scheduled interest amounts due on the nondeferrable notes at the end of that quarter is less than a defined
threshold; and
The sum of interest and principal proceeds scheduled for the issuer to receive and accrue but not paid in the
following quarter exceeds the scheduled interest amounts due on the nondeferrable notes at the end of that quarter.
In the first condition, if the proportion of assets that reset to a semi-annual basis is less than the defined threshold, the
switch does not occur. When we consider the effect of these triggers in our rating analysis, we would analyze on a
transaction-by-transaction basis whether the portfolio interest proceeds would be sufficient to pay the scheduled
interest amounts due on the nondeferrable notes during any given quarter. This is if the proportion of assets that reset
to a semi-annual basis in the preceding quarter is less than the defined threshold.
In the second condition, the transaction documents define a threshold, which typically has a buffer on the scheduled
interest due on the nondeferrable notes. Given the forward-looking nature of this condition, we believe a buffer is
important because the ratio is based on scheduled proceeds and therefore does not consider potential defaults or
additional assets resetting over the projected period. We would determine the adequacy of a buffer on a
transaction-by-transaction basis.
The third condition ensures that if the sum of scheduled proceeds that are due and accrued proceeds on assets that
pay semi-annually over the projected quarter is not sufficient to pay the scheduled interest on the nondeferrable notes
at the end of the quarter, the switch will not occur. In other words, if portfolio proceeds are insufficient to pay the
scheduled interest on the nondeferrable notes entirely due to poor asset performance, the switch will not occur and
could trigger an event of default.
European CLO Portfolios Continue To Include Senior Secured Bonds
Some current CLO issuers allow managers to include senior secured bonds in their portfolios. In our view, this is the
result of two factors. First, in contrast to the U.S. market, there has been a lack of supply in the primary leveraged loan
market. Second, leveraged loan borrowers are turning to capital markets for other funding sources in response to
traditional lenderssuch as banksbeing unwilling or unable to provide financing as they shrink their balance sheets.
In our view, collateral managers in Europe generally find it more challenging to source collateral than their U.S.
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counterparts. In all the transactions that we rated in 2013, the collateral manager had six months to fully "ramp up" or
increase the portfolio to the target size defined in the transaction documents (see "European CLO Managers Steer A
Steady Course With Portfolio Ramp-Ups," published on Feb. 17, 2014). This is greater than the three months we
generally see for U.S. transactions, although not very different from pre-crisis European CLO transactions. In our
ratings analysis, we consider the risk of negative carry (where assets are less than liabilities) for the ramp-up period.
In recent CLO 2.0 transactions, we've started to see issuers include more senior secured bonds in their portfolios. In
CLO 1.0 transactions issued before the financial crisis, we generally saw a minimum proportion of 90% senior secured
loans and a maximum allowance of 5% for fixed-rate assets. For example, the Cairn CLO III B.V. and ALME Loan
Funding 2013-1 Ltd. portfolios both have a minimum of 90% senior secured loans, although ALME allows a maximum
of 10% fixed-rate assets. By contrast, Dryden XXVII Euro CLO 2013 B.V.'s portfolio has a minimum proportion of 75%
senior secured loans or bonds, as well as a minimum concentration of fixed-rate assets of 20% and a maximum
concentration of 40% without any additional hedging. The transaction is partially-hedged because fixed-rate tranches
make up 30% of the capital structure. This trend of issuing fixed-rate notes and allowing a large amount of fixed-rate
assets continued with the Carlyle Global Market Strategies Euro CLO 2013-1 and 2013-2 transactions and Goldentree
Credit Opportunities European CLO 2013-1 B.V. Fixed-rate tranches comprise 13%-17.5% of these transactions'
capital structures and they have a maximum amount of fixed-rate assets ranging between 20% and 40%. In December
2013, Pramerica issued Dryden 29 Euro CLO 2013 B.V., which allows 30% of fixed-rate assets.
A further consideration for managers is the impact of the Volcker rulea key piece of the 2010 Dodd-Frank financial
reform law to protect the U.S. financial system from riskon potential U.S. investors. In an effort to boost the size of
the 'AAA' CLO investor base, collateral managers may increasingly seek to tap U.S. buyers. However, the need for
some U.S. investors to comply with the Volcker rule means that some European CLO transactions could be structured
with zero bond buckets, similar to some U.S. CLOs. That said, with European managers facing a reducing asset supply,
while we may see some transactions structured without bonds, we don't expect this to become a common feature in
European CLOs this year.
Eliminating bonds may not be the only way for CLO issuers to comply with the Volcker rule, however. We have
started to see CLO issuers make structural attempts to avoid transactions falling within the rule through transaction
documentation language, which limits trading to certain activities, as well as addressing noteholders' ability to
participate in the removal or selection of the collateral manager. We believe that this is an area that will evolve as
market participants gain more clarity on the rule from regulators and transaction counsels.
Optional Repricing Is Unpopular With CLO Noteholders
As with U.S. CLOs, during the early European CLO issuance revival in 2013, a new feature was the issuer's ability to
reprice its liabilities by issuing lower-spread tranches if the prevailing market spreads for liabilities fall. This feature
applies to any class of notes and the subordinated noteholders can generally request it on any payment date after the
period where the notes cannot be redeemed (the "non-call period"). The repricing feature offers a quicker and cheaper
alternative to refinancing. In the U.S., we've seen a limited number of repricings of early U.S. CLO 2.0 transactions to
take advantage of lower spreads. For example, Oak Hill Advisors' 2011-vintage Intrepid Leveraged Loan Fund saw the
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spread on its 'AAA' tranche reduced to 92 basis points (bps) from 150 bps.
In the European transactions that we've rated, optional repricing can only take place subject to various conditions.
Among others, these include Standard & Poor's being notified by the CLO issuer of the repricing and there being
sufficient excess interest proceeds for the issuer to make all payments according to the transaction's documented
interest priority of payments.
However, during 2013 and more recently, we have observed that these provisions are being structured in fewer
transactions, most likely because investors are concerned about early prepayment risk. For example, one principal
concern for senior noteholders would be determining the weighted-average life and return of their investments if the
issuer decides to exercise an optional repricing.
Single Currency Transactions Dominate The European CLO Landscape
Except for Goldentree Credit Opportunities European CLO 2013-1 and Hayfin Ruby II Luxembourg S.C.A., recent
European CLOs have all been single-currency transactions, with all the liabilities structured as fully funded
euro-denominated tranches. Furthermore, all the transactions allow the collateral manager to purchase
non-euro-denominated obligations provided that the foreign exchange risk is fully hedgedin other words, the issuer
enters into a currency swap with a suitably rated swap counterparty once the manager acquires the assets. To account
for the difficulty that collateral managers may have in entering into a swap for a primary asset, some transactions have
a maximum allowance of 5% of unhedged obligations, subject to a number of conditions. These conditions include that
the CLO manager's purchase of the asset is on the primary market and the asset is denominated in liquid currencies
(such as British pound sterling, U.S. dollars, Danish krone, Norwegian krone, Swedish krona, and Swiss francs). In
addition, there is a limit of six months on the maximum period that the obligation can be unhedged, and the
transaction documents stipulate that the transaction achieves a par maintenance condition.
...However, Multicurrency Transactions Could Become More Popular As
Managers Broaden Their Investor Base
We believe CLO transaction structures will continue to evolve in response to market developments and meeting equity
and debt investors' expected returns. Depending on both senior noteholders' appetite and equity investors' target
returns, we could see more multicurrency transactions as managers seek to broaden their investor base and include
non-euro assets in collateral pools, thereby alleviating some pressure on the sourcing of assets.
In our view, market participants are still interested in executing asset swap transactions, as we have observed through
form-approved swap documentation supporting 'AAA' ratings. That said, CLO issuers may consider more
cost-effective initiatives such as issuing senior non-euro-denominated notes to match-fund non-euro-denominated
assets. In turn, this may attract a more diverse senior investor base.
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Related Research
European CLO Performance Index Report Q1 2014: Collateral Credit Quality Remains Stable With Upgrades
Outnumbering Downgrades By Three-To-One, April 24, 2014
European CLO Managers Steer A Steady Course With Portfolio Ramp-Ups, Feb. 17, 2014
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Additional Contact:
Structured Finance Europe; StructuredFinanceEurope@standardandpoors.com
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