December 9, 2016 / 4:44 PM / 8 months ago

Apollo, KKR bring CLO reset trend to Europe

5 Min Read

* Managers rethink old deals as senior spreads narrow

* Resets increasingly attractive but equity control key

* Added pressure in 2017, as pricy deals come up for call

By Mariana Ionova

LONDON, Dec 9 (IFR) - Managers looking to capitalise on rapidly narrowing spreads are bringing CLO resets to Europe for the first time, but only a select few will be able to use this method to boost the economics of older trades.

The European CLO market has seen a dramatic tightening in senior tranches this year, as big-ticket Japanese, European and US buyers have driven spreads inside 100bp - their tightest level since the financial crisis.

Aside from triggering a wave of new issuance, the rally has also prompted CLO managers to revisit existing deals printed in 2013 and 2014, when levels were as wide as 145bp. A slew of CLOs have refinanced their upper tranches in the last few weeks, with at least another six slated to come to market.

Apollo pushed the market to a new frontier last week when it printed the first European CLO reset, a type of refinancing that reprices the whole transaction. KKR also followed with its own reset trade this week, clearing seniors at a fresh low of 91bp.

CLO resets are already popular in the US, with a wave seen this year as managers vie to ensure tranches of their deals don't run afoul of risk retention rules coming into effect later this month.

Several managers are looking at using this tool in Europe next year, with some noting it is more attractive than refinancing because it allows the deal to be extended. This means they can lock in attractive spreads for longer, effectively issuing a new deal with old portfolio collateral.

"I think everyone wants to take the opportunity," said one investor. "I can't imagine, if you can cut the cost of liabilities, why you wouldn't be doing it. Anyone that can do it, will do it."

Equity Hurdle

Resets can only be triggered by the equity holders in the deal, however, which makes them less accessible to managers who have broadly syndicated the junior risk in their trades.

Many CLO managers could find their hands tied, unable to trigger a reset without majority control of the equity risk in these trades despite how attractive the exercise is.

While the benefit to equity holders is clear, several managers said it is difficult to generate consensus in deals where the equity is held by six or seven different investors.

"You have to go to all of them and say 'I want you to call the deal and these are the economics that we think will come out the other side'," said a CLO manager.

"But if you've got the flexibility, it's an absolute no-brainer."

Both Apollo and KKR were the primary equity holders in the trades they reset, according to sources.

Opportunity Knocks

The rewards are potentially huge for the select few managers that can corral the equity holders into a reset.

CLO resets are backed by existing collateral - effectively reducing the ramp-up risk - which has become particularly attractive due to a persistent lack of leveraged loan supply.

The lack of net new issuance has been a major problem for managers this year. The dearth of new collateral has slowed down CLO formation for some, while others have taken more of gamble by printing deals that are barely ramped.

Taking this ramp-up risk out of the equation is also a boon to buyers of CLO liabilities.

"It's essentially like a new CLO but with more seasoned portfolio that you're probably already pretty comfortable with," said a second investor.

"Whereas a new issue, which is likely going to come in at around the same spread, but will have a lot more uncertainty on the ramp-up and the portfolio."

While refinancing allows managers to capture tighter spreads on a particular tranche, resetting encompasses the whole CLO and effectively resets the clock on its maturity and reinvestment window.

Since resets don't allow managers to pick which bonds to refinance, they expose them to potentially paying up on riskier notes. But even so, the benefits are too good to pass up, market participants argued.

Shedding some 20-30bp off the all-important senior tranche can translate into roughly 200bp increase on the equity returns, sources estimated. In Apollo's trade, one source pegged the uptick in equity returns even higher, to roughly 260bp.

"The Triple As are driving the structure," said a second CLO manager. "It's worth it, even if you pay a bit more on the Single Bs."

And if the rally in CLOs endures into next year, it could become even more tempting to try to reset particularly costly trades printed in 2015.

"These are very expensive liabilities," said the first CLO manager. "And I wouldn't be surprised if the more aggressive equity investors start trying to buy control to do the resets. Because it looks very, very attractive." (Reporting by Mariana Ionova, editing by Robert Smith and Alex Chambers)

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