GOLDMAN Sachs Group and Morgan Stanley are increasingly willing to temporarily hold onto some of the riskiest parts of new collateralized loan obligations (CLOs), in a bid to win more market share in the once again booming business of helping firms package leveraged loans into bonds.
The Wall Street banks have in recent months been selectively offering to underwrite the so-called equity portions of CLOs as part of a push to win deals, according to sources with knowledge of the matter. CLOs bundle leveraged loans into slices of varying risk and return. The equity piece, while offering potentially juicy profits, is the last to be repaid, often making it difficult for firms that run the structures, known as collateral managers, to drum up demand.
It is the latest attempt by banks to gain an edge in the lucrative industry of arranging CLOs. In years past, they emphasised their ability to source loan supply and ensure managers the best allotments, would offer more attractive terms on the credit lines that are used to gradually build a portfolio, and offer to buy up the largest, safest slices of the deals.
But as competition has ramped up and more banks seek to muscle into the fee-rich business of arranging deals, some are going to greater lengths to attract or retain clients. The risk with backstopping CLO equity, of course, is that if banks cannot quickly find a buyer, they will be forced to hold it on their balance sheet – incurring significant capital charges in the process – or sell at fire-sale prices.
Deutsche Bank, Mizuho Financial Group and Jefferies Financial Group are also underwriting CLO equity, the sources said, asking not to be named because they are not authorised to speak publicly.
“It’s one of the creative techniques we see arrangers deploying to entice managers,” said James Warbey, a London-based partner at law firm Milbank who heads its alternative investments group. “We’re seeing an increasing number of arrangers prepared to make significant commitments to managers, in some cases long-term commitments, by underwriting equity issuance.”
Representatives for Goldman Sachs, Morgan Stanley and Mizuho declined to comment, while Deutsche Bank and Jefferies did not respond to requests seeking comment.
Central bank rate hikes and fears of an impending recession kept the CLO market in the doldrums for much of the past two years, with signs of healing only emerging towards the end of 2023.
This year has been marked by a sharp improvement in sentiment. Key investors have returned or ramped up activity, and United States managers are creating new deals at a frenzied pace – US$30 billion so far, over US$10 billion more than this time last year, according to data compiled by Bloomberg.
“There’s definitely more demand for CLO equity than we’ve seen in a long time. It’s a decent environment right now for minority equity,” said Jihan Saeed, a managing director at Permira Credit.
Despite the increase in demand, finding buyers for CLO equity, which is not actually equity at all but rather more akin to deeply subordinated debt, remains one of the biggest hurdles collateral managers face when trying to launch new structures.
That’s especially true for firms that are not able to rely on captive investor cash raised via separate CLO equity funds, or those that lack established reputations, given any struggles will be felt most heavily by the equity holders.
“There are definitely a few managers on the sidelines that we know want to come and haven’t launched officially,” Saeed said.
That’s where the banks are starting to step in.
Those underwriting CLO equity (which makes up only about 10 per cent of any given deal, compared to roughly 60 per cent for the safest AAA slices) are typically offering to backstop about US$10 million, roughly a fifth to a quarter of the total, according to the sources familiar. They’re targeting “key clients”, often managers issuing their first CLOs and looking to build a franchise.
“It’s still an emerging dynamic,” said David Kim, head of US leveraged credit at Polus Capital Management. “What it shows more than anything else is banks wanting to solve for the most difficult part of the capital structure.”
‘Competitive advantage’
For the banks, it provides them a distinct “competitive advantage” in securing mandates from CLO managers, according to Kos Vavelidis, a partner at DLA Piper.
“It’s good for everyone. If managers can source more equity, then more CLO deals happen, and then there’s more leveraged loans, which means more money and activity for the economy,” Vavelidis said.
Of course, market watchers are quick to note that the move is not without risk. Banks have only recently extricated themselves of tens of billions of US dollars of hung buyout loans they underwrote at the peak of the cheap-money era but then struggled to offload.
While the scale of CLO equity underwriting is much smaller, getting stuck with it would tie up valuable balance sheet that could be deployed elsewhere, while selling at a steep loss is equally unappealing.
To mitigate the risk, banks are structuring agreements to limit their downside. While the fees they charge are not uniform, typically they have come out ahead even after selling the CLO equity at a discount, according to sources with knowledge of the situations.
For Milbank’s Warbey, collateral managers need to be cognizant of the disparate funding terms when considering CLO equity backstops.
“Managers do need to be aware that not all the equity underwrites proliferating are equal,” he said. “There’s significant variation in how attractive the terms can be.” BLOOMBERG
