Reed Smith was a proud sponsor of the IMN’s 11th annual Euro CLO Forum in London on 20 March 2024. Below is a summary of the events key takeaways and industry perspectives from the conference.
Opportunity in the European CLO market and lessons from U.S. CLO investing
2024 is expected to be a strong year for new issuance, refinancing and resets in Europe as certain bottlenecks to CLO creation are cleared.
The attractiveness of the current opportunities in CLOs cannot be understated. The U.S. market has seen a fast start to 2024, with issuances to the value of US$20 billion closing in February alone. CLO refis and resets have also experienced a notable uptick as spreads tighten and the market catches up with a more stable fundamental outlook. 2024 is set to challenge 2021 for record issuances.
A word of caution, however: with 2023 being characterized by high interest rates, the cash coverage reserves of underlying borrows has depleted. CLO managers must play a key role in identifying this and transitioning portfolios away from bad credits.
The United States is seeing the development of a broader and more diversified investor base, with pension funds increasingly looking to ETFs as an effective way to gain exposure to a new asset class.
More and more U.S. deals are complying with EU risk retention requirements, resulting in a critical mass of interest across the debt stack.
ESG for CLOs – practices, priorities and perspectives
CLO documentation is evolving to address key ESG considerations and criteria, but more needs to be done to help ESG standardisation and transparency across the market. SFDR/PASI reporting and third-party verification, alongside the active involvement of the rating agencies, will be needed to move the needle as more ESG ratings start to emerge for CLOs. The unenviable task is to balance the need for standardisation with the need to avoid stifling innovation.
CLO managers may face practical, regulatory and contractual difficulties in complying with ESG disclosure obligations.
CLO manager roundtable: an insider view
Interest rates and inflationary pressures remain a concern, with CLO managers needing to keep a watchful eye out for the early warning signs of default. Defaults are expected to sit at around 2.5% to 5% in 2024, but not all defaults are born equal and result in below par recoveries. CLO managers should be afforded the flexibility in the CLO documentation to perform their own analysis, rather than being forced into a knee-jerk reaction.
Performance of the underlying portfolios is holding up and CLO arbitrage is strong. Equity returns are outperforming historical averages and becoming more attractive for third-party investors.
Developments in CLO technology and loan data
New and emerging data and analytics technologies on the CLO scene are aiming to accelerate and improve productivity. Artificial intelligence (AI), machine learning and optimisation technology are starting to have an impact on the market and the review of CLO documentation, but there is no tangible first-mover advantage.
Private credit and middle-market opportunities
The European private credit market represents 27% of the US$1.7 trillion global private credit market. Owing to the rise of direct lending on both sides of the Atlantic, the European market may see MM CLO deals materialise in 2024.
However, issues persist with rating the concentrated underlying assets for MM CLOs, with the high costs of credit estimates being a significant barrier to entry. The adequacy or otherwise of MM loan collateral in Europe and the currency risk associated with building a portfolio of loans in more than one denomination are other notable obstacles, with a lack of diversity resulting in greater subordination and reduced returns for equity investors.
CLO structures and loan documentation
In an ever-changing macro environment and investment landscape, it is crucial that CLO investors and managers adapt to future-proof documentation. Of late, this debate has revolved around the ability of CLO managers to continue investing post-reinvestment period. CCC concentration tests can be an effective way to set parameters around subsequent investing.
CLO documentation is increasingly being structured to protect investors against restructurings, with funds coming from the interest account/advances from the CLO manager rather than being to the detriment of the rated debt.
Client Alert 2024-066
