Breakingviews: Fed jump-start leaves CLO buyout motor sputtering

The buyout machine’s engine is sputtering. Collateralised loan obligations set up by asset managers like Blackstone or Credit Suisse are the main buyers of the loans private equity shops often use to fund deals. The lockdown will tip many loans in the $800 billion-plus market into default and sap the appetite for new ones. The Federal Reserve’s attempt to jump-start the market may not help much.

The outlook isn’t pretty. Fitch Ratings expects some 15% of U.S. leveraged loans to default over the next two years. The pain won’t be felt equally by all investors in CLOs, which hoover up loans and package them into tranches of varying risk. Holders of top-rated senior-ranking bonds, typically banks, should be safe. They only take a hit when losses exceed 35%.

That’s bad news for the hedge funds, insurers and other investors who own the riskier junior securities. Once defaults pick up, or if enough of the loans are downgraded to CCC – indicating much higher default risk – CLOs can be forced to cut off payments to junior investors in order to repay senior ones. The share of CCC-rated loans in U.S. CLOs has already trebled since March to 12%, S&P reckons. The prospect of losses has also slowed new CLO issuance.

The Fed is trying to help. The central bank’s $100 billion Term Asset-Backed Securities Loan Facility now accepts CLOs’ highest-rated bonds as collateral. But this won’t make a huge difference because it only accepts deals that aren’t actively managed, and these represent a tiny fraction of the market.

Yet while the Fed’s liquidity injections and backstop announcements are making risky debt more appealing, CLO issuance is hardly about to rev up. Investors are demanding higher returns to own junior bonds, making it uneconomical to issue them. Just $4 billion of new CLOs were sold in April – down roughly 73% from a year ago, according to Citigroup.

As existing vehicles wind down and sales of new CLOs dwindle, appetite for leveraged loans should suffer. Private equity funds should be able to lean on other investors, like bond funds, but borrowing may be more expensive and less plentiful. So even if the virus is finally brought under control, the days of brisk dealmaking could remain in the rear-view mirror.

_____________________________________________________________________

Request a free trial of Breakingviews here