EUROPEAN CLO MARKET ANALYSIS

(Q1 2014)

A DETAILED ANALYSIS OF THE EUROPEAN CLO MARKET IN Q1 2014, PROVIDED BY EUROMONEY SEMINARS AND PEARL DIVER CAPITAL

© 2014 Euromoney Seminars Ltd. All rights reserved.

Introduction

Written by Tom Preselo, Senior Seminar Manager at Euromoney Seminars

2013 saw the European CLO marketreopen with a bang. Deal volumessurged from two deals in 2012 to over 20 issuances.

There is market optimism that thisyear will be even bigger with moredeal flow. Q1 saw 7 EUR deals for €3 billion close and March saw thelargest issuance volume since thefinancial crisis.

Driving this trend is recognitionamongst the central banks andregulators that securitised debt will play a key role on the road toglobal economic recovery. The CLOmarket and securitisation has beenidentified as a critical source of creditto SMEs and midmarket companies in the current credit drought, andcontinues to be a core funding tool for corporate financing activities and leveraged loan placement.

All signs are pointing towards the nextstage of the markets developmentand CLO deal fundamentals look setto remain aligned for 2014.

Leveraged loan bankers remain bullishfor the year ahead with a brighteroutlook for collateral supply andprimary loan pricing. Issuers seem tobe coping with regulatory pressures,whilst deal arbitrage and economicscontinue to stack up with CLO spreadsshowing a trend of tightening further.Appetite remains among the investorcommunity keen to gain access toEuropean corporate credit withattractive relative returns againstother asset classes.

In the document, Indranil (Neil) Basu,Managing Partner and CEO at Pearl Diver Capital, will provide more in-depth analysis of the marketdynamics. He is upbeat about theyear ahead, detailing recent activitiesin the US and European primary andsecondary CLO markets.

© 2014 Euromoney Seminars Ltd. All rights reserved.

Growth in European loan markets CLO markets gather momentumLoan markets in the US in Q1’2014 witnessed a drop in refinancing rates, growth of new issue loan supplyand a decline in the rate of inflows into loan retailfunds. M&A and LBO activity in the opening quarterhit the highest level since 2007 at $102bn, refinancingfell 14.4% compared to Q1’2013 and re-pricings inMarch slowed to a four month low. New issue volumespushed the S&P LCD LLI to a record $710bn as M&Aactivity increased. Q1 also saw an increase in 2nd lien issuance, up 130% year to date to $8bn with anaverage yield to maturity of 9.0%. The trend of cov-liteissuance remains high and is likely to continue.Amend to extend activity picked up in Q1’2014 with$22.2bn of volume, up from $11.0bn in Q1’2013. Loan markets in Europe have seen new issue volumesmoving higher and this is set to continue with a healthy pipeline of primary loans. In Q1’2014, €13.7bn of primary loans was issued marking anincrease from Q4’2013 (€12.3bn). The pipeline should however ensure that the sequential growth in new issue continues into Q2. There are a further 13 transactions with potentially over €17bn of loans to follow in the next quarter.

The primary and secondary CLO markets had a veryactive Q1 2014. After a slow start in January, global CLOissuance picked up speed considerably and reached $ 31 billion over 62 deals (55 US CLOs for $ 26.94 billionand 7 EUR deals for € 3.0 billion) in Q1 with March seeingthe largest issuance volume since the financial crisis.Current average weekly issuance is around $ 2.65 billion.Regulatory uncertainty around the Volcker Rule andimpending effect of Dodd-Frank have contributed tokeeping CLO AAA spreads at levels elevated from whatmany would consider fair value. However, overall, CLOinvestments, especially in CLO Equity, continued toprovide attractive risk adjusted returns far surpassingthat of most other asset classes. The benign defaultenvironment in the underlying leveraged loans helpsprovide strong stable cash flows to investors. Currentlythe most attractive relative value is provided by Equitytranches in 1.0 CLOs along with AAA and Equity tranchesof 2.0 CLOs. Going forward the CLO market is expectedto gather momentum with a very large proportion ofoutstanding 1.0 CLOs starting to amortise, offsettingthe new issue volume to a large extent, keeping netsupply of CLO bonds negative to slightly positive.

About Indranil (Neil) BasuIndranil (Neil) Basu has more than 15-years’ experience in European Securitised Products,ABS & Structured Finance. Prior to founding Pearl Diver Capital, he served in variety of seniorroles, most recently as Managing Director and European Head of Structured Products atinstitutions such as Nomura Securities and Wachovia Securities (now Wells Fargo) in London.

He has led a variety of securitisation transactions in asset classes ranging from consumerloans, mortgages, emerging market future flow assets, to sports event receivables, leveraged loans & high yield, ABS, private equity and hedge fund portfolios.

He is a graduate in Electronics Engineering from the Indian Institute of Technology (IIT) and holds an MBA from the University of North Carolina, USA.

© 2014 Euromoney Seminars Ltd. All rights reserved.

Monthly CLO Issuance Volumes

Leveraged Loan Issuance Volumes

The following market dynamics observed during Q1 2014 are expected to set the pace for the rest of 2014.

• Softening in Loan Prices: Since late January whenloan prices hit recent highs US S&P LCD LeverageLoan Index (LLI) flow names have declined -100bpsfrom 100.48 to 99.48 and the JP Morgan broaderleverage loan market reading declined -36bps from99.31 to 98.95. In Europe S&P LCD EuropeanLeveraged Loan Index (ELLI) flow names remainedflat at 100.68 over the same period however thebroader S&P ELLI reading declined -40bps from 91.86to 91.45. Lower retail mutual fund flows, combinedwith a net negative CLO supply seem to havecontributed to this trend and expected to benefitCLOs which are currently ramping or are in their re-investment period.

• Still Benign Default Outlook: In Q1’2014 the US 12month lagging default rate by principal balance ofthe S&P Leveraged Loan Index fell to an 18 monthlow of 1.21% falling from 2.11% at FY’2013. Bynumber of issuers the default rate decreased from1.61% to 1.02% marking a 22 month low. This marksthe highest level since July 2013. By percentage ofissuers the European default rate increased from4.90% to 5.30%.

• CLO New Issue Liability Spreads - US Primary CLOAAA spreads have started to show some tighteningtrends with most of the deals still being talked aboutin the L+150bps to L+160 bps range with a few recentones getting done at L+145 bps. In Europe PrimaryCLO AAA spreads have been in the E+140 bps toE+150 bps range with some recent deals being donein the E+135 bps. In summary the current arbitrage innew issue CLOs is slightly more in favour of Europecompared to that of the US. This is a function ofbetter spreads in the loan portfolio combined withrelatively tighter spreads on CLO liability.

• Healthy Secondary Volumes - During Q1 2014 thesecondary market continued to be very well bid withdemand for good quality CLO bonds far surpassingsupply with $ 4.65 billion of US CLOs trading onBWICs till date.

• Regulatory Uncertainty - One of the continuing keythemes in the CLO market has been regulatoryuncertainty. In particular the market has beenlooking for clarity around the Volcker rule and how itmight impact the AAA investor universe. In theirlatest update the US Federal Reserve has extendedthe effective date from which the rule would apply,with regard to bank ownership of CLO tranches, toJuly 2017. The extension will be applicable to CLOsissued before December 2013. The extension allowsbanks additional time before they have to comply byamending existing CLOS to remove bond buckets.The Volcker rule might facilitate debt refinancing assome banks may find it easier to exit non-compliantinvestments through refinancing. Equity investorsmight also be able to get more concessions in theform of tighter spreads or amendments to the WALtest, from the senior debt investors, in return foragreeing to remove the bond buckets.

• Prepayments - Another key issue surrounding CLOs,especially in the US, has been the rapid pace ofunderlying loan prepayments. The faster than usualrate of prepayment has resulted in a faster thanexpected rate of amortisation in some of the earliervintage CLOs. In Europe however the rate ofprepayments and spread tightening has beensignificantly lower compared to that of the US.

© 2014 Euromoney Seminars Ltd. All rights reserved.

Market dynamics in Q1 2014

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