When Blackstone hit the road last September to sell the bonds and loans that would finance its purchase of Refinitiv, many potential buyers were shocked at what they were being offered. The largest leveraged buyout financing since the financial crisis had already set off warning signs, triggering unfavourable comparisons with TXU and Clear Channel, top-of-the-market deals that had ended in tears.
As investors delved deeper into the documentation, comparisons to the heady days of 2006 and 2007 became even starker. Credit research firm Covenant Review said the US$13.5bn of bonds and loans being sold had some of the weakest investor protections seen since the crisis, highlighting “defective” covenants that were “riddled with loopholes”. Some believed Blackstone was pushing its luck a little too far.
But the firm was one step ahead. Since moving into the collateralised loan obligations space as a sideline to its main private equity practice in 2002, Blackstone had grown into the biggest CLO issuer, helping double the size of the market over recent years to US$600bn outstanding. With loan supply scarce after a slow summer, and over 1,200 CLO managers - including its own - all hungry to buy loans, it knew there was a pool of ready and willing buyers for the Refinitiv loans.
When books opened, hundreds of CLOs duly piled into the deal, snapping up US$2.8bn – just under a third – of the US$9.25bn of loans that were eventually sold. Within that pool, Blackstone’s own CLOs were the biggest buyers, purchasing US$200m of the deal. Such was the demand that Blackstone’s private equity arm was able to extract further concessions from investors, saving itself almost US$100m in interest costs and making its buyout of Refinitiv potentially more lucrative.
“As the CLO market gets larger and larger, [CLO managers] have little or no choice but to traffic in large deals such as Refinitiv – large deals are the only place they can get large allocations,” said Mike Terwilliger, a credit fund manager at asset management company Resource America. “It’s a perverse dynamic where the biggest deals end up coming with the worst terms because they attract significant demand. It’s one of the fascinating paradoxes of the market.”
In the end, the buyout of Refinitiv, the data and technology business of Thomson Reuters, completed in October. A consortium led by Blackstone purchased a 55% stake in the company, which owns IFR, valuing it at US$20bn.
STOKING DEMAND
But the role of private equity firms in helping stoke demand for their own deals, making them both easier to finance and more lucrative, has begun to attract attention. While nothing new – private equity firms were launching CLOs as far back as the 1990s – the trend has gathered pace in recent years, with a record US$128bn of new CLOs issued in the US last year. In Europe, issuance grew 40% to €27bn.
That growth has dovetailed with an increased aggressiveness from PE firms. In the US, PE outfits have doubled their LBO activity since 2016. Average purchase price multiples at almost 11 times are at an all-time high, while average leverage of seven times has not been seen since the crisis. And the CLO market, which is dominated by PE firms, is widely seen as the thing that has made this possible.
“It’s an interesting phenomenon: there is this kind of flywheel effect where private equity funds create these vehicles that help create demand for the paper that helps support their private equity business,” said Terwilliger. “In growing the credit markets, they are growing the demand for private equity deals. One sort of feeds off of the other; each benefits the other.”
Not everyone is convinced, however. Many see the growth in CLOs, which have for more than a decade owned about half of the leveraged loan market, as simply reflective of the growth in the underlying stock of loans. Increased appetite for mergers, acquisitions and LBOs has created the supply of loans that has allowed more CLOs to join the party.
“CLOs are a source of capital, but they tend to be a derivative of M&A activity – it’s not the other way around,” said Benjamin Edgar, who helped grow the CLO practice at private equity firm CVC but is now a portfolio manager at Intermediate Capital Group, which manages €35bn of assets. “That said, how are LBOs going to be financed if the CLO market at some point reverses? That is a much more interesting question.”
Others argue that retail loan funds, which account for just over 10% of the market compared to 50% or more from CLO money, is a bigger driver in the deterioration of terms.
“When retail funds get money, they have to invest it and they have to invest it right away because if they sit on cash it dilutes their dividend yield,” said one source who oversees CLOs at a large private equity fund. “They need to get the money deployed quickly and the flows can be quite heavy so they are probably, in my opinion, the most indiscriminate buyer in the market. They are the ones who, at the margin, set terms on price and covenants.”
“Clearly CLOs are complicit and aren’t necessarily rejecting those loans,” he said. “But I think the race to the bottom has been driven by the retail funds. It’s a little bit of the tail wagging the dog.”
CHICKEN AND EGG
What came first – the aggressive LBO or the CLO – is irrelevant, according to some, who say the bigger issue is risk building up in the system. While the growth of both is proving extremely lucrative to private equity giants such as Apollo, Blackstone, Carlyle and KKR, which collect fees on managing the CLOs and also get cheap financing for their acquisitions, the process creates significant risks for others in the chain.
Banks in particular are vital to the LBO-CLO chain, and are heavily exposed at various points through the process. First, they underwrite financing for the buyouts, sitting on billions of dollars of risk, sometimes for many months before loans are sold to investors; second, they provide billions in loans to CLO managers to enable them to build up inventory ahead of the sale of CLO notes to investors; and third, they are big investors in the CLOs themselves.
The surge in LBOs – there was US$150bn of LBO financing in the US alone last year, almost double what was seen two years earlier and the second biggest year on record after 2007 – is all underwritten by just a handful of banks. And the terms of the loans are often struck months before they are sold. The risk is that conditions change, and banks find themselves stuck with huge, under-priced loans.
Analysts have begun to flag concerns. JP Morgan chief executive Jamie Dimon brushed away such worries in an investor call in January, saying that the banking industry had only US$80bn of underwriting exposure to LBOs and leveraged loans at any one time – less than a quarter of their exposure in 2007. He also said banks had built in “flex” that allowed them to tweak terms on loans to make them easier to sell.
But the rapid growth in the leveraged loan market has some concerned that underwriting discipline may not be what it once was as banks underwrite loans based on the healthy bid from CLOs. If that bid disappears – and some say there are signs that the economics underlying CLOs are starting to fall apart – then banks may be left with no willing buyers for the loans on their books.
“While the CLO product in itself is fairly secure, has it led to new issuers accessing the market that historically would not have been able to access the market? I think it has,” said the head of credit at one large leveraged loan underwriter. “The types of companies that are getting access to credit right now – at much tighter levels and with a lot fewer covenants – could create a problem in the future.”
Exposure to the CLO machine isn’t just confined to loans in the pipeline. A handful of banks – often the same ones underwriting the LBOs – also lend billions to CLO managers so that they can fill their vehicles full of loans before issuing the CLO into the market. Citigroup alone lends up to US$5bn to so-called CLO warehouses, the bank’s head of private banking Mark Mason said last month.
These exposures are seen as less risky than the LBO pipelines for two reasons: first, they are much smaller; and secondly, they are well collateralised. But some banks have begun offering total return swap contracts to CLO managers to help them boost their returns, creating potential additional exposure. A big drop in loan pricing could leave banks nursing big losses on such deals.
BIGGEST INVESTORS
The third point of exposure is that banks are also among the biggest direct investors in CLOs once they are issued. One bank – Japanese agricultural lender Norinchukin Bank – owns US$60bn of the US$600bn of paper issued by CLOs. Wells Fargo owns a further US$35bn, while JP Morgan and Citigroup have about US$20bn each. In other words, four banks own almost a quarter of the entire CLO market.
While much has been made of how the Triple A notes that banks tend to invest in are highly unlikely to result in any losses (no Triple A note has ever defaulted in the history of the CLO market), much less has been made of what might happen if one or more vital players suddenly exits the market. The resulting crash in prices could lead to big mark-to-market losses for banks holding CLO paper.
“If you have a $600bn market that seems to rely on the whims of a Japanese farmers bank, that is not very sustainable,” said one bank analyst. “That doesn’t sound like a very healthy system. Are the banks going to have a lot of big direct losses? No, I don’t think they will. The bigger issue will be of second order impacts. If this party ends, then it’s the usual 15 fat blokes trying to get through the door at the same time.”
