Looking for collateral

A collateralised debt obligation, or CDO, is one of those rare ideas whose elegance and simplicity makes you wish you'd thought of it yourself. Whoever did think of it originally is a fact lost in history, although what is certain is that the technology grew out of the US mortgagebacked securities market some time during the 1980s. Today, having spread to Europe during the past five years, the CDO market constitutes a rapidly growing asset class within the alternative investment universe.

Securitisation techniques
A so-called arbitrage CDO applies securitisation techniques to a pool of debt securities, usually sub-investment grade loans or bonds. A range of rated bonds and equity are issued backed by this pool. The elegance of the structure stems from the simple fact that because of a comparatively large proportion of higher rated securities that can be issued, the average credit spread of the liabilities is around 1 per cent whereas the collateral pool will typically provide spreads greater than 2 per cent, leading to attractive returns for each category of instrument issued.

According to Willie Clark of Royal Bank of Scotland's Structured Finance unit, institutional investors are attracted by the structural characteristics that CDOs possess. ?CDOs offer a structure that suits the institutional mindset: it gives you flexibility, you can choose the level of risk you want, you can tailor the profile of the assets, and you can buy diversification,? he says.

This has helped a broad range of investors, including those that are initially unfamiliar with credit-driven investing, maintain diversity and return, especially since the advent of the single currency has eliminated the scope for investors to find yield in currency-based plays such as buying into European government debt. CDOs offer ways to fill this gap. Says Jim Finkel of Deutsche Bank's Global CDO Group: ?Given the lagging credit culture in Europe relative to the US, or for those without the necessary resources who wish to ?sub-contract? their credit analysis, the arbitrage CDO product is a great point of entry.?

The important difference between traditional securitisation and CDOs is the fact that when an investor makes the commitment, the pool of underlying assets is likely only to exist in part, if at all. This means that the skill of the asset manager is key to the success, or otherwise, of a deal. Bill Healey at Merrill Lynch Investment Managers (MLIM), for example, maintains that one of the key requirements for success is portfolio construction, ?with the active involvement of the analyst coupled with sophisticated thinking by the portfolio manager to assess the likely outcome if things go wrong.?

Pipeline, what pipeline?
Speak to European CDO arbitrage managers and their advisers in the current credit market environment, and the impression that emerges is of a market resembling a series of cultures in a laboratory ? dependent upon the nourishment supplied, likely to flourish given the right conditions, but still in its infancy, fragile and bound to lose part of the original population. Among the most pressing issues currently engaging the industry is the scarcity of quality collateral coming out of the high yield and leveraged loan markets.

The accompanying charts on page 43, based on deals already sold, provide a snapshot of the underlying European sub-investment grade credit markets at the end of the first quarter of this year. Since September of last year, the new issue market has been thin, partly because activity in the leveraged buyout market has tailed off. ?There is a great deal of hard work going on in the private equity community, but the conversion rate of deals is cripplingly slow, though it is now better than it has been over the last six months,? comments Ian Hazelton, chief executive of Duke Street Capital Debt Management, which manages the €1bn Duchess I CDO.

Andrew Phillips at Intermediate Capital Group's fund management arm agrees, albeit conditionally: ?The pipeline over the next six months looks decent, but who knows how quickly this will translate into real loan assets?? Other practitioners share this view, and it does not come as a surprise that one word used by everyone quizzed for this article to describe their current lives as CDO managers was ?tough.?

However, Finkel at Deutsche is nevertheless optimistic: ?Because of the funds' enforced diversity, the collateral in European CDOs has actually outperformed the underlying high yield markets ? after all, something like 35 per cent of the European high yield bond market by volume has defaulted this year alone. The problem however for CDOs is the leveraged exposure to high yield that investors are taking.? Or as Simon Hood, London-based managing director at ING Capital Advisors puts it: ?If you compare CDO returns with traditional fixed income and loans, or even private equity, we compare well if defaults are kept down to a sensible level.?

Differentiation
The need to both maintain the spread differential in order for the arbitrage structure to work and avoid defaults within the asset pool has led individual managers to come up with different nuances in approach. Healey at MLIM pursues a management strategy that is trading orientated. ?It is important to maintain flexibility in some areas ? such as the trading basket? (i.e. the proportion of the fund that it is permitted to churn every year). ?We have an annual basket of 30 per cent, compared with other managers of 20 and 25 per cent, and a higher equity component within the structure on purpose so that we have more cushion. Our investment turnover during the life of the deal so far has been higher than we expected to try and stay ahead.?

Others have looked to other markets for help in finding investment opportunities. ?We have addressed the diversity issue through the inclusion of a large proportion of sterling denominated leveraged loans in our Eurodenominated portfolio, and have also included a couple of sterling Floating Rate Notes, which is not as we initially expected, but it meets our credit quality and return requirements,? says Hazelton at Duchess.

At ING Capital Advisers, use of a global platform is the key factor. ?Our competitive edge is our access to the US market where the chances are we can access paper that others cannot,? says Simon Hood, like many others in the sector a widely experienced former LBO banker. Hood adds: ?Savvy investors can also focus on other selected opportunities such as Credit Linked Notes? (i.e. synthetic securities structured to meet investorspecific requirements such as currency and tenor), ?though you need to be tapped in to the people sourcing them. We further supplement our requirements in selected situations through the wider asset-backed securities market.?

Prudential M&G, the fund management arm of the UK insurance group Prudential is among those combining investment grade and sub-investment grade assets to provide an appropriate blend of risk and return. ?We have been able to differentiate ourselves because we have very broad, deep resources with which to look at the credit markets,? comments Mike Ramsay. ?Given the credit environment, we felt it made sense to construct such portfolios because we come at it from a low volatility viewpoint, looking to deliver low volatility returns. So far, our first two deals have performed well.?

AXA Investment Managers has arguably gone furthest down this road with its Jazz CDO I, which combines cash investments in investment grade bonds with synthetic exposure via the credit derivatives market. Most European CDO structures incorporating synthetic exposure have not been in the arbitrage class, but instead have been static, i.e. non-actively managed, balance sheet deals arranged for commercial banks whose aim is capital relief. Jazz is an early prototype of a new generation of deals that incorporate active management with exposure via credit derivatives.

And yet another proposition designed to stand out from the crowd that is already in the market is identified by Willie Clark, who at RBS built a £300m synthetic balance sheet deal which was probably the first to consist exclusively of leveraged loans: ?One trend currently gaining momentum is for single buyers to ask for tailormade products, effectively privately placed CDOs.?

Kissing frogs
The asset class is clearly headed for greater diversity through structural innovation to aid access to a market that is still characterised by illiquidity and supply inefficiencies. ?The market is aiming towards underlying credits with more stable characteristics,? comments Deutsche's Finkel. ?A more rigorous analysis of each credit's fundamentals, and a stronger sell discipline among managers will also be required.?

It is therefore no surprise that leveraged loans have become the asset of choice for recent transactions, though this presents further access problems itself. ?The weight of cash from investors in the market means that the secondary loan market has virtually dried up,? observes Andrew Phillips. ?Anything offered today is either hairy or overpriced. We are therefore dependent to a large extent upon the primary market ? which is not a market we can control in terms of timing or quality,? he adds.

Indeed, as Hazelton puts it, ?you have to kiss a lot of frogs before you get what you want. We've turned down two out of every three deals we've looked at.?

For a CDO manager, this presents further complications, because sitting on uninvested cash makes it difficult to meet the arbitrage spread requirements. This is yet another driver of structural innovation. ?We didn't want the structures of our loan funds driving the investment strategy,? explains Phillips, who in early July successfully closed Promus II, ICG's second loan-based CDO with €340m in commitments. ?We therefore have a revolving structure where we can draw down on a bank facility and refinance it periodically with term debt. We have four years to spend it, although we very much hope that we'll need far less time than that. Many in the market disagree with us because it can cause a drag on equity returns, but the way I look at it is that there is an arbitrage to be had between the quality of the returns as driven by the credit cycle and the rate of investment of the fund. Otherwise you're taking a bet that the market will deliver the assets you'll like within a short period of time.?

As Phillips himself points out, others try and go about solving this problem differently. ?We have considered ICG's approach, but we've decided it's not for the next deal,? says Hazelton, who is also working on a new fund. ?We've gone for a long warehouse facility [a bank funded method of beginning to build a portfolio during the fund-raising process] of up to a year, on favourable terms.?

Tremendous demand
All of this should serve CDO investors well, although they still need to do a fair amount of homework. ?There's tremendous demand ? investors are willing to put sizeable chunks of money to work in the equity of CDOs. Many are thinking through their portfolio as they want to build six, seven, eight, nine separate equity commitments,? observes MLIM's Healey. He continues: ?They're also more sophisticated, and they've done it before; they know the sensitivities. These are the ones we want to work with and can work with constructively if things were to go wrong.?

Another comment made universally was how difficult it is likely to be to raise a first-time fund from hereon. ?Investors are beginning to align themselves with particular managers for the long term, rather than necessarily investing in boutique funds,? comments Ramsay. Hazelton puts it even more succinctly: ?It's nice to be a second time manager.? Healey at MLIM expands further as to why this is: ?Each investment within an investor's portfolio will have a separate function, each needs to have a diversifying role within that investor's portfolio. Simply having the same strategy from a different source means there will be no interest as there will be no increase in diversity.?

Further complications are likely to arise in the post-Enron and WorldCom environment. Says Hood: ?The biggest challenge at the moment is to educate people about the CDO product ? too many early products were driven by financial engineering and have suffered from vintage problems [i.e. buying assets during times of generally high prices], which led to a number of people being burnt.?

None of the managers interviewed went as far as saying that the CDO is going to be the ?next best thing? in alternative investment. They recognise that an allocation to CDOs is only ever likely to be a relatively small component of an overall portfolio, added to produce diversity and, hopefully, decent returns.

Nevertheless, putting the risks and rewards that CDOs offer into context is encouraging. Says Hazelton at Duke Street: ?To invest in stocks, you have to believe in strong growth ? many have been overrated for some time now.? Relative to what can be expected from a weak equity market, the more modest prospect of returns in the mid to high teens that most CDO managers target for the equity in their deals doesn't look bad at all.

Robin Burnett worked in the European leveraged finance market on both the buy and sell side for nearly 10 years. He is now a training consultant at BG Training and works as a freelance writer.