• According to Fitch Ratings’ European leveraged finance group, defaults have yet to materialise in meaningful volumes in Europe. However, in future, while underperformance may not trigger defaults given the early life of most transactions and enough covenant headroom, debt levels are nonetheless unlikely to prove sustainable on the basis of standalone performance. Fitch expects value to erode for all creditors (including senior secured creditors) along the way towards distant though eventual defaults in 2009 and beyond. Clearly, the timing of defaults will depend critically on economic conditions and the timing for the resolution of the credit crisis.

• Greater divergence in CLO performance by manager is expected in future months and years while the forthcoming performance triage is expected to reveal differences between those managers which selected well balanced, defensive portfolios and those that ‘bought the market’ under pressure to issue new deals.

• Managing a CLO in a turbulent market does not necessitate a fundamental change in investment strategy; rather, active portfolio management creates value through secondary trading and heightened surveillance.

• The characteristics and rapid changes observed in the European CLO manager industry reflect the attractiveness of an overheated market up to Q3 2007. Out of over 60 European CLO managers:

– 60% of managers entered the market in 2006-2007, 50% of which were US managers;

– 50% have only one or two CLOs under management, 80% issued opportunistically at the peak of the market.

• The issue of the financial viability/vulnerability of the CLO manager becomes central in a deteriorating/closed market:

– Two or three CLOs of average size under management result in a European CLO manager platform breaking even in benign market circumstances;

– Four CLOs or more creates a sustainable, scalable business;

– Subordinated fees typically contribute to two thirds of CLO manager compensation; if subordinated fee income was reduced by 25% the breakeven point would move up to four CLOs under management.

• Key market success factors include critical mass, strong sponsor backing, (demonstrated) ability to manage through the cycle, and adequacy of corporate strategy or product range.

• The number of European CLO managers is expected to contract by about 20% in the next three years. Manager replacement or withdrawal, rather than mergers and acquisitions, will drive consolidation.

The critical competitive advantage

Whether or not a European CLO manager has a critical competitive advantage can be a key factor in its survival fortunes. This competitive advantage can be a combination of factors, largely driven by increased investor discrimination between managers. Such factors include:

• Established CLO market presence, size and financial strength;

• Proven track record in European leveraged loan and CLO management, across the cycle;

• Solid, recurrent investor base.

These characteristics, which are perceived by investors as signs of stability in a turbulent market, are necessary conditions for managers to be able to raise assets at all levels of the CLO capital structure in the next couple of years. Other factors include:

• An ability and willingness of the sponsor, if any, to support the CLO activity should it become unprofitable;

• An ability to retain key people. The risk of staff departure is largely a function of the above factors.

The winning corporate strategy (if any)

To the extent that observed market changes reflect medium or long-term trends, asset management companies need to revise their core strategy, to reach their growth and profitability objectives.

Fitch observes that, as of June 2008, most CLO managers had not changed and did not plan on changing their fundamental strategy.

Large established managers, for which the European CLO business is of strategic importance, expect to continue to grow as investors will clearly favour this type of manager in new issues. In the absence of new CLO issuances, their critical mass allows this type of manager to remain profitable in the absence of new CDO issuance.

On the other side of the spectrum, smaller, less established managers will have more pressure to develop new business initiatives to diversify their sources of revenues. In particular, pure-play CLO managers with no critical size will have to diversify or exit the market in the event of long-term CLO market closure. These managers will have to carefully manage the risks involved in deviating from their original expertise.

CLO platforms which are either an extension of the leveraged loan business or part of a larger

organisation are better positioned, even if they have not reached the critical size in terms of AUM.

It is worth pointing out that in this category, managers which are not serial issuers but issued CLOs opportunistically, may not all be threatened; this is assuming that cash flow CLOs are just one investment vehicle among others, all of which support their core credit expertise.

In all cases, managers focus their product development efforts on low levered funds (or flexible leverage), possibly using short-term financing. Only the largest and longest established managers have either priced a CLO or have a CLO pipeline at the time of writing.

Commitment to the CLO business

The considerations above enable Fitch to classify the European CLO manager population according to its level of commitment to the European CLO and leveraged loan market. Fitch analysts have exercised expert judgement in characterising this level of commitment for each European manager, depending on the strategic importance of the CLO business, ability and willingness of the sponsor to support the CLO platform, profitability and sustainability of the CLO business.

Fig.1 shows that, ultimately, the larger the CLO manager, the stronger its commitment to the business. Exceptions are small independent managers, whose business model is heavily reliant on CLO management. The fact that smaller managers show the least commitment to the CLO business opens the door to consolidation in the industry.

The scope of consolidation

Fitch estimates that around 20% of European CLO managers may exit the market in the next three years. The main reasons for this are poor profitability of the CLO platform relative to the manager’s commitment to the business, poor growth prospects or company-wide financial stress. Furthermore, even if a CLO platform breaks even, management may find the return on invested capital too low and the operations funding required too high to maintain the business. Likely candidates for consolidation are those managers which have not reached critical mass in terms of AUM and thereby have not demonstrated sustained profitability. Ultimately, the main driver behind CLO manager industry contraction is that investors (and bankers) are increasingly discriminating between managers based on their track record and financial strength; they are thus clearly favouring established managers.

US CLO managers that opened an office in Europe to manage European CLOs represent a particular case for CLO manager consolidation. Almost 80% of such practices established a European presence after 2006 and almost 60% have two CLOs or less under management. According to Fitch, about half of all US CLO managers are likely to close their European operations in the next three years, either managing the CLO from their US headquarters to save costs or simply resigning as manager.

CLO manager replacement

The CLO managers, surveyed by Fitch, generally show an interest in picking up existing mandates as a way of increasing their AUM.

There are several reasons why a CLO manager replacement event has not yet occurred in Europe. First and foremost, replacing a manager is a cumbersome process, as explained in Fitch’s research “Overview of the CDO manager replacement process”, dated 8 November 2007.

Furthermore, a manager replacement event is currently more likely to originate from a manager decision (eg. manager resignation) than an investor initiative (ie. a manager termination and replacement voting process). To date, CLO equity investors have shown no interest in changing their managers because overall returns continue to be in line with expectations. That said, few managers are currently willing to be removed as they continue to receive fees on their CLO mandates and are seemingly keen to wait and see if conditions improve before taking any decision. Furthermore, to preserve their reputation, managers may not wish to acquire existing CLO mandates as such portfolios or structures may be inconsistent with their own standards.

Other forms of consolidation

Fitch expects only a handful of merger and acquisition (M&A) activity among CLO managers in the next three years. The agency believes managers can more efficiently achieve their objective to reach critical mass in AUM through the acquisition of replacement mandates. For instance, M&A is generally defined in a CLO Collateral Manager Agreement (CMA) as a “cause” under which the manager can be removed. Therefore, managers have no guarantee that they would achieve their goal of increasing AUM through M&A.

The outright buy-out of a small manager by a larger player is unlikely also, owing to fear of reputation loss (see above) or an inability to amortise acquisition costs.

A further complication involves the difficulties involved in valuing a CLO manager business, particularly with regards to the incorporation of high goodwill and discounts for key man risk. Finally, the M&A pool is limited by the fact that less than five European CLO managers1 are fully independent, with only a couple being considered as pure-leveraged loan players.

However, consolidation may stem from small managers (managing all types of CDOs) clubbing together to increase AUM, to save costs through resource or cost sharing, and to improve sourcing capabilities while demonstrating deeper collective staffing experience. This type of consolidation can be achieved through forms other than straight mergers. THFJ

1. Excluding European based subsidiaries of US managers

“Likely candidates for consolidation are those managers which have not reached critical mass in terms of AUM and thereby have not demonstrated sustained profitability”

“The outright buy-out of a small manager by a larger player is unlikely also, owing to fear of reputation loss or an inability to amortise acquisition costs”