BY NEIL UNMACK AND ANNA SZYMANSKI

Private equity looks set for a tricky ride in 2020. And it will be thanks to ructions in the $1 trillion market for bonds backed by the leveraged loans that finance many deals struck by Henry Kravis’s KKR and David Rubenstein’s Carlyle, for example. A weaker economy will make investors wary of buying these so-called CLOs and force vehicles to curb lending. That means higher borrowing costs, and probably fewer takeovers – though some industries and regions, such as Asia, will buck the trend.

Collateralised loan obligations, to give them their full name, hoover up over 70% of the loans buyout shops often use to finance their deals. They slice and dice these loans into tranches offering higher returns for riskier cuts. The U.S. CLO market has more than doubled since 2012 to over $650 billion. JPMorgan reckons the amount of outstanding CLOs should top $1 trillion next year. But this securitisation bonanza is starting to sputter.

It’s all about the arbitrage – or lack thereof. CLOs work when cash flows from the underlying loans exceed payments to the CLO noteholders, leaving annual returns of 15% or more for the lowest-ranking tranches, and fees for managers. But fears of a U.S. recession and general economic skittishness have made investors demand higher returns for some CLO debt. If yields rise much higher, the CLO new-issue machine is likely to grind to a halt.

Downgrades could also be a problem. The rating models that govern CLOs allow them to account for loans at face value. But the moment a CLO holds more than a certain percentage of assets rated CCC, typically 7.5%, managers have to value them with current market prices, which are usually far below par. If enough companies are downgraded, and the CLOs’ assets sufficiently devalued, income from loans is diverted to repay senior bondholders, cutting off lower-ranking investors.

The situation already looks quite fragile. A combination of high company debt and a stagnating global economy mean the share of loans in U.S. CLOs rated B-minus, one level above CCC, is nearly 20%, twice the level before the 2008 crisis, according to Standard & Poor’s. UBS analysts expect the average U.S. CLO CCC exposure to reach 11% in 2020.

The effect could be doubly bad. Investors in lower-ranking CLO tranches will take steep losses, sapping appetite for new deals. Meanwhile, existing CLOs will be less able to lend to lower-rated companies, driving up borrowing costs. That raises the risk of the dealmaking debt machine blowing a gasket.

First published Dec. 19, 2019

IMAGE: REUTERS/Mike Segar