THE BIG WEAKNESS IN THE BUYOUT FUNDING CHAIN / THE WALL STREET JOURNAL

The Big Weakness in the Buyout Funding Chain

The risky loans that fund private-equity deals are more reliant on money from complex vehicles than ever

By Paul J. Davies

The boom in risky lending to fund private-equity deals and other takeovers has been fed by complex vehicles that sound a surprising echo from the most-recent debt bubble.

The good news: these so-called collateralized loan obligations, or CLOs, aren’t part of such a fragile chain of structured finance as in 2008. But they might still fall from favor as central banks end their bond buying programs. And that would be a major problem for private-equity deal makers who have hundreds of billions of dollars waiting to be invested.

The CLO investors to watch are banks and Japanese buyers: both may switch to traditional bond investments as yields recover to more normal levels. Both have been big buyers of the safest AAA-rated bonds issued by CLOs, although their exact share of the market is hard to track.

These senior bonds matter because they provide about 60% of a CLO’s funding, while hedge funds and specialist investors provide the rest through riskier bonds and equity. These bonds have attracted investors because they pay a better return than many government bonds, but have historically proved very safe: there have been no defaults in 20 years on AAA-rated CLO bonds, according to Standards & Poor’s, the ratings agency.

But other things affect demand too. For Japanese investors, favorable pricing of dollar-yen swap rates has been a big part of what makes CLO yields appear even juicier.



Japanese buyers have paused after recent currency and interest rate moves. Photo: kim kyung hoon/Reuters 


Recent currency and interest rate moves have seen Japanese buyers pause, which might help explain why CLO funding got more expensive in recent weeks. But analysts at Bank of America Merrill Lynch say the all-in return is still attractive and Japanese investors will be back.

Banks own senior CLO bonds for a bit of extra yield on money they would normally keep in liquid assets. However, CLOs don’t count toward the minimum liquid assets that regulators demand they hold, so banks will likely reduce or stop buying once true liquid assets pay a decent yield again.

The loans inside CLOs are by some measures worse quality than those before the most-recent crisis and investors worry that eventual defaults will lead to greater losses. But senior CLO bonds may still do well because all the riskier slices of CLO funding must be wiped out before they lose a cent.

However, we have heard this kind of story about subprime mortgage bonds and other structured credit before 2008. For safety-conscious investors, CLOs may just seem unnecessarily complex as soon as they no longer really need them to boost yields.

And given that they now buy more than half of leveraged loans, any interruption for CLOs will bring a major funding headache for deal-hungry private-equity firms.