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European LBO volume continues to increase Back  
In this overview of the European leveraged loans and CDO funds market, market participant AIB Acquisition Finance, which to date has issued three CDOs of leveraged loans, explains why and how AIB got into this market.
AIB Acquisition Finance (AIB) has built a very successful asset management business, originally through two mezzanine funds, and more latterly with its three CDOs of leveraged finance assets, Tara Hill, Clare Island and Galway Bay. For this reason, AIB is a useful case study in considering how CDOs have impacted the European leveraged loan market, and why AIB as a bank participant has developed a complementary asset management franchise.

AIB is a leading participant in the European Leveraged Buy Out (LBO) market, currently managing over €2.5 billion of acquisition finance assets (i.e. senior secured and mezzanine loans) split between its own balance sheet and its managed funds. It runs one of the largest and most diverse acquisition finance teams in Europe having over 50 dedicated staff in Dublin, London and Frankfurt, supported by a similar number from the credit, risk and business support departments of its parent, Allied Irish Banks, p.l.c.

What is a CDO?
A collateralised debt obligation (CDO) is a special purpose vehicle established to purchase a collateral pool, leveraged loans in this instance. The collateral purchase is funded by the issue of notes by the CDO, repayment being secured on and dependent upon the returns of the collateral pool. The notes will be tranched in order of repayment priority, with the most junior notes (equity) enjoying the excess cashflows of the deal but also taking a first loss position in the capital structure.

CDOs of leveraged loans generally have a maximum duration of approximately 13 years and are leveraged 8 to 10 times. Assuming that a collateral pool yields approximately 150 bps p.a. in excess of its funding cost (and ignoring the impact of portfolio gains and losses), Equity that is 10 times levered will expect an annual return in the order of 15 per cent.

Most CDOs are structured with the intention of either allowing the CDO manager to increase assets under management or to provide a regulatory capital arbitrage to the promoter of the CDO. AIB’s approach in this area is very much the former, as AIB’s transactions are not risk transfer motivated. Instead of removing assets from AIB’s balance sheet, its CDO assets are originated on the primary market at the same time and by the same team that originates for its own balance sheet. This co-investment by AIB in the same assets as its CDOs is a key attraction to AIB’s CDO investors.

The rationale for the development of this business was (i) to leverage on the skill set residing within the business in asset origination and selection; (ii) to earn a leveraged return on the equity that AIB retains in its transactions; and (iii) to allow AIB to participate at greater levels in the leveraged loan primary markets. This latter rationale yields a payoff not just to AIB, but also its CDOs, in that the backing of a bank balance sheet allows access to collateral that is not always available to pure institutional investors, often at fees that are not offered to non bank investors. Again, this feature was very attractive to AIB’s CDO investors.

European LBO volume continues to increase with LBO volumes for 2003 topping €27 billion as of September, exceeding the total 2002 outturn of e26.9 billion. Average deal sizes remain sizeable in the order of e600 million, and the market continues to be disciplined in terms of deal structures, although leverage multiples are rising. Nevertheless, the attractive security and due diligence aspects of European LBOs combined with a relatively attractive economic environment for many borrowers has allowed the LBO market to continue to operate with a remarkably low level of default. As the market is a specialised one, investors seeking exposure to the asset class have done so through investment in fund management vehicles, generally CDOs.

Unlike its US counterpart, the European LBO market is dominated by bank participants, with institutional investors such as CDOs providing slightly over 20 per cent of leveraged loan funding in 2002, although much of this volume was provided by bank sponsored CDOs (source: S&P LCD). The growth of CDOs has been remarkable, with 34 CDOs capable of investing in leveraged loan collateral having entered the market since 1999. These 34 CDOs have investing capability totalling in excess of e13 billion, with a further 4 deals in the pipeline for 2003 contributing an additional €1.5 billion of buying power.

European leveraged loan CDOs can be broken into two main categories, with each appealing to a slightly different investor base. The first can be described as the institutionally backed CDOs, the second being boutique operations. AIB’s CDOs are a good example of the former category, with investors in AIB’s deals being attracted by AIB’s institutional loan management framework, its long and successful track record in the LBO business and the strength and depth of its team.

CDOs have had a significant impact on the European LBO market in terms of increasing the number of investors prepared to back LBOs and also by offering liquidity in a market that has historically been illiquid. Nevertheless, the success of many new market participants will depend on the continued expansion of the European LBO market, as existing players are not seeking to reduce their commitment to the market. Many new entrants therefore rest their platform on exploiting a niche skill set, such as specialism in a particular asset class (e.g. high yield bonds), unique relationship access (e.g. through an affiliate or parent) or by having sufficient scale to guarantee access to what is ultimately a limited overall collateral pool.

AIB’s approach in developing its leveraged loan business has been to view CDOs and other asset management vehicles as an integral part of its overall leverage finance business, and consequently AIB has not sought to develop a separate CDO management style or approach. This approach is carried through to the management of AIB’s third party asset management vehicles (whether they be mezzanine funds or CDOs), in that the acquisition finance management team that makes the business decisions to invest or divest of collateral, takes the decision for both AIB’s balance sheet and for its fund management vehicles. Unsurprisingly, there is a very high degree of correlation between exposures on AIB’s balance sheet and those in its managed funds.

AIB’s asset management franchise has allowed it to materially increase its appetite for attractive assets in the marketplace. This is an increasingly important feature in an industry where demand for quality assets is beginning to exceed supply. AIB’s ability to underwrite transactions (e.g. the €5.7 billion buyout of Seat Pagine Gialle in Italy, and the e 880 million buyout of Danske Traelast in Denmark), as well as a large overall take and hold participation ability (up to €50 million per transaction), materially assist its ability to successfully supply its CDOs with quality credit exposure.

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