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European CLO Performance IndexReport Q4 2013: The MarketExperiences A Revival With DefaultRates Staying Low

Primary Credit Analyst:

Ruslan Akhmetshin, London (44) 20-7176-3968; [email protected]

Secondary Contacts:

Matthew Jones, London (44) 20-7176-3591; [email protected]

Emanuele Tamburrano, London (44) 20-7176-3825; [email protected]

Sandeep Chana, London (44) 20-7176-3923; [email protected]

Research Contributors:

Ian R Chandler, New York (1) 212-438-1538; [email protected]

Rakshadevi S Tawde, Mumbai; [email protected]

Table Of Contents

A Typical European CLO 2.0 And Structural Features

Default Rates In European CLO 1.0 Transactions

'CCC' Rated Assets

Defaulted Assets

Senior OC Ratios

Subordinate OC Ratios

Notes

Related Criteria And Research

STRUCTURED

FINANCE

RESEARCH

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JANUARY 24, 2014 1

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European CLO Performance Index Report Q42013: The Market Experiences A Revival WithDefault Rates Staying Low

Since Standard & Poor's Ratings Services published its Q3 2013 European CLO Performance Index Report, a further

seven new collateralized loan obligation (CLO) transactions have closed in Europe (Carlyle Global Market Strategies

Euro CLO 2013-2 Ltd., Avoca Capital CLO X Ltd., St. Paul's CLO III Ltd., Grosvenor Place 2013-1 B.V., Euro-Galaxy

III CLO B.V., Dryden 29 Euro CLO 2013 B.V., and North Westerly CLO IV 2013 B.V.). In 2013, 20 CLOs closed in

Europe, including five in December alone, bringing total issuance for the year to €7.15 billion.

We rated 18 European CLO transactions in 2013 (see table 1). In this report, we analyze these transactions' structures

and their evolution over time.

Overview

• We rated 18 European CLO transactions in 2013.

• We have analyzed their credit enhancement, 'AAA' spreads, and some of the structural features present in

several European CLO 2.0 transactions.

• This edition of our index report also considers European CLO 1.0 default rates and compares them with the

LCD S&P European Leveraged Loan Index.

• Default rates in European CLO 1.0 transactions were consistently lower than LCD S&P ELLI default rates since

Q3 2011.

• Senior OC ratios increased across all of the vintages tracked in our index.

• With the exception of the 2005 cohort, the subordinate OC ratio test cushions showed improved performance

for European CLO cohorts.

Credit enhancement for the 'AAA' tranche is a key characteristic of a CLO as it shows the extent of protection available

to the 'AAA' noteholders from the subordination of the junior tranches in the structure. Chart 1 shows the available

credit enhancement distribution for these tranches in the CLO transactions that we rated in 2013. Out of 18

transactions, 11 have available credit enhancement of between 39.1% and 42.0%. This is significantly higher than the

typical 30% that European CLOs had before the financial crisis.


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Chart 1

The distribution is positively skewed, with two transactions exhibiting much higher available credit enhancement than

the others (GoldenTree Credit Opportunities European CLO 2013-1 B.V. with 55.00% and Euro-Galaxy III CLO with

50.88%).

GoldenTree 2013-1 was the first multicurrency CLO 2.0 transaction to be issued in Europe. One of the senior tranches

was issued in British pound sterling, with the intention to invest in a comparable amount of GBP assets, thereby

forming a natural hedge. The higher available credit enhancement aims to account for the inherent foreign exchange

risk in the transaction because no counterparty is involved in foreign exchange hedging arrangements.

In Euro-Galaxy III, the 'AAA'-rated tranches did not rank pari passu with each other at closing. The senior tranches

within this category therefore benefit from higher credit enhancement. The break-even default rate (BDR) cushion for

these tranches was 11.87% at closing (the BDR cushion is the excess of the tranche BDR above the scenario default

rate at the assigned rating for a given class of rated notes). The junior tranche has available credit enhancement of

38.67% and had a BDR cushion of 1.05% at closing.

Most European CLO 2.0 transactions that closed in 2013 had spreads of 135 basis points (bps) for the senior 'AAA'

tranche (see chart 2). Almost all of the spreads are between 125 bps and 145 bps, with just one outlier—Hayfin Ruby II


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European CLO Performance Index Report Q4 2013: The Market Experiences A Revival With Default RatesStaying Low

Luxembourg S.C.A., which pays 155 bps on its class A1 and A2 notes.

Chart 2

Spreads on the senior floating-rate notes in European CLOs started at about 130 bps in 2013 and increased moderately

over the year, with later transactions closing at about 140 bps (see chart 3). There are two outliers—Hayfin Ruby II at

155 bps and Cairn CLO III B.V. (the inaugural European CLO 2.0), at 140 bps. Factors that may have contributed to

the widening spreads include a shortage of 'AAA' investors, regulatory initiatives (e.g., the Foreign Account Tax

Compliance Act [FATCA], and the 5% risk retention rule), and difficulties in asset sourcing. The Volcker Rule for CLOs

may contribute to this trend in the future as well.

Any further widening of spreads in 2014 without corresponding increases in asset spreads could constrain arbitrage

and equity returns.


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Chart 3

A Typical European CLO 2.0 And Structural Features

In 2013, the European CLO market reemerged, with early structures being relatively simple and less leveraged than

their pre-crisis counterparts. A typical European CLO 2.0 is a single currency, semiannual transaction, with a €300 to

€400 million target par balance, a four-year reinvestment period, and a two-year noncall period. It also has 40%

available credit enhancement, no fixed-rate tranches, a 4% weighted-average spread, a 6.5% weighted-average

coupon, an eight-year maximum weighted-average life, and a 37% minimum 'AAA' weighted-average recovery rate.

The majority of 2013 CLOs comply with the 5% retention rule by holding a horizontal slice of the equity in the capital

structure.

The most common concentration limits for a European CLO 2.0 include: 90% minimum senior secured loans and

bonds; 5% assets paying interest at least semiannually; 10% maximum fixed-rate assets; no limit on covenant-lite

loans; 5% maximum current pay assets; 5% maximum debtor-in-possession (DIP)/corporate rescue loans; and a

maximum of 10% of assets in countries that have a long-term 'A-' rating. Most transactions do not allow the purchase

of project finance loans, synthetic securities, structured finance, and long-dated assets.


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Typical senior and subordinated manager fees are 15 bps and 35 bps, respectively. We have observed that most equity

hurdle rates (the required rate of return before incentive management fee) are equal to 12%. The most frequent

incentive management fee is 10%, but 20% fees have been more common in recent transactions.

We have observed that CLO 2.0 transaction structures continued to evolve in 2013 and include some of our

observations below. We may see further evolution in these areas in 2014 as investors seek greater flexibility and more

customized investment solutions, and arrangers seek to increase the number of investors in the most senior parts of

the capital structure.

Multicurrency transactions

Only two European CLOs 2.0 that we rate are multicurrency transactions—GoldenTree 2013-1 and Hayfin Ruby II.

Both transactions have both pound sterling-denominated and euro-denominated tranches. While this attracts a broader

investor base and offers more flexibility, it also introduces a foreign exchange risk into the structure, arising from a

currency mismatch between the assets and liabilities. Attempts by arrangers and collateral managers to mitigate this

risk include offering higher available credit enhancement—as is the case in GoldenTree 2013-1—or adding foreign

exchange options provided by a derivative counterparty, like in Hayfin Ruby II.

Variable funding notes

In 2013, we rated two CLO 2.0 transactions that have variable funding notes (VFNs)—Hayfin Ruby II and Euro-Galaxy

CLO III. VFNs rank pro rata and pari passu with the most senior notes in the structure and have 'AAA (sf)' ratings.

VFNs give the collateral manager additional flexibility to purchase collateral debt obligations during the VFN drawing

period (as outlined in the transaction documentation), if the opportunity arises.

Quarterly transactions

Three CLO 2.0 transactions that we rate pay interest quarterly—Ares European CLO VI B.V., Carlyle Global Market

Strategies Euro CLO 2013-2, and Euro-Galaxy CLO III. While quarterly interest is desirable for some investors to gain

more liquidity, its practical implementation in Europe can be challenging. This is a result of reset risk—resetting

interest payment dates in the underlying loan documents. Substantial reset risk in European CLOs that are backed by a

leveraged loan portfolio became known after the financial crisis, when a significant number of European leveraged

loans became distressed. In the aforementioned CLO 2.0 transactions, arrangers and collateral managers implemented

a dual mechanism as a mitigant. An interest smoothing account retains an appropriate portion of interest from assets

paying less frequently than quarterly, and sets it aside for the next payment date. In addition, a liquidity facility is in

place to cover any potential shortfalls that may occur on the entire rated capital structure if the assets were to reset.

Fixed-rate tranches

CLO 2.0 transactions that we rated in 2013 containing fixed-rate tranches include:

• Dryden XXVII Euro CLO 2013 B.V.;

• Carlyle Global Market Strategies Euro CLO 2013-1 B.V.;

• GoldenTree Credit Opportunities European CLO 2013-1;

• Carlyle Global Market Strategies Euro CLO 2013-2;

• Euro-Galaxy CLO III;

• Dryden 29 Euro CLO 2013; and

• North Westerly CLO IV 2013.


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Specifically, fixed-rate tranches comprise a large part of the capital structure in transactions managed by Pramerica

Investment Management Ltd.—30% in Dryden XXVII and 24% in Dryden 29. Fixed-rate tranches generally offer

higher interest income for investors. However, they are exposed to additional interest rate risk if the low interest rate

environment were to end. In addition, there is an inherent interest rate risk in some transactions, given the presence of

higher buckets for bond purchases in the collateral quality tests.

Derivatives

The use of derivatives in CLO 2.0 transactions has been relatively small, and is mostly limited to perfect asset swaps

intended to hedge the foreign exchange risk of non-euro assets in the portfolios of single-currency euro transactions.

So far, three counterparties have been active as perfect asset swap providers in European CLO 2.0 transactions. In

addition, as mentioned previously, FX options have been used in Hayfin Ruby II to hedge the currency mismatch

between liabilities and assets.

Table 1

List Of Transactions Rated By S&P In 2013

Closing date Transaction Collateral manager

20/03/2013 Cairn CLO III B.V. Cairn Capital Ltd.

09/05/2013 Dryden XXVII Euro CLO 2013 B.V. Pramerica Investment Management Ltd.

15/05/2013 ALME Loan Funding 2013-1 Ltd. Apollo Credit Management (CLO), LLC

05/06/2013 Grand Harbour I B.V. Blackstone/GSO Debt Funds Europe Ltd.

17/06/2013 Carlyle Global Market Strategies Euro CLO 2013-1 B.V. CELF Advisors LLP

11/07/2013 Goldentree Credit Opportunities European CLO 2013-1 B.V. GoldenTree Asset Management LP

15/07/2013 Jubilee CLO 2013-X B.V. Alcentra Ltd.

24/07/2013 St Pauls CLO II Ltd. Intermediate Capital Managers Ltd.

30/08/2013 Hayfin Ruby II SCA Haymarket Financial LLP

05/09/2013 Ares European CLO VI B.V. Ares Management Ltd.

12/09/2013 Harvest CLO VII Ltd. 3i Debt Management Investments Ltd.

12/09/2013 Herbert Park B.V. Blackstone/GSO Debt Funds Europe Ltd.

01/10/2013 CARLYLE GLOBAL MARKET STRATEGIES EURO CLO 2013-2 Ltd. CELF Advisors LLP

26/11/2013 Avoca Capital CLO X Ltd. Avoca Capital Holdings

04/12/2013 St Paul's CLO III Ltd. Intermediate Capital Managers Ltd.

17/12/2013 Euro-Galaxy CLO III B.V. PineBridge Investments Europe Ltd.

19/12/2013 Dryden 29 Euro CLO 2013 B.V. Pramerica Investment Management Ltd.

19/12/2013 North Westerly CLO IV 2013 B.V. NIBC Bank N.V.

Default Rates In European CLO 1.0 Transactions

This edition of our index report also introduces our analysis of the asset default rates for European CLO 1.0

transactions that we rate (see chart 4).

Generally, all European cohorts exhibit similar 12-month default rate patterns. This is explained by a degree of overlap

in their portfolio composition for all issuance years (see "Portfolio Overlap in European CLOs Means Changes in

Corporate Creditworthiness Can Have A Widespread Effect," published on Oct. 10, 2011).


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However, chart 4 also shows that transactions from earlier vintages tend to exhibit larger default rates than those from

later ones. This is a result of their amortization over several years—their portfolios are reducing in size and becoming

more concentrated. As a result, a single obligor default may represent a higher percentage of the total amount of assets

outstanding.

The default rates decreased steadily between Q1 2010 and Q3 2011, increased slightly between Q3 2011 and Q3 2012,

and then decreased. This pattern reflects general market movements over this period. For example, borrowers now

have a greater ability to refinance and roll over their obligations, which has contributed to decreasing default rates.

Chart 4

We have aggregated the results for all cohorts and compared them with the LCD S&P European Leveraged Loan Index

(ELLI). At the outset of the financial crisis and shortly after, a significant number of loans in CLO 1.0 transactions

became distressed and had high default rates. However, since mid-2011, default rates have been consistently lower

than the S&P ELLI benchmark. They increased to some extent between Q3 2011 and Q3 2012, but decreased after.

This pattern is similar to the LCD S&P ELLI default rates over the same period, but default rates in European CLO 1.0

transactions were consistently lower than the ELLI default rates since Q3 2011. In our view, this reflects CLO

managers' ability to use credit selection to outperform the leveraged loan market.


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The decline in both European CLO 1.0 default rates and the ELLI default rates suggests improving credit conditions

and a greater amount of available liquidity for refinancing.

Although most of the CLOs are now amortizing, they are still being managed subject to reinvestment criteria

restrictions. Collateral managers have attempted to shift out the maturities of underlying loans via amend-to-extend

(A-2-E) transactions (see "European CLOs: Life After The Reinvestment Period," published on May 14, 2013). This may

have contributed to the decrease in default rates.

The default rates for European CLO 1.0 transactions and the LCD S&P ELLI index are calculated by adding the par

amount of the defaulted assets in the 12 months prior to the date of a data point, and dividing it by the total amount

outstanding at the beginning of such 12-month period. As of the beginning of January 2013, the par amount of

European CLO 1.0 transactions that we rate outstanding was €66 billion and the par amount of loans tracked in the

S&P ELLI index was €103 billion.

Chart 5


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'CCC' Rated Assets

'CCC' rated assets are an important measure of European CLO performance as an increase in 'CCC' rated assets can

indicate a reduction in the credit quality of the collateral portfolio. The level of 'CCC' assets can also have the effect of

reducing overcollateralization (OC) test results as 'CCC' rated assets may not be carried at their full par value.

From September 2013 to November 2013, the percentage of assets rated in the 'CCC' category ('CCC+', 'CCC', or

'CCC-') has shown mixed performance for various European CLO cohorts (see chart 6).

By vintage, the reported level of 'CCC' rated assets in European cash flow CLOs, as a percentage of total assets in

November 2013, was as follows:

• 2004 vintage CLOs: 12.83% of total assets (up from 10.18% in August 2013);


• 2006 vintage CLOs: 5.04% of total assets (down from 5.15% in August 2013);

• 2007 vintage CLOs: 3.91% of total assets (down from 4.28% in August 2013); and

• 2008 vintage CLOs: 6.21% of total assets (down from 7.07% in August 2013).

The changes in 'CCC'-rated assets are explained by rating migration in the underlying portfolio, they depend on the

pool composition of individual transactions. In addition, all else being equal, the percentage of 'CCC'-rated assets

increases as the portfolios become smaller in size and more concentrated, due to deleveraging. Deleveraging has a

greater effect on the 2004 and 2005 vintages, showing the highest percentages of 'CCC'-rated assets.


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Chart 6

Defaulted Assets

Defaulted assets are a key indicator of CLO performance as a defaulted asset may result in a loss of principal to the

CLO and a corresponding decline in credit enhancement.

From September 2013 to November 2013, the percentage of defaulted assets (i.e., assets from obligors rated 'CC', 'C',

'SD' [selective default], or 'D') in collateral portfolios increased for all of the European CLO cohorts.

As of November 2013 , the percentage of defaulted assets in each underlying collateral portfolio was as follows:




• 2007 vintage CLOs: 2.27% of total assets (up from 1.91% in August 2013); and

• 2008 vintage CLOs: 2.47% of total assets (up from 1.16% in August 2013).

These calculations show the proportion of assets that are currently in default, over total assets (not including principal

cash). All else being equal, the percentage of defaulted assets increases as the portfolios become smaller in size and


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more concentrated, due to deleveraging. The data shows that the defaulted assets now constitute a higher percentage

of all CLO cohorts—a trend that is mostly explained by deleveraging and by the presence of assets reported as

defaulted for several periods in a row.

Chart 7

Senior OC Ratios

The senior OC ratio test is a par value test to protect senior noteholders. Declines in the senior OC ratio test results

can indicate decreasing credit quality of the CLO.

The senior OC ratio test cushions signaled improved performance (based on transaction trustee reports) across

European CLO cohorts since August 2013. The cushions increased for all cohorts included in our index (see chart 8).

The senior OC ratio test cushions (based on reported information) as of November 2013 were as follows:






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The increase in senior OC ratios can be partially attributed to the fact that many European CLOs included in our index

are now beyond their reinvestment period. As the CLO deleverages, the senior OC ratio will increase.

Chart 8

Subordinate OC Ratios

The subordinate OC ratio test is the par value test for the junior notes in the CLO. Failure to satisfy this test would

cause interest and principal to be redirected to pay down the most senior class of notes until the test is satisfied.

With the exception of the 2005 cohort, the subordinate OC ratio test cushions showed improved performance for

European CLO cohorts, since August 2013.

As of November 2013, the subordinate OC ratio test cushions (based on reported information) were as follows:

• 2004 vintage CLOs: -2.85% of total assets (up from -4.93% in August 2013);

• 2005 vintage CLOs: 0.56% of total assets (down from 1.42% in August 2013);



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Again, as CLOs deleverage, this can increase subordinate OC ratios. However, for certain vintages, the deleveraging

has been offset by defaults and junior notes deferring interest, causing the junior OC ratios to decrease.

Chart 9

Notes

Due to the timing of transaction trustee reports, our Q4 2013 data take into account September 2013, October 2013,

and November 2013.

For specific definitions of the performance fields used in this report, see "Glossary Of Cash Flow CLO Performance

Index Fields," published on Jan. 30, 2009. For the list of transactions this report tracks, see "List Of European CLO

Transactions Included In CLO Performance Index Report (As Of February 2013)," published on Feb. 13, 2013.

Our European CLO Performance Index Report provides aggregate performance statistics across most of our rated

European cash flow CLO transactions backed primarily by corporate loans. We provide this information to help market

participants track the overall performance of European cash flow CLO transactions and to benchmark the performance


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of the transactions they follow against the performance of cohorts of similar transactions.

Our quarterly European CLO Index Report highlights what we view as a number of key risk areas for the transactions,

and which we use as part of our analysis of the credit quality of securitized portfolios and of the transactions' payment

structure and cash flow mechanics. These include rating migration within the underlying collateral portfolios, as well

as other information relevant to the sector.

We divide the performance information in the CLO indexes into five cohorts, each containing data for most of the

European CLO transactions we rated and issued in a specific vintage year from 2004 through 2008. We collect the

performance information from transaction-level performance data in our collateralized debt obligation (CDO)

surveillance databases.

Information prior to the most recent 12 months is available on CDO Interface, Standard & Poor's Web-based portal for

CDO performance information, at www.cdointerface.com. To generate, view, and download data from the CDO

indexes, log onto CDO Interface, and then select the "Indexes" tab.

Related Criteria And Research

• New Issue: North Westerly CLO IV 2013 B.V., Dec. 19, 2013

• New Issue: Dryden 29 Euro CLO 2013 B.V., Dec. 19, 2013

• New Issue: Euro-Galaxy III CLO B.V., Dec. 17, 2013

• New Issue: St. Paul's CLO III Ltd., Dec. 4, 2013

• New Issue: Avoca Capital CLO X Ltd., Nov. 26, 2013

• New Issue: Carlyle Global Market Strategies Euro CLO 2013-2 Ltd., Oct. 1, 2013

• European CLOs: Life After The Reinvestment Period, May 14, 2013

• List Of European CLO Transactions Included In CLO Performance Index Report (As Of February 2013), Feb. 13,

2013

• Portfolio Overlap in European CLOs Means Changes in Corporate Creditworthiness Can Have A Widespread Effect,

Oct. 10, 2011

• Update To Global Methodologies And Assumptions For Corporate Cash Flow And Synthetic CDOs, Sept. 17, 2009

• Glossary Of Cash Flow CLO Performance Index Fields, Jan. 30, 2009

Additional Contact:

Structured Finance Europe; [email protected]


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