On February 21st last year, the day Italy recorded its first Covid-19 death – a 78-year old retired roofer from a small town called Vo’, near Venice – some 1,300km away in Amsterdam, an “earthquake”, as one international law firm put it, of another kind rattled an obscure part of the financial world.
It emerged that day that the Dutch tax authorities had slapped a 21 per cent VAT rate on managers of esoteric vehicles for repackaged loans of highly-indebted companies with low credit ratings, or what are known as collateralised loan obligations (CLOs), based in that country.
International corporate law and professional firms that service this section of the world of non-bank finance – or what’s dubbed “shadow banking” – swung into action.
Clifford Chance, a "Magic Circle" London firm that breathlessly wrote a note to clients at the time titled VAT Earthquakes Strikes Dutch CLOs, said there was one obvious destination for the under-fire CLOs to seek refuge: Ireland.
Business services group Vistra also pitched Dublin as the "Emerald answer" for poor Dutch CLOs, highlighting that the Republic has no VAT charge on such vehicles, CLOs here don't need to be licensed or authorised by the Central Bank, and the fact that the already low-tax jurisdiction becomes much more tax friendly when it comes to special purpose vehicles (SPVs).
They were only two of dozens of firms that offered to help CLOs with safe passage to the Irish International Financial Services Centre (IFSC). And it worked. In the final three months of last year, 79 CLOs, with more than €31 billion of loan assets, moved from the Netherlands to this State, pushing the total in Irish-domiciled vehicles to just under €153 billion, across 414 vehicles.
The IFSC has developed an almost €5 trillion shadow banking hub – one of the world's largest – in the past three decades
Dublin already accounted for about 70 per cent of European CLO assets before the flight of Dutch vehicles. Now it’s home for almost the entire market, even if the assets are managed predominantly from overseas. The level of CLO assets in Ireland is now 10 times what it was six years ago, making it the fastest-growing business area in the already outsized Irish shadow banking hub – relative to the size of the economy.
Financial alchemy
CLOs are cousins of key causes of the 2008 financial crisis, collateralised debt obligations (CDOs), which were used to repackage pools of US subprime mortgages and refinance them in the international bond markets through a process called securitisation. In the case of CLOs, however, the borrowers are not households, but companies.
Typically these companies have high levels of borrowings, usually tied to acquisitions, and credit ratings that are considered below investment grade. Through financial alchemy, CLO managers buy bundles of these corporate loans from banks and private equity firms and can turn them into AAA-rated bonds to attract even the most cautious of pension managers, by dividing interest payments among different groups of investors.
The highest-ranked bonds issued by a CLO stand first in line to receive payments from companies servicing their loans and carry the highest credit ratings. Investors that take the lowest-rated securities, and those that put money into the equity portions of a CLO, only get paid when all is going well with the group of original borrowers. The riskier bonds carry higher interest rates, or coupons.
CLOs play an important role in the financing of the modern economy, allowing for the spreading of risk as companies borrow to grow. Unlike the boomtime subprime collateralised debt obligations (CDOs) that were exposed to all too many of one type of borrower – mortgage holders with no income, no job and no assets (Ninjas) – CLOs are typically exposed to companies from different industries and of varying sizes, making widespread defaults less likely.
For lawyers, accountants and bankers that are part of the ecosystem of the IFSC, which has developed an almost €5 trillion shadow banking hub – one of the world’s largest – in the past three decades by becoming a key domicile for international investment and money market funds, CLOs have become another gravy train.
Fees from Irish SPVs to service providers amounted to about €400 million last year, according to industry sources. CLOs probably accounted for €60 million.
Post-pandemic
While many investors feared the worst 12 months ago as Covid-19 stunned the global economy and sent market interest rates, or yields, on CLO bonds higher, loan defaults by companies have so far turned out to be lower than anticipated as economies were buttressed by extraordinary government and central bank support. The wall of money that central banks have pumped into financial markets over the past year has also lured even more cautious investors back into triple-A-rated CLO bonds as they struggled to get income yield in an ultra-low interest rate environment.
Indeed, the first two months of the year saw CLO managers raise €6.6 billion in Europe in 17 transactions and a further €10.3 billion in entire refinancings of existing vehicles, making it the busiest period since the European CLO market reopened in 2013 after the financial crisis, according to ratings agency Scope. The market has rebounded in tandem with the wider market for mergers and acquisitions backed by huge levels of borrowings.
However, the concern is that multitrillion euro government and central bank actions since the outset of the pandemic are merely delaying a spike in corporate bankruptcies.
Meanwhile, market interest rates are on the rise again as bond market followers have started to believe that all that stimulus – and the prospect of households letting rip with built-up savings once economies reopen – will fuel inflation and central bank rate hikes. The yield on 10-year US government treasury notes has doubled since the start of the year to more than 1.7 per cent this week.
While the corporate world will inevitably benefit from an economic rebound, for some it will be too late. Rising interest costs may tip some of the most heavily-indebted companies in CLOs over the edge.
For Ireland, the prospect of a CLO running into trouble would cause more reputational damage than a direct cost for Irish taxpayers. But even that carries a price.
