It’s a marriage between two of Wall Street’s hottest products.
Collateralized loan obligations — typically chock-full of broadly-syndicated debt — are increasingly being stuffed with private loans made to highly leveraged medium-sized companies with limited access to bank financing. Known as middle-market CLOs, the asset class has ballooned to $57 billion, from just $20 billion six years ago. Five new entrants this year — including Owl Rock Capital and PennantPark Investment Advisers — suggest issuance is only set to increase.
The frenzied growth is another example of how banks, insurance companies and pension funds continue to reach for higher-paying securities in the face of almost $15 trillion of negative-yielding debt around the world. Middle-market CLOs can offer premiums of as much as 200 basis points versus their garden-variety peers, in part due to the reduced liquidity that comes with direct lending, which bypasses traditional capital markets. Analysts say the products could saddle investors with even steeper losses if credit conditions sour.
“Some investors want the excess return to take on the illiquidity of the underlying middle-market loans,” said Michael Herzig, a portfolio manager at THL Credit. “You can’t trade a middle-market CLO the way you can broadly-syndicated ones. You really have to be diligent and careful when you structure.”
About $10.4 billion of new middle-market CLOs have priced this year, according to data compiled by Bloomberg, near last year’s pace, which was the fastest since the financial crisis. Still, that’s dwarfed by about $80 billion of traditional CLO issuance. The $57 billion of middle-market CLOs outstanding compares to more than $600 billion of the conventional variant.
There are plenty of distinctions between middle-market and more typical CLOs that pool syndicated loans. For one, the firms that make the private loans are also the ones that oversee the securitizations. The combination of origination, underwriting and management fees is a potentially lucrative setup.
But the arrangement also means they’re forced to keep a slice of the securities they offer in what is known as risk retention. These are rules intended to align lender and investor interests — largely to prevent a repeat of the subprime mortgage fiasco.
[Insurance Journal Editor’s Note: The Capital Markets Bureau of the National Association of Insurance Commissioners (NAIC) monitors developments in the capital markets globally and analyzes their potential impact on the investment portfolios of U.S. insurance companies. Its most recent report is a primer on Collateralized Loan Obligations.]
“In a middle-market CLO versus one in the broadly-syndicated market, the active management isn’t centered on discretionary trading of the loans within the portfolio,” said Vivek Mathew, head of asset management and funding at Antares Capital, one of the largest middle-market lenders with $26 billion of assets. “It’s originating the loans and actively managing the underlying assets from a credit perspective, including working them out if they begin to struggle.”
Middle-market loans also tend to carry more safeguards — known as covenants — than broadly-syndicated loans, where investors have recently started to push back against some of the riskiest financings.
Only about 30% of middle-market debt is covenant lite, versus 70% to 80% for loans sold to investors, according to Michael Boyle, a managing director at Bain Capital Credit.
On the other hand, the underlying debt in middle-market CLOs tends to be smaller in size, as many borrowers have annual earnings of $100 million or less. That makes the debt significantly less liquid compared to traditional loans. In addition, it makes the CLO bonds themselves harder to sell.
“If you decide you don’t like what the CLO manager is doing, you’ll pay a higher price to exit the position,” said Dave Preston, a CLO analyst at Wells Fargo.
Many of the new entrants issuing middle-market CLOs are already major players elsewhere, including business development company FS KKR Capital and conventional CLO manager THL, which sold its first middle-market securitization in March.
The A rated chunk of Bain Capital’s middle-market collateralized loan obligation from August pays an interest rate of 3.6% over the London interbank offered rate, according to data compiled by Bloomberg. The similar-rated tranche of its most recent conventional CLO from September yields 2.85% over the benchmark. Corporate bonds with comparable rankings pay an average of about 2.64%, according to Bloomberg Barclays index data.
Still, some are steering clear of middle-market CLOs given the difficulty conducting due diligence on the underlying companies. Investors have good reason to be wary, according to Jason Merrill, an investment specialist at Penn Mutual Asset Management, which oversees about $28 billion, largely on behalf of insurers.
Financial Crisis Lesson
“One of the lessons we were supposed to learn from the financial crisis is that it’s important to understand the collateral and understand the risks,” Merrill said. “We do deep analysis when we look at credits, and that’s harder to do with middle-market CLOs,” he said, adding that it has “caused us to shy away from the middle-market space.”
That’s why it’s critical for investors to choose a firm whose lending and management approach aligns with their own, according to Bain Capital’s Boyle.
“There’s less collateral overlap than in the broadly-syndicated market,” said Boyle. “Finding the right asset manager really matters.”
For now, there’s little sign of a supply slowdown anytime soon. Middle-market lenders say CLO issuance is an increasingly popular source of term financing as they seek to expand their private-credit business. And fundraising for North America-focused direct lending is booming.
New money reached $6 billion in the third quarter, bringing this year’s total to $22.6 billion, according to London-based research firm Preqin. That compares to $16.2 billion a year ago. Fundraising typically jumps in the fourth quarter, and cash raised may come close to the record $36.3 billion of inflows in 2017.
“There’s been more competition but there’s still growth opportunity in direct lending,” said Craig Packer, co-founder of Owl Rock, which manages $13 billion of assets. We’ve seen investor appetite for our CLOs, and we expect to do more.”
–With assistance from Charles Williams and Adam Tempkin.
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