Middle market CLOs have never recovered the role that they played in lending to small and medium-sized companies before the financial crisis. Unlike CLOs backed by broadly syndicated loans, which are now the biggest buyers in their space, middle market CLOs have been crowded out by other alternative lenders.
They may finally be poised to play a starring role.
Before the financial crisis, nonbank lenders used collateralized loan obligations as a vehicle to fund loans to small and medium-sized companies unable to obtain bank financing. At the 2006 peak, issuance of middle market CLOs reached more than $22 billion, according to Thomson Reuters.
But after the CLO market went dormant in 2008, other lenders picked up the lending slack, notably business development companies, private investment funds. These players retained the lead position, even as CLO issuance picked up again, reaching more than $7 billion in 2014. BDCs alone have accounted for more than 70% of the $47 billion growth in middle-market lending since 2007, according to Moody’s Investors Service.
CLOs now appear to be poised for a bigger comeback, in part because BDCs pull back on lending under pressure from shareholder activists.
In a report published this week, Moody’s projected that new-issue CLOs will play an increasingly crucial role in both direct lending and the refinancing of middle-market corporate loans. The rating agencys notes that regulators’ leveraged lending guidelines are keeping large banks on the sidelines of the mid-market, and there is an acute lack of capacity in the private equity space (and with existing CLOs) to handle the $48 billion of loans held in outstanding CLOs that will need to be refinanced by the end of 2020.
“Several technical restraints will likely mute BDCs' appetite for both new loans, and refinancings if the U.S. economy slows down,” the report states. “This volume of debt could [also] prove too large for PE firms and hedge funds, which would have to triple their MM lending to roughly $60 billion from the current $20 billion.”
Middle-market CLOs, on the other hand, have only the restraint of investor interest to cap their capacity to lend to the middle market, which is typically defined as companies with between $15 million and $50 million in annual revenue.
DBRS is also calling for an increase in middle market CLO issuance, citing appetite among institutional investors, particularly insurance companies, for facilities with credit ratings. In a recent report, the rating agency said the increased investor interest in senior secured loans to middle-market borrowers is “driven by the yield pickup relative to syndicated bank loans, stronger covenant packages and regulatory support for non-bank direct lending.”
Growing investor interest by pension funds, insurance companies and sovereign wealth funds is evident in how middle-market lenders are “seeing a massive amount of capital coming into the market” for CLOs and other managed asset vehicles filled with senior-secured, primarily first-lien loans, according to Tennenbaum Capital Partners managing director Philip Tseng. Tseng was speaking on a CLO investment conference panel last week in New York, hosted by Information Management Network.
Kevin McLeod, a managing director at Cerberus Capital Management, discussed at the conference the inverted market share that has evolved for nonbank lenders in the middle-market corporate space. Prior to the financial crisis, U.S. and foreign banks controlled two-third of the space; today the non-bank lenders hold 75% of the market.
In addition, McLeod noted that size of the credit facilities for the underlying loans to companies has risen from $100 million to $150 million to $150-$250 million. “In the midst of all this, we’re not changing any of our lending guidelines,” said McLeod.
Tseng noted that the new cash coming from pension fund and insurance company investors is being drawn to the attractive, high-single digit returns that they are not seeing in other high-yield vehicles.
Newer middle-market CLOs differ from CLOs backed by broadly syndicated loans as well as traditional mid-market CLOs. Their senior tranches typically are rated no higher than single-A or double-A, compared with triple-A for the senior tranches of broadly syndicated CLOs. They are backed by fewer loans, perhaps 30 to 40, where CLOs backed by loans to bigger companies may have exposure to hundreds of credits.
Warehousing collateral for new deals can take much longer too, up to 18 months.
Under the middle-market CLO warehouse format, managers can also invoke more changes in upsizing the tranches and extending the reinvestment period.
“The main difference in the middle-market space is the financing is a capacity trade vs. an arbitrage trade for the most part,” said Mike Romanzo, a managing director for Wells Fargo, who was also a guest panelist at the IMN conference. “Everybody obviously is mindful of equity returns that they’re trying to generate and making sure they are across as liabilities as reasonable relative to spread on the assets, but different from the broadly syndicated world where it’s exclusively trying to generate financial arbitrage between assets and liabilities.”
They are often privately sold, making it difficult to come up with a precise figure for annual issuance. And typically the manager holds on to the equity, or most subordinated securities issued by a securitization trust.
There is also little trading of loans used as CLO securities in the secondary market. At the New York conference, McLeod said the secondary market is simply not suitable for a high-touch product like middle-market CLOs, where the originators must keep weekly, or even daily tabs, on procurements, revenues, covenants and debt levels of companies in their portfolios.
Unlike the secondary market for CLOs backed by broadly syndicated loans, where the most high-demand corporate loans are performing assets trading at par, any loan available in the middle-market would only likely be an underperforming or distressed loan that another lender or manager might want to buy opportunistically, but even on that front McLeod was blunt: “The question of whether we exit the underlying loans? We don’t,” said McLeod.
Like many middle-market direct lenders and CLO managers, Cerberus has more flexibility than BSL CLO managers to work out terms and restructurings on problem loans within portfolios they have directly originated. “We don’t think anybody is in a better position to extricate value from a loan than us,” said McLeod.