Anticipating a growth in the segment, Fitch Ratings recently launched its methodology for CLOs backed by middle market loans - a product somewhere in between conventional business loan securitizations and commercial loan-backed CLOs.

To date, Fitch has rated four such transactions, said Elizabeth Russotto, an analyst in Fitch's credit products group. The rating agency expects the pace of the product to pick up gradually this year and more so into 2003.

The middle market CLO is a novel concept and, until recently, the smaller regional banks and specialty finance companies that typically extend loans to middle market companies were unable to access the CLO market because the loans they make are smaller in size, not widely syndicated and often extended to privately owned businesses.

This is changing, though, Russotto said, as more specialty finance companies are looking to grow their businesses with cheaper costs of funds in order to become more competitive players.

"A CLO allows specialty finance companies to raise new capital [and] to make loans at lower costs of funding, and it's one way of gaining more leeway," she said. "If they were to raise capital alone on a corporate basis, it would be much costlier."

Stuck in the middle

A middle market company, according to Fitch, is one that has revenues of between $10 million to $400 million, and borrowing needs in the $1 million to $75 million range. Middle market loans can be used for acquisitions, management buyouts, business growth, liquidity and/or recapitalizations.

Given their size, the amount of available sources of credit for middle market businesses is limited. These businesses, which are for the most part privately owned, do not have to publish financial information to the general public and therefore receive little or no research coverage.

Some of the larger banks such as Bank of America have been building up dedicated middle market businesses. But as a result of the ongoing consolidation in the financial services industry, there are fewer lenders who extend credit to these smaller companies.

Therefore, the traditional middle market lenders are the specialty firms, which are picking up the slack, and for that, they need additional resources, Russotto said.

Though there is interest in this CLO product, many of the risks associated with middle market loans are different than commercial loans (and more similar to small business loans) - not the least of which is the higher probability of default. This borrower base generally does not typically have a large degree of financial flexibility, and is susceptible to economic conditions, the rating agency said.

As such, a typical middle market loan portfolio will have an approximate weighted average rating of between triple-C and singe-B-minus, with a higher expected cumulative default rate.

It is also difficult to find consistent and accurate historical data for middle market loans, the rating agency said, as most of the borrowers are private companies. Fitch will therefore be using its high yield default matrix as a proxy for the expected default rates of middle market loans. The differing risk profiles of the two asset types, high yield bonds and middle market loans, are taken into account by the lower weighted average portfolio ratings and the higher expected cumulative default rates assigned to middle market loan portfolios.

Conversely, middle market loans often have higher recovery values than high yield bonds, largely because middle market lenders have greater flexibility in covenant negotiations.

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