Fitch Ratings is taking issue with the triple-A ratings that two of its rivals assigned to a middle- market CLO with a particularly heavy concentration in two related industries.
A report Fitch published Monday disagreeing with recent high investment-grade ratings granted to the transaction, due to an initial industry concentration risk exceeding 75% for software and IT firm debt exposure. Fitch did not name the sponsor or either of the rating agencies involved.
However, the description of the deal's top-heavy exposure to the software industry, and the reference to the lack of caps on industry exposure, clearly fits the $305 million VCO CLO 2018-1 that Vista Credit Opportunities Management priced in August via Wells Fargo and GreensLedge Capital Markets.
Fitch expressed concern over the heavy concentration in high-tech, which it said could elevate default risk to senior noteholders in the event of a downturn in the sector, similar to the recent experience of many 2013- and 2014-vintage collateralized loan obligations with heavy exposure to oil and gas.
S&P Global Markets and DBRS rated the deal. S&P declined to comment on Fitch’s report.
DBRS managing director Jerry van Koolbergen did not address Fitch's specific concerns, but in an email statement said that DBRS "analyzes concentration risk based on fundamental business drivers.
"Industry concentration is relevant in the referenced transaction, given the portfolio has concentrations of enterprise software companies," van Koolbergen said. "However, it is mitigated by the diversity of business risk drivers."
Investors appear to recognize that the deal carries additional risk. The senior, $158 million tranche of Class A notes pay 150 basis points over three-month Libor; that's among the widest spreads of any publicly rated middle-market CLOs to close last month, according to Thomson Reuters LPC and Deutsche Bank.
By comparison, Antares Capital priced the senior tranche of its second middle-market CLO at a spread of 140 basis points over Libor the same month.
In addition to rating the senior notes, S&P assigned ratings to four subordinate tranches of notes ranging from AA to BB. DBRS did not rate any of the subordinate notes, which could indicate that they were split-rated. The banks and insurance companies that buy senior tranches often require two credit ratings; not so the typical buyers of subordinate tranches. This makes it easier for issuers to drop the less-flattering rating.
Vista Credit Opportunities Management is an affiliate of Chicago-based alternative investment firm Vista Equity Partners (VEP). Most of the loans in the CLO were originated by VEP-controlled funds, according to DBRS' presale report.
The senior notes cannot be called for 1.5 years and may be actively managed for up to two years.
In Fitch’s view, the deal was far from triple-A material, given given the “unmitigated” industry concentration risk described in the presale reports issued by what it identified as "a major" and "a minor" rating agency.
“The major rating agency described the portfolio as a ‘diversified collateral pool’ even though their industry distribution chart shows that 'software' and 'internet software and services' represent over 75% of the indicative portfolio with no specified industry concentration limitations,” Fitch's report stated.
Fitch conceded it had not reviewed the “specifics” of the transaction itself, but the agency believes that the publicly available deal details in the agency presale reports alone are insufficient to warrant AAA ratings on the Class A notes. “The minor agency identified industry concentration as a primary risk, but neither presale report provided specifics on how they gained sufficient comfort to assign their agency's highest rating to the CLO's senior-most notes.”
Had Fitch been tasked with rating a CLO in which the “concentration goes beyond what we deem to be mitigatable,” it would cap the deal at a A or BBB, or might even “decline to rate the transaction.”
The deal itself is lightly leveraged at just 5.52x, compared to 9.65x for the three-month average of broadly syndicated CLOs rated by S&P. It also provides a higher subordination ranking to the senior AAA notes (48.15% vs. the 40.8% peer average) and also has a weighted average spread of 4.32% above the average 3.44%.
The largest obligor represents 2.68% of the collateral loans in the pool.
S&P stated in its presale report that the transaction passed its “largest” industry concentration sensitivity test. Nearly 58% of the underlying loans have credit ratings assigned by S&P, and 75.5% have recovery ratings.
According to DBRS, Vista Credit (founded in 2013) has funded $1.6 billion across 67 portfolio companies since 2013, growing to $1.2 billion in assets under management. Most of the deal flow is through Vista Private Equity or intermediary firms. Vista Credit may also elect to acquire loans through the secondary market for its portfolio.
In his email statement, van Koolbergen said that in analyzing concentration risk, "the relevant starting point is the appropriate business risk for each borrower."
In the example of enterprise software developers (the primary obligors in Vista's CLO), firms that cater to software and data tools for retailers "could be more exposed to the business risks associated with the retail industry than more diversified software companies.
"Another example includes accounting firms," van Koolbergen wrote. "Accounting firms that specialize in financial services business clients are more exposed to business risks associated with the financial services market compared with accounting firms with diversified specialization."
Vista Credit lends to companies with an average $40 million in annual earnings, ranging from $25 million to $100 million. (It only invests in about 15% of approximately 600 firms its screens annually for investments, according to DBRS.)
It's not the first time Fitch has publicly criticized the rating of one of its rivals. In late August Fitch also panned a preliminary 'AAA' rating DBRS assigned to a European commercial mortgage securitization — Elizabeth Finance 2018 DAC — citing a risk to senior noteholders in the event that one of the two mortgages used as collateral is refinanced.
And last year, Fitch
