Several firms are eyeing securitization to fund their middle-market and mezzanine-debt investments, using variations of the commercial business CLOs that companies such as American Capital Strategies, MCG Capital Corp. and CapitalSource have brought to the 144A market several times in the past few years.
At the top of the list are mezzanine and middle-market fund managers desiring leverage, sources said.
Ableco Finance, a specialty finance company and affiliate of Cerberus Capital Management, has an established revolving CLO structure funded by group of ABCP conduits via lead agent CIBC World Markets. Ambac wraps the senior debt. The vehicle, which has grown to $1 billion in size, was established in the late 1990s and is structured to issue term CLO paper as well. Sources predict that Ableco will become a programmatic term issuer.
Other potential middle-market players, according to an industry source, include Madison Capital Funding, Capital Resource Partners, The CIT Group and bank lending affiliates such as Merrill Lynch Capital, Wachovia Capital Partners, Foothill Capital Corp. (a subsidiary of Wells Fargo), and CDC IXIS Capital Markets North America.
Heller Financial was said to be in the market with a transaction called West Loop before being acquired by GE Commercial Finance (see ASR 7/30/01).
Though interest in the structure has picked up substantially over the past two years in the U.S., the European SME securitization market (CLOs backed by small and medium-size enterprise loans) has been robust for several years. According to a recent Fitch Ratings criteria report, the agency has rated about 30 SME CLOs abroad.
Before the wave of banking consolidation in the late 1990s, banks were the primary lenders to the middle-market companies, which are generally not rated but have revenues exceeding $100 million per year.
As the bank lending community shrank, especially for unrated, illiquid credits that carry high capital charges, specialty finance lenders - most of which do not have the same balance sheet concerns - found a niche underserved.
"Over the past several years, there's been a lot of room for specialty finance companies to make these loans to the middle market," said Elizabeth Russotto of Fitch.
When Wachovia Securities brought American Capital Strategies to market in 2000, the deal was shopped as a "commercial business" loan securitization, described as hybrid between a traditional small business loan securitization and a CLO. "The CLOs are a nice tool for them, because they can finance at more attractive levels," said Russotto.
As the motivation is generally a need for financing, these types of issuers often retain all or most of the equity in the deals.
While other specialty finance companies established programs following ACAS, more traditional portfolio managers - such as Antares Capital Corp., which brought its first middle-market hybrid in 1999 via CIBC - were just beginning to crack the arbitrage between the illiquid middle-market loan universe and the CLO funding costs. Indosuez Capital is also an asset manager in this space.
These arbitrage deals are not necessarily backed entirely by middle-market loans. Also, the risk tends to be tranched out further, with the issuer selling off a large portion of the equity.
Challenges and change
While the illiquidity for middle-market whole loan portfolios is a logical fit for CDO technology, the debt is unrated, which presents a challenge for the rating agencies, as the underlying ratings in the collateral pool is generally a major factor in the structuring.
Because of this, middle-market portfolios require a hybrid analysis, part CLO methodology and part actuarial, more in line with traditional securitization technology, such as applied to small business loans and consumer assets.
Beyond mezzanine funds and specialty finance companies, regional banks have also provided loans to the middle-market commercial clients, and often have portfolios of these illiquid assets, which could, theoretically, be a target area for the arbitrage oriented players. The regional banks themselves would face diversity issues in structuring their own programs. A major challenge for collateral picked up from regional banks is the absence of underwriting conformity. A rating agency source said that companies purchasing assets from regional banks will probably have to re-underwrite the loans before they can be securitized.
One obstacle for the sector is a lack of conformity. For example, not everyone has the same definition of "middle market." Banc One Capital Markets groups middle-market companies in the $10 million to $500 million revenue per year range, and $500 million plus as large commercial loans. Wachovia Securities, on the other hand, view the middle-market as capping out at about $250 million per year.