Middle market CLOs have remained relatively scarce since the financial crisis, as it is still difficult for deal sponsors to get financing to warehouse loans to small and medium-sized companies.
Most of the deals to date have come from middle market lenders opting to securitize loans they are already holding on their books. NXT Capital is one of the latest commercial lenders to come to market with a CLO; this month it priced a $308 million deal, NXT Capital CLO 2012-1. The senior, 'AAA'-rated tranche printed at Libor plus 190 basis points, which the firm said was the lowest level for a middle market CLO since the financial crisis.
In an interview with ASR's sister publication Leveraged Finance News, Neil Rudd, NXT's chief financial and administrative officer, explained that this kind of pricing makes CLOs an attractive form of financing for a firm that would otherwise rely on equity capital or on a line of credit from its own lenders. NXT held on to the equity in the CLO, but the deal still freed up a significant amount of capital to make more loans.
While this was NXT Capital's first CLO, the firm's management is hardly inexperienced, having launched a middle market CLO while at Merrill Lynch in 2007.It won't be NXT's last deal either; Rudd said the firm expects to issue more, market conditions permitting.
LFN: How do middle market CLOs differ from securitizations of more broadly syndicated loans?
Neil Rudd: The market for middle market CLOs is smaller, with far fewer issuers. Post-crisis, there have been half a dozen middle market CLOs. Most middle market CLOs, especially these days, are issued by buy-and-hold balance sheet lenders such as NXT Capital, who view CLOs as financing rather than arbitrage.
What are NXT's other sources of financing?
Rudd: So far, NXT's funding has been largely done via a bank line of credit facilities. We currently have almost $800 million in bank financing for our corporate finance business. Our bank financing has term-out features, so it's different than a traditional warehouse line. It provides flexibility: If a window opens and there's an attractive opportunity to complete a capital market transaction, we can do so. If the window closes, we can continue to originate and hold on our balance sheet.
Is pricing the only appeal of financing via a CLO, or are you also looking to diversify your sources of funding?
Rudd: Another attraction of CLOs for NXT Capital and other issuers is CLOs' ability to reach institutional investors. NXT has successfully attracted additional banks to our financing facility; we currently have six banks led by Wells Fargo. But we also believe bank financing is ultimately a finite market. CLOs give us access to a new class of investors that aren't lenders but are interested in exposure to the middle market asset class. Issuing a CLO gives NXT additional capacity to grow by reaching a larger investor base. We expect to issue additional CLOs. Timing will play a role; I don't see NXT being purely opportunistic, but the last two years have demonstrated that some times are better than others for issuing a CLO.
How long did it take to put the deal together, given that you had already the collateral in place?
Rudd: Our first CLO took just under three months to complete. With much of the upfront investment in documentation and systems out of the way, we expect to be able to execute on future CLOs even more quickly.
In its presale report, Moody's Investors Service said most of the loans would be in place when the deal closed; what was the exact percentage?
Rudd: NXT's CLO was fully ramped at close. As the loans pay off, we expect to replace them with other senior secured middle market loans. We may have a small bucket for second lien loans, but 100% of the initial portfolio consists of senior secured loans, which are our primary focus. NXT can also provide junior capital, but it's a small part of our business.
These days it's possible to launch CLOs of more broadly syndicated loans without warehousing the collateral; what level of warehousing is typical for middle market CLOs?
Rudd: Middle market CLOs have traditionally had a high percentage of loans funded at close and a smaller ramp-up, even pre-crisis. There might have been a ramp of 25% - 30% of the collateral over 120 to 180 days. Post-crisis, ramp time has become shorter and the percent of collateral funded at close is higher. NXT could have built a ramp into our CLO, but we chose to identify 100% of the loans at close because that was more attractive to investors.
What percentage of the firm's corporate finance portfolio is in CLO?
Rudd: NXT has almost $1 billion in loan commitments to middle-market companies, including the assets in the CLO. NXT is retaining all of the equity in the CLO, so we have substantial skin in the game in terms of how the collateral performs. NXT has also typically retained a portion of each loan sold to the CLO.
Do you expect to see many more middle market CLOs from other managers, either those who have done deals recently or other first-time deals from new managers?
Rudd: I think there will be a gradual pickup in the number of middle market CLOs as more investors recognize the diversification opportunity this represents and how well middle market loans performed during the recent recession.
Recent evidence suggests that CLO issuers will be companies like NXT Capital, Golub Capital and Ivy Hill Investment Management (a portfolio company of Ares Capital). These companies have a proven track record and access to permanent sources of capital so they can secure the bank financing needed to aggregate loans, which typically requires up to 35% equity subordination.
There are other viable middle market CLO issuers today, including Madison Capital, NewStar Financial and a handful of others. But I think it's unlikely we'll again see the proliferation of middle market CLO managers that took place in the 2004 - 2007 timeframe. Banks are no longer prepared to provide almost 100% financing of the collateral for thinly capitalized managers, so the business model that many of those CLO managers relied on in the past doesn't work today.
Can you give a sense of how the costs of funding loans via a CLO compares with the cost of bank capital? Ares Capital recently disclosed that it was paying Libor plus 225 basis points on its $900 million revolving line of credit.
Rudd: The best comparison to consider is the weighted average spread of the CLO securities that need to be issued to achieve similar leverage to bank financing. In the case of NXT's CLO, this is through the 'AA' level, and prices at a blended rate for the AAA and AA securities of Libor+210. This is significantly lower pricing than typical bank financing.
In the case of Ares, a number of factors may impact the cost of their bank debt financing. For example, Ares' strong historical track record, comfort that lenders derive from the overall leverage limit of 1:1 for a BDC and other revenues banks derive from Ares, such as underwriting fees for follow-on equity offerings.
What other benefits has NXT realized by accessing the CLO market?
Rudd: The CLO offers NXT a number of advantages. In addition to expanding and diversifying our funding sources, the CLO also helps NXT obtain increased leverage on our portfolio, which frees up capital to re-invest in the business and drives enhanced returns for our investors. Plus, the CLO allowed us to even more effectively match fund these assets.
Presumably, NXT isn't in a position to put all of the money raised by the CLO to work right away; in the interim, are proceeds used to pay down the firm's line of credit?
Rudd: Yes, in the short term. But we will be redeploying this capital to fuel additional growth in our corporate finance group and other business groups in the coming months.
What's your outlook for middle market lending-are there plenty of places to put the additional funding to work?
Rudd: Demand for middle market lending is divided into companies owned by private equity firms or institutional owners and privately held companies. NXT focuses almost entirely on the former, for which there's good equilibrium in the market. Supply and demand are well-balanced, which means structures are rational and pricing makes sense for lenders and borrowers.
There are good reasons to believe middle market transaction volume will continue to grow. The amount of private equity firm dry powder and potential tax changes should drive more M&A. Investment banks also tell us they're working on a large number of mandates. Activity dipped in early 2012 when compared to the end of 2011, but overall, we expect this to be a good year for middle market lending.