October 4, 2019
Collateralized loan obligations (CLOs) typically go heavy on broadly-syndicated debt. Increasingly, though, CLOs are being stuffed with private loans made to highly leveraged medium-sized companies with limited access to bank financing, Bloomberg News reports.
Known as middle-market CLOs, the asset class has ballooned to $57 billion, compared to $20 billion six years ago, says Bloomberg. The entrance of new players into the middle-market arena this year, including Owl Rock Capital and PennantPark Investment Advisers, suggest issuance is only set to increase.
The rapid growth is another example of how banks, insurance companies and pension funds continue to reach for higher-paying securities in the face of almost $15 trillion of negative-yielding debt around the world. Middle-market CLOs can offer premiums of as much as 200 basis points versus their garden-variety peers, due partly to the reduced liquidity that comes with direct lending, which bypasses traditional capital markets.
The flip side, though, is that analysts say these products could saddle investors with even steeper losses if credit conditions sour.
“Some investors want the excess return to take on the illiquidity of the underlying middle-market loans,” Michael Herzig, a portfolio manager at THL Credit, told Bloomberg. “You can’t trade a middle-market CLO the way you can broadly-syndicated ones. You really have to be diligent and careful when you structure.”
The pool of middle-market CLOs remains small compared to conventional CLOs. About $10.4 billion of new middle-market CLOs have priced this year, according to data compiled by Bloomberg. That approaches the pace set in 2018, which was the fastest since the financial crisis.
Still, that’s dwarfed by about $80 billion of traditional CLO issuance year to date. The $57 billion of middle-market CLOs outstanding compares to more than $600 billion of the conventional variant.
Middle-market loans tend to carry more safeguards—i.e. convenants—than broadly-syndicated loans, where investors have recently started to push back against some of the riskiest financings, Bloomberg reports.
Nonetheless, some are steering clear of middle-market CLOs, given the difficulty conducting due diligence on the underlying companies. Investors have reason to be wary, said investment specialist Jason Merrill at Penn Mutual Asset Management, which oversees about $28 billion, largely on behalf of insurers.
“One of the lessons we were supposed to learn from the financial crisis is that it’s important to understand the collateral and understand the risks,” Merrill said. “We do deep analysis when we look at credits, and that’s harder to do with middle-market CLOs,” he said, adding that it has “caused us to shy away from the middle-market space.”
That’s why it’s critical for investors to choose a firm whose lending and management approach aligns with their own, according to Bain Capital Credit’s Michael Boyle.
“There’s less collateral overlap than in the broadly-syndicated market,” Boyle told Bloomberg. “Finding the right asset manager really matters.”
Connect National Investment & Finance is coming to New York on Oct. 23. For more information, or to register, click here.
For comments, questions or concerns, please contact Paul Bubny