Private Markets 360° | Episode 5: Diving into credit estimates for middle market CLOs

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Presentation

Brandon Newland

Hi, everyone. Welcome back. My name is Brandon Newland. I lead our Private Markets Product Management Team at S&P. I'm joined by Jocelyn Lewis. Jocelyn, how are you doing today?

Jocelyn Lewis

Hey, Brandon. Doing great. Thanks. I'm Jocelyn Lewis, Managing Director at S&P Global Market Intelligence, where I'm head of Private Debt Commercial Strategy across software and services.

Brandon Newland

All right. So we're going to jump into some exciting guests and focus on the leading industry trends private markets here on the podcast. Jocelyn, should we jump right into it?

Jocelyn Lewis

Yes, for sure. So this podcast is dedicated to enlightening you to the world of private markets from different views. So yes, Brandon, let's go.

Brandon Newland

So today, we are joined by Ramki Muthukrishnan, Head of Leverage Finance for S&P Global's U.S. Corporate Ratings. As an analytical manager, Ramki oversees a team of analysts that have extensive experience in the leveraged finance space.

Ramki also is an author of leveraged finance, private debt and middle market research and thought leadership pieces here at S&P. In his free time, he spends time playing the guitar, seeing classic rock to balance out the vast critical thinking of his management responsibilities. Ramki, welcome to Private Markets 360. How are you today?

Ramki Muthukrishnan

Very well, and thank you for having me, Brandon and Jocelyn.

Question and Answer

Brandon Newland

Jocelyn and I are excited to chat through credit estimates. And hopefully, maybe we could just start there. Maybe just tell us a little bit about what are credit estimates, how they're used, et cetera.

Ramki Muthukrishnan

Sure, sure. What are credit estimates? So credit estimates are a point-in-time credit view on the profile of a company. This credit view is based on an abbreviated analysis, which borrows heavily from S&P's corporate ratings methodology.

Credit estimates also share the same scale as a rating, but they are denoted in lower case. Almost all credit estimates are done at the request of a middle market CLO manager. More specifically, we provide credit estimates on unrated companies that issue loans, which collateralize CLOs that S&P rates.

So for S&P to rate a CLO, we need to have a credit opinion on the underlying companies, and that's where credit estimates come in. They are issued based on financial information and other documentation that's provided to S&P by CLO managers.

The one thing I'd say is it's a point-in-time view. We don't monitor the performance of the company or do an ongoing surveillance as we do for a credit rating. We may review a credit estimate many times a year depending on number of managers that hold the loan.

Jocelyn Lewis

And Ramki, if it's a point-in-time estimate, is there a reason why for credit ratings, you would do that kind of next rating again and again, but for credit estimates, it's more so just that point-in-time?

Ramki Muthukrishnan

Correct. So credit estimates are different from credit ratings. Credit ratings are monitored. Every quarter, we get quarterly financials. We look at them and revise our forecast if we have to. Credit estimates are a point-in-time, and they can be used in a CLO for a period of 12 months.

They have a shelf life of about 12 months. Now it's possible that another CLO manager, who may hold another piece of the loan, may want a credit estimate 3 months down the line, 4 months down the line. In which case, they request a credit estimate.

And in those instances, we refresh the credit estimate. And if there is a change in the score, we send it to all the managers holding it. So it's curatively possible that they get reviewed more than once, depending on the number of managers holding the credit.

Brandon Newland

And based on the activity picking up in private credit as a whole, I mean, are you seeing an increased demand for these credit estimates as part of CLOs?

Ramki Muthukrishnan

Absolutely. If you look at the number of middle market CLOs that were done, from 2018 to 2022, over 150 middle market CLOs were issued. This is almost double the middle market CLOs issued in the 5 years before that.

And really, this growth sort of mirrors the growth in direct lending funds, where the funds under management more than double in the same period. And just to put some numbers for credit estimates. During 2016, we did about 600 credit estimates. And in 2022, we did over 2,000 credit estimates. Again, on account of the growth in the number of middle market CLOs seeking credit estimates.

Brandon Newland

Are there any trends you're seeing in the middle market as you're going through this from an analytical perspective? Is there a particular industry that's making up a larger portion of these? We saw a big run on tech.

Ramki Muthukrishnan

Good question, Brandon. Certainly, software services and health care are sectors that are most represented in the middle market space. Together, they account for 25% of the total credit estimates that we've done in middle market CLOs. And I believe this is not very different in the broadly syndicated loan space as well.

I think both the sectors have attracted a lot of growth capital from PE firms in the last several years. And on the private credit side, a lot of GPs have allocated their capital for these 2 sectors, given the growth prospects and potential for health care and technology space.

Jocelyn Lewis

And you mentioned about these middle market CLOs. So when we think of a middle market CLO, is that similar to that of just your traditional broadly syndicated loan CLO?

Ramki Muthukrishnan

From the way the structure works, there's not much of a difference. You do have senior and subordinate clauses and you do have coverage ratios as you would in a broadly syndicated CLOs. But where the difference lies is a middle market CLO is a part of the direct lending ecosystem.

Typically, the middle market CLO managers, they originate the loans and they hold equity in the CLOs. They allocate loans, portions of the loans to other direct lending funds or BDCs that they manage. Even on the documentation, because these are held to maturity, there is a lot more engagement that the lenders or the middle market CLO managers or the GPs have in how they sort of drive documentation because there is no really secondary loan market if they want to exit a position.

Now this is different from a broadly syndicated CLO, where a manager can buy and sell out of a loan position. They have trading buckets that they can use. And I think there are also topical concerns around documentation in the broad-based syndicated loan CLO space around liability management transactions, which are really not a concern in the middle market CLO space.

Jocelyn Lewis

When we think of middle market, one of the things that comes to mind is there's very different terminology for middle market depending on who you speak to. So are there any kind of threshold when you think of, I don't know, maybe more of I'm thinking maybe the lower middle market? Is there a threshold of where you would start doing a credit estimate at a particular threshold? Or just it doesn't matter, based on whatever a manager wants to put in a middle market CLO, they will just come to you and ask for the credit estimate on that?

Ramki Muthukrishnan

So as long as we have all the information that we require to do a credit estimate, we are fine doing it, notwithstanding the size of the entity. But that said, the median EBITDA we've seen this year is about $35 million, which was a little different. A couple of years ago, it was more in the mid-20s. So it's been growing.

So we see bigger companies enter the middle market space and seeing more of these loans issued to the big companies used to collateralize middle market CLOs. But to answer your question, size is really not a consideration. As long as we have the relevant information, which is 3 years of audit, covenant compliance certificate, amendments and all other relevant documentation, we should be able to generate a credit estimate.

Jocelyn Lewis

What is driving the demand for these middle market CLOs? And why are they important in the direct lending ecosystem?

Ramki Muthukrishnan

I think the biggest demand is better spreads. The AAA spreads for a middle market CLO is a good 45, 50 basis points higher than what you would get for a broadly syndicated CLO.

Jocelyn Lewis

And we touched on it a little bit already. But how is that credit estimate different from a corporate rating other than that point-in-time estimate versus a recurring update?

Ramki Muthukrishnan

So credit estimates are not ratings, and they cannot be used in place of ratings. For starters, they don't include all aspects of a credit rating. There is no direct contact with the issuer or the obligors management. So we don't have really an in-depth view into the company's operating financial or strategic issues that such a contract would allow.

Also, credit estimate is a point in time. So unlike corporate ratings, there is no forward-looking analysis or forecast. The analysis for credit estimate places a lot of weightage on historical performance. The credit estimate also makes some conservative assumptions given that there is no direct contact with the issuers and there is no clear information flow. So we cap liquidity at adequate. We don't net cash against debt and a few other conservative assumptions compared to corporate ratings.

Brandon Newland

So with the credit estimates, like you said it does focus on historical performance. What would happen if a company's credit materially deteriorate within that 12-month period?

Ramki Muthukrishnan

Right.

Brandon Newland

Is there any safeguards in place?

Ramki Muthukrishnan

Really good question. CLO indentures do have a clause that require the CLO manager to notify S&P of these material events that affects the capital structure or payment of the obligation. Typically, these events include nonpayment of interest or principal, or rescheduling of interest or principal in any part of the capital structure, changes in terms of payments, say, conversion of cash interest to payment in kind, any restructuring of debt, any pushback of maturity or change in coupon reduction of interest.

So there is an obligation on the part of the CLO manager to notify S&P when there are such consequences to the capital structure. So what we do then is we take that into consideration and refresh the credit estimates. To the extent that there is no adequate and offsetting compensation, we may lower the credit estimate to what we term as selective default and then refresh the credit estimates based on the revised terms of payment. Sometimes the revised credit estimate could be at the same level, assuming the other credit metrics look good. But many times, it tends to go out at a lower scale.

Brandon Newland

How often does that happen? Do you see that frequently?

Ramki Muthukrishnan

We saw that pick up a lot during the pandemic, where clearly, there were concerns around liquidity. And I think the order of the day was to preserve liquidity for most of the companies just given the uncertainty about duration of the pandemic. And that resulted in either cash interest being converted to payment in kind or reduction in interest or pushing back schedule amortization of principles to a bullet maturity.

And in all those cases, we revised the credit estimate. We also took into account a few other qualitative factors based on our conversations with the CLO managers. So to answer your question, we saw a lot of that during the pandemic, and it kind of slowed down. But we've seen a slight pickup in that, just given the somewhat distressed economic environment some sectors are experiencing now.

Jocelyn Lewis

So this must be an interesting time for credit ratings, I would think. Right now, there's so much going on that's impacting credits with rate hikes, with the war in the Ukraine. Hopefully, we're past supply chain issues, but TBD there. Can you comment on any of these kind of trends that you're seeing across credit?

Ramki Muthukrishnan

We're certainly seeing all the macroeconomic headwinds that you mentioned. Last year, the sort of momentum from COVID recovery drove a lot of upgrades. In fact, we had more upgrades than downgrades last year. And the upgrade to downgrade ratio for credit estimates in 2022 was 1.35. But clearly, that trend changed.

In the fourth quarter of last year, we saw some weakness. Both in the fourth quarter of 2022 and the first quarter of '23, downgrades have dominated. We've seen about 66 downgrades in that 6-month period compared to 45 upgrades. Downgrades are predominantly from increased interest, although the full impact of increased interest will be felt for companies later this year on an LTM basis.

But what we did was we already applied those increased benchmark rates and analysis. So clearly, this higher interest rate is definitely one of the drivers of downgrade. There are other issues that you talked about, inflation, wage inflation. Some sectors are hit particularly hard by wage inflation.

There's also other increase in freight costs, increase in material costs. There are some lingering supply chain issues, but a lot of them are getting resolved. But big picture, we expect to see more downgrades this year. Downgrades will continue to dominate in 2023. We also expect to see an uptick in selective defaults as companies will look at ways to preserve liquidity.

Brandon Newland

Just curious, you mentioned the demand is really on the spread, right, that clients can ultimately get from credit estimates. What are the roles that private equity GPs play in the equation? Are they interested in credit estimates? Do they push their portfolio of companies towards credit estimates as the liquidity markets are obviously changing quite a bit here?

Ramki Muthukrishnan

So almost all the companies we provided credit estimates for are owned by sponsors. There is just 1 manager that I know of that does not lend to private equity portfolio companies. I think sponsors like private credit for reasons of confidentiality, certainty of execution and predictability of outcome.

I think with a broadly syndicated loan, it tends to be issued with flex terms that could flex up or down depending on the market conditions. Sponsors also get more flexible and sort of customized solutions in private credit, which really may not pass muster in the credit trading space in the syndicated loan market.

And I think this relationship-based lending also helps some of the private credit lenders. They have greater access to companies' management. And sometimes they get first bids. So -- and then they have -- some of them have worked with sponsors, are very sort of familiar with the sponsor model. So I think there is a general sort of relationship component that keeps the private equity sponsors more active in the private credit space, at least in the recent past.

Jocelyn Lewis

So we talked a little bit also about the size of the company is getting credit estimates, where you mentioned that even some of the lower middle market is also, you're performing credit estimates there. Now what about if we think about the distribution of those estimates? Because for credit estimates, you're still giving a letter. So is that distribution similar to that what you're seeing across ratings or just completely different?

Ramki Muthukrishnan

You're right. There are bigger firms that have entered the private credit market for which we've provided credit estimates. But the estimates for most part are on traditional middle market borrowers. And like I said, median EBITDA is about $35 million.

And most of the borrowers for whom we provide credit estimates, like I said, are owned by private equity sponsors. So in our methodology, the financial risk of a private equity-owned company is commensurate with those of highly leveraged companies. Given the combination of the small size of these companies, coupled with our view on leverage, the business and the financial risks tend to fall at the lower end of the spectrum.

So the business risk tends to be weak or vulnerable, and the financial risk is that of a highly leveraged company. So about 75% of the companies for which we issue credit estimates have a score of B-, and another 10% are in the CCC range. Now this is not a post-pandemic phenomenon. This has pretty much been the case since 2016, 2017, given the profile of those companies and the nature of ownership.

Brandon Newland

If there was a song that you thought would align to where the CLO market was going, is there anything that comes to mind?

Ramki Muthukrishnan

I'm a big fan of The Beatles, so I'd say Getting Better All The Time.

Brandon Newland

That's great.

Jocelyn Lewis

Thank you, Ramki. That was great just to get your perspective on credit estimates, compare and contrast with ratings and just provide the overall coverage. Thank you so much. And with that, we have an announcement that we need to make regarding Private Markets 360. Brandon?

Brandon Newland

Thanks, Jocelyn. So it's with a little bit of a bittersweet sadness here that there will be a changing of the guard for our host. I will be passing the baton to our esteemed colleague, Christopher Sparenberg, who leads up Commercial Strategy for Private Markets here at S&P.

He's been in the industry quite some time. And I trust him implicitly on having a spectacular career here as cohost of Private Markets 360. I just want to thank Jocelyn. You've been -- what an incredible co-host and collaborator, and I continue to look forward to work with you. And I'd like to thank our listeners for just giving us a chance.

We're a fairly new podcast in the market here. But continue listening. I think we really have a great strategy around content moving forward to connect kind of private markets holistically, that private equity view, that private credit view and telling a full broader story here. So stay tuned. A lot of great content to come onward and upward.

Jocelyn Lewis

That's right. Well, Brandon, we'll certainly miss you, but also excited about Chris coming on as a cohost. So we'll see how it all plays out. But thank you so much for everything that you've done to help get Private Markets 360 off the ground.

Brandon Newland

Thanks, Jocelyn.