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Credit Estimates Within Middle Market CLOs: Fourth-Quarter 2019 And Overall Year-End Summary

(Editor's Note: This is part of a continuing series highlighting the credit performance and other metrics of middle market loans for which S&P Global Ratings provided credit estimates. The focus of this report is on all middle-market companies for which we provided estimates during a specific quarter and whose loans collateralize middle market collateralized loan obligations (CLOs) we have rated or are in the process of rating.)

S&P Global Ratings rated a total of 31 middle market CLOs in 2019, compared with 28 in 2018. Attractive spreads and this asset class' history of performance brought more investors into the fray. Further, the year also saw the addition of five new middle market managers. These new managers include ones who might have previously managed broadly syndicated CLOs.

In the fourth quarter of 2019, 63 entities refinanced their existing debt, 58 held a leveraged buyout (LBO), 44 used incremental debt to facilitate an acquisition, and 14 executed a dividend recapitalization. On average, entities that refinanced their debt had an average spread over LIBOR of 5.22%, almost 50 basis points less than the 5.70% average spread for all entities in the fourth quarter. The increase in refinancing activity continues to push back the maturity wall for loans in this space. About 62% of the middle-market loans evaluated by S&P Global Ratings in 2019 mature in 2023 or later while short-dated maturities (2020) only comprised 6% of the loans.

In recent years, business and consumer services, technology--software and services, and health care services have dominated sector representation for companies whose loans collateralized middle market CLOs. These three sectors accounted for 50% of credit estimates in 2019 and 47% in 2018. The top 10 sectors in credit estimates were generally the same year over year.

Entities from the railroad and package express, media and entertainment, and oil and gas industries had the highest spreads over LIBOR, reporting average spreads of 6.70%, 6.35%, and 6.33%, respectively. Sectors with the lowest spreads included auto suppliers, metals and mining downstream, and consumer durables, with average spreads of 4.41%, 4.50%, and 4.63%, respectively. In the fourth quarter of 2019, one entity from the midstream energy sector had an 8.5% spread over LIBOR.

Due to their high levels of representation, issuers from the business and consumer services, technology--software and services, branded non-durables, and health care services sectors were most likely to have a change in credit estimate and accounted for more than half of the issuers that were either upgraded or downgraded in 2019.

Given their relatively small operating scale and the fragmented nature of the markets they operate in, the majority of entities for which we produce credit estimates result in a vulnerable business risk profile. Also, the private equity nature of ownership with high leverage puts the credit estimate score at the low end of the spectrum. A total of 77% of entities we reviewed received a score of 'b-' in 2019, which is comparable with the 77% seen in 2018. In the fourth quarter of 2019, investors with capital in the 'ccc' category received an average spread of 6.3% over LIBOR, about 70 basis points higher than the average spread of 5.6% over LIBOR that characterized the single 'b' entities. Credit estimates in the fourth quarter of 2019 showed minimal narrowing in spreads compared with the third quarter 2019 because the average spread over LIBOR for entities reviewed moved to 5.7% in the fourth quarter from 5.8% in the third quarter.

Nearly 12% of the credit estimates completed for 2019 had a score in the 'ccc' category. This is similar to 2018, in which credit estimates in the 'ccc' category also accounted for 12% of the total. In 2019, approximately three-fourths of credit estimates that received a 'ccc' score received a 'ccc+', signaling vulnerability and dependence on favorable economic conditions; however, we did not envision defaults over the next 12 months. In this category, 31 of the entities received a 'ccc' score, signaling a potential default over the next 12 months, and nine received a 'ccc-' score, signaling a potential default within the next six months.

The median debt to EBITDA for credit estimates in the 'ccc' category was 13x. For those credit estimates, only 36% of the entities had adequate liquidity, 48% had less than adequate liquidity, and 16% had weak liquidity, reflecting a material deficit in sources of liquidity and a likelihood of a covenant breach.

Of the 98 entities downgraded in 2019, 76 were downgraded into the 'ccc' category due to an increase in leverage, liquidity pressures, and potential inability to refinance oncoming debt. In 2019, 76 entities received upgrades due to performance improvements, including reduced leverage from debt pay downs and improved earnings. After a notable increase in EBITDA, 25 of these entities received upgrades out of the 'ccc' category to 'b-'. These entities experienced a median increase in EBITDA of 76% since their last review.

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Table 1

Credit Estimate Upgrades And Downgrades By Sector, 2019
Sector Upgraded Sector Downgraded
Business & consumer services 13 Business & consumer services 20
Technology--software & services 12 Technology--software & services 15
Branded non-durables 7 Branded non-durables 11
Health care services 7 Health care services 10
Media and entertainment 4 Building materials 5
Auto suppliers 3 Retail & restaurants 5
Building materials 3 Aerospace & defense 4
Consumer durables 3 Capital goods 4
Health care equipment & supplies 3 Media and entertainment 4
Oil & gas 3 Auto suppliers 3
Capital goods 2 Health care equipment & supplies 3
Containers & packaging 2 Specialty chemicals 3
Environmental services 2 Technology--hardware & semiconductors 3
Retail & restaurants 2 Leisure and sports 2
Technology--hardware & semiconductors 2 Pharmaceuticals 2
Aerospace & defense 1 Environmental services 1
Commodity chemicals 1 Railroads & package express 1
Leisure and sports 1 Telecommunications & cable 1
Pharmaceuticals 1 Transportation infrastructure 1
Real estate investment trusts 1
Specialty chemicals 1
Telecommunications & cable 1
Transportation--cyclical 1
Total upgrades 76 Total downgrades 98

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This report does not constitute a rating action.

Primary Credit Analyst:Stewart M Webster, New York + 1 (212) 438 8619;
swebster@spglobal.com
Secondary Contacts:Tejaswini Tungare, Toronto;
tejaswini.tungare@spglobal.com
Zoya Alam, New York;
zoya.alam@spglobal.com
Analytical Manager:Ramki Muthukrishnan, New York (1) 212-438-1384;
ramki.muthukrishnan@spglobal.com

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