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Middle Market CLOs Face Unexpected Headwinds Amid Rising Private Debt Demand

With volatility and uncertainty hampering capital markets, direct lending from private debt providers is increasingly competing with broadly syndicated loans and the high-yield market as an alternative source of funding. In response to volatile market conditions, several broadly syndicated loan borrowers have seen their prices flex wider this year, and deals are taking longer to finalize. By contrast, private debt borrowers typically have more certainty around pricing and timing by working with direct lenders.

Middle market (MM) CLOs are one source of funding for the private debt market. These CLOs are often part of a broader lending platform for private debt, which also includes BDCs, separately managed accounts, and private debt funds. Larger asset managers use the funds locked into the MM CLO as a source of funding for private debt lending that is not vulnerable to investor redemptions.

With private debt demand growing, MM CLOs could be expected to grow as well, but this has not been the case so far this year.  U.S. CLO volume trailed last year's pace, down 9% year-over-year through July, following the record $187 billion in new issuance in full-year 2021. Among CLOs, MM CLO issuance has declined more than broadly syndicated loan (BSL) CLO issuances. MM CLO issuance is down nearly 33% in 2022 (through July) to just $5.8 billion, while BSL CLO issuance showed a more modest decline of 6% (to $79.2 billion) off of record issuance in 2021.

More challenging credit markets for CLOs were largely expected following the remarkably favorable financing conditions of last year, but issuers are facing an unexpectedly strong gale of headwinds from inflation, energy prices, rising risk of recession, and aggressive tightening of monetary policy. The ongoing challenges posed by the pandemic and the Russia-Ukraine conflict are further complications.

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Amid markedly deteriorating credit conditions, credit spreads have widened considerably this year. And with economic, business, and geopolitical risks intensifying, investors are worrying that today's spreads have yet to fully price in tomorrow's risks.

Dry Powder Suggests Sustained Demand For Private Debt

According to Preqin, direct lending funds had over $175 billion in committed capital as dry powder at the beginning of second-quarter 2022. Because funds typically have up to three years to deploy committed capital, the clock is ticking for managers to line-up borrowers.

With dry powder at hand, asset managers have more to lend to the middle market. This demand could be helping keep widening spreads in check despite the risk-off environment. After average new-issue MM spreads initially widened more sharply than 'B+'/'B' BSL spreads in the first quarter of 2022, the spread on MM loans swiftly pulled back in the second quarter, narrowing with the BSL spreads. And the trend appears to have continued in July.

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With demand for private debt running high, direct lenders have been able to provide ever-larger loans. After's $2.6 billion unitranche funding set a record for direct lending in 2021, so far in 2022, direct lenders have already provided a $2.15 billion for Nielsen Holdings and $5 billion in direct lending to Zendesk Inc.

By offering financing packages of this size, direct lending is increasingly competing with the BSL market for borrowers. Between this demand from borrowers and the dry powder to be deployed, direct lending is expected to maintain an active pipeline for new lending.

Rate Shock Rattles Credit Markets

Investors typically flock to floating-rate assets (including CLOs) when they expect rates to rise. During the prior rate hike cycle, which began at the end of 2015 and continued until 2018, both BSL CLO and MM CLO issuance ramped up before the beginning of the rate hike cycle, only to suddenly drop shortly before the initial rate hike amid rising global growth concerns. However, issuance of both BSL and MM CLOs rebounded during that cycle as growth concerns eased and rates continued to move higher.

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With central banks taking aggressive actions to tighten monetary policy, the rate hikes this year have been faster and steeper than expected. This pace of hikes--coupled with persistently high inflation and the risk of a hard landing--has rattled investors.

Issuance has slowed amid the resulting market volatility. Investors have become increasingly selective with their purchases of riskier assets, and many arrangers largely adopted a wait-and-see approach to gauge market conditions before launching new MM CLOs.

Market Volatility Is Adding To MM CLOs' Cost Of Funding

Amid the market turbulence and with little new issuance coming to market, the average 'AAA' tranche spread on a new-issue MM CLOs widened 92 bps since the end of 2021--to 245 bps in July. Meanwhile, BSL CLO 'AAA' spreads widened by just 95 bps to 211 bps.

Since the end of last year, the difference in the 'AAA' spread of MM and BSL CLOs has narrowed somewhat, to 34 bps in July from 45 bps at the beginning of 2021. However, this excludes spreads on other tranches, which provide a fuller picture of funding costs.

Chart 6


MM CLO structures are less uniform than those of BSL CLOs. The 'AAA' spread in an MM CLO reflects the level of 'AAA' subordination, which is higher, and varies more than among BSL transactions.

The total cost of funding a new MM CLO has risen by more than that of BSL CLOs over the past year. The weighted average cost of capital (WACC), the average coupon for all floating-rate tranches within a deal, weighted by tranche size, for new issue MM CLOs, widened by 66 bps in the first half of 2022 to 287 bps. This was a larger increase, albeit on fewer deals, than for the WACC of BSL CLOs, which widened by 52 bps to 221 bps.

The WACC on a U.S. MM CLO is expected to be higher than that of a BSL CLO given the differences in risk profiles of the companies of the underlying leveraged loans and a lower level of transparency than the BSL market. The more pronounced widening of MM CLO WACC relative to that of BSL CLOs likely reflects investors' risk aversion.

Chart 7


In response to rising funding costs, some CLO managers are making adjustments to continue to price deals despite higher liability costs. For instance, some managers have been willing to price shorter-dated deals, with a one-year non-call and three-year reinvestment period, compared with the more traditional two-year non-call and five-year reinvestment periods.

Transition To SOFR May Cut Into Excess Spread

Adding to the uncertainty in the market, the transition away from LIBOR is well underway. All new-issue CLOs in 2022 have priced off of SOFR, while loans may continue to reference LIBOR until the June 2023 deadline.

During this transition period, this creates a potential mismatch between the underlying reference rates of CLO assets and liabilities. In the short term, this exposes CLOs to some basis risk. And for CLO issuance, the difference in benchmark rates could lead to a decline in excess spread, which is generally the surplus of asset spread over a CLO's liability funding costs, including fees or amounts payable senior in the priority of payments waterfalls.

While it is unlikely that this will lead to material MM CLO rating movements, the more likely impact would be more limited given additional credit enhancement (see "LIBOR Transition, Excess Spread, And U.S. CLO Ratings," June 30, 2022).

Despite Market Headwinds, MM CLOs Continue To Show Strong Interest Coverage

Even though rising liability costs and narrowing spreads on MM loans may squeeze new MM CLO formation, interest-coverage ratios for existing MM CLOs remain strong. And for BSL CLOs, interest coverage ratios (IC ratios) even improved in the first half of 2022. The median IC ratio for a MM CLO held at 316% in the second quarter of 2022, well above the median IC trigger of 113%.

A component of credit enhancement for CLOs is interest coverage ratio (IC ratio) tests, whereby interest generated by the pool of assets must be greater than the interest paid out on the outstanding debt. This helps ensure timely interest and principal payments are made to the bondholders. IC ratio test thresholds are stipulated in the deal covenants and are calculated each month, as they are subject to triggers, like other forms of credit enhancement such as overcollateralization.

Most loans have an interest rate floor, while CLO liabilities generally do not, and this discrepancy helped boost spreads above the cost of liabilities during the ultra low-rate environment. As a result, IC ratios rose sharply in 2020 and 2021. However, with benchmark rates now exceeding most floors, these are no longer providing the additional benefit to excess spread.

Furthermore, with rates rising sharply, and the transition from LIBOR to SOFR also chipping at excess spread, IC ratios could be expected to moderate from current levels, especially if spreads on newly issued loans don't widen further.  During the prior rate-tightening cycle from 2015 to 2018, the IC ratio for MM CLOs narrowed from above 300% to just below 200%. As before, MM CLO IC ratios stood above 300% at the beginning of the current rate tightening cycle.

Chart 8


Could Issuance Volumes Rebound?

As managers adapt to the market gyrations, MM CLO issuance could yet resurge. While private demand might be dipping into the spread of MM loan assets, increased demand for private debt deals could lead asset managers to launch more new MM CLOs as a committed source of funding. Meanwhile, despite a narrowing excess spread on new deals, median IC ratios on existing CLOs remain strong, and this is currently providing a support to CLO credit quality. With asset spreads widening, creative managers will likely find ways to make the economics work for new transactions.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Evan M Gunter, Montgomery + 1 (212) 438 6412;
Secondary Contacts:Brenden J Kugle, Centennial + 1 (303) 721 4619;
Jon Palmer, CFA, New York 212 438 1989;
Stephen A Anderberg, New York + (212) 438-8991;
Daniel Hu, FRM, New York + 1 (212) 438 2206;

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