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Credit FAQ: Is There A Middle Ground For European Middle Market CLOs?


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Credit FAQ: Is There A Middle Ground For European Middle Market CLOs?

In contrast with the established U.S. middle market collateralized loan obligation (CLO) market, Europe is yet to see an equivalent market. That said, this is a topic that is increasingly on European CLO market participants' minds, with related panels at almost every CLO conference. S&P Global Ratings has received an increasing number of questions about its analytical approach for European middle market CLOs. In this Credit FAQ, we address some of these key questions, and discuss how the market may evolve considering ongoing market discussions.

Frequently Asked Questions

What is a middle market CLO?

Middle market CLOs have existed as a U.S. asset class since at least 2004. This is a fast-growing segment of the U.S. CLO market, with more than $21 billion of new issuance year-to-date, as of Q3 2023. Middle market CLOs have become a significant funding source for mid-size corporates in the U.S. alongside business development companies (BDCs) and other types of funds. Middle market CLO managers are often direct lenders for some or all the companies in their portfolios.

Like broadly syndicated loan (BSL) CLOs, U.S. middle market CLO portfolios typically comprise senior secured loans, cash, and eligible investments. The companies are smaller, however, typically with an EBITDA of less than $50 million (and often a lot less). Capital structures vary from transaction to transaction, but often include 'AAA' rated through 'BBB' rated tranches, without a 'BB' tranche. Because many middle market CLOs are used to fund direct lending, rather than for arbitrage purposes, and because the managers often hold the equity, there is less impetus to produce capital-efficient structures.

The average transaction size is slightly smaller than a U.S. BSL CLO at about $475 million. Reinvestment periods also vary, but many are shorter than the five-year reinvestment period and two-year non-call period often seen for U.S. BSL CLOs. The weighted-average life (WAL) is within the same range of four to four and a half years.

How does a middle market CLO differ from a BSL CLO?

Unlike in a BSL CLO, many of the corporate obligors backing a middle market CLO do not carry a rating. In our ratings analysis, we therefore rely on credit estimates, rather than corporate ratings, to evaluate the credit risk of each obligor. When an obligor has a credit estimate it will typically not carry a recovery rating. In the absence of recovery ratings, we apply certain recovery assumptions (as outlined in our ratings criteria) based on seniority, security, and country groupings. Credit estimates are also occasionally used in European BSL CLOs, though very infrequently. As of November 2023, only four credits in the outstanding European CLOs that we rate had credit estimates. Compared with typical BSL CLOs, proposals we have received for middle market CLOs typically have the characteristics listed in table 1, with corresponding relatively positive or negative effects on credit risk.

Table 1

Comparing middle market CLOs with BSL CLOs
Negative factor (-) Positive factor (+)
Higher concentration Lower WAL
The average portfolio comprises 40 to 50 obligors compared with 120 to 160 obligors for a typical BSL CLO. The higher obligor concentration results in a lower obligor diversity measure (ODM) and a lower industry diversity measure (IDM), producing higher default rate expectations. The typical WALs for the middle market CLO proposals we have received have been between 4 and 4.5 years, compared with 4.5 to 5 years for typical BSL CLO portfolios.
Lower portfolio credit quality Higher derived recovery rates
As borrowers are typically unrated, the average portfolio credit rating is derived through credit estimates and is typically 'B-' compared with an average portfolio credit rating of 'B' for a typical BSL CLO. The typical 'CCC' asset bucket is also higher. As a result, middle market CLOs typically have a higher SPWARF and a higher default rate expectation. Depending on the seniority of the assets, middle market CLO portfolios have weighted-average recovery rates which can be higher at the 'AAA' rating level. This partly reflects a much lower proportion of covenant-lite loans among middle market obligors than in the BSL loan market.
Higher weighted-average cost of debt Higher WAS
The middle market CLO proposals we have seen typically have a higher weighted-average cost of debt than BSL CLOs. The typical WAS of a middle market CLO portfolio can be in the 5.5% to 6.5% range compared with a BSL CLO portfolio which typically generates a spread between 4.0% and 4.5% and produces a higher excess spread for middle market CLOs.
Higher subordination
Middle market CLOs typically benefit from higher subordination, particularly for the 'AAA' tranche, with credit enhancement in the low 40% range compared with the high 30% range for BSL CLOs. Middle market CLOs sometimes do not issue lower-rated (e.g., 'BBB' and 'BB') tranches due to the subordination levels afforded to the senior notes.
SPWARF--S&P Global Ratings weighted-average rating factor. WAL--Weighted-average life. WAS--Weighted-average spread.
How do these differences affect our credit analysis?

As a starting point, we consider a hypothetical BSL CLO with 150 obligors, an S&P Global Ratings weighted-average rating factor (SPWARF) of 2,900, a WAL of 4.7 years, and average concentration across obligor, industry, and regions, resulting in a 63.81% 'AAA' scenario default rate (SDR).

Table 2

Portfolio characteristics for a hypothetical BSL CLO
S&P portfolio benchmarks BSL CLO
Number of obligors 150
SPWARF 2,900
Weighted-average rating B
WAL 4.70
ODM 133.98
IDM 23.43
RDM 1.22
'AAA' SDR 63.81%
SPWARF--S&P Global Ratings weighted-average rating factor. WAL--Weighted-average life. ODM--Obligor diversity measure. IDM--Industry diversity measure. RDM--Regional diversity measure. SDR--Scenario default rate.
How do middle market portfolio characteristics affect SDRs?

(-) Higher concentration increases SDRs  As the number of obligors reduces, a fall in the obligor diversity measure increases SDRs (see chart 1).

Chart 1


(-) Lower portfolio credit quality  More than 70% of assets in U.S. middle market CLOs come from obligors with a rating, or credit estimate, of 'B-' compared with less than 30% for the average BSL CLO, and exposure to assets from 'CCC' rated companies is also higher. As such, we expect the SPWARF to be considerably higher. Chart 2 shows the impact of increasing the SPWARF to 3,600 from 2,900.

Chart 2


(+) Lower WAL   As the WALs of the middle market CLO portfolios we have reviewed are generally shorter than in BSL CLO portfolios, chart 3 shows the related positive impact on 'AAA' SDRs, which is approximately a 1.5% lower SDR for a half-year shorter WAL.

Chart 3


What's the impact on breakeven default rates (BDRs)?

(-) Higher weighted-average cost of debt  Typically, depending on the capital structure, a 10 basis points (bps) increase in the margin of the 'AAA' note results in an average 30 bps decrease in the BDR.

(+) Higher derived recovery rates  In the absence of recovery ratings, we apply recovery assumptions from our criteria based on seniority, security, and country groupings. Depending on the seniority of the assets, middle market CLO portfolios we have seen have weighted-average recovery rates (WARRs) in the region of one percentage point higher at the 'AAA' rating level compared with BSL CLOs. A large majority of loans in middle market CLOs include maintenance covenants which may affect the recovery rate that we assume under our CLO framework. However, one point of consideration is where the covenant is set and what influence it has on the loans in the portfolio.

Generally, we consider a senior secured loan as one that it is (a) either secured by assets of the obligor or by a high percentage of the equity interests in the shares of an entity owning such assets, and (b) no other obligor obligation has any higher priority security interest in such assets (or shares). Under our criteria, if a revolving loan has a higher priority security interest we would expect the transaction documentation to limit the sum of the principal balance and unfunded commitments of these loans to a small percentage (20%, for example) of the sum of the revolving facility amount, plus the principal balance of the loan, plus the principal balance of any other debt that is pari passu with such loan.

Overall, we consider a senior unsecured loan as one that is (a) not secured by fixed assets of the obligor or by a high percentage of the equity interests in the shares of an entity owning such assets, and (b) is senior to any subordinated obligation of the obligor.

Middle market CLO portfolios may include 'unitranche' debt, which has frequently been a hybrid loan structure, containing both senior and one or more subordinated tiers in a single debt instrument. If the debt is senior, then we would treat it as such. If the debt is clearly subordinated, such as a "last out" tier, then we would treat it as subordinated.

(+) Higher weighted-average spread (WAS)   Normally, depending on the capital structure, a 10 bps increase in the WAS of the portfolio results in an average 35 bps to 40 bps increase in the BDR. As such, increasing the WAS to 6.0% from 4.4% in a typical BSL CLO in line with the proposals we have received would increase the BDR by approximately six percentage points.

Chart 4


(+) Higher subordination   In the same way, depending on the capital structure, each 50 bps increase in credit enhancement results in a 50 bps increase in the BDR.

In our hypothetical example below, we imagine a middle market CLO with a 1% spread premium across liabilities, a portfolio WARR of 39.0%, and a portfolio WAS of 6.0%. Table 3 compares the SDRs we have calculated above with BDRs at hypothetical credit enhancement levels to demonstrate the impact on 'AAA' BDR cushions (i.e., BDR minus SDR). It is worth noting that the analysis performed is based on our assumption and not any specific proposal received.

Table 3

Portfolio characteristics of a hypothetical middle market CLO
Inputs Middle market CLO BSL CLO Difference
SPWARF 3,600 2,900 +700
WAL 4.25 years 4.70 years -0.45 years
'AAA' liability spread 2.8% 1.8% +1.0%
Portfolio WARR 39.0% 37.7% +1.3%
Portfolio WAS 6.0% 4.4% +1.6%
SPWARF--S&P Global Ratings' weighted-average rating factor. WAL--Weighted-average life. WARR--Weighted-average recovery rate. WAS--Weighted-average spread.

Chart 5


How does our analysis of middle market and BSL CLOs differ?

We use the same criteria for middle market and BSL CLO ratings, and the credit and cash flow models we use to generate SDRs, recovery expectations, and BDRs are the same. However, some particularities apply when rating middle market CLOs:

Payment-in-kind (PIK) obligations.  In our experience, BSL CLOs are commonly restricted from purchasing more than 5% of PIK obligations. However, in middle market CLOs the exposure can be higher and as a result, and in line with our criteria, we would apply a PIK haircut on the excess portion above 5%. The PIK haircut removes the interest credit from the obligations which form the excess over 5% to simulate a scenario whereby these loans trigger the ability to defer the interest payment. As such, this reduces the WAS generated by the portfolio and decreases the BDRs by, on average, 30 bps for each additional 2.5% PIK allowance.

Table 4

PIK limitation impact on 'AAA' BDRs
PIK limitation PIK stress Impact on 'AAA' BDR
5.00% 0.00% No impact
7.50% 2.50% -0.30%
10.00% 5.00% -0.60%
12.50% 7.50% -0.90%
15.00% 10.00% -1.20%
PIK--Payment-in-kind. BDR--Breakeven default rate.

Foreign exchange risk.  We have received proposals with up to 15% of the portfolio balance in loans that are not euro-denominated. The challenge is typically to understand how the foreign exchange risk will be addressed other than increasing CLO subordination, e.g., with a non-euro denominated tranche, perfect-asset swaps, or an option.

How likely do you think a European middle market CLO will be issued soon?

We are often asked this question. The solomonic response is yes and no. Yes, because European middle market CLOs respond to similar needs as BSL CLOs, but for smaller corporate borrowers. Nevertheless, some challenges remain: The unrated and concentrated nature of the underlying assets, potential currency risk, and making the arbitrage of the structure work. Despite clear progress toward the first European issuance, market participants will need to judge not just credit and structure, but also potential liquidity for these types of products which is an additional challenge, especially for the first few transactions.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:John Finn, Paris +33 144206767;
Secondary Contact:Emanuele Tamburrano, London + 44 20 7176 3825;

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