In the first three quarters of 2021, middle-market (MM) CLO activity exploded. Per S&P Global Market Intelligence, “New issuance of middle-market CLOs totalled $12.53 billion through the first three quarters of the year, according to LCD, already exceeding the full-year 2020 tally of $11.33 billion.”[1] The trend towards middle-market CLOs vs broadly syndicated market (BSL) is in part due to the flexibility and customization of deals, as compared to that of structured lending.
Earlier this summer, I attended the Middle Market CLOs and Direct Lending Conference in New York presented by the LSTA and DealCatalyst. This trend was the leading topic of conversation on the agenda. According to the conference, the uptick in MM CLOs is in part due to “capital in-flows and the introduction of new market lenders providing collateral…” Furthermore, last year “…was a banner year for new issuance totaling nearly $19 billion. Volumes are expected to remain robust in 2022 as Middle Market CLOs appeal to both managers and investors both as an area of diversification and as a structure that has shown resilience through the pandemic.”[2]
BSL vs. MM CLO
The BSL market is comprised of larger loans with public ratings. This market offers more liquidity to the credit market, as well as more transparency. Conversely, the MM is comprised of smaller, more private firms that offer direct origination. There are many factors to consider when comparing direct lending vs BSL. For example, direct lending is:
- Faster: The speed to execute deals is exponentially faster than the BSL market, as well as more effective. It’s easier to manage smaller group of lenders: single or small "club.”
- Less volatile: When executing deals in the direct lending market, there is less concern for market volatility, as there is little to no secondary market. Firms will hold these positions to maturity and are more committed for the long-term.
- Private: The direct lending market is more private and confidential. There is an added cost for executing transactions in this market, but it’s worth it for access to private, more secure deals.
- Controlled: There is less liquidity, given the structure of this market, but that provides more control and offers a seat at the table for decision making.
The private credit expansion, continues
We’ve written a lot about the exponential growth in private credit over the last several years, only to intensify during the pandemic of 2020. This is in part due to the easier access to funding, as well as the growth in the size of loans. Other factors that have fuelled this growth include:
- Compelling asset class: strong risk-adjusted returns, income payout and lightly leveraged. In some cases, it offers better performance than the BSL market.
- Diversification: MM provides portfolio diversification compared to BSL; there is a lot of overlap in the BSL market. Additionally, private equity firms have turned to private debt (non-bank) lenders, as banks have exited this space over the past 25 years.
- Investor demand: There is an explosion of investor interest, as LPs have adopted private credit and direct lending as part of their portfolio strategy.
- More accessible: There are different ways to access this asset class, including BDC, closed-end funds, feeder funds, etc.
What does all this mean?
Private Credit and private equity have largely risen during a sustained period of low interest rates, yet this is now changing, putting this asset class to the test. As many can attest, rising interest rates are a double-edge sword, offering a better yield for investors, yet the cost of financing increases. For the middle market, debt has been resilient and attractive, but that may change with the potential for turbulent times ahead.
[1] Fest, G. S&P Global Market Intelligence. As credit stabilizes, middle-market CLO activity booms toward record year. (2021, October 5).
[2] The LSTA and DealCatalyst present: The Middle Market CLOs and Direct Lending Conference. (2022, June 15).
