Better yield and fewer participants have sent several new managers and lenders scurrying to the middle market with new funds and portfolios featuring larger middle-market buckets. "We have seen more candidates for issuance and more desire on part of managers to come to market with middle-market CLOs," said Alla Zaydman, a director in Fitch Ratings' credit products group. But as the space becomes more crowded, some say tightening spreads may push out short-term players.
According to JPMorgan research, middle market CLO issuance reached an all-time high of $10.6 billion in the U.S. in 2005 and could hit about $16-18 billion in 2006. Citing Standard & Poor's data, the JPMorgan report says that those loans tracked are yielding about 300 basis points over LIBOR, though some can be in the 400-700 basis points over LIBOR range. S&P estimates that about 90% of middle market deals factor into that calculation.
"On a relative basis, there is more yield, [but] I think there is also a little more structural integrity," said Jason Van Dussen, senior v.p. at GE Capital Markets, who works on the product. "You still have tighter credit terms, not quite as much leverage and typically a little more yield."
New firms that have entered the space include Katonah Debt Advisors, which has hired a new portfolio manager to prep its new middle-market CLO; Churchill Financial, which provides senior and mezzanine financing for smaller middle-market companies and will do a CLO in the future; and Commercial Industrial Finance Corp. (CIFC) which also provides funding for deals of about $50 million.
"There is strong demand from investors who want to diversify CDO holdings heavily weighted to the syndicated loan and bond markets," Chris Lacovara, a principal at Kohlberg & Co., which owns Katonah, said by email. "In a tight interest rate spread environment, wider spreads on middle market loans are attractive and investors and CDO managers have gotten more comfortable with the risk profile of middle-market loans due in part to recent rating agency research that has helped quantify default risk and recovery rates relative to larger syndicated loans."
Churchill's Ken Kencel noted that bank merger activity during the last few years has pulled a number of banks that had focused on middle-market leveraged lending to the larger syndicated loan market, leaving room for middle-market specialty lenders. Because it is not a syndicated market, and most are club deals, Kencel said the middle market can be more credit intensive. Churchill currently has more than $500 million in committed capital and credit facilities in place, and Kencel anticipates the firm will launch its first CLO in the next six to nine months.
As the middle market grows more popular, players inevitably will start to look for the tipping point. Will spreads become too tight? "I think it may be factor of transparency," Zaydman said. "For spreads to tighten as much as the syndicated market, it needs as much transparency. This market, most of the time, is not publicly rated...the risk of the unknown is still in this market and you do have a bit of reflection of that in pricing of loans."
Tom Shandell, partner and co-head of GoldenTree Asset Management's capital solutions group, which is involved in the middle-market, said some new players may not have a long-term stomach for the market. "The envelope is getting pushed farther in terms of leverage, the quality of the deal of the company [is being affected] and people are pricing it too tight for what it is," he said. "When some of these deals that are pushing the envelope don't work out, people are going to wake up and say, 'What do I own here? I didn't realize the risk I was taking,' and they will abandon the market."
