Stop dreaming of private credit CLOs, the arb is enough of a nightmare
Debt investors would demand even higher equity buffers, but they don't have the leverage
In Europe, private credit CLOs are impossible to find, yet hard to escape.
No deal has come anywhere near pricing, yet every conference has a panel asking when it will. The answer remains — unchanged for months — not anytime soon.
Yes, direct lending is booming in Europe. Every week another asset manager seems to launch a new fund — most recently, Fidelity. Before that, Ares. Eventually, middle market and private credit CLOs will follow — there is some debate about the definition of these terms — but for now, neither really exists in Europe.
And neither will, as long as the CLO market does not recover from its fundamental problem. It seems somewhat futile to dream of a new market when the one that already exists isn’t working properly.
The issue with regular CLOs consisting of broadly syndicated loans (BSLs) is that the arbitrage has been terrible. Asset prices have been so high and CLO liability spreads so wide that junior debt tranches often get better returns than equity holders at lower risk, which is a long way from how it should be. For 18 months, almost all managers who priced CLOs in Europe relied on captive equity funds.
For a private credit CLO, debt investors would demand even more equity to provide the buffer they need for protection. But lower leverage would further lower returns for equity owners — altogether a very difficult sales pitch when third party equity investors already shun BSL CLOs.
There is also the problem of diversity. While the European middle market for loans is growing, as it stands it would be hard to cobble enough loans together for a proper CLO. Because different European markets have different jurisdictions, loans are particularly difficult to package together across borders. Secondly, the UK has a big middle market, but while UK issuers of broadly syndicated loans tend to borrow in CLO-friendly euros, direct lending usually happens in sterling.
Another major obstacle comes from ratings. In the private market, companies enter bilateral agreements with the lender, and often without a rating. A CLO, however, requires a rating of all tranches by two ratings agencies. Broadly syndicated loans already have a rating when the CLO portfolio is assembled. Getting 100 direct loans rated from scratch would be a very expensive undertaking.
These issues have been stumbling blocks to progress for some time now and seem little closer to being fixed but it is the arbitrage that is really in the way. While more tinkering and talking could help figure out a solution to the ratings question, it is all a rather pointless exercise so long as poor arb makes even regular BSL CLOs hardly viable.
But what if ?
Still, rumours keep flowing that the first non-broadly syndicated loan CLO will be priced next year.
A panellist at the European CLO Summit in early October kicked off lunchtime speculation when casually mentioning open warehouses, which suggests that some managers are getting more serious about putting a portfolio together, and some banks are willing to provide the funding. But as one banker pointed out: an open warehouse does not mean that a CLO will materialise.
And even when — or if — a deal does end up happening, it might look very different to its US cousins. It could be a much more private affair itself, perhaps, as one banker suggested, with just one triple-A investor.
That would also mean that it could get away with just one rating agency, potentially a smaller one. KBRA could be first in line for that — they are said to have been working with ThinCats on the lender’s attempt to bundle its loans to small and mid-sized enterprises into a CLO-like structure.
This reality may not be too far away. But a proper market for middle market or private credit CLOs in the shape of the existing US one is much further off.