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Opinion Direct lending
As direct lenders seek efficient, scalable financing tools, private credit CLOs are growing fast
by Randy Schwimmer
Randy Schwimmer
Vice chairman
Churchill Asset Management
PCLOs have reached USD 135bn, or 13% of the overall CLO market
Readers of this publication know CLOs are attractive as standalone investments for equity investors seeking mid-to-high-teens returns and consistent quarterly cash distributions. When used as financing technology in fund complexes, CLOs provide strong economics (in a functioning market), better leverage, attractive durations, and predictable ratings for ramped pools of collateral. For BDCs, commingled funds and SMAs, CLOs are typically cheaper alternatives to asset-backed financing facilities from banks — the former with spreads of 160-170bps, the latter at low 200bps, for comparable leverage profiles.
Private credit CLOs (PCLOs) have seen a natural evolution. Beginning as balance sheet financing tools for specialty finance companies, they provide attractive financing within a levered fund, typically as a replacement for asset-based facilities. While CLO technology has been around since the early 1990s, the private credit CLO market was less than USD 20bn as recently as 2015. With fewer than 10 transactions completed annually, it was only 5% of the overall CLO landscape. Today, PCLOs have grown to USD 135bn, or 13% of the market.
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What differences are there between BSL and PCLO collateral and structures? Leverage, for one thing — six-times for full capital structure or arbitrage PCLOs, versus 10x for BSL, and 3-4x for CLOs issued out of BDCs or private commingled funds. But there’s not enough BSL loan supply. PC annual CLO issuance has grown from 10% of the market to about 20% as BSL CLOs amortise.
More private credit managers are using CLOs as a financing tool. The difference in triple A spreads (135-140bps for BSL, compared to 160-165 for PC) has compressed to around 25bps. Finally, triple C baskets for PC are 17.5%, versus 7.5% for BSL. PCLOs receive underlying asset ratings primarily with credit estimates issued by rating agencies.
The smaller size and lower liquidity of PC assets means a notch or two lower rating than publicly-rated loans. PCLOs historically have shorter reinvestment periods than BSL transactions — say, four versus five years. They also have less ability to reinvest after that period ends, with prepayments and recovery proceeds paying down debt. Both these factors serve as investor protections, given the illiquidity of the assets.
There’s scarce liquidity for middle market loans, but managers can create liquidity within CLOs by transferring assets to the fund level. Of course, BSL managers can trade loans in their CLOs, building par depending on market conditions and collateral strength. PC CLO managers can’t trade, so they focus on portfolio management, asset selection and diversification — making manager selection critical.
One evolutionary step is the use of CLO technology in other areas of the market. PCLOs are becoming more of a focus for insurance companies looking to improve risk-based capital charges for private credit loans on their balance sheet, as well as increasing operational efficiency. We also believe there will be continued growth in the use of PCLOs as AUM generators for managers raising third-party capital via distinct SMAs or funds.
Banks and institutions re-engage
What changes have we seen in the middle-market CLO investor base? Japanese banks (both large domestics and regionals) are back and active in triple A tranche investing. Many who are approved for BSL investing are in various stages of diligence for the private credit space, with an increasing number of participants receiving approval for investing in PC triple A. European banks are showing increased interest, as are US, Middle Eastern and North African banks. Insurance companies, pension funds, family offices and asset managers are looking at tranches further down the CLO capital stack.
There is also consistent interest from existing investors in BSL CLOs in finding opportunities in PCLOs, given the increased yield and stronger structural protections (leverage) relative to their BSL counterparts.
In short, private credit CLOs will continue to grow in popularity and usefulness as the overall private market expands into fund finance and more complex securitisations. Innovation will be the watchword in the fastest growing area of the capital markets.
