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CLO managers find AI risk spreading far and wide
by Lisa Fu
Welcome to the latest sector to be disrupted by artificial intelligence (AI) — the leveraged loan market.
CLO managers are finding that the ramifications of AI are central to their business. Will the technology have a marginal effect on the companies to which they have lent money, or could it wreak havoc?
Concern about AI-related risks is hitting secondary loan prices. Take Calabrio, a customer engagement software company backed by private equity firm Thoma Bravo. In late October, Calabrio was forced to price its USD 1.5bn, SOFR-plus-400bp term loan at a steep 95 original issue discount — the deepest discount for a Thoma Bravo-sponsored deal in at least five years — amid concerns over AI disruption, Debtwire reported.
Lead arranger Santander had to extend the commitment deadline three times due to weak investor demand.
Bid price of AI affected loans ($)
Source: S&P Global & IHS Markit
Other credits the market perceives as exposed to AI risk, such as Newfold Digital, have tumbled, while loans to Epiq, a legal software company, have started to decline.
“Worries about AI have fed into the ‘sell first, figure out later’ mentality currently encapsulating the leveraged loan market,” said Leland Hart, portfolio manager at Warwick Capital. “The market is definitely attempting to chew through what is real and what is not when it comes to the impact of AI.”
CLO managers now specifically consider AI risks as part of the diligence and underwriting process. Many fear staying invested in companies that face secular shifts — which could go the way of the Yellow Pages.
“AI has now become part of our rubric when we’re looking at businesses,” Jeremy Hyatt, co-portfolio manager and head of loan trading at Vibrant Capital, said. “In the past, there were pretty clear examples of a business that faced obsolescence risk. It now takes a lot more questions to figure out what will survive in five or seven years.”
Managers should be especially attuned to the risks presented by AI as spreads everywhere look tight, Ajeet Atwal, senior BlueBay portfolio manager at RBC Global Asset Management, told Creditflux. CLO managers are operating in a market that has compressed no matter the risk bucket, which makes any mistake costly.
What is more, borrowers are operating with leveraged balance sheets, so their financial performance and ability to pay lenders could come under threat from an AI-enabled competitor that upends the status quo.
“You need to seek to identify trends early on,” Hyatt said. “You can’t wait for others to identify risks and try to go along with the crowd because it could cost you 15 points on a loan.”
In analysing AI’s impact, RBC BlueBay is taking pains to evaluate any sector that employs a lot of people, Atwal said. So far, the introduction of AI to people-heavy businesses has largely been seen as a cost-cutting exercise, but his firm is asking if the adoption of AI will bring about fundamental change.
For its part, Vibrant Capital has broken down credits into three categories in relation to AI: high risk, medium risk and low risk. The firm focused on re-underwriting high-risk names from November until May, before moving on to medium-risk names, Hyatt said. That list is constantly evolving, he added.
As a result, the firm was able to sell out of a legacy web-hosting company in November 2024. That credit has since fallen and now trades in the 50s, Hyatt said. Conversely, Vibrant has also watched some names become oversold and used the opportunity to add to positions.
Atwal said some sectors are underappreciated, which could open up opportunities for thoughtful managers. For example, Enterprise Resource Planning (ERP) would appear to be vulnerable to disruption but, on closer examination, may be more resilient than expected.
ERP companies that have access to high-quality data may come out ahead of AI competitors because they can always outsource the AI component, Atwal explained.
