The emergence of European middle market CLOs

Collateralised loan obligations (CLOs) are a significant element in the European capital markets. In 2023, the public issuance of CLOs in Europe maintained a steady volume of €26 billion across 69 deals, mirroring the previous year’s performance despite a sluggish start. As of February 2024, the market has shown promising growth, with year-to-date volume reaching €6.3 billion, and market participants predicting a prosperous year ahead.

CLOs are securitisations of broadly syndicated loans (BSLs), which are liquid leveraged loans arranged by banks for larger borrowers (typically with EBITDA over €100 million and total indebtedness exceeding €150 million). In Europe, discussions have persisted for years about creating CLOs backed by middle market (MM) loans, which are leveraged loans to smaller borrowers arranged by private credit funds. However, the market has seen few deals involving mixed pools of BSLs and MM loans, with purely MM loans being financed or leveraged privately.

In contrast, the US has a small but notable segment of its larger CLO market consisting of MM CLOs. This disparity raises questions about why an MM CLO market has not developed in Europe and whether this might change, as several European MM CLO issuances are anticipated later this year.

The European private credit market is approximately half the size of the US market, with about a third of it located in the UK. This necessitates the inclusion of both euro and sterling loans in European MM CLOs to achieve adequate size and diversity. Although solutions for multicurrency pools exist, such as sterling tranches of notes or hedging, these add complexity and stricter rating requirements to initial deals.

MM loans and their borrowers are typically unrated, requiring significant rating or estimation processes to support the necessary ratings for MM CLO notes. This process can be costly and administratively burdensome. Additionally, MM CLOs tend to have lower diversity, with as few as 40 obligors compared to the typical 150 in BSL portfolios, complicating the rating process. While challenging, these hurdles are not insurmountable, with rating agencies prepared to model these characteristics as needed.

Managers of European MM CLOs need a strong presence in the direct lending or private credit market due to the less developed secondary market for MM loans in Europe. Managers will likely need to originate a significant portion of the portfolio and handle non-performing assets effectively. Larger managers, with the capability to substitute and replace assets, are better positioned to bring initial deals to market.

MM CLOs require more equity due to less senior leverage, likely sourced from the manager’s own capital or an existing investor already engaged with the manager. Larger managers with their own capital are better equipped to meet this requirement.

While there are several challenges to the development of European MM CLOs, these obstacles are surmountable. With various managers taking steps towards launching deals, 2024 could mark the beginning of this long-anticipated market.

Volta Finance Ltd (LON:VTA) is a closed-ended limited liability company registered in Guernsey. Volta’s investment objectives are to seek to preserve capital across the credit cycle and to provide a stable stream of income to its Shareholders through dividends that it expects to distribute on a quarterly basis.

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