Private credit European CLOs have fast become a popular topic of conversation at industry conferences. But while there are still considerable hurdles to overcome, market participants argue it is a matter of when, rather than if, Europe follows the US to bring these deals to market.
Already, managers are adding flexibility into their vehicles to allow potential greater inclusion of private credit-sourced assets. For a purely middle market vehicle, the barriers in the way of new deal formation are well documented, and include the challenge to source assets at sufficient size and diversity, currency hurdles due to a significant portion of European private credit being denominated in sterling, and perhaps most significantly, how they would be rated.
While a broadly syndicated loan CLO in Europe might have upwards of 120 obligors, market participants note that a European middle market CLO would realistically include half that amount, with the vehicle likely requiring higher subordination and wider spreads.
Less mature
Indeed, the private credit market in Europe is far less mature than in the US, where mid-market CLOs have traditionally served as balance sheet vehicles used to fund lending. “In a middle market CLO, the manager cannot necessarily be very active, so investors have to do more work on their side — which is difficult if you don’t have analysts for that. Also, if you’re going into recession, you don’t want to be in a static CLO,” commented one European CLO investor.
So far this year, US middle market issuance has made up the greatest share of overall CLO activity in the 2.0 era, with volume totaling $21.82 billion. This equates to 21.5% of total US CLO issuance this year, which compares with 9.3% ($11.98 billion) for all of 2022 and 12.0% ($22.53 billion) in 2021.
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Expectations from investors that have spoken to LCD are that a private credit CLO in Europe would need to pay 50-75 bps extra on the triple-A notes, but given that the European market is smaller, a leveraged loan and high yield bucket would be of benefit to the structure.
Drum beat
Nevertheless, a number of arrangers are beating the drum for private credit CLO issuance in Europe, and speakers from one major US-based CLO arranger at the Global ABS Conference in June said they expect to see one-to-three such deals in Europe within the next 12 months. At least one European bank is also understood to have been actively gauging investor sentiment over the prospect, while rating agencies have noted an uptick in proposals for such deals.
Proponents of private credit CLO issuance in Europe argue that, while difficult, such deals are possible, with banks — for instance — able to offer swap products to solve the currency issue.
Investors also have to be convinced that past mistakes can be avoided. “I’m old enough to have seen this before,” said an investor. “There used to be middle market CLOs in Europe with privately rated assets which performed terribly. Ultimately you want large PE-owned names, so if the crunch comes, then they have deep pockets. If it’s small PE and small companies, then sometimes the plug gets pulled. It’s something to watch out for.”
Plan B
The difficulty in getting purely middle market deals off the ground means managers may investigate other routes. The second point of entry for private credit in European CLOs then becomes the ability for managers to take on private credit in broadly syndicated loan CLOs, a point which may have already started to emerge in documentation on recent deals.
As flagged by the independent CLO documentation research firm Review Port, documentation on some recent European CLOs has included defined capacity for both private rating obligations and credit estimate obligations in portfolio profile tests.
This has featured on at least four deals since late August, all from managers with private credit arms, with capacities varying from 5%-20% for private ratings and 1%-10% for credit estimates, according to Review Port.
In these instances, private rating obligations are defined as obligors that only have a private rating, while credit estimate obligations are obligors where the ratings are only based on a confidential credit estimate, insofar as they do not have a private or public rating from another rating agency.
The note of caution here is that CLO documentation is nuanced, while the counterpoint to the above is that the inclusion of caps is a fundamentally protective measure, and serves to limit future potential for private credit capacity. Further, investors note that the portfolios for such deals were standard at pricing.
“I’m not sure if it necessarily buys more flexibility, but it’s the first step to take direct deals that you’ve originated into your portfolio,” commented one CLO note investor.
“I think it’s a way of getting more flexibility when you have direct lending platforms,” said a CLO manager, adding that if a well-known name, such as Adevinta, did go down the private credit route, some managers might be happy to hold it long term, and sprinkle it across its CLOs. “It would help with the weighted average spread,” they added.
And what about liquidity?
This mixed approach also has challenges. “You get penalized a lot if a deal is not rated, as it gets treated as CCC. These managers have direct lending arms, so it depends on who the manager is. If a manager without a private credit arm had this language, then investors would have a lot of questions,” said a second manager.
“I’m not sure about a CLO with private credit. You would need trust in the manager, and have a strong underwriter. If 5%, maybe 10%, of the portfolio is private credit, then fine, but to be honest I’m not super happy about it,” the second investor said.
Questions over liquidity and recoveries are also important for investors, given CLOs typically hold clips of deals from €1 million to €5 million. “The attitude might be that a CLO can be perpetual, so you don’t have to worry about liquidity. But where do valuations come from when it’s held by less than a handful of people?” questioned the aforementioned investor.
“You clearly can’t trade out of those names. In the US, the structure and sector is different, where private credit deals have been done through a small syndicate,” said the first CLO investor.
In the end, this all could be part of a process of a market evolution that has seen managers over the past two years increasing bond buckets, but more crucially, utilizing them.
“Managers are pushing the boundaries as to what they can invest in. Some are trying to widen out the remit of what CLOs can do, pushing for private credit,” said a third investor. “CLO managers want to push further into private credit, which is miles away from what a CLO should be, which is broadly syndicated leveraged loans. If you want to do a private credit-only CLO, then go for it.”
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