In Practice: European Middle Market CLOs Could Rise in 2024 — Despite Some Challenges
Collateralised loan obligations (CLOs) are a prominent feature in the European capital markets landscape. Last year, public issuance of CLOs in Europe generated a volume of €26 billion from 69 deals, remaining relatively steady from 2022 despite a slow start to the year. However, the market is off to a strong start in 2024, with year-to-date volume at the end of February standing at €6.3 billion and with market participants predicting a bumper year.
Background to the CLO Markets in Europe and the US
CLOs are securitisations of a pool of broadly syndicated loans (BSLs), which are liquid leveraged loans arranged by banks and offered to larger borrowers (typically with EBITDA greater than €100 million and total indebtedness exceeding €150 million). In the European public capital markets, the creation of CLOs that are backed by middle market (MM) loans (i.e., leveraged loans to, typically, smaller borrowers and arranged by private credit funds) has been a popular discussion topic for a number of years. However, to date, the market has seen only a limited number of deals with mixed pools of BSLs and MM loans. Portfolios of purely MM loans are instead financed or leveraged privately away from the public capital markets.
This situation stands in stark contrast to the United States, where a small but notable segment of the much larger CLO market consists of CLOs backed by pools of MM loans (MM CLOs). This raises the question: Why is an MM CLO market yet to develop in Europe and why do market participants increasingly expect to overcome these challenges (with a handful of issuances of European MM CLOs earmarked for later this year)?
Challenges in the Development of European MM CLOs
Market Size
The first notable challenge is the size of the European private credit market. Credit rating agency data indicates that the size of the European private credit market is approximately half the size of the US market. This problem is compounded by the fact that approximately a third of that market is situated in the UK. While denomination of loans does not entirely track the geographical location of borrowers, any European MM CLO will likely need to include both euro and sterling loans to meet an appropriate size and diversity. While tried and tested solutions to multicurrency pools exist (for example, a sterling tranche of notes, or hedging), these solutions will heighten the complexity and ratings requirements of the first deals that come to market.
Rating Requirements
Ratings themselves pose another challenge to the development of MM CLOs. MM loans (and their underlying borrowers) are typically unrated, so in order to support the required ratings on the MM CLO notes, the rating agencies, sponsors and obligors will have to undertake a significant rating or estimation process on all of the MM loans, which needs to be completed by the time the MM CLO comes to market. This rating requirement can impose a burden both from a cost and an administrative perspective. Other characteristics, such as lower diversity (the US market suggests a MM CLO may have as few as 40 obligors against a typical BSL portfolio of 150 obligors), also contribute to rating difficulties. The rating agencies themselves have worked hard to model these and other characteristics of MM loan portfolios, and are ready to provide these services as required. Again, while the rating process may be more difficult than in a typical BSL CLO, it is not an insurmountable barrier.
Manager Characteristics
A further challenge to the development of European MM CLOs has been the characteristics a manager will have to fulfil to bring a deal to market. The manager will need to have significant presence in the direct lending or private credit market, since the less developed secondary market in MM loans in Europe indicates that the manager will have to originate a significant portion of the portfolio. The lack of liquidity in the MM loan space also places more reliance on the manager in negative scenarios, with US managers who are also the loan sponsor often retaining the ability to substitute and replace non-performing assets. These characteristics suggest that a larger manager will be better suited to bring one of the first deals to market.
Equity Provider
A final consideration worth noting is the identity of the equity provider. MM CLOs will have less senior leverage and, accordingly, will require more equity. It seems likely that the source of such equity will be either the manager’s own capital or an existing investor with the relevant manager (probably one that is already engaged with a single mandated arrangement (SMA)). This is another factor that would benefit a larger manager that has its own capital to deploy in this way.
Conclusion
The challenges in the path of a European MM CLO are all surmountable, and a number of managers appear to be taking steps towards bringing a deal to market. 2024 could therefore finally be the year in which this long overdue market develops.