October 11, 2024 - As we’ve highlighted previously,funds that invest in private corporate credit (PCC) (e.g., commingled funds, separately managed accounts and business development companies (BDCs)) often utilize collateralized loan obligations (CLOs) as a financing mechanism. The private credit CLO (PCLO) market has developed alongside the growth of PCC, to around 19% of total U.S. CLO issuance year to date through September, compared to around 10% historically. As of 2Q24, PCLOs account for about 13% of the U.S. CLO market, up from about 10% in 2Q21 and 8% in 2Q18.
What’s driving this trend? Material growth and diversification in PCC portfolios and the need for alternative sources of financing for their managers. PCLO leverage can be higher than traditional asset-based loans (ABLs) provided by banks and unsecured bonds issued by BDCs. Yet this benefit comes with trade-offs: PCLO formation is a capital markets exercise and therefore subject to market conditions, the financing is costlier, ratings are necessary, and there are more structural restrictions in place to protect investors.
PCLOs employ the same technology as BSL CLOs (i.e., they securitize a pool of loans into tranches of investment-grade and non-investment grade risk). However, unlike broadly syndicated loan (BSL) CLOs, which are typically designed to finance BSL assets gathered in the open market and capture arbitrage benefits for investors, PCLOs are not solely focused on equity arbitrage. Rather, PCLOs are typically issued for the purpose of financing a portfolio of direct lending assets originated by a manager.
Most PCLO managers hold on to the equity tranche of their CLOs. This practice is common because PCLOs are generally subject to risk retention unlike their BSL CLO counterparts. For vehicles such as BDCs that consolidate their PCLO transactions, the PCLO debt is factored in their leverage calculation.
PCLO formation is dependent on a portfolio having achieved a critical mass of diversification (generally 40-50 loans). In this sense, a PCLO may be a complimentary alternative for an ABL, which also requires portfolio diversification but not to the same extent. As noted above, an advantage of PCLOs is that advance rates (i.e., the amount of credit extended against the value of collateral) may be higher. The higher advance rates translate to meaningful additional investment capacity for the portfolio that the PCLO is used to create.
Like the BSL CLO structure, PCLO leverage is long-term and stable, which makes it well suited for long-term assets such as PCC. The financing covers the maturity of the assets in the portfolio (i.e., it is match-funded), eliminating the need for refinancing, while allowing for a reinvestment period (RP) during which proceeds from paydowns or maturities can be used to fund new collateral. (The RP for a PCLO is typically four years compared to five years for a BSL CLO). Additionally, it is non-recourse to the rest of the portfolio and non-mark-to-market. This latter feature, which PCLOs share with BSL CLOs, prevents forced selling.
The average stated maturity of PCLO debt is around 12 years. In practice, the debt will not typically stay outstanding until maturity given PCLOs amortize (i.e., deleverage) more quickly than BSL CLOs because they generally do not have flexibility to reinvest after the end of their RP. While they may be refinanced or reset as market conditions allow, PCLOs are less likely to be called prior to maturity given that their collateral is originated with the intention of being held until maturity.
Fundamentally, as in BSL CLOs, PCLOs are structured to provide protections and credit ratings that benefit debt investors. However, certain attributes of PCLOs are unique, driven by the difference in their underlying collateral. First, while the underlying portfolios of PCLOs are actively managed, they are not actively traded. As such, turnover in PCLOs is infrequent. (Morgan Stanley estimates the annual sell percentage for PCLOs at 9%, compared to 15-16% for BSL CLOs.) Generally, assets are removed from a PCLO’s collateral only when they prepay or mature, although there may be instances where they are swapped out for better performing assets in the portfolio the PCLO is used to finance to meet quality or collateralization tests. (This ability to self-manage through active credit monitoring compares to other forms of financing in which the lender may have consent rights on collateral and can revise advance rates based on changes in credit metrics.)
Active management in PCLOs is a function of a manager’s commitment to each credit in the portfolio throughout the credit’s lifecycle, including working with financial sponsors and/or borrowers to resolve changes in credit risk. These relationships are key to a manager’s originations pipeline. For this reason, the selection of a PCLO manager has outsized importance.
Second, while a PCLO’s debt tranches are publicly rated by a nationally recognized statistical ratings organization (NRSRO) such as S&P or Moody’s, its underlying loans typically are not. (As a practice, PCC loans are not typically rated at origination given the lender base. This aspect underscores the underwriting discipline that is embedded in PCC lending.) Instead, they are assigned a credit estimate (i.e., a point-in-time confidential credit rating assigned to an unrated loan by a ratings agency at the request, and expense, of a manager).The credit estimatesare used to determine ratings of the PCLO tranches and must be updated annually.
Third, certain concentration limits, including around industries and CCC exposure, are more flexible in PCLOs than in BSL CLOs. Fourth, PCLOs have higher par subordination (i.e., credit enhancement) than BSL CLOs, with AAA attachment points around 42% compared to as low as 36% for BSL CLOs, including thicker equity tranches.
The stronger credit support has obvious positive implications for portfolio stress and potential loss. In an analysis conducted by Morgan Stanley, PCLO breakevens – the points at which CLO tranches become impaired – were 1.7-2.2x BSL CLO breakevens, on account of PCLOs’ higher spreads and par subordination. (The low end of the range maps to AAA tranches and the high end of the range maps to BB tranches.) These multiples translate to constant default rates – the assumed effective annual default rates of portfolios – of 65.6% for PCLO AAAs and 39% for BSL CLO AAAs (for deals closing in 2023) and 17.8% for PCLO BBs and 4.5% for BSL CLO BBs. Not surprisingly, PCLO tranches have historically been downgraded less often than BSL CLO tranches, according to BofA Global Research.
This track record and level of protection is notable, particularly given the well-recognized truth that BSL CLOs do not pose systemic risk. Considering these features and the additional leverage, lack of refinancing risk and control they afford managers relative to other financing sources, it is easy to see why PCLOs are an effective financing tool for PCC portfolios and will continue to be used to support the growth of the PCC market.
