Narrowing the gap

The benchmark for a 5/2 BSL CLO new issue is SOFR+135bps, while the benchmark for the equivalent long-dated new issue CLO in the middle-market is S+162.6bps — a 27.6bps differential. During the past two years, that basis has been much wider, according to 9fin data.

An expansion in the investor base for mid-market CLOs lately has improved liquidity, which in turn has helped drive spreads closer to those in the BSL CLO market, a source said.

On that basis, this marks an ideal time to print middle-market CLOs. Two debut middle-market CLO managers have capitalised, bringing new issues this year: Comvest priced Comvest Credit 2024-1 CLO via Deutsche Bank on 2 July with the triple-As at S+170bps, and Willow Tree Capital Partners is partnering with GreensLedge to market Willow Tree CLO I which is expected to price in late July, according to marketing materials seen by 9fin.

Arlene Shaw, a middle-market CLO managing director at Brightwood, expects the basis to narrow further from here. “There is an illiquidity premium, but the private CLO market has grown and matured,” she said.

On the other hand, one middle-market manager said they’ve perceived that the narrowing spread basis may be leveling off as they’ve noticed some resistance from investors to further tightening.

Given the relative scarcity in new loan supply, BSL CLO managers have been under pressure from sponsor-backed issuers to accede to looser loan terms. Here too, middle-market CLOs have likely won points with investors through touting their own greater relative safety compared to BSL CLOs. A middle-market manager said onstage in a US CLO conference panel this spring that “we hold the pen” when it comes to controlling terms of the loans. He was implying a contrast to BSL managers, who generally have less control in determining loan documents.

Burgeoning baskets and the rise of private credit CLOs

That said, there is no longer the clear difference in cov-lite baskets that once prevailed.

Prior to 2022, middle-market CLOs tended to have quite tight cov-lite baskets with 15% to 20% being a common size, with room to negotiate and swap basket size with other kinds of flexibility, according to Daniel Oshinsky, a partner at Schulte Roth & Zabel, who specializes in mid-market and private credit CLO deals.

“These days I'm seeing it creep up, with 25%-30% being more common and even to 40%, 50% or so in certain cases,” Oshinsky said. “I've seen managers push for 60%, which becomes more like a BSL level. This is especially true for CLOs designed to include the large private credit loans that have become prevalent in the market.” Typically, a BSL CLO will have around 60% or so as its cov-lite basket.

The general understanding is that this has only been happening for the larger mid-market CLOs, whose loans have morphed from formerly smaller loans around $50m to $250m into private credit loans rivaling BSL loans for size.

But one ‘classic’ mid-market manager that previously had cov-lite baskets of around 20%, priced their most recent CLO this year with a 50% basket, according to a 9fin source. The manager in this case sometimes ramps mid-market CLOs with BSL loans, which has contributed to the cov-lite baskets expanding, the source said.

“There are more and more cases where the manager successfully obtains a larger basket,” Oshinsky said.

How large the basket ultimately becomes will depend on whether the deal is being marketed as a private credit CLO, or a classic middle-market CLO.

Triple-A investors and in some cases senior mezz CLO investors may push back or object to larger baskets, especially if they were previously accustomed to greater protections. Issuers engaging in liability management exercises have brought the issue of cov-lite documents to the fore in the CLO industry with renewed urgency in recent months, as defaults tick up. But the manager could make the case that this is important to their business plan and persuade them to accept it, Oshinsky said.

A CLO investor told 9fin that, in general, the appearance of larger cov-lite baskets is still firm-specific and depends where the manager tends to play. If the manager does more loans in private credit (with issuers reporting $100m+ EBITDA), then it will have more cov-lite loans and by extension a larger bucket in its middle-market CLOs.

Core middle-market players, whose portfolio companies report $25m to $75m EBITDA, remain very focused on docs and keeping covenants in check, the investor said, adding that the larger cov-lite baskets for bigger players is a reactive move to typical BSL loan issuers moving into private credit. Those issuers are accustomed to fewer covenants in BSL deals, which puts pressure on private credit lenders to accede to similar terms. And given loan supply shortages make it more difficult for lenders, whether in BSL or the middle-market, to push back.

However, middle-market CLOs may also be willing to agree to smaller, tighter cov-lite baskets if the “cov-lite” definition includes certain flexibilities, Oshinsky said. For instance, the definition can be crafted to carve out a loan that is cross-defaulted or pari-passu with another loan that has a financial covenant that it can be linked to, he said. The other exception is when the loan features a springing covenant — a financial maintenance covenant that ‘springs’ into effect under certain circumstances, such as when the obligor draws upon a corresponding revolving facility.

BSL CLO investor cross over

The changing composition of the mid-market CLO investor pool mirrors how spreads and cov-lite baskets have become more like the BSL market.

In general, much of the new money buying up middle-market CLO paper this year has come from traditional BSL investors who are seeking relief from ever-tightening spreads in the BSL market, according to 9fin sources.

Notably, asset managers and Japanese banks are among the parties showing greater interest this time, sources said. “My last trip to Tokyo, everyone was interested,” a middle-market manager told 9fin, adding though that some Japanese banks had already been buyers of middle-market CLO paper.

At Brightwood, Shaw said, “we’re seeing interest from a variety of investors. We have people in insurance, hedge, bank and treasury groups, opportunistic funds, everywhere from Australia to Ireland to the West Coast,” Shaw said.

At the bottom of the capital stack, there is hope that more third-party equity investors might enter mid-market CLOs in greater numbers. "There are much fewer middle market CLOs with third-party equity investors out there as compared to BSL CLOs,” Oshinsky said. “We've worked on successful deals that closed with third party equity, but it's less common.” We think BSL equity investors are likely to try to participate, he said.

Shaw said although the market for third-party equity in middle-market deals is small, “it's unclear whether there aren't a lot of buyers because people don't sell it, or people don't sell it because there aren't a lot of buyers… we'd love to see that part of the market grow.”

“We're always happy to talk to folks about it, because we think that there's a good risk-reward that exists.”