Rise of CLOs increase default risk

The invasion of the debt market by collateralised loan obligations (CLOs) has fundamentally altered the lender/borrower relationship which could threaten the stability of many private equity-backed companies should the credit cycle take a turn for the worse.

This is opinion of leveraged debt consultants Blenheim Advisors, which has issued a report called The Changing Face of Lending in the European Leveraged Loan Market. In the report Blenheim argues that the shift away from traditional relationship banks towards dedicated credit fund vehicles (CLOs and CDOs) has enabled dramatically increased the demand for European leveraged loan assets, enabling private equity sponsors to make larger and larger deals with increasingly complicated debt structures.

The high liquidity in the debt market brought about by the flock of CLOs feasting on LBO deals means sponsors will have to be alert to the fact that, in times of hardship, lenders can change quickly. Whilst the old credit world would see private equity firms rely on their relationship with a select band of banks to see them through hard times with distressed companies, this dynamic in the new world, one full of CDOs and CLOs, has changed.

CLOs can only hold a certain amount of distressed debt, which means that they are much more likely than banks to sell the asset to a specialist distressed or hedge fund. This exposes borrowers to investors with much higher default sensitivity.

Blenheim recommends that sponsors arm themselves with improved documentary protection against the risk of defaults as lenders become more aggressive