Sharp CLO drop weighs on middle-market credit for deals

  • Middle-market has some exposure to CLOs
  • Analyst cuts view on CLOs, but sees uptick
  • Tight credit foils Z Capital bid for Affinity Gaming

A steep drop in collateralized loan obligations (CLOs) in 2016 has contributed to tighter credit for middle-market deals, but conditions improved on some fronts late in the first quarter, according to specialists in the credit space.

Collateralized loan obligations invest in broadly syndicated loans — typically above $500 million — for larger buyouts from a variety of debt issuers and industries. But CLOs often include up to 10 percent of their portfolio in the larger end of the middle market, market participants said.

So as CLOs shrink, less capital will be available for loans of all sizes.

Along with lower CLOs issuance, liquidity for leveraged loans has also been choked off by retail investors pulling money out of junk-bond funds, executives said.

Although an expected increase in distressed debt may present an opportunity for credit specialists to find discounted investments, it’s also making it harder to finance deals.

“There is an opportunity, but the punchline is, big or small, buyout deals just don’t have the financing capability,” Jim Zenni, CEO of Z Capital, said in a phone interview.

More difficult borrowing conditions caused the firm to scrap its $15 a share offer to buy Affinity Gaming after an effort that stretched back years, he said. Z Capital alerted the company in a formal letter on January 31 that flagged the state of credit markets.

“The math is the math,” Zenni said. “The market for the debt isn’t there. It is a good example of the state of the marketplace; a year ago we could have gotten it done.”

While roughly two-thirds of CLOs typically contain less risky senior debt, the equity and junior-debt portions have become more difficult to raise in recent months.

“If there is no demand for the junior piece, you can’t get them done,” Zenni said.

For this and other reasons, only about $1.7 billion of CLOs were issued as of February 21, well below levels in early 2015, when it wasn’t uncommon for $4 billion to be raised, according to market sources.

“Currently it is a really low number, and nothing suggests to us that CLO new issuance will pick up suddenly in the near term,” said Andrew Curtis, managing director at Z Capital, who runs its credit business.

John Fraser, managing partner of 3i’s U.S. debt management unit, said the decline in CLO issuance is not a major factor in tighter middle-market borrowing, but it’s part of an overall trend.

“The volume of new loan issuance across the board is down pretty dramatically,” he said. “That’s due to a number of concerns that borrowers have. They’re concerned about borrowing costs going up because (debt) prices have declined. They’re concerned about the broader capital market, including the equity and bond markets and whether that has implications for them. And they’re a little concerned about some of their sources of capital, including CLOs.”

These headwinds seem to be impacting deal-making as well, he said.

“A question we’re all asking each other is have the volatile conditions in the first few months of the year potentially … decreased the pipeline of new deals for the first half of the year and maybe longer? It certainly looks like that’s the case right now,” Fraser said. “Whether that remains the case for the foreseeable future has yet to be seen. More broadly, corporate M&A is going to continue, but the activity around the leveraged-buyout market is going to remain at diminished levels for the near term.”

Bank of America sees improvement

In a recent update on the CLO market, Bank of America Merrill Lynch analyst Chris Flanagan said “improved investor risk appetite” helped stoke activity around CLOs focused on mezzanine tranches of loans. In a sign of stronger demand, the pricing gap, or spread, between buyers and sellers of the assets has narrowed.

“Spreads tightened for the second week in a row following a number of positive developments for the CLO market in recent weeks, including higher oil prices, dovish global central bank policy, and improving technical trends,” Flanagan said in a March 18 research note.

The firm sees demand for U.S. CLOs of debt higher up in the capital structure where investors are less exposed to credit risk, he said.

Despite these positive moves, BAML continues to expect overall CLO issuance to drop sharply this year. In February, BAML cut its estimate for U.S. volume by nearly 40 percent to $45 billion from $70 billion.

However, CLOs have made it out the door of late, including Denali Capital CLO XII, Magnetite XVII, Madison Park Fund XX and Neuberger Berman CLO XXI, according to

Action Item: Data on CLO market,

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