According to a report this month by Charlotte, North Carolina-based Wachovia Securities, which has underwritten several US middle-market CLOs, the number of US banks declined from 15,000 in 1990 to less than 9,000 by 2001. The report notes that consolidation has raised earnings targets for many newly large banks, requiring them to increase average loan sizes and therefore move away from middle market lending. The smaller banks left, meanwhile, do not have the credit expertise for middle-market lending. The resulting gap, the report notes, has left a void in the middle market-lending sector. The Wachovia report says these effects, coupled with changes in the syndicated loan market, will lead to “tremendous growth” in the CLO asset class.
Specialty finance companies such as American Capital Strategies, CapitalSource Finance and MCG Capital Corporation, all of which have originated CLOs in the last two years, use the structures as a financing tool. Unlike collateralised debt obligations used by commercial banks to transfer risks off-balance-sheet, specialty finance company CLO originators leave the structures on-balance-sheet. Compared with high-yield CDOs, whose equity piece ranges between 7% and 10%, only 25% or less of which is owned by the originator, the middle-market CLO equity tranche is about 15-25% of the total structure, with the originator retaining 100%.
According to Elizabeth Russotto, director of credit products at Fitch in New York, interest in middle-market CLOs has been strongest from investment banks either representing specialty finance companies or seeking to fund their own middle-market loan books. Russotto declined to say which investment banks had contacted Fitch.
Russotto said distress in credit markets and the current inability of many middle-market companies to fund themselves through issuance of high-yield debt would also create more interest in structuring CLOs. “The lenders are drawing back a bit, but there are more borrowers out there that need loans because they are not able to access the capital markets as easily as they could be if we were in a better economic environment,” said Russotto.