Direct Lenders Find Middle-Market CLO Funding Is Scarce: Q&A

Direct lenders have had to increasingly rely on bank funding for middle market loans, because the collateralized loan market has been a tough place to fund, according to Derek Dubois, treasurer and head of Deerpath Capital Management’s CLO business.

Deerpath is a private credit firm targeting the lower end of the U.S middle market that manages $5.4 billion of assets. Dubois spoke to Bloomberg’s Carmen Arroyo and David Brooke in a series of interviews that ended on Jan. 31. Comments have been edited and condensed.

Last year, middle-market CLO issuance dropped by over 40%. Do you expect the market to recover in 2023?

“My expectation is that new issuance will continue to be muted this year. Investors are buying debt from top tier managers that are multiple time issuers, and staying away from first time issuers. That is slowing down CLO issuance.

Still, with the start of the year we have seen some tightening across the CLO market as investors get their new budgets and put some money to work. In that context, middle-market CLOs still offer a compelling premium compared to broadly syndicated loan CLOs. Investors can get good relative value there.

However, spreads are going to stay wide for the CLO market in 2023 until there’s more clarity around inflation and how much appetite banks will have as they assess their loan loss reserves.”

Is it possible that the AAA spread tightening we’ve seen in CLOs this year will trigger more selling?

“I don’t view it as an impetus for wide spread selling. I believe the spread tightening will help some CLO investors that took mark-to-market writedowns on their investment book from the widening of spreads that we saw over the summer of 2022. In addition, some of the tightening is in reaction to the tightening of underlying loan spreads.

It is still uncertain whether the current rally is sustainable as of right now. It appears that capital has opened up in the beginning of 2023 as new budgets and investment mandates for the year roll out, but for how long is uncertain.”

With CLO issuance muted, where are middle-market firms finding cash?

“Direct lenders are using their contingency plans, which is typically to access bank lines. They would rather use CLO financing, which is much more efficient than bank capital but that’s not an option now. Despite the macro environment, banks haven’t cut those lines, although they reduced their appetite to just servicing existing clients instead of expanding their books. In addition, banks are tightening their credit parameters and scrutinizing the underlying collateral in these loans more closely.”

The rising rate environment is benefiting private-credit firms, but what are the biggest risks for lenders this year?

“We were obviously in a very compressed environment for a number of years and that reduced returns. But with the vast majority of middle-market credits pegged to the base rate it’s now nice to see those enhanced yields as rates rise.

There has been a period where lenders have been aggressive on things like Ebitda add-backs, as well as reduced cushions for covenants – if the lender even has covenants. There is going to be a test in the middle-market space this year and we’ll find out who did a better job of underwriting credits over the last few years.”

How do you expect fund-raising to evolve this year?

“Fundraising has slowed as a lot of institutional capital is assessing where they’re at in the broader market, be it bonds or equities. They’re evaluating their entire investment mandate right now, which trickles down to private credit. And yes, fundraising has slowed down across the industry as a result.”