Issuers of middle-market collateralized loan obligations (CLOs), such as NXT Capital, are reaping the benefits of increased investor confidence in the security class. Performance results demonstrate that instruments that pool the debt of middle-market companies behave similarly to those of large-cap companies. For middle-market CLO issuers, the increased investor comfort translates into paying lower interest rates.
As little as two years ago, institutional investors that considered investing in the AAA tranche of a CLO believed that investing in CLOs made up of middle-market loans was riskier than investing in CLOs made up of large-cap loans because of the lack of transparency surrounding middle-market borrowers. That mindset required the CLO issuer to pay a higher interest rate to investors on the tranche.
In the past two years, the interest rate premium for the top tranche of a middle-market CLO has fallen by about 50 percent, when compared to their large-cap bretheren according to NXT Capital's CFO Neil Rudd. According to Rudd, the pricing improvement reflects growing investor demand for middle-market CLOs, as well as recognition that middle-market CLOs are not necessarily more risky than broadly-syndicated CLOs.
NXT just closed its third CLO in three years in May with $357 million. The CLO has a four-year reinvestment period, with pricing on the AAA-rated securities at Libor plus 1.75 percent.
CLOs are part of Chicago-based lender NXT's business plan. The lender functions with three sources of capital: equity capital, an investment made by the firm's owners; bank credit facilities, which NXT uses to originate loans; and different types of securitization, including CLOs, according to Rudd.
Before the May CLO, NXT closed a $358 million CLO in April 2013. The year before, in May 2012, the company closed a $308 million CLO with pricing on AAA-rated securities at Libor plus 1.5 percent, which at the time was a post-crisis low for a middle-market CLO, according to NXT. The year before, in May 2012, the company closed a $308 million CLO.
The process allows NXT to take loans that it financed through its bank credit facility, put them in the CLO, and free up equity capital to invest in new loan originations, Rudd says. "By using less equity with the same assets we can achieve a higher return on equity for investors."
NXT expects to continue closing one to two CLOs per year, according to Rudd.
Private equity firm Cerberus Capital Management is also reportedly marketing a $450 million CLO. In April 2014, NewStar Financial Inc. closed a $348 million middle-market CLO.
"Our ability to generate strong demand for the deal from a range of global investors highlights the value of our direct lending platform and growing interest among institutional investors in the middle market," says NewStar CEO Tim Conway.
For more coverage on CLOs, see "Apollo Prints Biggest CLO Since Financial Crisis."