Dealmakers looking for high yields may want to consider investing in middle-market collateralized loan obligations (CLOs), which are specialized vehicles containing middle-market loans traditionally proffered to companies with lower credit ratings.

CLOs give investors a chance to invest in middle-market loans, said panelists at the 2nd Annual Investors’ Conference on CLOs and Leveraged Loans, pointing out that the loans in a CLO are often unrated. The conference was produced by the Information Management Network in New York and held at the Conrad Hotel on April 10 and April 11. 

De facto ratings get done behind the scenes, said panelist Kelli O’Connell, director at NXT Capital. However, many of the loans in question are backed by private equity sponsors, which conduct an extensive amount of due diligence and have the funds to put in more capital to support an investment.

“I think there’s a huge amount of cash on the sidelines looking for yield,” said panelist Marc Steinberg, managing director of Guggenheim Securities. Yields from middle-market CLOs are higher than yields from large corporate loans, the panelists agreed.

High yields are driving interest from all asset classes - especially public pension funds, which are expected to continue investing in the space, said panelist Manish Kapoor, a former Lehman Brothers official that founded investment firm West Wheelock Capital

Pension funds have been a constant investor for middle-market CLOs, despite waning interest from other groups.

“Banks have somewhat withdrawn from the space,” said Kapoor. Basel III, a set of regulations that are not fully implemented in the U.S., which aim to improve supervision and risk management in the banking sector, published by the Basel Committee on Banking Supervision, has made it more expensive for banks to lend, he said.

Middle-market CLOs face a supply-demand imbalance when it comes to dealmakers electing to invest in the vehicles, partially because many investors view the middle market CLO space as less liquid than the broadly-syndicated CLO space.

Nobody ever got fired for investing in a broadly-syndicated CLO, but middle-market CLOs don’t offer the same familiarity, said Steinberg.

In addition to higher yield rates, middle-market CLOs typically involve low default rates and less leverage than other types of loans. The loans are less levered because of their conservative structure, said panelist Michael Mullins, a partner at Winston & Strawn LLP.

Because middle-market lenders originate and hold loans and are generally more patient, “people are going to come to the table to work out a situation,” said O’Connell.

“Middle-market lending is lending as it was 20 years ago,” said Steinberg. With fewer lenders, it’s easier to make quick decisions, he said.

A lack of supply is forcing lenders to recapitalize to preserve their portfolios, O’Connell said. About $400 billion in loans are coming up for refinancing in the next four years, says Kapoor, which should help.

But what middle-market CLOs really need is a “continuation of long-term investors,” said Kapoor. 

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