Middle Market CLOs Return — But It's Different This Time

Middle market collateralized loan obligations have remained relatively scarce since the financial crisis, as it's still difficult for deal sponsors to get financing to warehouse loans to small and midsize companies.

Most of the deals to date have come from middle market lenders opting to securitize loans they are already holding on their books. These lenders compete with traditional banks for borrowers, though banks often collect fees as underwriters of the securitizations.

NXT Capital is the latest commercial lender to come to market with a collateralized loan obligation; this month it priced a $308 million deal, NXT Capital CLO 2012-1. The senior, AAA-rated tranche printed at Libor plus 190 bps, which the firm said was the lowest level for a middle market CLO since the crisis.

Neil Rudd, NXT's chief financial and administrative officer, explained in a recent interview that this kind of pricing makes CLOs an attractive form of financing for a firm that would otherwise rely on equity capital or on a line of credit from its own lenders. NXT held on to the equity in the CLO — the riskiest segment of the securitization — but the deal still freed up a significant amount of capital to make more loans.

The following is an edited version of the interview, conducted by Leveraged Finance News, a sister publication of American Banker.

How do middle market CLOs differ from securitizations of more broadly syndicated loans?
Neil Rudd: The market for middle market CLOs is smaller, with far fewer issuers. Post-crisis, there have been half a dozen middle market CLOs. Most middle market CLOs, especially these days, are issued by buy-and-hold balance sheet lenders such as NXT Capital, who view CLOs as financing rather than arbitrage.

What are NXT's other sources of financing?
So far, NXT's funding has been largely done via bank line of credit facilities. We currently have almost $800 million in bank financing for our corporate finance business. Our bank financing has term-out features, so it's different than a traditional warehouse line. It provides flexibility. If a window opens and there's an attractive opportunity to complete a capital market transaction, we can do so. If the window closes, we can continue to originate and hold on our balance sheet.

Is pricing the only appeal of financing via a CLO?
Another attraction of CLOs for NXT Capital and other issuers is CLOs' ability to reach institutional investors. NXT has successfully attracted additional banks to our financing facility; we currently have six banks led by Wells Fargo (WFC). But we also believe bank financing is ultimately a finite market. CLOs give us access to a new class of investors that aren't lenders but are interested in exposure to the middle market asset class. Issuing a CLO gives NXT additional capacity to grow by reaching a larger investor base. We expect to issue additional CLOs. Timing will play a role; I don't see NXT being purely opportunistic, but the last two years have demonstrated that some times are better than others for issuing a CLO.

How long did it take to put the deal together, given that you had already the collateral in place?
Our first CLO took just under three months to complete. With much of the up-front investment in documentation and systems out of the way, we expect to be able to execute on future CLOs even more quickly.

In its presale report, Moody's Investors Service said most of the loans would be in place when the deal closed; what was the exact percentage?
NXT's CLO was fully ramped at close. As the loans pay off, we expect to replace them with other senior secured middle market loans. We may have a small bucket for second lien loans, but 100% of the initial portfolio consists of senior secured loans, which are our primary focus. NXT can also provide junior capital, but it's a small part of our business.

These days it's possible to launch CLOs of more broadly syndicated loans without warehousing the collateral; what level of warehousing is typical for middle market CLOs?
Middle market CLOs have traditionally had a high percentage of loans funded at close and a smaller ramp-up, even pre-crisis. There might have been a ramp of 25 — 30% of the collateral over 120 to 180 days. Post-crisis, ramp time has become shorter and the percent of collateral funded at close is higher. NXT could have built a ramp into our CLO, but we chose to identify 100% of the loans at close because that was more attractive to investors.

What percentage of the firm's corporate finance portfolio is in CLO?
NXT has almost $1 billion in loan commitments to middle-market companies, including the assets in the CLO. NXT is retaining all of the equity in the CLO, so we have substantial skin in the game in terms of how the collateral performs. NXT has also typically retained a portion of each loan sold to the CLO.

What's your outlook for middle market lending?
Demand for middle market lending is divided into companies owned by private equity firms or institutional owners and privately held companies. …There are good reasons to believe middle market transaction volume will continue to grow. The amount of private equity firm dry powder and potential tax changes should drive more M&A. Investment banks also tell us they're working on a large number of mandates. Activity dipped in early 2012 when compared to the end of 2011, but overall, we expect this to be a good year for middle market lending.