The intersection of public and private credit is gaining steam in markets and the media. This convergence is pronounced and transparent in the broadly syndicated loan market. In this piece, we explore the impact of this trend on CLO equity and the unexpected benefit it has driven in recent years.

The growth of private credit

BSL and MMDL are two sides of the same coin. They are both senior loan facilities that are financing US corporations, often because of private equity buyout activity. As private credit dry powder has grown (Figure 1), private lenders have moved upstream to finance larger transactions. This has taken share from the broadly syndicated loan market which has seen the smaller end of its market shrink as it migrates to private lending (Figure 2). 

Many in the market have jumped to a rhetoric that this is the end of the BSL market as we know it, and private credit is taking over. We take a much more balanced view: The emergence of private credit is a natural evolution of the market to a more symbiotic relationship between the BSL and MMDL markets.

Figure 1

Figure 2

The beginning of a complex friendship

In our view, both MMDL and BSL serve core functions required for healthy credit markets. The BSL market is more efficient at lending larger facility sizes and generally offers a lower cost of financing to companies. But one challenge of BSL is that during bouts of volatility, banks are typically less willing to lend to companies, so lending slows. Companies have reacted to this, smartly, by diversifying their borrowing base and tapping into private credit markets when BSL financing is not available. Figure 3 shows how, when bank lending slowed in the volatile credit environment post the collapse of Silicon Valley Bank in 2023, companies shifted their borrowing to private credit. However, when normalcy returned to markets in 2024, the tide flowed back to BSL.

We think this is a very healthy dynamic for borrowers because it reduces their default risk if their maturities fall in a period of heightened volatility. They now have multiple options to roll their borrowing forward and not be caught in a situation of having a good balance sheet, but no liquidity because public markets are closed.

Figure 3

Another important and emerging trend is the divergence between the types of companies tapping BSL versus private credit. Historically, when a company was under stress with a potential downgrade to CCC, it faced a borrowing cliff. CLOs are the largest buyer of bank loans and have tight restrictions on their ability to own the lowest-rated debt category of CCC. This often meant that loan prices would hit an air pocket between CLO demand and distressed buyers who buy at lower prices. Private credit has emerged as a natural buyer of those challenged credits, taking the loans private, offering more creative lending terms bilaterally, and potentially earning a higher spread while doing so. This has shifted some of the riskiest loans off the balance sheets of CLOs and into private credit funds.

Bottom line for CLO equity

The convergence of public and private markets has thus far benefited CLO equity by improving credit fundamentals. High CCC exposure and defaults have historically been the primary risks to CLO equity tranche holders, potentially restricting trading activity and reducing future interest and principal payments. Private credit entering the market as a buyer of these loans was an unexpected but welcome development.

Critically, though these loans are trading at stressed prices, they are refinanced at par. So, CLO equity goes from owning a credit trading at a steep discount that could take a principal loss to instead being paid back at par. As long as this trend continues — and given today’s ample dry powder and strong demand for private credit, we expect it to — CLO equity could be a significant beneficiary of the growth of private credit.

The flip side of this coin is that private credit taking market share from the bank loan market has the negative technical impact of tightening bank loan spreads because of lower loan supply. We see this today with almost 60% of BSLs trading above par.¹ This reduces the income and potential price appreciation to equity buyers when creating CLO collateral pools. We are less concerned about this trend because the CLO machine has the natural regulator of the equity arbitrage. If loan supply drops, leading to tighter spreads/higher dollar prices, new CLO creation is likely to slow. All else equal, CLO issuance should slow over time at a pace that leads to an equilibrium between the two markets and should not be a long-term challenge to equity returns.

¹Source: Morningstar LSTA Leveraged Loan Index. Data as of 31 May 2024.

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