Private lenders are having the traditional bankers' lunches.But as they do so, the asset managers and private equity companies pushing out Wall Street lenders are becoming more and more like the conventional financial industry. Investment banks, for instance, typically sell the loans they've made to funds that bundle them into debt that has been securitized. Private loans that are unique and difficult to trade are now being treated similarly. Recently, massive lender Blackstone just launched a collateralized loan obligation for private credit. It is a powerful tool, but it has weaknesses.
Collateralized loan obligations, or CLOs, package together large pools of hazardous corporate IOUs and divide their cash flows into bonds with different levels of risk. Additionally, the bonds with the highest rating after coming out of the sausage machine have the opportunity to receive the gold standard AAA rating from rating agencies, enabling them to be sold to investors such as banks and insurers that are hesitant to take on riskier bets. Generally, investors' demands for a lower return on the CLO securities than they do on individual loans result in profits for the lowest-ranking tranches and fees for the managers who put the loans together.
Such CLOs are obviously appealing to private credit experts such as Blue Owl Capital and Blackstone. Because they are able to borrow far more than banks were previously willing to lend, using CLOs can expand their influence and increase returns. To put it more simply, banks would provide maybe $1 in loans for every $1 in equity, or capital, from investors. $1 of stock can finance as much as $5 of debt when the investment is organized through a CLO, with the fund's investors choosing the lowest-ranking tranche. Furthermore, a person working on recent deals claims that the all-in cost of borrowing via a CLO is a quarter of one percentage point less expensive than conventional bank leverage.
Because of this, CLOs made from these non-bank, private loans are becoming more popular; according to Citigroup analysts, $30 billion, or over 30% of the whole CLO market, will be issued in 2024. Private CLOs accounted for more than 10% of the market in 2021. However, those have primarily consisted of comparatively small pools of minor loans. Blackstone and other players are taking it a step further by introducing CLOs that are supported by far greater debt. For instance, loans financing software company Zendesk's ten billion-dollar private equity buyout, which ended in 2022, were part of Steve Schwarzman's group's 400 million-dollar deal in December.
However, arranging personal debt is more difficult than chopping up the syndicated loans, which constitute the majority of CLO fodder. Private lenders usually let businesses borrow more in relative to their profits. For businesses that aren't very profitable, private lenders may even impose loan limitations depending on revenue. A diversified portfolio with as many names is more difficult to put together with these loans because they often have larger ticket sizes; private credit CLOs may have less than 100 loans, compared with more than 200 in a typical deal.
There are risks associated with the combination of private credit and conventional loan alchemy if it turns out that borrowers have overstretched. Private loans are more challenging to rapidly sell if something goes wrong because they lack standardized, publicly available credit ratings from organizations like Moody's, Standard & Poor's, and Fitch Ratings. Therefore, it's reasonable that some typical CLO buyers could be wary. Furthermore, because of the relative opacity of these loans, rating agencies would be more inclined to degrade a private CLO's bonds — which typically do have credit ratings — if there are more defaults or larger-than-expected losses.
Because of this, there are fewer prospective purchasers for private CLOs than for conventional vehicles. However, Blackstone has taken some steps to protect its most recent, larger deal: instead of the normal 70% of the entire pool, the higher-rated, most senior tranche now makes up 50% of it. Additionally, before having to write down any problematic assets, it can retain about 20% of its holdings in the riskiest class of loans — more than twice the level seen in typical CLOs.
Nonetheless, lenders will have to consider a contradiction. Private markets have historically been appealing because they are less prone to price fluctuations caused by transient shifts in mood or liquidity. The more private lenders depend on CLOs, the more they will be susceptible to the vagaries of a large investor base. Blackstone is one company that keeps lending to high-risk businesses in the face of economic uncertainty and rising interest rates. Becoming more like Wall Street means embracing more of its shortcomings as well as its advantages.