CLOne wars. Private lenders are eating old-school bankers’ lunches. As they do so, though, the asset managers and private equity firms shoving Wall Street lenders aside are beginning to look more and more like the traditional world of finance. An example: investment banks, by and large, sell on loans they have made to funds that package them into securitised debt. Now, bespoke, hard-to-trade private loans are getting the same treatment. Giant lender Blackstone just launched a so-called collateralised loan obligation for private credit. It’s a potent tool, but with vulnerabilities.

Collateralised loan obligations (CLOs) package together pools of risky corporate IOUs and slice their cashflows into bonds of varying risk. And the highest-ranking of the bonds that emerge from the sausage machine can win the gold-standard AAA from rating agencies, which allows them to be sold to investors who shy away from riskier bets, like banks or insurers. Overall, the return demanded by investors in the CLO securities is lower than that demanded on the individual loans, creating a profit for those lowest-ranking tranches, and fees for the managers that assemble the loans.

Such CLOs have obvious appeal for private credit specialists, like Blackstone or Blue Owl Capital. Using CLOs can expand their firepower and boost returns, because they can borrow much more than banks were historically prepared to lend. In simplified terms, banks would offer perhaps $1 of loans for each $1 of investors’ capital, or equity. When the investment is structured through a CLO, with the fund’s investors taking the lowest-ranking tranche, $1 of equity can support as much as $5 of debt. And the all-in cost of borrowing through a CLO is also a quarter of a percentage point cheaper than traditional bank leverage, according to a person who has worked on recent deals.

As such, CLOs formed from these private, non-bank loans are picking up steam; analysts at Citigroup expect $30 billion to be issued in 2024, nearly 30% of the total CLO market. In 2021, private CLOs were closer to 10% of the market. Those have been mostly formed of relatively small pools of tiny loans, though. Blackstone and others are pushing further, launching CLOs backed by much chunkier debt. Steve Schwarzman’s group’s $400 million deal in December, for example, included pieces of loans like the one supporting software firm Zendesk’s $10 billion private equity buyout, which closed in 2022.

But packaging up private debt isn’t as easy as slicing and dicing the syndicated loans that make up most CLO fodder. Private lenders often allow companies to borrow more relative to their earnings, or even set lending limits based on revenue for companies that aren’t very profitable. And because these loans tend to come in larger ticket sizes, it’s harder to assemble a diverse portfolio with as many names: private credit CLOs will have perhaps fewer than 100 loans, compared with over 200 in a standard deal.

The fusion of private credit and traditional loan alchemy also brings risks if borrowers turn out to have overstretched. Private loans don’t carry standardised, publicly disclosed credit ratings from agencies like Standard & Poor’s, Moody’s and Fitch Ratings, making them more difficult to quickly sell if things go wrong. It’s therefore easy to understand why some typical CLO buyers might be leery. Worse, these loans’ relative opacity means rating agencies may be more quick to downgrade a private CLO’s bonds – which generally do have credit ratings – if more companies default, or losses are higher than expected.

As a result, the pool of potential buyers for private CLOs is smaller than for traditional vehicles. Blackstone, though, has taken some measures to safeguard its recent, bigger deal: the higher-rated, most senior tranche accounts for 50% of the total pool, rather than the norm of around 70%. And it can keep some 20% of its assets in the riskiest class of loans, more than double the ratio seen in typical CLOs, before having to mark down any troubled assets.

There’s a contradiction that lenders will have to reckon with, though. The appeal of private markets has been that they are less susceptible to price swings driven by short-term changes in sentiment or liquidity. The more private lenders rely on CLOs, the more they will be exposed to the whims of a broad investor base. Blackstone is one firm that kept lending to high-risk firms even when economic turbulence and rising rates made traditional lenders close up shop. Becoming more like Wall Street means taking on more of its weaknesses as well as its advantages.

Collateralised loan obligations package together pools of risky corporate IOUs.

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