Middle Market CLOs
Middle Market (MM) CLOs are securitizations backed by private credit loans to smaller companies (typically $10M-$100M EBITDA), as opposed to Broadly Syndicated Loan (BSL) CLOs which hold loans to larger public/rated borrowers. MM CLOs represent ~$50B of the $1.2T total CLO market and offer higher yields but with less liquidity and greater information asymmetry.
Middle Market vs. BSL: Core Differences
| Characteristic | Middle Market CLO | BSL CLO |
|---|---|---|
| Underlying Borrowers | $10-100M EBITDA companies | $50M-$1B+ EBITDA companies |
| Loan Size | $5-50M per loan | $50-500M per loan |
| Loan Market | Private credit (bilateral/club deals) | Syndicated institutional market |
| Credit Ratings | Mostly unrated (shadow B/B-) | Rated by S&P/Moody's (B+ typical) |
| Loan Spreads | SOFR + 550-800 bps | SOFR + 300-550 bps |
| Covenants | Maintenance covenants (quarterly tests) | 95% covenant-lite |
| Liquidity | Illiquid (no secondary market) | Liquid (active secondary trading) |
| Portfolio Diversity | 50-100 loans | 150-300 loans |
| Default Rates | 3.8-5.0% annually (higher) | 3.2% annually (long-term avg) |
| Recovery Rates | 65-70% (slightly lower) | 76% (1st lien BSL) |
| AAA Spreads | SOFR + 175-225 bps | SOFR + 120-150 bps |
| Equity IRRs | 15-22% | 12-18% |
What Is Middle Market Private Credit?
Borrower Profile
Typical MM borrower characteristics:
- EBITDA: $10-100M (sweet spot: $20-50M)
- Revenue: $50-500M annually
- Leverage: 4.5-6.5x Debt/EBITDA (similar to BSL)
- Ownership: 80-100% PE-backed (lower middle market PE firms)
- Credit quality: Unrated, but shadow ratings of B/B- (slightly below BSL average)
- Public disclosure: None (private companies, no SEC filings)
Why These Companies Use Private Credit
- Too small for BSL market: Need $200M+ loan to efficiently syndicate broadly
- Speed and certainty: Private credit closes in 30-45 days vs. 60-90 for syndicated
- Relationship lending: Single lender or small club (3-10 lenders) vs. 100+ in BSL
- Flexible structures: Can customize terms (delayed draw, accordion features)
- Confidentiality: No public disclosure of financials or ownership
MM CLO Structure
Typical Capital Stack
Example: $400M Middle Market CLO
| Tranche | Size | % of Capital | Rating | Spread (SOFR+) |
|---|---|---|---|---|
| Class A (AAA) | $230M | 57.5% | AAA | +200 bps |
| Class B (AA) | $32M | 8.0% | AA | +275 bps |
| Class C (A) | $24M | 6.0% | A | +340 bps |
| Class D (BBB) | $24M | 6.0% | BBB | +500 bps |
| Class E (BB) | $20M | 5.0% | BB | +750 bps |
| Equity | $70M | 17.5% | Unrated | 17-22% IRR target |
| Total | $400M | 100% |
Key differences from BSL CLOs:
- Lower AAA percentage (57.5% vs. 62-65%) due to higher risk
- Larger equity tranche (17.5% vs. 8-12%) to absorb higher defaults
- Wider AAA spreads (+200 vs. +120-150) compensating for illiquidity and opacity
MM CLO Collateral Characteristics
Portfolio Composition
Typical $400M MM CLO portfolio:
- Number of loans: 60-100 (vs. 200+ in BSL CLOs)
- Average loan size: $5-8M (vs. $2-3M in BSL CLOs)
- Top 10 concentration: 25-35% (vs. 15-20% in BSL CLOs)
- First lien %: 90-95% (similar to BSL)
- Fixed rate %: 5-15% (vs. <5% in BSL - some MM loans are fixed-rate)
- Weighted average spread: 625-700 bps (vs. 425-475 in BSL)
Industry Exposure (Typical MM CLO)
| Industry | % of Portfolio | Why Prevalent in MM |
|---|---|---|
| Business Services | 18% | Fragmented industry, roll-up opportunities |
| Healthcare | 14% | Dentistry chains, urgent care, medical devices |
| Software (vertical SaaS) | 12% | Niche software for specific industries |
| Industrials/Manufacturing | 15% | Specialized manufacturing, distribution |
| Consumer Services | 10% | Franchises, specialty retail |
| Transportation/Logistics | 8% | Trucking, 3PL, specialty logistics |
| Other | 23% | Food & beverage, construction, etc. |
Covenant Structures: MM's Key Advantage
Maintenance Covenants Provide Early Warning
Unlike 95% covenant-lite BSL market, MM loans typically include quarterly-tested maintenance covenants:
| Covenant Type | Typical Test | Benefit to Lender |
|---|---|---|
| Max Leverage | Total Debt / EBITDA ≤ 5.5x | Forces deleveraging if EBITDA declines |
| Min Fixed Charge Coverage | (EBITDA - Capex) / (Interest + Taxes) ≥ 1.10x | Ensures minimum cushion for debt service |
| Min Liquidity | Cash + revolver availability ≥ $10M | Prevents liquidity crises |
What happens if covenant is breached:
- Lender can declare "Event of Default"
- Accelerate repayment (demand immediate payoff)
- Block additional borrowings, dividends, acquisitions
- Negotiate amendment (typically borrower pays 50-100 bps fee + tighter terms)
Historical impact: Maintenance covenants allow lenders to intervene 6-12 months before payment default, improving recoveries by 5-10 percentage points vs. covenant-lite.
Performance: Defaults and Returns
Default Rates
Middle market private credit default rates (2000-2024):
- Long-term average: 4.2% annually (vs. 3.2% for BSL)
- GFC peak: 11.5% (2009) (vs. 9.8% for BSL)
- COVID peak: 5.8% (2020) (vs. 3.4% for BSL)
- 2021-2024 benign period: 1.8-2.5% (vs. 0.5-1.5% for BSL)
Why MM defaults are higher:
- Smaller companies more vulnerable to shocks (less diversification)
- Lower credit quality (shadow B/B- vs. rated B+)
- More concentrated revenue base (fewer customers)
- Less access to capital markets for refinancing
Recovery Rates
- MM 1st lien: 68% average recovery (vs. 76% for BSL)
- Why lower: Smaller companies have fewer buyers in bankruptcy; assets more specialized; less robust bankruptcy bidding process
- Offset: Maintenance covenants allow earlier intervention (limiting downside)
Equity Returns
MM CLO equity IRRs by vintage:
- 2007-2008 vintages: 8-10% (suffered in GFC)
- 2010-2013 vintages: 18-24% (post-crisis strong performance)
- 2014-2019 vintages: 15-19% (mature cycle, healthy)
- 2020-2022 vintages: 17-22% (wide spreads compensate for higher rates)
Premium over BSL CLO equity: 300-500 bps due to higher spreads, less competition, illiquidity premium.
MM CLO Managers
Leading Managers (2024)
| Manager | MM CLO AUM | # of Deals | Parent Platform |
|---|---|---|---|
| Owl Rock (Blue Owl) | $8B | 12 | Blue Owl Capital |
| Blackstone Private Credit | $6B | 10 | Blackstone |
| Ares Direct Lending | $5B | 8 | Ares Management |
| Golub Capital | $4B | 9 | Golub Capital |
| Monroe Capital | $3B | 7 | Monroe Capital |
Investor Considerations
Why Invest in MM CLO Debt?
Advantages over BSL CLOs:
- Higher spreads: +50-75 bps wider across capital stack
- Maintenance covenants: Better downside protection
- Manager relationship lending: Origination advantage from direct lending relationships
- Less mark-to-market volatility: Illiquid loans held at par (no MTM swings)
Disadvantages:
- Less liquidity: Harder to exit position in secondary market
- Information asymmetry: Private companies, less disclosure, no ratings
- Higher default risk: 4.2% vs. 3.2% for BSL
- Concentration risk: 60-100 loans vs. 200+ in BSL
- Manager selection critical: Wider performance dispersion (good vs. bad managers)
Who Invests in MM CLO Debt?
- Insurance companies: Buy AAA/AA for yield pickup (50-75 bps vs. BSL AAA)
- Pension funds: Buy A/BBB tranches for illiquidity premium
- Private credit funds: Buy mezzanine tranches (BBB/BB) as leveraged loan alternative
- Family offices: Buy equity for 17-22% IRRs with diversification
Market Size and Trends
MM CLO Issuance
- 2024 issuance: $8-10B (vs. $130B for BSL CLOs)
- Total outstanding: ~$50B (vs. $1.2T for BSL CLOs)
- Growth rate: 12-15% annually (faster than BSL CLOs)
- % of MM loan market: MM CLOs represent ~8% of $650B MM direct lending market (vs. 60% for BSL)
Why MM CLOs Are Growing
- Private credit boom: MM direct lending grown from $200B (2015) to $650B (2024)
- Funding arbitrage: MM lenders earn SOFR+650 on loans, borrow at SOFR+200 via CLO = 450 bps spread
- Diversification demand: Investors seeking exposure to private credit without direct lending operations
- Regulatory capital relief: Banks securitize MM loans to free capital for new originations
Key Takeaways
- MM CLOs backed by private credit loans to $10-100M EBITDA companies
- Higher spreads (+50-75 bps) compensate for higher defaults (4.2% vs. 3.2%) and less liquidity
- Maintenance covenants provide early warning system (vs. 95% cov-lite BSL)
- Equity IRRs of 17-22% (300-500 bps premium over BSL CLO equity)
- Smaller market ($50B vs. $1.2T BSL) but growing 12-15% annually
- Manager selection critical - wide performance dispersion due to origination quality