Private credit collateralised loan obligations… an emerging trend in Europe?

Collateralised loan obligations (CLOs) are a popular alternative financing tool, which involves the issuance of rated debt securities to public capital market investors. These securities are backed by a diversified portfolio of leveraged loans (typically broadly syndicated loans (BSL) arranged by banks for large corporate borrowers). 

In recent years, there has been growing interest in private credit CLOs (PCLOs), i.e., CLOs whereby the relevant portfolio is comprised of loans advanced by private credit funds (which are generally middle market loans to smaller corporate borrowers). This is driven by the continued and increased growth and diversification of private credit portfolios, managers seeking alternatives to traditional asset-backed lending (ABL) facilities, and the relative success and notable increase in the issuance of PCLOs in the US market. According to the LSTA and Bank of America, as of December 2024 the US PCLO market had grown by 16% since the previous year consisting of $36bn of new issuances with PCLOs now representing 19% of the total new issue CLO volume in the US market.[1]

There are a number of advantages to PCLOs for private credit funds.

 In particular:

• advance rates (which determines the amount of credit by reference to the value of collateral) are often much higher compared to traditional funding options like ABL facilities – in other words, managers are able to borrow more while freeing up investment capacity in the portfolio;
• the leverage that PCLOs provide is also long-term with little volatility. The maturity of PCLOs matches the maturity of the underlying assets in the portfolio, reducing the need for refinancing (and therefore providing a cheaper funding option). In the US market, the average stated maturity of PCLO debt is around 12 years; and
• PCLOs in the US have generally benefitted from stronger credit ratings compared with other CLO products due to lower default rates (65.6% for AAA-rated PCLOs against 39% for AAA-rated BSL CLOs for deals closing in 2023).[2]

The European market landscape for PCLOs

Whilst the European PCLO market is in its infancy, the European private credit sector is experiencing continuous growth and development and market sentiment is optimistic about the potential for PCLOs to establish a significant presence in Europe. In fact, the launch of the first European PCLO in November 2024 sparked a renewed interest among industry participants.[3] 

That said, whilst prospects for mid-market CLOs in the European markets are promising, there remain a number of potential bumps in the road, including:

• rating requirements – the underlying loans for any PCLO established in the European market need to be rated to meet regulatory requirements. Mid-market loans provided by private credit funds are typically not rated (and as a consequence, assigned ratings from rating agencies are also not as readily available). Accordingly, managers would need to undertake a significant rating and estimation exercise in respect of the underlying portfolio, which takes time and is also costly;
• underdeveloped market – PCLOs generally only work (in terms of achieving diversity and therefore reducing credit exposure) if the underlying portfolio of loans has achieved a critical mass (typically at least 50 individual loans). The market (and therefore the secondary market) for private credit is currently much less developed in Europe than in the US which presents an impediment to creating a diverse pool of assets. This means that the manager would need to originate a significant portion of the PCLO portfolio – a barrier to entry for small managers; and
• currency limitations – private credit loans are typically denominated in a number of currencies, whereas CLOs are typically denominated in one currency. Limiting the portfolio to one currency would have impacts on diversity and achieving a critical mass. There are also time and cost implications for obtaining the necessary hedging.

We are excited to observe how the European PCLO market navigates these challenges and trends in the years ahead.
 

[1] CLO issuance sets annual record, posed for Busy 2025, LSTA, 3 December 2024.

[2] Leverage in Private Corporate Credit Vehicles: PCLOs, LSTA, 11 October 2024.

[3] Barings Launches First European Middle Market Private Credit CLO at €380 Million.