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The explosive expansion of direct lending is elevating the issuance of middle market collateralized loan obligations (CLOs), alongside our credit estimates that are used as key inputs into the CLO ratings process.

As investors increasingly allocate capital across private markets, evolving macro-credit and financial conditions may require a need for greater transparency. In this edition of Private Markets Monthly, Global Head of Private Markets Analytics Ruth Yang interviews S&P Global Ratings' leveraged finance subject matter experts about the rise and role of credit estimates in providing transparency on middle market credit performance.

What is the difference between a credit estimate and a rating?

Scott Tan, Managing Director & Head of Credit Estimates:  A credit estimate is a confidential indication of the likely long-term credit rating of a business. Credit estimates are a point-in-time credit view, assigned to small or middle market companies with less than $500 million of total debt. For any business with committed debt of over $500 million, we provide a private credit analysis. While both are analyzed based on our corporate ratings methodology, they do not include all aspects of a rating—and are not a rating. The output of credit estimates and private credit analyses is in the form of a score denoted in lowercase, rather than uppercase like a rating. Both credit estimates and private credit analyses are typically requested by third-party CLO managers, who are lenders.

Minesh Patel, Managing Director & Sector Lead for U.S. Leveraged Finance:  In contrast, a credit rating is a forward-looking opinion about the creditworthiness of a business (issuer) or its debt financial obligations. Issuer credit ratings can be long-term or short-term, are denoted in upper case, feature ongoing surveillance, emphasize our credit measure forecasts, and benefit from direct interaction with management.

Scott Tan:  A key difference between credit estimates and credit ratings is that we don't meet with the company's management team for the former. Without this ability to receive more in-depth insight into operating and strategic issues that such contact allows, we may consider taking a more conservative view. For credit estimated companies, the terms and conditions for providing the scores require CLO managers to notify us of "material changes" to the loan terms, including amendments or other changes that have a material impact on our assessment, such as the nonpayment of interest or principal, changes in payment terms, any restructuring of debt, among others. In 2023, roughly 30% of the credit estimates we assessed were updated more than twice due to material events or requests from another CLO manager. When we update the scores on a company, all of the CLO managers holding this credit receive the updated score.

Scott Tan:  As a point-in-time analysis, historical financials are emphasized in credit estimates—and the pro forma adjustments related to the material transactions are incorporated. This is different from a corporate credit rating, where financial projections are incorporated into the analysis, and there's a more forward-looking focus. We typically update a credit estimate within 12 months; however, it depends on the update schedule for each CLO manager who has requested a credit estimate. Theoretically, the more manager requests, the more often we update the credit estimate within 12 months. Still, there's no ongoing surveillance in the general sense, unlike a credit rating. For credit estimates, we don't signal the potential future direction of a score due to the lack of ongoing surveillance. Comparatively, our credit ratings use CreditWatch placements or outlooks to communicate the potential future direction of a credit rating.

Minesh Patel:  There is a significant difference between the size of EBITDA generated from an issuer for a credit estimate and a credit rated issuer. Most businesses with a credit estimate typically range from zero to a maximum of around $100 million—while with credit ratings, we see the majority of issuers' EBITDA start greater than the $50 million mark. For credit-estimated companies reviewed in the first quarter 2024, the median EBITDA was $34 million compared to the median of about $270 million for the U.S. speculative-grade portfolio.

Scott Tan:  We do observe some overlap with companies that could have been analyzed as a private credit analysis or a rating at various times. In far many more cases, we see that when a credit rating is withdrawn, it could be done subsequently as a private credit analysis when the debt is refinanced and private debt sources are used. In a smaller number of cases, we do see instances where an issuer is assessed with a private credit analysis at one time and then a rating when the debt sources go from private to public borrowing.

How are credit estimates performing so far this year?

Ramki Muthukrishnan, Managing Director & Head of Leveraged Finance:  The exponential growth of credit estimates mirrors the overall expansion of direct lending. Credit estimates have more than doubled since 2021—from 1,200 then to over 2,800 now, in tandem with the strong formation of middle market CLOs over this period and due in part to robust issuance in 2023. In the first quarter of this year, we saw a record 750 credit estimates completed—217 of which were new estimates.

Ramki Muthukrishnan:  Revenue has increased year over year in 80% of our credit estimates, as many companies have grown through mergers and acquisitions. This is part of a broader trend we're seeing: Not only is the outstanding number of credit estimates growing, but also the companies themselves.

Many companies we assign credit estimates to are financial sponsor-owned and generally highly leveraged. For credit-estimated companies reviewed in the first quarter of this year, the median EBITDA was $34 million (having increased nearly 50% since 2021, due in part to larger companies going private), and median adjusted debt was about $207 million. Median leverage and interest coverage for all credit estimates completed in Q1 2024 were 6.4x and 1.6x, respectively.

Because of their weaker business and financial risk profiles, a large majority of these companies tend to have credit estimate scores at the lower end of the credit spectrum, especially 'b-'. In terms of their credit quality, credit estimates scored 'b' have dominated since 2016 and increased up to Q1 2024. Scores at 'b+' and 'b have shrank as a percentage of outstanding U.S. credit estimates, which is to be expected considering the generally more aggressive levels of debt used to fund transactions since 2016.

Ramki Muthukrishnan:  Many downgrades of credit estimates have been driven by negative funds from operations due to high interest rates, upcoming maturities with no refinancing plans in place, unsustainable capital structures with high leverage, and residual inflation resulting in increased wages and material costs. This year, downgrades continued to dominate during the first quarter, although they fell from the peaks observed in the second half of 2023. In fact, 2023 saw record downgrades eclipsing 2020. For the companies reviewed in the first quarter of 2024 (excluding new estimates), 80% were affirmed, 15% were downgraded, and 5% were upgraded—the same breakout as in 2023. Overall, downgrades dominated in the health care and software sectors in Q1 2024.

Looking ahead, we expect downgrades to continue. The volume will likely moderate, given the resilience and sustained growth of the U.S. economy, some stabilization in inflation, clarity for now around the direction of policy rates, and efforts companies have taken to contain costs. This could change if inflation ticks up and rates remain higher for much longer, putting pressure on interest coverage and free cash flow.

What role do credit estimates play in middle market CLOs?

Stephen Anderberg, Managing Director and Sector Lead, U.S. CLOs:  Credit estimates are primarily used as inputs into the ratings process for middle market CLOs. The growth in middle market CLOs over the past few years has fueled the growth in the number of credit estimated companies we have. Investor interest in private credit has been sky high this year, and middle-market CLO issuance through May is $15.144 billion, up more than 41% over the same period last year. This is lower than the 75% increase in broad syndicated loan (BSL) CLO issuance, but still very robust. Just over 17% of total U.S. CLO issuance this year has come from middle-market CLOs this year.

Credit estimate downgrades have continued at an elevated level, but middle market CLO metrics have remained stable in recent quarters. Exposure to 'CCC' assets in April was 14.49%, up from 10.01% a year ago, and compared to a typical excess 'CCC' asset threshold of 17.5%. But the average junior overcollaterization test ratio is at 6.83%, down only slightly from a year ago, and target par hasn't moved much over the past year. We don't expect to see many CLO tranche ratings lowered this year, including for middle market CLOs. Some downgrades could come from 'BB' tranches of CLOs originated prior to the pandemic, but these would likely be more on the BSL CLO side.

Writer: Molly Mintz