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Twenty years after middle-market collateralized loan obligations (CLOs) emerged as an asset class in the U.S., Europe executed its first middle-market private credit CLO in November 2024. Backed by a portfolio of middle-market senior secured loans, Barings' €380 million middle market CLO 2024-1 DAC defined a momentous milestone for a region that has struggled to develop this market due to regulatory challenges, lack of investor familiarity, limited loan supply, and competition from established debt markets.

Market participants will be balancing this meaningful progress toward the first European issuance with an array of credit, structure, and liquidity risks—including the unrated and concentrated nature of the underlying assets, potential currency risk, and how the structure's arbitrage works—that may pose additional difficulties for market development, particularly for the first few transactions.

In this special EMEA edition of Private Markets Monthly, Global Head of Private Markets Analytics Ruth Yang interviews S&P Global Ratings' analytical and methodologies leaders about our criteria for rating middle-market CLOs and how we are adapting our ratings as the structured finance and private credit markets evolve. We also explore the idiosyncratic characteristics of the European middle-market CLO market and what the launch of this asset class means for the region moving forward.  

2024 was a year to remember for middle-market CLOs, with record-high issuance from the U.S.' more than 300 investment vehicles and the debut of Europe's first. Why has it taken so long for Europe to enter this market? 

Sandeep Chana, Director, Structured Credit: 

Historically, market participants have certainly considered the idea of structuring a European middle-market CLO, but its realization has been hindered by several challenges—making it difficult to create a product that is economically viable; appealing to investors; and competitive with more straightforward U.S. alternatives, which have market dynamics and issuer profiles more conducive to the success of such CLOs. 

One of the primary challenges has been assembling a sufficiently diversified portfolio of middle-market corporate issuers. In Europe, the pool of these issuers is arguably not as deep or varied as the U.S.', which has limited the scope for creating robust portfolios that meet investors' criteria.  

Another challenge unique to the European market is the issue of loans denominated in multiple currencies, which introduces the complexities and critical concerns of managing foreign exchange risk. Fluctuations in currency values could affect the overall CLO arbitrage. This is an issue that the U.S. market doesn't contend with to the same extent, given the dominance of the dollar and the relative homogeneity of its corporate loan market. 

Cian Chandler, Chief Analytical Officer, Structured Finance:  The traditional market in Europe has been predominantly bank relationship-based, with most small to medium enterprises' (SMEs) relationship banking lines making it unnecessary to turn to the capital markets. Because European banks are now moving away from this relationship-based lending due to capital constraints, large asset managers have stepped in to serve this space. These alternative players have effectively deployed capital in these traditional sectors and are originating loans.

The number of loans has now reached a critical mass in Europe to the extent that market participants like Barings are able to structure a CLO. The Barings private credit CLO loan portfolio primarily consists of middle-market senior secured leveraged loans and some broadly syndicated speculative-grade senior secured term loans.

Beyond being the first mover, why is the Barings private credit middle-market CLO deal significant for the European market—and what further deals and market growth could follow? 

Sandeep Chana: 

The successful execution of the Barings transaction provides proof of concept. This deal serves as a clear demonstration that such a transaction is possible, setting a precedent for other market participants to seriously evaluate and explore this avenue. While the process is not without its difficulties—such as achieving adequate diversity within the portfolio and navigating the inclusion of payment-in-kind (PIK) features—these are precisely the complexities that distinguish a European middle-market CLO from a more straightforward broadly syndicated loan (BSL) CLO. The fact that these challenges have been successfully addressed makes the completion of this deal even more significant by essentially proving that these hurdles can be overcome.

Marta Stojanova, Director, Private Credit:  The Barings deal solved some of the concerns that market participants had about the depth of the European market in terms of number of suitable loans, the diversification factor, and how to solve for liquidity. Euro middle market CLO 2024-1 DAC features an ability to add and hold BSL tranches of up to 15% of the portfolio, which provides liquidity. Additionally, by making the deal static, this transaction demonstrates the robust ability to return money to investors.

Sandeep Chana:  Since its debut late last year, we are already seeing tremendous interest in the transaction and a growing curiosity about how Europe's market will evolve over 2025. We expect to see more middle-market CLO issuances in Europe this year—with each new CLO likely to have its own unique characteristics, designed to align with the specific needs of investors in this space.

In our view, the next wave of CLOs will likely be actively managed as reinvesting CLOs, and there is a strong possibility that some of these deals will incorporate foreign exchange exposure for the first time. The next phase of European middle-market CLOs could see portfolios that include loans denominated in multiple currencies, including euros, pounds, and dollars—which would ultimately introduce multi-currency risk within both the loan portfolio and potentially the CLO liabilities. The possibility of multicurrency portfolios is gaining attention because this approach offers an alternative method for increasing the overall diversification of the CLO. These features distinguish themselves from what we saw in the Barings transaction, which was a static CLO and entirely euro denominated. 

Equally, we also expect future European middle-market CLOs to be complemented with BSL loans to help add diversity to the portfolio, which is known as a BSL sleeve. (This was a feature of the Barings transaction.) The goal is to enhance the diversity of the CLO, mitigating potential concentration risks by blending smaller middle-market loans with larger syndicated loans. This additional layer of diversification could prove vital in making the product more appealing to a wider range of investors, particularly those looking for more balanced risk profiles. 

Marta Stojanova:  Looking ahead, we believe the market will move away from static deal structures—but will likely retain that BSL sleeve as a feature. The number of CLOs in Europe will most definitely rise. With seven years of fundraising and fund deployment coming to the fore, institutional investors and insurance companies are increasingly realizing the benefits of CLO structures and are assessing the potential anecdotal evidence of their future performance in Europe based on the U.S. market's default risk and risk-adjusted returns. 

Emanuele Tamburrano, Managing Director, Structured Credit: 

In general, we see solid investor appetite in this market. In terms of pricing, the Barings deal was not as substantial as a typical U.S. middle-market CLO, so investors may still be asking whether they're being rewarded enough for taking on this risk. When moving down the capital structure, there is also liquidity risk to consider—and market participants need to be comfortable with the manager, framework, and infrastructure beyond the portfolio itself. As such, we are likely to see large alternative asset managers in the region who have this expertise taking on the next few deals.

Marta Stojanova:  Overall, middle-market CLOs are likely to be much more palatable in Europe. But the source of assets could present prominent roadblocks for the growth of the European middle-market CLO market in the coming years. Similar to the BSL market, the lack of supply of new assets or new obligors is the biggest challenge—especially considering how Europe is a fundamentally smaller market.

Although there are multitudes of middle-market companies that are natural clients for private credit funds, these players face massive competition from regional banks in France, Germany, and other countries that have preexisting relationships and can lend at lower rates. We also have yet to see appetite from European SMEs grow or expand beyond their localities. The U.S. market may arguably allow for greater competition and risk-taking, which inevitably is funded through debt capital raising.

Emanuele Tamburrano: 

Importantly, the European market will still need to see how middle-market loans fare in a true downturn. While the pandemic period created complicated credit conditions, there was still significant liquidity from central banks providing additional support—and middle-market CLOs in the U.S. have shown impressive resilience. This recent performance may not be a suitable test or indication of their true performance through the credit cycle.

How does S&P Global Ratings approach rating CLOs within the umbrella of our structured finance and private credit framework?

Cian Chandler:  Credit is credit. Private and public credit is, at a foundational level, differentiated by slightly separate origination formats. As investors look to expand their exposures and understand their risk across public and private markets, we are continually looking at the credit fundamentals to provide this systemic transparency. We utilize our collective analytical expertise in fund and structured finance to assess the diversity of risks across esoteric and novel transactions in all markets and regions.

For our Dec. 16, 2024, rating of the Barings middle-market private credit CLO, we conducted our credit and cash flow analysis by applying our criteria for corporate cash flow CDOs. The ratings assigned to the notes and loans reflect our assessment of the static collateral pool and the credit enhancement provided through the subordination of cash flows, excess spread, and overcollateralization. Our ratings also reflect the transaction's legal structure (which is bankruptcy remote) and the transaction's counterparty risks (which are in line with our counterparty rating framework).

Sandeep Chana:  Across our rating analysis within this market, we use the same fundamental methodology and criteria for evaluating both private credit middle-market CLOs and BSL CLOs. Any notable differences in how the underlying assets behave and/or how these transactions are structured may, in turn, require further consideration at the CLO rating level.

One such key distinction lies in the inclusion of PIK features, which are increasingly prevalent in private credit. A typical BSL CLO generally won't have PIK features attached to senior secured loans. These loans are typically structured to require cash interest payments—which, in our view, provides a more predictable cash flow for the CLO and helps stabilize the arbitrage dynamics. Comparatively, many middle-market loans come with some form of PIK toggle feature. When a borrower exercises the PIK option, the interest is accrued and paid in kind instead of being paid on a current basis. This can lead to an increased risk profile for middle-market CLOs, as it may result in reduced cash flows that could affect the ability of the CLO to meet its obligations and ultimately the economics of the CLO arbitrage.

In terms of structure, we've seen that middle-market CLOs in the U.S. typically have higher credit enhancement levels compared to their BSL counterparts. This is a direct response to the increased risks associated with middle-market loans and potentially higher default rates relative to larger syndicated loans. The higher credit enhancements provide an additional layer of protection for each rated tranche, helping mitigate some of the risks involved. We expect this trend to continue in the European market—where middle-market CLOs are likely to mirror the U.S. market's approach to higher credit protection.

We're observing important nuances in documentation as a key factor in distinguishing the unique risks and opportunities of middle-market and BSL CLOs. For example, we've observed changes in how senior secured loan definitions are framed for middle-market loans—which is an important consideration because these definitions affect both the performance and recovery potential of the loans within the CLO. Redemption mechanisms are more streamlined than in BSL documentation, and there is specific treatment toward those assets that are being participated with the CLO issuer. 

Writer: Michelle Ho