Hail the new private debt machine: private equity, leveraged loans, and collateralised loan obligations

Abstract

The Covid-19 pandemic and the subsequent worldwide economic slowdown have exposed the fragility of the financial sector, among others. This article argues that the seeds of this fragility, while being exposed by the pandemic, were sown earlier, in the post-2008 years, through the revived synergy of three elements of the financial system: private equity firms ascending the role of ultimate intermediaries in the system of private debt creation; leveraged loans becoming the new asset class that replaced what mortgages represented in the pre-2008 years; and collateralised loan obligations (CLOs) which in some ways replicated the function of CDOs as mechanisms of private debt creation. This article explains this phenomenon, analysing in particular how CLO structures morphed during the last decade and how this new transactional innovation facilitated a return to dangerous levels of leverage. As of 2019, the level of CLO issuance neared $120bn in the US, whereas in the EU they were close to Euro30bn. While the IMF warned at the end of 2019 about the dangers associated with the increasing levels of corporate leverage, confidence in the banking system was reiterated, largely due to the alleged safeness of CLOs, and particularly the capacity of these transactional structures to shift risks away from systemic banks. This article provides some clarity on these apparently contrasting statements, drawing inter alia some parallels with the crisis of 2008.