Market Wrap

Excess Spread - Missing the middle-market, what's next for Jefferies, Kensington goes long

Owen Sanderson's avatar
  1. Owen Sanderson
11 min read

Putting the fun in fund financing

Why is it that the capital markets act like the Britain of my childhood, when new toys, trends, crazes and cultural excitement in all its forms took forever to cross the Atlantic? Luckier kids than me would report back from trips to Disneyworld in hushed and reverential tones; rare and elusive electrical gadgets would be tucked away on trips to New York. But surely these days we’re all one big transatlantic community?

We’ve already discussed the first steps in starting a European CRE CLO market (and the several other deals in the works) — so the obvious next question is, where are the middle market CLO deals in Europe?

All the building blocks should be there. Behind the publicly distributed CLOs we all know and love, there’s a large market providing private leverage against private credit portfolios, using CLO technology, and often executed off CLO desks.

There are differences, of course — lower advance rates, simpler tranche structures, often senior and equity only, and the collateral itself is illiquid, hard-to-value bilateral loans, rather than liquid broadly syndicated TLBs.

The returns to the debt tranche are also considerably higher, perhaps 375 bps-400 bps on a 50% advance rate — a level which is interesting enough for these facilities to stay on investment bank balance sheets for the carry, in many cases.

But in the US, this type of underlying exposure comes out in the markets, either in public middle market CLOs, or through the Business Development Companies (BDCs), often managed by the large credit funds. Both structures are more efficient funding sources than leverage from bank balance sheets, though BDCs rely on a particular US regulatory regime. But middle market CLOs often achieve a 70%-80% advance rate, depending on how far down the capital structure managers choose to sell.

Many of the managers active in the US middle market have regular CLO shelves in Europe — Blackstone CreditKKR CreditApolloGuggenheim off the top of my head — so there’s clearly the appetite and experience to execute these structures. 

So what’s missing? Collateral might be a little more difficult than in the US. Multijurisdictional deals are harder to pull together, especially if the underlying ticket size is small, and there’s an awkward currency split between the biggest direct lending market in Europe, the UK, and the rest of the Continent. 

The bigger private credit funds often have lumpy portfolios with large unitranches and some sub debt in, and these don’t work well for MM CLOs — the best portfolio for a CLO structure is a granular book of senior loans to firms too small for the syndicated market, and lots of this lending remains the province of the banks in Europe.

Investor demand in Europe is untested, of course, but looking at the strong bid for the regular variety of CLOs all year, surely there’s enough spare cash to look at a few other structures?

We’re hearing that some mezz investors are so keen to get their hands on CLO paper that they’re placing “reverse enquiries” with arrangers for transactions that don’t even exist yet, hoping to get a jump on the syndication bunfight and lock in protected tranches ahead of deal announcements.

Senior anchor accounts and equity have been doing something similar more or less forever, but that’s just how CLOs work — lock up the top and bottom of the capital structure, fill in the middle in the market. But if mezz investors are elbowing their way into new deals before they start bookbuilding, perhaps we’ll see more deals effectively pre-sold before announcement.

Equity providers, for their part, are literally queuing up to get into the market, with big managers running multiple warehouses at once, not all of which can exit into the market. Blackstone Credit, for example, has filed for four new vehicles since June, and surely has to be running low on Irish parks to name them after….

That’s a stark change from the pre-Covid period, where third party equity was scarce and sought-after, and managers often had to cut fees or structure in rebates to attract outside accounts to their deals — for the top shops, expect full-fat fee structures for the foreseeable.

Primary this week so far has seen a new issue from Carlyle, executed via Jefferies (of which more below) — the top of the stack saw solid execution at 95 bps, though a 96.5 print for 965 bps DM on the single B looks a little soft. It’s a slightly longer issue than a lot of other primary supply, at a full 2 NC / 5 reinvestment length, rather than the 1.5/4.5 structure that’s been usual recently.

Partners Group refinanced the full stack of Penta 8, a 2020-vintage CLO, through JP Morgan — a relatively unusual move, as most managers have opted to reset their 2020 deals rather than refinance. A reset extends the deal lifespan and allows new doc changes (in effect, it’s a full new issue with an existing asset pool), while a refi just reprices the liability structure. Most refis have been of older deals, and have focused on the investment grade part of the structure,, leaving the junior-most classes alone. 

But the short WAL of the resulting structure, with reinvestment period ending in January 2024, allowed the deal to cut costs handily up and down the stack, with senior bonds printing at 82 bps vs 115 bps at first issue in October last year.

Onwards and upwards for Jefferies 

Many banks have tried to start primary CLO franchises, and most have failed. Which makes the success of Jefferies all the more striking.

The formula was pretty simple — hire the whole senior team of the reigning #1 CLO arranger, Citi. Laura Coady, the head of the desk, moved first as co-head of securitised products EMEA, then hired Hugh Upcott-Gill and Luis Leoncarsi, who now co-head CLO origination at Jefferies.

Their departure last year then set off a round of musical chairs in the CLO industry, with Citi hiring from Credit Suisse, Credit Suisse from Natixis, and Natixis promoting and shifting internally to plug the gap, ahead of the busiest year on record for the European CLO market.

The newly staff Jefferies shop started firing on all cylinders pretty quickly, with several top tier mandates executed by the end of 2020, and this year took its place in 2021 as the biggest CLO arranger in Europe, passing Barclays, historically #2 to Citi’s #1, back into second place. This answers the fundamental investment banking question of whether it is the seat or the individual - it’s pretty clearly the individual in CLO land.

It’s all the more striking because Jefferies does not have a natural balance sheet for the bread-and-butter of CLO origination — providing cheap senior warehousing. It’s an investment bank with a high cost of capital, so low returning senior warehouses in large size aren’t an easy pathway to profit, unless it can strike a deal with a partner institution to fund its warehouse lending.

What’s next for Jefferies though? It’s been hiring people in roles tagged as “FIG DCM” — Samir Dhanani, as head of financial institutions group solutions and debt capital markets in Europe joined this month, and Tom Blackmore to run UK FIG (both from Credit Suisse) will join later.

But it’s hard to see Jefferies slotting seamlessly into the reciprocity merry-go-round that is the covered bond market, or taking its turn in the rotation for big bank funding trades — instead, expect to see more fintech coverage, warehousing, structured lending, and ultimately, securitisation takeouts, filling out the primary markets piece of the Jefferies securitisation puzzle. 

When will the big banks be back?

The multi-billion dollar question for the securitisation market is when, and if, it becomes a funding source for large banks again. The best part of a decade of cheap central bank funding has squeezed all private sector bank debt products, but securitisation has been hit particularly hard — it’s more expensive than covered bonds, thanks to the preferential regulatory regime for these products, and banks don’t need to issue for regulatory reasons, as they have with MREL debt and AT1. 

Securitisation has its own “STS” regulatory regime, supposed to benefit the kinds of deal banks usually bring to market, but large regulated institutions have generally been reluctant to issue in size whatever the incentives. Some firms have kept a toe in the water, issuing the odd deal in minimal size to keep investors happy and credit lines open, but in general it’s been pretty dead. UK FI securitisation activity is at its lowest level for a decade, according to Bank of England statistics, either for retained or placed issuance.

For the UK, though, the central bank support rolls off in 2023, meaning that forward-thinking funding teams, might, just maybe, look again at securitisation. New structures like the Coventry Building Society “Economic Master Issuer” shelf in theory allow a cheaper and more flexible route to market than traditional master trusts, which may lower the barriers to going to market — though the effort required to replace an existing issuance vehicle is likely to put off the likes of Lloyds, Santander, Nationwide and Virgin from using the structure in the short term. Barclays has had a similar structure on the books since last year, but hasn’t done RMBS funding for more than a decade, so don’t hold your breath.

The bigger competition for securitisation might not be other secured funding instruments (UK ring-fenced covered bond assets are also close to decade lows) but not funding at all. UK banks are flush with deposits — sector-wide, deposits are up more than £300bn since the end of 2019, to their highest-ever level, which is an awful lot of wholesale funding to potentially disappear from fixed income investors. Ring-fencing and lending restrictions make it difficult to do much with this liquidity except write more prime mortgages, so the last thing the ring-fenced banks need to do short term is raise more cash.

Kensington goes long

I had the considerable pleasure of moderating a panel discussion between funding heads at three of the UK’s specialist lenders earlier this year - Francois Tual at Habito, Hugo Davies at LendInvest, and Alex Maddox at Kensington….here is a writeup from my old publication. 

At that time, Habito had just launched “Habito One”, the UK’s first 40 year fixed rate mortgage, with junior funding from CarVal, and it proved a fertile area for discussion between the participants….with Alex quizzing Francois on how originations were going for the new ultra-long product.

Fast forward a few months, and Kensington has unveiled its own range of 40-year fixed mortgages, funded through a partnership with Rothesay Life

As we discussed in relation to RGA’s equity release deal, pension insurers and annuity providers like Rothesay love a bit of duration, and if this comes with a certain illiquidity and complexity premium, so much the better. Kensington remains owned by Blackstone (for now), which formerly owned Rothesay, so the institutions already had a relationship — and developed the product together, balancing a product that customers would actually use, with a product which worked for Rothesay’s desire for duration. 

So the mortgage can be repaid only when customers move house, or experience major changes in life circumstances — unlike the Habito product, which can be repaid essentially at the customer’s option, making it relatively expensive and complex to hedge. Kensington’s headline rate is considerably cheaper, thanks to stripping out some of that customer optionality, but some may be nervous about the restrictions.

What both products share is that they render mortgages more “affordable”, thanks to the awkward way in which UK regulators want to calculate affordability. UK borrowers have affordability assessed according to the full lifetime of the mortgage. This covers a short period of a low fixed rate plus a long period of an expensive reversion rate, which the majority of customers never see, refinancing before they step up to pay the SVR. Fixing a rate for the full life of the mortgage might mean a higher initial rate, but means stressing customer income coverage on this rate, rather than against the reversion rate, thereby allowing customers to borrow more.

This product won’t ever see the inside of a securitisation — Rothesay will almost certainly buy and hold — but a move to longer term fixes in general will change the UK securitisation game. Very few RMBS deals have a WAL longer than five years, with most sitting somewhere between two and five, reflecting the most popular fixed rate / refi periods in the UK mortgage market. 

If we start seeing lots of mortgages originated with 10 year plus fixes, that’s got to mean longer WALs in RMBS — and may even mean it’s worth looking at fixed rate bond tranches, as longer-dated balance-guaranteed swaps are already scarce and expensive.

That’s if we keep the same model at all…a further game-changer could be Perenna, founded by former BNP Paribas securitisation and covered bond structurer Arjan Verbeek. I won’t do justice to the pitch here, but the basic idea is to bring Danish-style covered bond markets to the UK, enabling 30 year fixes with five year prepayability, and funding this through pass-through covered bond instruments listed on the LSE. Perenna is still applying for its banking licence, so has yet to write any of these loans, but could one day transform UK house purchasing.

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