Agencies open door to lower par subs

What’s a percentage point between friends? I refer, of course, to the latest euro CLO from Partners Group, Penta 10, which priced last week, and which pushes par subordination another notch lower to 37%, rather than the 38%-40% that’s been the post-Covid norm, and well through the 40%+ levels of the immediate post-pandemic period.

It is apparently the lowest par sub in the CLO 2.0 era — all fun and games if the rating agencies will let you do it, as Moody’s and Fitch on the Partners deal apparently did. There may well be more in the tank as well, with the new Fitch methodology allowing lower triple A par sub levels down to around 35%.

Fitch updated its CLO methodology during the summer, publishing a draft document in August, which it began applying immediately. This ‘updated’ default rate assumptions, taking account of the low default rates during the pandemic, and weighting this more highly than downturns in the 80s and 90s, as well as tweaking the “assumed risk horizon” to be below the maximum Weighted Average Life (WAL) of the deal and adjusting the “back default timing curve”.

All defensible changes — default rates really were surprisingly low last year (because of massive central bank intervention, but still), and it really is very rare that CLOs run to their full WAL. But the changes added up to upgrades for lots of CLO tranches, and more generous leverage terms for managers bringing new issues.

Add this to the Moody’s changes we discussed a couple of weeks back, and life has got a lot easier for CLO structurers.

The most interesting par sub question arises, however, with the static deals issued by Palmer Square. The latest European edition, 2021-2 via JP Morgan on October 15, came with 32% par sub, which is also a nod to investors, rather than the agencies — Excess Spread understands that Moody’s and Fitch, who rate the issue, would have gone into the 20s at the senior level, but that investors prefer to see a healthy 3-handle on their triple-As.

The reasoning is relatively simple — agencies rating active deals have to stress a portfolio assuming the worst, with managers using the maximum flexibility available to them to maximise returns for themselves and equity. In a static (and relatively conservative) portfolio, the agencies can simply rate the loans in front of them.

That leaves the defence of CLO structures up to investors, rather than the agencies — perhaps the way it should be. The relatively shallow pool of triple A accounts active at all, and continued use, as in the Partners’ deal, of anchors, means that big senior investors can successfully hold the line on par subordination, even as the rating agencies loosen up.

But if more investors show up, the current round of rating agency generosity means there’s clearly the space for CLO leverage to crank up some more.

The return of tiering

Partners Group did, however, pay up a bit for its deal, printing back above the 100 bps line despite apparently strong demand at the senior level and consistent high 90s levels in other primary transactions the same week. It was a longer deal than most, with a February 2024 non-call and full five year reinvestment, compared to the 1.5/4.5 year structures seen in most new issues, so this accounts for some of the widening.

Going long is slightly counterintuitive against the present backdrop — as we discussed last week, rising medium term Euribor rates reduces the floor value embedded in CLO bonds, with the greatest proportional effect at the senior end of the capital structure. 

Partners Group may also have suffered somewhat from its patchy track record. Its early deals from the 2.0 era have very low equity NAVs, with a minimum of 33%, according to September trustee reports, though an average of 58% across all of its issues.

Penta 10 priced wider down the stack as well, as one might expect on a more levered deal, leaving overall capital costs some 10 bps wider than KKR’s Avoca XXV, which priced the same week — though this might be a reasonable price to pay in return for locking in longer term capital. 

Looking at the rest of recent primary supply, it appears that a healthier level of manager tiering is coming back to market.

Taking just senior spreads, we’ve had Alcentra’s Jubilee 2021-XXV at 96 bps, Permira’s Providus VI at 97 bps, resets for Hayfin Emerald III and Dryden Euro CLO 69 at 98 bps, and Napier Park’s Henley VI at 100 bps.

BlackRock, readying  BlackRock European CLO XII via Natixis, has price talk for senior notes at 94-95 bps — suggesting dispersion has widened from September, when more or less every deal priced in a 100-102 bps range.

Wednesday also saw a rare flash of liquidity in CLO seniors, with a €103m BWIC across four lines circulated, largely short-dated bonds originally issued in 2017. Covers here underlined the increased dispersion, ranging from 92 bps to 105 bps DM.

Pimco and the SORD

Doesn’t time fly when you’re having fun? I’m too young to have been around at the Granite non-asset trigger in 2008, but I remember a time when Granite bonds were effectively their own mini-market index, and I remember the financing for the first Granite bidding war, and Cerberus winning the portfolio, and the first capital markets takeout, and the refi in 2019 where Morgan Stanley and Bank of America’s traders underwrote the placement against the backdrop of some Brexit nonsense….and now, I guess, I remember the refi of the refi.

For those of you less nostalgic - this is Northern Rock’s old RMBS structure, the Granite master trust, which was one of the first big portfolios sold on by the UK “bad bank” UKAR (a £13bn portfolio at the time).. Thanks to the Rock’s massive appetite for securitisation funding before its collapse (IFR’s Financial Borrower of the Year 2006, arf arf), pretty much everyone owned some Granite in the immediate post-crisis period, and the non-asset trigger made the bonds exceptionally liquid by securitisation standards.

Last week saw Cerberus exercise the “SORD” (subordinated optional redemption date) in Towd Point Mortgage Funding 2019-Granite 4, the most recent securitisation incarnation of the Granite portfolio. 

The SORD is a feature which crept into Cerberus-sponsored deals a few years back, along with its cousin the EORD, as US imports, giving the sponsor more ways to keep deal structures efficient. It allows the sponsor to redeem and retranche only the subordinated part of the capital structure, leaving senior notes untouched.

The baroque optionality in Morgan Stanley’s Irish RPL deals aside, most publicly placed European RMBS tends to keep things relatively simple, with a FORD (first optional redemption date) and not much else besides. There’s quite enough to worry about when you consider step-up margins, WAC caps, turbos and other extension risk-related issues, without adding extra layers of callability in the front end.

The point of the Cerberus SORD is clear enough, though — like a full call, it allows the sponsor to relever the portfolio, allowing a portfolio amortising through strict sequential pay to stay relatively efficient over longer periods of time. 

In this case, an extra £286m of A2 notes was layered into the structure. The old senior tranche had paid down, taking the senior advance rate down to 75% or so, so adding in the new layer gets the deal back up to a more respectable 85% level.

But it can’t have been a cheap process. The replacement deal was issued from the same SPV, but it needed a new round of ratings, a new round of distribution from Bank of America, and a new set of deal documents. A certain amount of copy-and-pasting may have been permitted, but that’s likely the case for any new Cerberus issue off the same portfolio as well.

All told, the cost savings of using the SORD rather than a full call and reissue may not have been particularly extensive, while some investors in the original deal may not all have appreciated the extra complexity of the SORD option.

There is one notable advantage to SORD structure, however — it leaves senior investors in place. 

For an ordinary syndicated RMBS this might not amount to much, but the Granite book has had major anchors in its senior notes in the past, and there may have been good reasons to leave them in place while still relevering the structure. 

A quick look at fund filings confirms that everyone’s favourite Large West Coast Asset Manager is indeed an anchor, with well north of £1bn in the A1 notes allocated among its funds which disclose holdings, and probably more elsewhere.

Analysis from Deutsche Bank shows that the A1 notes (the original senior tranche) are some of the most frequently seen bonds on BWICs over the last 12 months, having appeared on 16 lists, but these BWICs have only accounted for £84m of the now £1.8bn tranche — and it’s a safe bet that keeping Pimco happy and in place is worth a certain amount of messing with the deal structure.

Placing the new notes still took some work  — the new senior class was £286m, and the rest of the subordinated capital structure totals £779m. Some existing investors in the bonds may well have rolled their positions, but 15 accounts participated in the refi overall, split between Europe and US.

Does lender engagement work?

We discussed the quest of Article 8 CLOs last week — if you’ve the appetite for a deeper discussion (including an even larger amount of Chris McGarry) I’d recommend this White & Case webinar, with two CLO managers and an arranger as well — available on YouTube.

There are already active Article 8 senior secured loan funds, so many of the problems that might come up in structuring an Article 8 CLO must have already been solved. Invesco has one, as does M&G.

Marketing materials for both of these funds relies on the possibly unique levels of “engagement” with companies which lenders have come to rely on, thanks to the private nature of the leveraged loan market. Loan managers do indeed have a better call into management and sponsors than investors in public securities — but the slide and slide of leveraged finance documentation, though, suggests that the power of lenders doesn’t extend far beyond having their phone calls answered. 

This isn’t the place to run through the multi-year slide in docs terms — let’s just acknowledge here that large cap LBO lenders in Europe are now further from the table, with worse information, worse security, and fewer rights than ever before. Top tier sponsors have spectacular flexibility to beat up their lenders, should they choose to do so, despite some token resistance over, for example, triple margin ratchets.

If lenders can’t get sponsors to, for example, commit to not adding essentially imaginary savings to EBITDA, what chance do they have of driving meaningful environmental impact?

The crucial difference between economic terms and ESG which might save the day is that sponsors do actually want to make ESG improvements. 

Their LPs are asking, regulators are on the march, and top tier firms are vying to demonstrate their credentials in the area. The issue is not whether or not the sponsors make ESG improvements, but what improvements and how they report these — areas where lender feedback might have a real impact. 

By contrast, the balance between debt-friendly and equity-friendly in documentation is as old as the hills, and doesn’t show any signs of going away. The interests of sponsors in flexibility are directly contrary to the interests of lenders in security, and supply and demand sets the levels for documentation terms.

Forwards to fintech

Parts of the market still grumble about securitisation’s structural disadvantages compared to covered bonds, which benefit from more attractive regulatory treatment, more aggressive central bank buying, and deliver a lower cost of funds to regulated banks. Along with direct central bank facilities, covered bonds are probably the biggest factor suppressing volume growth in European securitisation, since they effectively cut the big banks off from using RMBS as a funding source — which means no blockbuster multi-billion master trust issues.

But the revolution in the last few years has been the use of securitisation as the dominant funding tool for the fintech lenders. Volumes might be small compared to the prime mortgage lending of a Halifax or the credit card book of a Barclaycard, but securitisation financing has allowed increasingly innovative financing products to come to market and grow — and the economics for the securitisation industry are far more interesting than a four-handed mandate on a cookie-cutter prime RMBS or auto deal.

Longer term, would you rather be an industry aligned to explosively growing fintechs, or trundling along covering legacy lenders? Both would be nice, but if you had to pick one….

That’s meant a steady stream of market debuts, offering more interesting paper and establishing regular securitisation shelves.

To take one example which crossed my desk this week, Capital on Tap, an SME credit card lender, signed its largest warehouse facility yet, a £450m deal with senior funding from BNP Paribas and HSBC and a £90m mezz piece from Atalaya Capital Management, ahead of its debut term deal next year. 

It competes with the likes of American Express and Barclaycard to offer SMEs business credit cards — meaning a new and more granular form of SME risk will be offered to investors for the first time. The company is owned by Drake Capital Management, a US hedge fund, and it has open lines on both sides of the Atlantic.

By 2023, we should see the company established as a regular issuer in term securitisation markets — and doubtless there will be plenty more fintechs also looking to follow. 

The never-ending story (European regulation)

Did you know that, if you set aside an hour every day just to read European banking regulations, it would take 32 years to read it all? Of course, even this would be impossible because we’d probably be on Basel 10 by then, and everything you’d already read would have become obsolete multiple times in the intervening years.

Securitisation is but a small part of this broader regulatory whole (hole?), but it still feels like a constantly moving target. At this point, probably the majority of securitisation professionals have never known a time during their careers when the regulation governing the sector was not in flux.

With that in mind — welcome to the European Commission’s latest call for evidence on securitisation. The Commission is asking the three European regulatory agencies, the European Banking Authority, European Securities and Markets Authority, and the European Insurance and Occupational Pensions Authority (EBA, ESMA, EIOPA), for views on whether securitisation capital and liquidity treatment should be calibrated differently.

It’s a pretty promising paper, hinting generally in the direction of better treatment in both respects, and suggesting some sensible tweaks to the more obviously eccentric bits of regulation — for example, capping securitisation risk weights at the risk weight of the underlying portfolio, and potentially bumping liquid STS tranches up the liquid pecking order. 

But as the good folks at PCS note, the road is very very long indeed. The regulatory authorities, who already have plenty of work on their plate, don’t have to report until September 2022, meaning (perhaps) a new regulation by the end of 2022. Throw in some regulatory technical standards, implementing technical standards, each with a little consultation ahead of execution, and we’ll be a good 15 years post-financial crisis before securitisation regs see any real stability. 

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