Excess Spread - Rejecting ratchets, Fidelity’s ESG innovation, Elliott’s big bridging bet

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Excess Spread - Rejecting ratchets, Fidelity’s ESG innovation, Elliott’s big bridging bet

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

Fidelity looks set to make a splash with its new European CLO deal, Fidelity Grand Harbour 2021-1. Arranged by Barclays, which will be the first, as far as we’re aware, to hard-code ESG ratings into the documents — rather than a commitment to avoid certain sectors, or even a reported and scored ESG methodology, it will have a firm trigger level associated with ESG ratings on companies, with more than 50% of assets required to be scored ‘C’ or above, meaning the companies are good or better than their sector on an ESG basis. This will also flow through comprehensively into investor reporting for the deal.

The scores are assigned by Fidelity itself according to a proprietary methodology, rather than from a third party, but at a firm-wide level, with reference to Fidelity’s existing large exposures to public fixed income and equities, as well as loans. That means that the “private credit” team is not marking its own homework — many of the large cap leveraged borrowers have bonds or even public equity outstanding, already graded under Fidelity’s scoring system. 

This also allows the scores in question to be based on a wider view of industries or sectors. A company like watchmaker Breitling, in the market this week with a divi recap, has no direct peers in the universe of European leveraged loans, so it may be hard for pure-play CLO managers to take a sector view on its ESG credentials. But a large investment firm like Fidelity or BlackRock might be in the equity of Swatch Group, and all over the massive capital structure of LVMH, which owns TAG Heuer — giving better credit comps and a broader ESG view.

Should the CLO breach this level, it will be required to maintain or improve its ESG level in subsequent trades, just as if it was in breach of credit-based triggers. It’s another baby step along the road, but it’s meaningful. The essence of CLO investment is managing assets according to a set of rules, and bringing ESG further into the fold of the rules is a meaningful step forwards — some of the previous “exclusion list” approaches have been very light on consequences for managers which find themselves in breach.

The deal is effectively the coming out party for the old Mediterranean Bank / MeDirect loans team, which moved en masse to Fidelity, alongside the management contract for a single CLO. Grand Harbour 2019-1, earlier this year. 

The team is large and well-seasoned, and a single CLO contract is unlikely to be covering their costs — but that doesn’t necessarily mean a rush to print, with two deals a year the likely pace of issuance. The warehouse for the new deal was open since May, at a time of heavy supply in primary leveraged loans, suggesting no particular hurry to market. Fidelity is also establishing a risk retention vehicle, which will support its plans to grow their CLO platform. 

Regardless of how you feel about the morals or the mechanics of ESG scoring, the regulators are already coming over the hill, with the EU’s Sustainable Finance Disclosure Regulation crashing down on the asset management sector, essentially mandating a huge amount of data gathering and disclosure on the underlying sustainability of investment positions.

As is usual for EU regulation, it seems to have been drafted with equity funds in mind. It doesn’t yet apply to securitised products, and the authorities are still mulling over how the mechanics should work, but the problems are considerable — perhaps an ESG assessment for a few large, listed stocks is easy enough to achieve - but what’s the ESG score of 500 SME loans? 

Nonetheless, it’s got to be done, and CLO managers are starting to get ready, with Tikehau Capital’s reset of Tikehau CLO II, priced on Tuesday via Jefferies “addressing the forthcoming SFDR” — that is, providing enough information for their debt investors to report under the regulation.

In primary, senior spreads still seem stuck at around the 100 bps mark, with Tikehau II at 99 bps, from 100 bps-102 bps guidance, and Redding Ridge 10 at 100 bps dead on, as was BlueMountain Euro CLO 2021-1.

The presence or absence of large anchor accounts could see levels go tighter, but managers and arrangers report adequate demand up and down the stack, with no immediate catalyst for tightening.

There’s still something of a term structure present, underlined by the refi of Anchorage Capital European CLO 1, where seniors printed at 78 bps. This pushed out the non-call to next year, almost on top of the July 2022 end of reinvestment period. A 21 bps differential between a 2022 and a 2026 deal like Tikehau might not seem a lot, but there’s not a lot of spread to play with at the senior end, and that’s just life in floating rate products.

In primary, the bottom of the stack looks somewhat softer — Tikehau came at 940 bps — but this could reflect its status as a reset of a pre-Covid portfolio, still featuring some names yet to fully recover, such as Hotelbeds, Stage Entertainment, and Merlin. BlueMountain’s clean 2021 new issue came at 930 bps at the bottom of stack, though, in touch with last week’s 915 bps, 930 bps and 910 bps for Bain, Blackstone and Fair Oaks respectively.

Prytania Solutions’ CLO index (thanks to the team for my login) tracks single Bs pricing 5 bps tighter on the week, based on a broader mix of pricing sources — boding well for the next wave of issuance.

Ratchets rejected

This week also saw the first time, according to 9fin’s deal tracking, that a leveraged loan ESG margin ratchet has been binned during syndication

It’s become almost standard practice to scrap or restructure leverage-based margin ratchets — sponsors continue trying to gain approval for stepdowns on quarter turns of leverage, and try to bake three into deal docs, while investors generally bargain back to half turns at least.

But ESG ratchets have largely been left unchallenged. Even if, as in many deals, the KPIs are a soft target, with companies almost certain to hit them, the actual margin reduction is usually relatively small, so at worst it’s usually ignored, rather than rejected. In Amedes, the small size of the ratchet at 5 bps made it easier to ditch — when investors questioned the softness of the targets, leaving out the ratchet was more straightforward than recalibrating.

CLO managers rarely have a pleasant word for the structures, which emerged at the initiative of sponsors, and do little to match with CLO managers’ attempts to present their own ESG credentials. They reliably squeeze margins, without serving as a definitive signal that a particular loan is ESG friendly. 

Some CLO managers are even mulling new deal structures that incorporate an ESG ratchet into some CLO debt, passing through the cost of LevLoan ratchets, instead of forcing equity and managers to take it on the chin. 

If this kind of deal gets done, that might make them more sanguine about ESG ratchets in the underlying loans — but for now, expect more pushback.

Take it to the bridge

It’s no secret that securitisation people love high margin unregulated lending products, and bridging loans — short term secured lending to cover complex property situations or property development — certainly qualify. Rating agencies report increased enquiries about the treatment of these assets, and there’s certainly some serious cash swirling round the sector.

Excess Spread’s eye was caught by an announcement from Tenn Capital, a Guernsey-based lender, that it had a £300m funding line and JV from Elliott Advisors for bridging loans — real money from a serious institution, and an excuse for me to recommend this superb New Yorker long read on Elliott, despite its lack of securitisation content. I’ve yet to dig into Tenn Capital’s undoubtedly excellent capabilities, but when a firm’s CFO is called “Nick Diligent”, what more reassurance do you need?

TAB HQ, another bridging lender, trumpeted a “funding line from a global private equity firm” last month, though the impact was perhaps softened by its unwillingness to disclose either the institution or the size of the facility.

These institutions, however, are likely to want leverage on these portfolios — and that means securitisations waiting in the wings.

These are private deals, and doubtless there are more out there — Together Money funds its bridging book through its £200m Delta ABS 2 conduit line, rather than in its public securitisations, so there are clearly enough banks comfortable with the risk to fund a potential vibrant securitisation market to come.

Amicus Bridging did a club deal in 2015, which had ISINs and a prospectus, though not a full public distribution — take a look at this case study from Brookland Partners for more info — though it didn’t exactly open the floodgates for follow-on trades from other firms.

The race to rate

More than a decade after the financial crisis, for which rating agencies took a big chunk of the blame, ratings are arguably more important in securitisation than ever before — leading to vigorous jockeying for position among the “challenger” rating agencies, and continued furious competition among the top three.

Politicians might have mandated regulators to get rid of ratings, but it remains the official sector that drives many issuers to seek a credit stamp — and it’s the official sector that defines the haves and have nots among the agencies.

Basically all the agencies, even the small ones, have official EU status, meaning that they are regulated by the European Securities and Markets Authority and comply with all the relevant rules, and can operate in the bloc. But only the big three and DBRS Morningstar have European Central Bank approval, meaning their ratings can feed into repo-eligibility and ECB purchase programmes. This means that all the retained issues and most of the publicly traded euro-denominated transactions out there need a rating from two at least of Moody’s, S&P, Fitch and DBRS — a licence to print money for those inside the club.

That leaves the smaller agencies competing for more complex pockets of ratings business, such as NPL transactions, risk transfer, warehouse lines, or fund financing, where central bank eligibility doesn’t matter, but where institutions can still score a capital benefit from having a rated position.

The competition, though, is hotting up. Kroll Ratings made a big splash at the Global ABS conference, as a top tier sponsor, as well as paying for the official Monday night drinks. It’s been hiring extensively, most recently bringing over Gordon Kerr from DBRS to run securitisation research in Europe, and winning a string of high profile mandates - including the Starz deal discussed last week. It’s a far more established agency in the much larger US market, and has gained share partly through championing emerging asset classes such as solar and marketplace lending ABS.

Arc Ratings has also had a heavy-duty revamp, moving into the heart of Canary Wharf from its previous HQ in….Sevenoaks (a leafy commuter-belt town outside London), hiring former leveraged finance banker Oliver Howard as chief executive, and relaunching its website and content tools. 

Scope Ratings is also jockeying for position, and has had some success rating Italian NPL deals, as well as a wide range of financials and covered bonds (if not always on a solicited/paid-for basis). It has, however, had a few trouble spots in recent times, with the investment-grade rating assigned to Greensill Bank a particular embarrassment — especially since one of its shareholders was the chairman of Greensill Capital’s board.

Apart from scoring the coveted European Central Bank recognition, all of the challenger agencies need to be willing to play a very long game, gradually worming their way into investment mandates, so that issuers will start to see the other agencies as essential, rather than a speculative addition or nice-to-have.

Rating agencies need deep pockets or strong backers to fund this process and issuers have good reason to care about the financial strength of the agencies. They want an agency to be around in five or 10 years if they’re given a mandate.

“Competition” in ratings is also a difficult concept, especially in the aftermath of the global financial crisis. The Big Short movie presents the basic worry about the structure of credit ratings with Hollywood panache, but it’s been debated over and over again, and successive doses of regulation have attempted to sever the commercial arms of the agencies from their rating function.

But the issuer-pays model remains, and that means at a high level, agencies only have a few levers for competition. 

Price (which nobody wants to do), quality of service (which is expensive), or more attractive treatment — which can be the most crucial lever of all.

CLO shenanigans

Last year’s CLO shenanigans underline the point. The major agencies responded very rapidly to the Covid pandemic, placing great swathes of the corporate landscape on negative watch or negative outlook, and in many cases leaving them there.

This mattered most for Moody’s, historically dominant in the CLO market, and baked into most deal documentation. 

The treatment of “negative outlook” within a CLO’s weighted average rating factor (WARF) calculations meant that large numbers of deals found themselves “WARF-constrained” — less able to trade or buy lower rated new issues — until the rating agency revised its calculation mechanics for CLO ratings, deciding to notch negative outlook down by one notch instead of two.

Deal docs often had to be updated to handle the change, but the switch eased the pressure on managers, slashing WARFs at a stroke, and effectively reopening the leveraged loan market to B3-rated issuance.

Moody’s market share responded rapidly to its methodology shifts.

Of the 26 European CLO new issues between the reopening of the market in April 2020 and Moody’s new methodology announcement on September 17, Moody’s gave full stack ratings on just three, Albacore Capital’s debut, Angelo Gordon’s Northwoods 21, and Hayfin Emerald IV. It also rated senior notes for Redding Ridge, CVC Credit, and BlackRock — a less painful proposition for the managers, since the old Moody’s methodology mainly hurt tranches lower down the capital structure.

Fast forward to the present, and Moody’s is mandated on 11 of the last 12 new issues in Europe, covering the full stack in all but one of those.

No doubt the decision to switch methodologies was taken in a highly compliant and regulation-friendly manner — but it’s a stark reminder that apparently small methodology changes can make the difference between dominance and irrelevance in the race to rate.

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