Market Wrap

Excess Spread - The future of ESG CLOs, Rizwan diversifies, JPM boosts BTL book

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

Following my speculations about how to do CLOs on the cheap, a wise reader pointed out that static CLOs go part of the way there.

There aren’t many European deals out there — Kansas-based Palmer Square Capital Management issued the first to use the structure just last year — but they make the same trade-off between lower management fees and less active management (none, in this case).

Being static is not the same as hugging an index, but it does mean investors in CLO liabilities spending less time evaluating a manager’s style, or tabulating the total years of experience in investment committees, and more time looking at specific corporate credits. The lower liability costs in static deals can open up a greater possible universe of loans, since active CLO managers will find deals under 350bp or so painful to hold.

Loans with aggressive margin ratchets which have stepped down a couple of times might be found cheaply, as they’ll be dragging on the weighted average spread of a regular active CLO. But, of course, static managers can only take advantage of this opportunity when first printing a deal. If only you could get static-style spreads with active management....

A trade-off of the static structure is that deals are shorter, meaning a more rapid refi cycle — but static deals also deliver a smaller payoff to investment banks and lawyers, helping to cushion the cost of repeatedly returning to market.

There’s also, in effect, now a “premium price” CLO option to go for - perhaps a Harrods hamper, instead of Waitrose.

Many managers in recent years have cut fees to 40bp all in, rather than the 50bp (15 bps senior and 35 bps junior) that used to be the standard, while some have offered rebates or tweaked structures to achieve the same end, tempting equity investors in with discounts. This has left the standard CLO of three or four years back as, in effect, a premium-priced product.

Ratchets for all

One innovation that will surely come to pass in the next few years is a CLO with ESG ratchets built in. Nearly all managers active in Europe profess to be operating with some kind of ESG screening already, though the quality and depth of the ESG diligence remains variable.

Lots of managers have the sort of ESG screen which excludes industries hardly present in European leveraged finance, like shale oil, the bad sort of arms company (ideally not a nice big capital structure like Cobham), pornography and so forth. Many managers also go further, with proprietary scoring methodologies and detailed ESG reporting — though this in itself raises uncomfortable questions.

If you go a step further and bake in hard ESG criteria to CLO docs, as ratings and spreads are baked in, could you see managers buying “deep green” assets like Flender or European Energy to make room for a few companies whose credentials are shakier? Can you average goodness across the portfolio, or should ESG only operate on a per-asset basis?

Taking the haircut

But that kind of screen is separate from the increasing trend towards ESG-based margin ratchets in leveraged loans. At the beginning of this year, I could count the number of loans with this feature on one hand, but now it’s getting on for half the new issues in Europe.

CLO managers have mixed feelings about the trend. Avoiding ESG risks is one thing, but giving up spread to support someone else’s improving sustainability is quite another — especially as the targets are often set to be laughably easy to achieve.

In practice, many ESG ratchets can be treated as just another slice off the headline spread, a cost which must be paid, in effect, by the CLO equity. Of course, if the idea is to incentivise the good works behind the margin ratchet, someone has to accept a lower spread — but arguably, CLO debt ought to put something in the pot as well.

Hence the CLO margin ratchet idea — if 40% of leveraged loans or so have a 10bp ESG margin ratchet, could one structure a deal where one of the debt tranches also ratchets down when a given proportion of the underlying loans hit their targets? Would anyone buy such a thing?

I suspect this is already being worked on, and the answer, probably, is “yes”. It might mean buying CLO debt slightly off-market, but in return, an investor willing to do this gets bragging rights, preferential allocation, lots of input into the docs, and a chance to shape the future of the market.

Sticky seniors

Primary CLOs, back in the regular market, are still streaming out, at remarkably similar levels - 102 bps for seniors seems to be the anchor. Cairn Capital squeezed its deal via Goldman down to the 100 bps mark, the tight end of guidance, pointing the way tighter, but the resistance level appears to be holding.

Apollo unit Redding Ridge returned rapidly to market with another deal, Redding Ridge 9, just a month after it priced Redding Ridge 8. Since the Covid pandemic first hit the market, Redding Ridge has been running lower levered deals, issuing only investment grade tranches in its first issue back and now declining to issue single-B notes — an option available to managers flush with captive equity capital, and which allows a lower risk portfolio. Redding Ridge is indeed found in the “low WARF low WAS” sector of the European manager universe, along with the likes of Fair Oaks, Brigade and GoldenTree.

Capital Four also priced its third deal at 102 bps, though was a little softer down the stack, with single-B notes at 945 bps, while the reset of HPS Investment Partners’ Aqueduct 5 was (gasp) at 103bp for the seniors. This marginal widening was more than compensated for by tighter levels right through the belly of the capital structure, though, with a fixed rate B-2 tranche inside 2% and a single-B at 845 bps.

Black Diamond Capital Management refinanced the investment grade tranches in its Black Diamond CLO 2019-1 deal, via original lead Natixis. Like other Black Diamond deals, it is a partly dollar-denominated vehicle, an unusual approach within European CLOs — but one which allows Black Diamond to include a sprinkling of dollar-denominated assets in the portfolio matching the split of the notes.

That’s led to Black Diamond being something of an outlier in the European CLO manager universe, as demonstrated in the chart below courtesy of Deutsche Bank’s CLO barometer publication this week.

Moody's WARF vs WAS
Source: Deutsche Bank European CLO Barometer

It may also have affected pricing — though Black Diamond successfully tightened all the refi tranches, the 98bp senior spread is well wide of ICG’s refi of another 2019-era deal last week, St Pauls XI, where seniors landed at 85bp courtesy of Jefferies. Down the stack, Black Diamond’s class D was refi’d at 375bp, against 305bp for ICG.

Black Diamond also has the highest S&P triple-C percentage in the European market, at 7.8%. Against this, it has one of the highest equity NAVs and highest double-B market value overcollateralisation ratios in European CLOs — perhaps helped by a clutch of high coupon US bond positions, including TMX Finance 11.125% 2023s and Digicel 10% 2024s.

Loans BWIC flow remains heavy, with a €370m portfolio up for sale on Tuesday arising from a CLO liquidation. Rumours suggest this is due to a particular CLO equity buyer taking money off the table, but managers and bankers suggest no shortage of new equity capital available in the market, and a substantial pipeline to come.

JP Morgan bulks up Buy-To-Let

JP Morgan has yet to tip its hand on its plans for its possible return to principal finance RMBS deals, though the contours are starting to become visible. Announced funding deals include an agreement to buy £250m of WestOne’s buy-to-let origination, and £500m from UK fintech LendInvest.

The US bank seeded the LendInvest arrangement with a £125m portfolio purchase, taking the total size to £625m. JP Morgan can be allocated up to 50% of LendInvest’s origination, with no separate criteria for JPM mortgages compared to LendInvest’s ordinary origination.

This week, JP Morgan bought a further £100m portfolio, taking the total LendInvest arrangement to £725m. It paid a premium for this portfolio which resulted in an extra £1.67m gain for LendInvest. At the inception of the JP Morgan deal LendInvest booked a £4.1m gain on transferring the initial £125m portfolio, while arrangements disclosed in LendInvest’s “admission document” following its IPO this year show LendInvest expects to receive around 2.5%-3% returns on loans sold on into JP Morgan’s £500m funding arrangement (though some of this likely comes from fees and servicing rather than premium selling price).

Combining the initial £125m, the new £100m and the likely flow of origination this year probably takes JP Morgan’s ownership of LendInvest mortgages to a scale where it could exit via a securitisation, perhaps similar to Citi’s longstanding Canada Square programme. Some investors argue Canada Square’s typical £200m-£250m portfolio size is too small to ensure liquidity through the capital structure, while others dislike the multi-originator approach — but a larger, all-LendInvest deal might be just the ticket.

Despite widespread expectations for a deal, JP Morgan has yet to confirm it will do a securitisation at all, however — and it has just launched a “Chase” branded digital bank in the UK, perhaps generating a flow of UK retail deposits which can fund UK mortgage portfolios more cheaply.

Requiem for Rizwan

I’ve been following the activities of Rizwan Hussain in securitisation markets for quite some time now, mostly at my previous employer, and consider myself among the country’s foremost amateur Rizwanologists. Certain professionals engaged in fighting him through the courts no doubt have deeper knowledge of the legal complexities, but I’ve spilled a bit of ink in my time.

For those new to the story — Hussain and various associates have tried to seize control of several different securitisation structures, using a variety of, uh, “unconventional” tactics including posing as administrators and SPV directors, tender offers with no intention of settling, selling assets he did not own, and furious clouds of litigation.

These activities were briefly interrupted by a spell in prison for contempt of court, following a failure to pay his rent on time, but resumed rapidly with a further attack on an RMBS deal controlled by Bluestone.

It therefore came as little surprise that his latest venture had been unceremoniously panned by yet another High Court judge, who said the claims were “totally without merit”.

This was an attack on Hurricane Energy, the AIM-listed oil explorer which recently went through a highly contentious battle between bondholders and management on one side, and an activist equity investor on the other, with the broad victory of the latter, after a botched UK Restructuring plan was rejected by the English High Court.

It’s the first time he has targeted an operating company, rather than a securitisation, but there were several attractive elements to the Hurricane situation (from his point of view).

First, it’s a big retail stock. The gameplan for Hussain’s tender for RMAC RMBS bonds was to encourage bondholders to tender for above-market prices, then use the tendered bonds to vote through changes to a structure, and seize the underlying assets. But word quickly went around the securitisation market to steer clear — it is, after all, a fairly clubby place — and this, along with prompt legal attention by Paratus, stopped him in his tracks.

For a retail stock recently embroiled in difficult restructuring negotiations, with competing claims and counterclaims hitting the tapes, the underlying dynamics are far less clear — with correspondingly higher chances that some owners of the shares could be suckered by Rizwan’s assertions. Hurricane seems to have responded promptly, though, issuing a notice disavowing a “False Attempt to call an EGM”, and heading straight to court for an order to stop him.

Rizwan’s diversification to equities also appears to extend to Symphony International Holdings, a London-listed holding company based in Singapore, which owns a series of mainly Asia-based companies. Symphony said that Hussain et al were “holding themselves out as entitled to act as directors”, a classic modus operandi also used in the still ongoing attack on Bluestone through the Clavis RMBS deals.

Targeting listed equities, however, probably comes with bigger risks for Rizwan. Plenty of institutions active in securitised products have already complained to the regulator about his conduct, with no apparent result. Whether that’s down to an overwhelming regulatory workload, a desire to let wholesale investors and banks fend for themselves, or a general disdain for the complexities of securitised products it’s hard to say.

Tangling with retail stockholders active on London exchanges (admittedly AIM, rather than the main board), however, is exactly the kind of thing the FCA cares very much about — and is far more likely to bring down belated regulatory trouble on Hussain and his associates.

Conference ahoy

There’s nothing quite like Global ABS. It holds a special place in the history and culture of the European securitisation market, and even if it’s going to be a somewhat attenuated edition this year, plenty of market folks are keen to be back seeing clients and counterparties in person on Monday and Tuesday next week.

Covid, sadly, has forced it back to its temporary post-financial crisis home on London’s Edgware Road, and attendance is set to be well down on the 4000 or so that attended the last Barcelona event in 2019. UK-based market participants will likely make up most of the physical attendees, though many more may dial in from elsewhere as part of the “hybrid” model.

Sadly Edgeware Road lacks a good supply of beach bars, but Kroll Bond Rating Agency has managed to score a canalside venue for the first night drinks it is sponsoring, named “Bondi” — about as close to sand and sea as west London is likely to get.

Sponsorship looks a little light on a normal Global ABS. At the time of writing, no Credit Suisse, no Goldman, and no Morgan Stanley were listed on the event page, among other absentees. But kudos to the sponsors that have put their hands in their pocket to keep a crucial event alive in its 25th anniversary year — look forward to seeing a few of you there.

Next year we’ll be back

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