Market Wrap

Excess Spread — Big carrots, caught short, keep your counterparties close

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

Big carrot

We’re not always good at making the right calls around here (Cerberus will call its deals! Sixth Street will buy CS SPG! The market will be dead!) but sometimes the serendipity comes together.

Last week we talked about the increasingly important role of banks’ own bond buying powers in supporting business in securitised products, and now it seems that Société Générale has finally started scoring some points in the still-cheap market for European CLO primary.

That, at least, is the most obvious interpretation of its co-placement agent and co-arranger roles on CVC Cordatus XXVI and Tikehau VIII, alongside Barclays and Goldman Sachs respectively. SG has been in the mix for a while….it had a European mandate around February, blown off course by the Russian invasion, it’s got an active US operation pumping out primary (and distributing into Europe) and a global trading business.

But, as we noted last week, the mandate conversation is considerably more powerful if you’ve also got an anchor ticket to offer as well. We understand the money’s not coming from the bank’s treasury (though SG’s securitisation team has been on a journey of gentle persuasion with them for many months) but from the asset-backed unit. That makes it more like the Deutsche Bank’s approach seen in Cordatus XXII than the Citi treasury loan note thing, but it’s still a nice way to solve the senior problem — and it’s clearly allowed CVC Credit to do a nice long deal with a two year non-call / five year reinvestment period (2NC/5RP) structure, unlike the short WAL transactions which has increasingly been a feature of the market.

CVC, as has been well-documented, ended up on the wrong side of Norinchukin’s decision to step back from the market, as the Japanese bank had been lined up to anchor Cordatus XXV with Citi as arranger. Fresh off the XXVI print, we understand CVC has put XXV on pause until 2023 rolls around, though presumably conversations are continuing in the background with other potential anchors.

Last week’s Ares transaction also managed a more traditional maturity structure (1.5/4.5), while the KKR Credit (Avoca) deal still in market also gives the manager time. PGIM’s Dryden 103 Euro CLO 2021, priced this week via Natixis, is another long-end example, but we’d put that in a slightly different category.

As the “2021” in the SPV name suggests, this is an old deal, which should settle just before 2022 is out — it looks more like bloody-minded determination to term out this warehouse come what may in what might be the last meaningful issuance window of the year, rather than the structuring of a new issue to reflect current market conditions.

Away from the managers with equity already spoken for, the backdrop’s still not easy, as underlined by Napier Park’s undersized static print Henley IX. No manager for whom a €400m 2NC/5RP trade is on the table would voluntarily do a sub €300m static, but, as with Sound Point IX, the tiny equity cheque (just €13.3m) is doubtless part of the appeal.

It’s not all doom and gloom — there’s a better tone in mezz, with some asset managers stepping back in to a more stable market. Discount margins are now no longer too embarrassing to publicly disclose; generic triple Bs tightened some 30 bps last week. And, y’know, there’s loads of actual deals getting done.

Other than providing triple-A capital, the other solid that arranging banks can do for their favoured CLO manager clients is to source some reasonably priced collateral. We talked a little last week about the technical squeeze in the loan market, driven by the heavy activity in primary CLOs, with the ELLI up nearly three points and top CLO names squeezed further. Some managers, though, may have prepositioned portfolios lined up with the trading desks ready to help them ramp — this is part of the natural synergy which a CLO business brings to leveraged loan sales and trading.

Clearly this isn’t a free lunch though. Even if the arrangement is to buy at mid instead of offer (call it half a point on €100m), that’s an expensive proposition for the bank and puts a meaningful bite in the economics of the CLO arranging business.

It also doesn’t really solve matters on market-wide level. This helps an individual CLO manager get a portfolio at a decent price, but the technical squeeze is real whether it comes from traders loading up on inventory to help CLOs ramp….or from the CLOs ramping directly. It’s all still demand, meeting not quite enough supply.

Caught short

Away from the primary market, we’ve been thinking more about the increasing numbers of CLOs which are out of reinvestment period. In good times, managers try to essentially avoid this with judicious resets to extend the lifespan of active portfolio management as long as possible. But these times are not good, and the reset option is out of the money for the entire market.

While a CLO that doesn’t refinance ought to eventually pay down in good order, using the tail period and loan repayments to return investor capital, the underlying borrowers do not have the same luxury, and that’s where things get interesting.

There aren’t too many 2023 TLB maturities, but there are lots of 2024s that will be “going current” next year, lots of 2023 RCFs that need terming out, and sponsors would be foolish to wait until the last minute to get a refi done. If 2022 has shown anything, it’s that hope isn’t an a business strategy.

So what’s a sponsor to do? Full stack refinancings are spectacularly expensive, so more limited amend & extend transactions are likely to be the first port of call. These ought to help the CLO market, from first principles; most A&Es will boost margins, and the more 350 bps deals that end up with a five-handle, the better for the squeezed CLO market.

Israeli garden furniture/shed maker Keter was in the market in September with a relatively complex refi, which we’ve touched on before — it wasn’t just a straight margin boost for maturity type trade off, but included a new second lien layer, new money and a covenant-stripping mechanic.

Anyway, a big part of the initial failure of the Keter transaction, was, we understand, down to CLOs that were out of their reinvestment period and couldn’t play the deal.

Post RP vehicles in Keter included Bain Capital Euro CLO 2018-1BNPP IP Euro CLO 2015-1BNPP AM Euro CLO 2017Bosphorus IVCVC Cordatus III and VIMan GLG I and II, Marlay ParkMilltown Park and Newhaven II, St Paul’s IIIIV V and VIII, and Palmerston ParkRichmond Park and Willow Park.

All of these deals will have slightly different documentation with different implications for participation in A&Es. Much turns on exact definitions and mechanics — can a facility whose economic terms, security package and maturity is different be considered the same? How close is the CLO to its existing WAL test limits and how are these defined? When does a rating agency consider something a distressed or coercive exchange, and what’s the treatment of “distressed” or defaulted obligations under the documents? Is it better to have a failed A&E and a triple-C downgrade (as in the case of Keter), or a distressed exchange that takes a loan out of the par calculation altogether?

These are deep legal waters and well above our pay grade — the point is, sponsors need to approach the process of structuring A&Es with exquisite care given the constraints of CLO documentation post-reinvestment.

For managers, too, these transactions will pose a puzzle. Consider a manager with 20% of CLO AUM post-reinvestment and 80% reinvesting. Perhaps they’re able to play the A&E to considerable advantage for 80% of their book….but they are still supposed to be working on behalf of the equity in the 20% that’s post-RP. How should they vote if those interests diverge? Will they penalise sponsors for damaging their old deals, even if the A&E is generous for newer transactions? Should they vote the loans in the CLO vehicles on opposite sides?

These issues are going to be increasingly important — one CLO PM we talked to this week expected between 10 and 15 A&Es from European issuers in the early part of 2023, with some sponsors likely looking to get ahead of the queue and sounding out lenders late this year. The responses will be credit and deal-specific, as always, but this is going to be crucial for ekeing out the returns from the older generation of CLO transactions.

Get by with a little help from my friends

NewDay has also been a beneficiary of the bank bid, pricing a pre-placed ABS transaction late on Friday evening last week. Leads were tight-lipped about the distribution (no investor stats), but we can do a little creative reading-between-the-lines.

We’re talking about a four-handed deal here, with JP Morgan, Lloyds, Societe Generale and Standard Chartered all on as arrangers. Nice of NewDay to pay these fees when presumably any one of the four would have been perfectly capable of structuring the deal alone…but what did they get for the fees?

The deal was also placed with no senior notes offered to the market, and the senior note in question was also super-sized, swallowing what would normally be class ‘B’ and ‘C’ in a single-A rated £196.8m slice of the deal.

This is most likely the portion of the capital structure banks would have found most congenial to fund in private VFN format, termed out into privately placed bonds.

Graham Stanford, head of funding at NewDay, gave us a statement: “We took a different approach with this deal, with it being entirely pre-placed. This private placement approach, including utilising the support of our relationship funding banks, gave the business flexibility and comfort on execution and was the right strategy in a very uncertain market environment”.

That sure sounds like the banks did it to me — but their support allowed NewDay to crank out a bit more leverage through placing the class ‘D’ and E’ with investors. This wasn’t cheap (the double-B note came at 950 bps over Sonia), but, as with fellow high yield/securitisation player Together, it’s worth considering the alternatives….and observing that NewDay’s 7.375% 2024s were yielding nearly 17% when it placed this ABS.

That’s exactly as it should be (most of NewDay’s assets are pledged to securitisation vehicles, so the HY bonds are ‘secured’ on whatever is left). NewDay said in its results this week that it would be looking to refi these bonds “including by way of new issuance, an exchange offer or other form of liability management transaction”, and they’ve since tightened on the news, but they’re pretty expensive funding.

The results announcement also flagged that “it is currently anticipated that the remaining ABS deals maturing in 2022 will be repaid by drawing on VFNs”.

Sure enough, NewDay also called NewDay Funding 2019-2 this week a welcome, if not unexpected sign (it’s still only Cerberus and Lone Star letting the side down), funding the call through “drawings under the existing committed senior variable funding loan notes”.

Presumably, therefore, reloading the bank facilities through this private term deal was a very worthwhile enterprise — though it’s hard for an outsider like me to see why the banks should feel particularly differently about a term bond secured on NewDay’s assets vs a NewDay committed VFN. From a credit and risk perspective, isn’t it just a bigger line to NewDay?

Whatever the magic is, it does show the value of having plenty of counterparties, treating them well and making sure they get paid. This is exactly the kind of market that underscores the point.

The rates competition is on

The dust seems to be settling on the UK rates crisis, with UK swap rates falling sharply over the last month — and UK mortgage lenders back to the same furious competition which caused them trouble to begin with. Following the Bank of England’s base rate hike on November 3, Molo (whose suspension of BTL origination in April 2022 was one of the first public signs of the specialist lending sector’s distress) has trumpeted a round of active rates cuts (50 bps off the five year fixed, 15 bps off the trackers).

MPowered has also trimmed rates, with around 50 bps off the two year and 15-20 bps off the five year. Some of this is probably pure swap rates (five years are more than 100 bps down on the month), but there’s also a point about the capital structure of the firms in question.

Since the troubles of the spring, Molo has taken a capital injection from Australia’s ColCap, which is also providing equity for BTL mortgage origination going forward (allowing Molo to restart originations). Patron Capital was Molo’s former equity funding partner, and may have taken more determinedly financial approach to buying origination. Perhaps ColCap is willing to spend to win market share; perhaps Molo feels it needs to push hard to erase the reputational hit it suffered earlier in the year with the broker community.

There is a fair bit of clear water between the Molo rack rate and swaps, and the Bank of England’s comments during the hike that the terminal rate would be below “market expectations” made it a “dovish hike” (sterling slipped). Macro musings are not what we do around here, but we’d observe that many of the problems seen in the specialist lending sector during 2022 were not so much about the level of rates, but about the speed of the movement. Hedging origination was expensive and difficult to get right, requiring accurate line of sight between offer and completion; more than a few lenders ended up writing mortgages that were money-losing by the time they were funded.

If the Bank of England can give a decent line of sight to the terminal rate (and if, after the year we’ve had, you believe the central bank), then perhaps you can have the confidence to aggressively bid for market share?

There’s also the question of the absolute numbers involved now. Molo said that its five year fixed’s now start at 6.19%, and you have to think that a headline figure like that changes the ultimate appetite from landlords. The easy times when landlords could just sit back, let their tenants pay their mortgage and route calls about dodgy boilers straight to voicemail are over.

One of the market’s bigger forward flow providers was explaining to us last week that they essentially weren’t offering any more funding for BTL specialist origination. We were discussing the fate of the various lenders, and they made the point that….if few people want a BTL mortgage, and fewer still want to fund them….the value of the pipe connecting the two naturally tends towards zero.

This is clearly an exaggeration, and few people have bust in the last 30 years by overestimating the desire of the British public for YOLO property speculation, but the times are still difficult out there. Lenders with deep-pocketed backers might hope to be predators rather than prey in the coming consolidation; others are likely looking to the friendly embrace of deposit-taking institutions, and as the sector shakes out, it’s likely to mean more portfolios up for sale.

For these topics and others, we’re excited about DealCatalyst’s “Specialist Lenders’ Forum on Private Credit Finance”, a conference running in London next Thursday. This event does not include the dubious pleasure of me moderating a panel, unlike the UK Mortgage Finance conference in September, but there’s still some great-looking sessions coming up, and the conference theme is nicely chosen — private credit investment in specialty finance has been the defining theme of the last few years in Europe.

Look forward to seeing some Excess Spread readers and friends of the publication over there! Find out more here.

Capital when you need more of it

We talked about Klarna’s risk transfer deal the other day — the product is arguably a slam dunk for a capital-constrained institution with a lot of risky loads and a banking licence. In terms of the specific transaction, one investor described it as “a bit structurally bull market”, with too much flexibility for Klarna to dump bad loans in the portfolio, but never mind, the deal got done.

Now the BNPL giant is said to be in market again, this time with a portfolio of term financing loans it is looking to sell.

This is a much easier proposition that a portfolio sale on short term BNPL products — you really need to structure BNPL facilities with lots of revolving flexibility, whereas term financing loans might end up with anyone who’s axed in consumer credit. The sale is, in theory, to keep the firm well-supplied with growth capital.

There’s a certain plausibility to this approach. Klarna grew truly monstrous during the tech boom years (look at the €46bn valuation!), but in these more troubled times, it may not have the capital to be everything it was before.

Is it a bank, a lender, a tech firm, a “platform”, an origination engine, a set of retailer relationships, a slick marketing effort?

Whatever it decides to be, perhaps its no longer the best owner for a fat slug of high risk loans, and would be better off focuses on the tech/origination/relationship part.

Even the down-round valuation of $6.5bn is arguably kinda punchy for a negative Ebitda business (you can buy one of the top mortgage lenders in the UK for £300m?) but if it’s justified at all it’s justified by the extraordinary dominance Klarna has achieved. The value of the business is in the fact that Klarna is everywhere, popping up and suggesting a tiny taste of consumer credit at every online point of sale on the internet; if it’s going to weather this particular storm it needs to double down on that dominance….and fund that through the sale of the stuff that might have a better owner, rather than shaking the tin with the venture capitalists again.

We should note here that Klarna didn’t respond to my request for comment on this….the above is my surmise, as per usual. Comments highly appreciated though!

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