Market Wrap

Excess Spread — Feline good, sitting ducks, bad trade or bad structure?

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

Feline good

We’ve been working away on 9fin’s CLO Outlook 2023. We titled the 2022 Outlook “From Strength to Strength”, so hoping we can manage a slightly more accurate read on the market this year.

To be fair, we were in good company; research desks across the Street had bountiful numbers in the €35bn range for 2022’s issuance.

We dipped into Irish corporate filings to get a sense of the forward pipeline, and it’s a mixed picture.

On the one hand, there in black and white we have evidence of the continued attractions of setting up a European CLO shop — vehicles incorporated from AB CarValSignal Capital Partners and Canyon Capital Advisors are all debuts waiting in the wings. Rever CLO and Margay CLO I are also shelves with which we’re unfamiliar.

Given that a Margay is apparently “a mid-sized cat which can be confused with the ocelot”, this could well be M&G’s debut — the 1.0 shelf was called “Leopard”, so perhaps a more modestly sized and less dangerous spotted cat is lending its name to the 2.0 revamp.

But there are also SPVs suggesting the continued presence of Partners Group, Onex, Hayfin, BlueBay, Sound Point, Ares, Acer Tree, Capital Four, PGIM, ICG, Spire Partners, WhiteStar, Sculptor, Tikehau, Barings, Palmer Square, Anchorage, Blackstone and Five Arrows. This is some way from being an exhaustive list of active CLO managers, but not every institution works through the same process in setting up its vehicles and opening warehouses — some may reuse warehouse vehicles, obtain TRS leverage against a fund. Some may even use vehicles without “CLO” in the name, a dastardly subterfuge.

A simple search of CLO+2022 (which throws up SPVs mentioning 2022 in the name, as well as vehicles registered in 2022) gives 77 results; that’s down from 127 mentioning 2021. But 2019 wasn’t a terrible year, and that gives 67. Those mentioning “2023” in the name are pretty thin on the ground (two deals), but many managers number their deals sequentially rather than by year of intended issue.

Perhaps a more important question is how full are these warehouses, and what the exit plan is?

We’d bet on “mostly empty” and “we’ll see” respectively. Setting up a warehouse vehicle isn’t free, it needs equity, you have to pay lawyers and investment banks, but if you have the cash available, it’s a cheapish option on the future of the market. Better to have capacity to buy loans if the right collateral comes along than be constrained by the structure of your outstanding fully invested CLOs; better to be able to pivot and issue low-ramped transactions if conditions support it.

Primary loan markets are active, with the Santa rally encouraging banks to chip away at their previously acquired TLA exposures, but we’re mostly talking about bits and pieces — €95m of KronosNet, €150m of Barentz, €73m of Emeria, €220m of Cerba Healthcare….and the Ekaterra financing slipped out in the background. There’s even a €470m trade out for Safic Alcan.

But this is “active” in the sense that the lights are on, not active in the sense that’s needed to redress the balance of supply and demand and form a strong basis of ramping CLO portfolios. It’s a year-end clean-up exercise, not a blossoming of new LBO supply.

Sitting ducks

According to 9fin’s distressed debt team, some of the advisors and lawyers working on restructurings have the CLO market in their sights….and not in a good way.

CLO documentation since 2020 has been overhauled and improved to allow the vehicles to participate more flexibly in new money, through the corporate rescue loans, the “loss mitigation obligation” language that crept in from 2020, and more recentlypriming debt language, first seen in Bain Capital Euro CLO 2022-2.

That’s great news for managers that have the new language in their deals (though the state of the art only applies to the handful of deals we’ve seen since the summer), but much less good for older vehicles.

Given the closure of the reset market in 2022, plenty of deals ticked out of their reinvestment period this year, and these were predominantly older transactions (the standard five year reinvestment period points back to 2017).

Next year things get even worse, as some of the heavy 2018 supply slips out of reinvestment. Some estimates suggest perhaps 40% of the market will be through reinvestment by the end of 2023, unless the reset market reopens.

These older deals don’t have loss mitigation language or priming debt language, and, as they’re out of reinvestment, and don’t even have much flexibility for a common-or-garden amend & extend transaction.

These look like the playbook for Europe’s leveraged borrowers at the moment — we’ve seen Sebia, Altice International, Stada, Entain and Ineos of late — but stressed credits looking to push out maturities will need to be a little more aggressive (consider the coercive elements in Keter, for example).

Even the traditional remedy for CLOs (sell!!) isn’t always available. Tough whitelist language in some facilities, such as GenesisCare, mean the lender list is still full of par funds even as the loans have slid into the 30s.

So next year’s inevitable round of restructurings (see 9fin’s “Watching the Defectives” restructuring tracker for some candidates) will see some interesting dynamics play out. CLO creditors, the natural bulk of any potential senior secured loan group, will end up with quite radically different interests, depending on whether they can play new money or priming facilities, and on what terms.

That might make it harder to form coherent ad hoc groups to resist aggressive sponsors or other debt classes — or at least, harder for these groups to hit the required thresholds to participate in a restructuring on advantageous terms.

Or it could mean that the CLOs without the recent language get hosed. Post reinvestment deals can be a good bet in some respects — amortisation usually brings ratings upgrades, and a clear line of sight to bonds paying back is worth having — but some of these transactions are surely going to get hosed in the coming restructuring wave.

Me, talking to people

I had the considerable pleasure of sitting down with CDPQ’s James Ruane, who runs the giant pension fund’s Capital Solutions business in Europe and internationally, the other week. The team has a super interesting mandate looking across specialty finance, portfolios, real assets, and special sits corporate credit, and I’d expect to see them pull off some rather interesting financings in the months and years ahead. It’s a good time to have a lot of capital to deploy and a lot of flexibility!

Read the interview here.

Bad trade or bad structure?

Following on from the Intrum debacle we discussed last week, we’ve been thinking a bit about the broader Italian NPL market, the largest and most active in Europe….and whether it’s actually been a good trade for the funds and debt purchasers that piled in.

Any reasonable assessment of the GACS scheme and the broader efforts around cleaning up Italian bank balance sheets has to be pretty positive — huge volumes traded from the regulated banking sector into the hands of funds that actively wanted them.

Here’s a handy chart from PWC’s generally excellent reports on the market to show the progress.

But lots of the individual portfolios that we have information on, through the GACS securitisations, have proved disappointing to their buyers — business plans below target, sometimes catastrophically behind, which switches off cashflows down the stack (part of the problem for Intrum/CarVal’s Penelope SPV/Project Savoy trade).

Another lift from PWC / Scope Ratings underlines the point.

Disappointment all round. Some of this is due to unfortunate circumstances; Covid didn’t help the business of collections, and Italy may not implemented legal and administrative reforms as quickly as it could have done. Passing NPLs between different pockets of capital helps the banks, but unless there are robust mechanisms for working through these portfolios they tend to hang about.

You could think of this partly as a feature of GACS, not a bug. The whole idea of a government-guaranteed securitisation scheme was to close the “bid-offer” between banks that hadn’t provisioned vigorously enough against their portfolios, and the funds that wanted to buy NPLs. Since proper provisioning would have destabilised the banking system (or at least a lot of local banks), cheap government-guaranteed leverage would fill the gap.

The classic trade for the banks selling NPL portfolios was to keep the GACS-guaranteed piece on balance sheet and use it for repo funding — being Italian government-guaranteed (even if the guarantee could only be called down the road), investment banks could view it like a BTP and give decent terms.

The rash of ratings downgrades (several deals are now triple-C on the senior) might, however, give banks pause for thought. Even if the guarantee is in place it still looks like an ugly exposure. The GACS needs an IG rating at issue, and doesn’t fall away on a downgrade…..but it does if noteholders vote to replace the servicer in a way that triggers a downgrade, potentially limiting the options for transactions which are underperforming.

Anyway, another way to express the essence of GACS is to say that the Italian government helped NPL buyers to overpay for portfolios, and now we’re seeing what happens when you’ve overpaid for assets and hit a downturn. The GACS guarantee was scheduled to shut down this year, but there’s still a lot of transactions out there to examine.

It doesn’t help that some of the funds may have overpromised on their capabilities. We’ve been on a hunt for a Davidson Kempner or Bain Capital Credit pitchbook from c. 2015-2016, largely without success, but a recent DK book for its fifth distressed opportunities fund (thanks to the pensioners of Rhode Island for the link) promises much in the way of “hard-to-source and/or exclusive transactions”.

However, it does also note that as of 2018, “Even though we have experienced a lower “hit rate” on recent European NPL portfolio sales and have lost out to higher bidders, we remain unwilling to compromise on price, relax our underwriting standards and/or employ more leverage than what we deem as appropriate for the portfolio.”

That’s kind of the issue in a nutshell.

The Italian NPL market in more recent years has been brutally competitive, with highly orchestrated processes targeting all potential buyers. No doubt some proprietary dealflow did exist, but all the big tickets were contested auctions. The big buyers of NPLs in this period succeeded in the old-fashioned way…they paid the most for portfolios. Already by 2018 or so, many potential NPL funds considered Italy overbid, and were turning their attention to Greece, where Hercules (HAPS), a similar guarantee mechanism, was swinging into place, or to smaller southeastern Europe markets like Romania or Bulgaria.

As the gold rush cliché goes, it’s more consistently profitable to sell picks and shovels than to do the prospecting yourself, and as it happens, many of the large funds did both. Fortress was an early entrant and exit with doValue; DK still owns Prelios, Elliott own Credito Fondiario. NPL servicing is big business, and high quality servicing can make the difference between an underperforming disappointment like Penelope and a trade that works out.

The way to square the circle for the Italian NPL market was to get in early and get out early. Secondary NPL markets (i.e. between funds rather than disgorged from banks) aren’t super deep and active in most jurisdictions but everything is bigger in Italian NPLs, and the secondary market there is pretty vigorous, as the early players took some chips off the table. PWC reckons it was 30% of Italian NPL sales in 2021, and there have been some decent trades in 2022 (Apollo sold a €1.6bn book to illimity, for example).

Of course, this brings us full circle — CarVal’s miserable €10m for its piece of Project Savoy / Penelope had some idiosyncratic reasons for the low print, but perhaps the window has already closed for early buyers to get out at a decent level.

As the Intrum boss said last week….”The current market environment from risk perception and price perspective the worst we’ve seen in quite some time.”

Looking for leverage

We’re hearing increasing rumblings around bank provided total return swap (TRS) leverage in the loan market. There’s an nice piece by IFR’s Eleanor Duncan here for those with access, and funds and sell-side alike have been alluding to the possibilities.

It’s not a particularly new idea — some funds always use TRS leverage, some CLO managers construct their warehouse lines this way, and fundamentally, banks are in the business of lending money — but perhaps it’s on the rise as a tool to help clear some hung LBO debt. We’re hearing of package trades on offer with attractive leverage terms attached…take these positions off our hands and we’ll help make the numbers work.

This is arguably a move backwards compared to the CLO market, which traditionally delivers long term, stable high advance rate leverage that doesn’t mark-to-market. You can structure a TRS pretty much however you like, but it’s probably going to have more mark-to-market elements than a CLO, and, being a bank-provided exposure, the economic advance rate is likely lower.

In this particular confluence of circumstances, though, perhaps it’s just the ticket.

Whatever remains of the underwritten pipeline from earlier this year probably has pretty off-market cap rates attached, so the unfortunate LevFin desks have to take the pain through hefty OIDs.

That’s the exact opposite of the kind of collateral recent vintage CLOs want; the structure works much better with high margin par-ish loans than low margin facilities at deep discounts. Interest payments flow happily through the structure to gladden the hearts of equity investors; trading gains and par gains are, by design, more difficult to extract and push out. In happier times, resets were a nice opportunity to flush out some par, but we’re not going to be seeing those for a while.

But there are financial markets where investment banks provide most of the leverage, and those where it’s most non-banks or market-based solutions doing the heavy lifting. The CLO market at the moment is leaning heavily on investment banks anyway, with arrangers helping their triple-As over the line.

What if the business of leveraged loan investing tips more decisively towards the use of bank leverage through TRS, through repo, or through fund-based back leverage instead of through the CLO structure?

This is already roughly how the private credit and mid-market funds get their leverage — bank-provided senior facility, sometimes but not always backed out to insurers — and there’s a thousand flowers blooming in the commercial real estate debt sector, where public CMBS in Europe is pretty dead and CRE CLOs never fully got started.

We highly recommend this note from Morgan Lewis’s Rick Hanson on some of the private leveraging action that’s going on in CRE debt in Europe.

By offering back leverage in a more structured manner, for instance through repackaging the CRE loan into a note, a private securitisation—also known as “private-label” commercial mortgage-backed securitisation (CMBS)—a master repurchase arrangement, a loan-on-loan or a derivatives-based financing such as a total return swap (or a combination thereof), back leverage providers can apply a lower risk weighting, which in turn reduces the amount of capital the back leverage provider is required to hold against the exposure. As a result, back leverage providers in structured deals should be able to provide cheaper pricing to private credit fund borrowers.”

“Throughout 2022, we saw greater complexity with structures being combined (such as repack-to-repo structures, repo-to-repack structures, and repack-to-repo-to-private securitisation structures) to optimise the abovementioned features as well as to achieve the desired regulatory treatment. Aside from regulatory capital treatment, the key structural drivers in these transactions include maximising tax efficiency and achieving the required accounting treatment within a fully cross-collateralised structure for the private credit fund sponsor. Where the financing takes the form of a repack-to-repo structure for example, back leverage providers have shown a preference for cleared notes which are (at least in theory) more liquid and rehypothecable, with a non-EU listing venue for the notes preferred by private credit sponsors due to European Market Abuse Regulation considerations.”

For a possible example of the sort of thing he’s talking about, I’d recommend having a poke around the Channel Islands Stock Exchange for a company called “ENIV” — here’s the link to make it easier.

What you will find is really quite a lot of CMBS notes, issued throughout the year and running back to 2017. Considering the deadness of the public market in 2022, this is good going.

These bonds appear to track back to Cheyne Capital, a firm with a long history in real estate investing, real estate debt and CMBS, which even has a listed fund. An amusing exercise is to try to match ENIV notes to disclosed Cheyne investments.

Unfortunately neither Cheyne nor the exchange give the disclosures needed to get under the hood and look at structures — but the fund knows a thing or two about real estate leverage.

In good times, the leveraged loan market has little need to go down this route, but these are not good times, so perhaps it’s time for an alternative.

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