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Owen Sanderson

I doubt many of my readers have been following the action in a US-listed mortgage trust called the Vertical Capital Income Trust, but bear with me, for it is a curious tale. The trust was managed by Oakline Advisors (me neither), who appear to be resi mortgage specialists based in Texas who buy whole loans.

But all has not been well with the trust, and last year, the board engaged a boutique investment bank to see about making a change. In January this year, it announced that Carlyle was interested in taking it over, and as of this week, that deal closed.

Carlyle’s plan for the trust has absolutely nothing to do with the previous activities. Carlyle Credit plans to convert it into a CLO equity fund, the Carlyle Credit Income Fund, and 95% of the assets have been sold. Carlyle will waive some of the management fees during the six months to a year that it will take to reorient to CLO equity investment, and has put in some $50m via tenders, buybacks and new share issues to take its investment in the trust to 40% or so.

This is interesting to me for several reasons — what is Carlyle actually purchasing here? 

It is replacing the trust’s investment adviser, obviously, with itself. It is almost entirely replacing the assets. It is replacing the brand (there’s a brand new website, from which you can find out “why CLO equity”). It is completely changing (increasing!) the fee structure.

It is acquiring a pool of money, true, but is putting in a lot of its own money in order to obtain a relatively small amount of other people’s money (it will own c. 40% of shares). As far as I can tell, it’s mainly acquiring a listing and a corporate shell, but this is Carlyle we’re talking about. 

One would assume there are any number of legal and corporate services firms falling over themselves to set up any structure Carlyle wants. There’s nothing especially complicated or difficult about listing a small investment trust. 

Perhaps capital-raising for such a vehicle is more challenging these days, but again, Carlyle. 

Some of the best capital-raising people in the world are presumably on hand to shake the tin. Markets might have been difficult last year, but Carlyle Credit raised a $4.6bn credit opps fund, and is targeting $8.5bn for illiquid credit. The credit business reported $116bn in AUM last year. The $100m or so in Vertical Capital is quite literally a rounding error.

Personally, I love a listed CLO fund; nothing I enjoy more than wading through a bit of forced disclosure on a relatively illiquid and private corner of the market. 

But it’s absolutely not obvious that this is the best pool of capital to invest in hard-to-mark illiquid securities like CLO equity. 

The Carlyle pitchbook expects the fund to trade at a premium to NAV, as you’d hope, but several of the existing funds have suffered from a persistent NAV discount — this is one reason why Blackstone is planning an orderly winddown of its BGLF fund, which dates from the beginning of the 2.0 era and holds equity stakes in all the Blackstone Credit/GSO European deals and warehouses. It’s been a handy permanent capital vehicle and a way to meet risk retention obligations, but it’s time to pack up.

Maybe the difference between the strategies from the #1 and #2 CLO managers in the world, one starting a listed fund and the other starting to pack it up, is mostly just the difference in which part of the market one chooses to invest in. 

Primary CLO equity isn’t the best trade now, even for a top tier manager, as the wide liabilities / expensive assets status quo squeezes arb right from the start. But it is arguably an excellent time to scoop up some secondary bargains from across the market, which seems to be the Carlyle plan.

Credit where it is due to my current competitor and former colleague Richard Metcalf — he’s got a nice piece out on JP Morgan marketing a European SRT referencing leveraged finance RCFs. I’d encourage everyone to go read it (it’s in front of the paywall) and then we can discuss it a little. 

According to Richard, JP is dusting the deal off from 2021, but 2022 was also a big year for banks to sound out investors on possible leveraged finance SRT deals (I caught a vague whiff of a JPM deal in the autumn last year but couldn’t stand it up).

European banks were under pressure from the ECB’s supervisory arm to manage their LevFin risk (after five years of essentially ignoring the ECB leveraged lending guidance, the supervisors finally got annoyed) and one way of demonstrating that risk was being priced correctly was to see about selling it in the market. The ECB might not have had “do lots of SRT deals” in mind as its ideal outcome from the regulatory wrist-slapping, but it was a workable policy, and I’m sure some bank management teams were rolling their eyes at their hung bridge books in any case.

The biggest European LevFin banks were naturally in the firing line (Deutsche Bank’s boss hit back against the regulator on classic “disadvantage vs the US” grounds) but the ECB also supervises the European entities for the major US banks. 

JP Morgan SE, the German-licensed entity with branches in Dublin, Luxembourg and Helsinki, probably has far more leveraged finance exposure as a proportion of total balance sheet than, say, Deutsche Bank or BNP Paribas, so if anything it’s likely to attract more scrutiny on this business line.

But nonetheless, this is a meaningful departure. US investment banks have been historically more likely to flip and ship their RCF piece wherever possible — they might have needed to be in the RCF to win a deal, but were interested in arranging fees and placing TLBs, not in hanging about in capital-inefficient undrawn credit facilities.

The big European SRT issuers (who are also the big leveraged lending banks in Europe) have long mixed some amount of leveraged finance exposure into their large corporate deals, though this tends to be better-rated large cap names. 

Occasionally, there’s a pure play leveraged loan SRT — Deutsche Bank’s LOFT 2022 deal last year is a good example, and we hear of some middle market transactions out there as well. 

But pure play LevFin can be controversial, and a little tricky. 

We asked Christophe Frisch, head of alternative assets at Axa Investment Management about the market.

“This has been a growing trend in recent years (ranging between 2% and 5% of the SRT market),” said Frisch. “But those deals should be compared with cash CLOs and in general, we think are less attractive than CLOs in terms of portfolio composition (i.e. more concentrated), structural features (such as no excess spread or portfolio management) and have less overall upside.”

On the other hand, SRT deals, despite the opaque nature of the market, have some attractively simple points in their favour — they’re purer corporate credit risk view, without having to layer in manager style and expectations, call optionality, restructuring outcomes and so on. Portfolio limits can be complicated for both asset classes, but leveraged loan SRTs are generally disclosed pools, which helps matters.

But there is also counterparty risk to consider, especially in the wake of Credit Suisse.

Frisch said: “The banking turmoil we witnessed in Q1 this year saw that risk increase in SRT deals. However, since then it seems that many investors are still comfortable with letting cash collateral sit at the originating bank, especially for larger and regular issuing banks, while specific solutions can be found for other banks. AXA IM Alts has always taken care of originating bank’s credit risk as well as mitigants for counterparty risk in the deal documentation…it may be the case that selected banks will offer the two structures above (with or without counterparty risk), but this may impact the economics of such a deal, raising questions around risk and returns.”

Richard writes that the JPM deal is around €200m for a €2bn portfolio, which may not be the full deal structure — Deutsche’s deal last year transferred the risk on the first 19% of its portfolio, across three tranches. 

If the leveraged loan default rate is going to be, say, 3%, then you blow through a full 15% tranche in a five year deal (bank RCFs will be better than average but as a rough expectation).

But it’s quite possible that other tranches in the deal are already spoken for, perhaps placed with unfunded investors such as insurers. The first LOFT tranche was a 0-10% tranche (so equivalent to JPM) and paid SOFR+1900 bps; where will JPM land, in a different currency and with a different portfolio?

We did some musing on the economics of the DB trade last year, but I guess the key point is that CLO equity is both more levered and better quality than leveraged loan SRT — so should, from first principles, be the most attractive capital source for owning leveraged finance risk. This tallies quite nicely with the actual world, in which the vast majority of leveraged loans do end up in some kind of CLO vehicle and leveraged loan SRT remains kind of niche.

So it’s only when the exposure in question is something quite annoying like an RCF where the calculation breaks down. These are harder for cash CLO managers to hold because they aren’t funded….maybe some kind of managed portfolio of corporate CDS would do the trick, but I guess the market has been there and done that.

When Apollo took over Foundation Home Loans back into 2021 I assumed, along with many others, that the glory days of Paratus in the capital markets were behind it; the mortgage lender was plugged into an obscenely deep pool of capital in the shape of Athene, Apollo’s captive Bermuda-reinsurer. 

The CEO of Athene even supplied a quote noting that Foundation Home Loans would “add direct origination asset sourcing capabilities…being a complementary addition to our expanding asset sourcing capabilities”. No need to securitise, just write loans and ship them off to Athene.

But it didn’t turn out that way. Foundation successfully weathered last year’s rates and LDI-driven chaos, not an easy thing for one of the big volume players in buy-to-let, but it continued to access essentially the same range of warehousing banks, private and public securitisation funding that it always had. 

Twin Bridges, Foundation’s BTL shelf, had three outings last year, while Brants Bridge, the owner-occupied programme, had one. Admittedly the market was so lousy last year that two out of the three Twin Bridges deals were preplaced (a Citi senior loan note in 2022-3), but the point stands; not much Apollo or Athene money involved.

This year seems to be a little different, and Apollo’s appetite has increased. There’s a debut issuer in the market, Apollo-owned Haydock Finance (bought in 2017), with its first public issue, Hermitage 2023. It’s an equipment lease ABS, a rare-ish asset class in Europe and very rare in the UK — and Apollo is buying the Class C (and/or) Class D notes.

There’s another Citi loan note at the top, and with the originator retaining the class E, so there’s only one actual tranche on offer for this debut.

FHL was also out three weeks back, for another heavily Apollo-placed transaction — Class B,C, and D in Brants Bridge 2023-1 all went to an “affiliate of the Seller”, such that actually selling the deal was the bottom and top of the stack alone. The 2022 version also saw some affiliate placement in the class C and D, so it’s not entirely new for this shelf, but as we say in journalism “two things are a trend”.

The interesting thing is which part of the gigantic Apollo complex is involved here? The classic private equity or hedge fund investment is the bottom of the stack; maximise leverage, maximise upside. If placing junior mezz is expensive, buy that too where necessary.

But here we see Apollo buying basically investment grade mezz, and leaving its portfolio companies to hold equity. That looks more like an insurance investment to me; some sort of mandate for a regulated balance sheet. This doesn’t narrow it down hugely; Apollo has two captive insurers to draw on, Athene AND Athora, neither of which are native sterling buyers. 

But I guess there’s a sort of regulatory arbitrage here. 

Depending on the regime, securitisation equity can be a capital deduction for banks or for insurers (apparently Bermuda is different in some way, but life is too short). For a non-regulated company, a securitisation residual is just a hard-to-value asset. There’s no regulatory capital regime in place so no regulatory risk-weighting to worry about. Athene ultimately owns FHL, but as a subsidiary, not as a look through.

There’s been a ton of work from industry lobby groups and regulators to try to get insurers to play more in securitisation markets — should have just given Apollo a call.

Did you know that the last publicly placed Penarth credit card ABS from Lloyds was repaid in June? Possibly not, and possibly you didn’t care; it’s been a long time since any big UK bank used its credit card receivables to raise funding from the market. 

Indeed, with the repayment of Penarth, I think that’s everything done and cleared out — there are some outstanding notes from the Barclays Gracechurch trust, but they look very much like Bank of England collateral.

But perhaps it is darkest before the dawn. When Lloyds repaid the final investor-placed notes from its mortgage master trust, Permanent, it took the opportunity to overhaul the trust, clean up the documentation to remove the defunct Funding 1 vehicle, restructure the swaps, strip out the mezz notes, and prepare it for a new lease of life.

Since then it’s been to market twice, raising £1.75bn in a five year and a three year outing, getting ahead of any competing prime supply later in the year and taking a big bite out of the likely Lloyds secured funding needs. 

The bank is likely to raise around £15bn of wholesale funding in 2024, and somewhere between £2bn and £5bn is likely to be in secured format. At the moment that’s covered bonds and RMBS, but the Lloyds funding team has always historically wanted to keep every avenue open, so surely there’s an opportunity to give Penarth a tune-up?

Pricing, though, is debatable. NewDay has been by far the largest issuer of UK credit card deals in recent times, and the latest print was 140bps on the senior for its Partnership Funding shelf this month. Lloyds is a very different sponsor, and the Lloyds collateral a very different proposition from NewDay.

But the latest Perma deal landed at 50bps, so even with a big haircut from the NewDay level it’s a long way from cheapest-to-deliver.

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