Market Wrap

Excess Spread — Instant buying, the disappearing agency, delayed drawing

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

Excess Spread is on holiday next week

Drawing closer

When does it make sense for a CLO to issue single-B notes? One approach is to work back from equity, figure out what that costs, and if single-B costs more, it’s probably not worth it.

One assumption you could make is that the 12% IRR threshold for CLO equity (managers get paid their incentive fees after this) is a reasonable starting point for thinking about the cost of CLO equity. Incentive fees are what makes CLO management an interesting business to be in; clipping 50 bps or less for active portfolio management in a complex asset class with a complex leverage structure isn’t a particularly exciting proposition. If you can’t expect more than 12% IRR on the equity, why bother doing it at all?

There’s been a certain amount of fee discounting going on in recent CLO transactions — Bain Capital Credit, for example, in Bain Euro CLO 2022-1, charges 13 bps senior and 30 bps sub management fee, compared to the standard 15/35 structure, while Redding Ridge 12 charges 10 bps senior fee (but keeps the 35 bps sub).

But the 12% IRR Threshold, with 20% of performance above that, has remained fairly sacrosanct, at least in the docs we have seen. Only deals with unconventional structures, such as Carlyle’s 2022-3 print and sprint, have adjusted this (to 12% above 12% in that case). Sound Point’s static deal massively slashes senior and sub management fees, to 10 bps and 12.5 bps (it is static, so fair enough) but keeps the 20% above 12% mechanic.

So it’s some measure of the dysfunction in the CLO market this year that managers have been continuing to issue single-B notes massively wider that this level, keeping up with the widening secondary market. Reported DM on Tikehau VII, from last week, was 1415 bps, reported DM on CSAM’s Madison Park Euro Funding XX was 1375 bps.

Even that somewhat flatters the figures — if Madison Park gets called somewhere near the first call in February 2024, you’re looking at 16.5 points of cash upside across 1.5 years, on top of 1029 bps running. Other managers have sweetened the terms on their single-Bs still further, structuring the tranche as a turbo note, which creams off part of the excess spread which would have otherwise gone to equity.

If we look at what investors are saying, that reinforces the point — as we saw a couple of weeks back, some of the CLO equity funds (Axa IM and Fair Oaks, as listed and transparent players) are advocating a move up the capital structure, to get equity-like returns from buying more protected debt tranches. So why play into their hands and issue such tranches?

Partly it’s because the real cost of CLO equity isn’t actually 12% or anything close to it. That’s what it says in the deal docs, sure, but that doesn’t take account of the price at which one might raise CLO equity. All outstanding CLOs were trading with negative equity NAVs, at prices which are widely dispersed, but still pretty bombed out. The incremental cost of more equity (to fill the missing single-B hole), was still well above the worst case pricing assumptions for single-B, and that’s if more equity could be found. Those who ordinarily allocate to CLO equity might have found distressed or credit opps funds more to their taste this year; those who had equity stuck in uneconomic deals wanted to get it out, not put more in.

Nonetheless, managers are now addressing the situation. Bain Capital Credit and Fidelity, with Bain Euro CLO 2022-2 and Fidelity Grand Harbour 2022-1 respectively, have structured single-B notes in their deals as delayed draw tranches, not offered at the time of pricing.

This is a neat trick allowing the deal to get fully levered down the road when market spreads are more attractive, rather than issuing an expensive note up front — and was on display at a couple of points in the post-Covid period, with PGIM and Fair Oaks issuing delayed draw single-Bs.

What it symbolises now, however, is most likely the rapid rally in loan prices, rather than a belated realisation that single-B notes are actually really expensive.

Issuing a single-B in the low 80s gives you, let’s say, a 15 point hit on a €15m tranche — €2.25m of upfront pain, fairly acceptable if you’re sure there are cheap loans to be had. But the European Leveraged Loan Index is up the best part of three points over the last week. Loans are still cheap compared to January’s levels, but they’re no longer bargain basement, and CLO liabilities are lagging. Doing a delayed draw tranche, though, means managers can wait for CLO liabilities to catch up.

Moody’s melts

CLO ratings has been a bit of a battleground for the last couple of years, with stark swings to and from agencies as methodologies changed and waves of downgrades swept the markets.

Most investors don’t really care one way or the other who rates the transaction…unless it’s in their mandate, and that usually means one of the big three. Ratings mandates are sticky, and the choice of agency flows through into the documentation, making it tough to break into the business without a comprehensive loan rating operation alongside the CLO tranche business.

But it’s been a viciously fought battle, and there’s good money in dominating the CLO market successfully.

So Moody’s is probably hurting pretty bad now it’s market share has once again fallen off a cliff.

Sound Point’s static deal is the only CLO transaction in Europe since mid-May with a Moody’s rating, and you have to go back to mid-March to find Moody’s in its usual dominant position in the market. It’s a collapse comparable to the immediate post-Covid era, but probably driven by very different factors.

As the pandemic hit, the major agencies fired up their downgrade machines, putting large swathes of the leveraged finance universe on Negative Outlook, CreditWatch and so forth.

That was fair enough at the time – large portions of the economy did cease to function in 2020 — but the mechanics of how this fed through to the CLO market were distinctly unfavourable, as deal docs required managers to aggressively notch down collateral ratings, even when the actual downgrade had yet to flow through.

That was a particular issue for Moody’s, and the agency basically disappeared from the market between March and September 2020. Then, happily for the Moody’s biz dev team, its rating team decided that maybe the notching treatment was too harsh, and signalled a methodology change was in the works.

Market share bounced back, and by December, when the change was confirmed, Moody’s had pretty much returned to its pre-pandemic place on the majority of European CLOs. Managers had to update deal docs to take account of the alterations, but the huge flow of reset activity in 2021 offered an excellent opportunity to tweak some of these deals, and investors generally waved the changes through on the deals which weren’t called.

Fitch also made some changes to its methodology, which broadly led to favourable outcomes for managers — better treatment for underlying collateral and lower WARF (weighted average rating factor), so more flexibility in buying and holding loans, and again, happily for Fitch, this meant a firming up of market share.

At the back end of 2021, though, Moody’s updated its methodology again, following Fitch in changing its WAL assumptions — instead of modelling CLO WAL according to the WAL covenant, the switch meant it would model to the longer of the WAL covenant minus one year, or portfolio WAL plus one year, capped at the WAL covenant.

More importantly for the current state of the market, Moody’s methodology was already relatively harsh at the bottom of the capital structure, and as CLO spreads have blown out and modelled excess spread has come down, using Moody’s means a much less efficient capital stack — much higher par subs on the single Bs and double Bs.

Par subs have gone up everywhere, with 40%+ now common at the senior end — in this context, using Moody’s wouldn’t hurt the senior part of the structure, but it would squeeze the bottom, and managers and equity can ill afford to leave incremental debt on the table right now.

Banks have been mulling structures featuring Moody’s up top only, and others in the mezz, but these have yet to come out in market in Europe.

In short — it’s not like the pandemic period, where the agency’s trigger-happy downgrade watches played a big part…it’s more that the Moody’s methodology is particularly ill suited for an environment of costly liabilities and skinny excess spread.

This might end up benefitting the agency in the long run — the methodology switch in 2020 was doubtless done according to all the right rules and regs, but it looked optically bad.

A process that goes Lost Share —> Changed Methodology —> Winning Business isn’t particularly endearing to regulators or casual observers, especially when it concerns WEAPONS OF FINANCIAL MASS DESTRUCTION ALPHABET SOUP SLICING AND DICING products. But if that market share disappears again and the agency holds firm, it looks much more like a methodology that’s the product of sincere credit conviction. Perhaps the lost deal fees are a price worth paying.

Buying a lot of houses is expensive

Lots of startups over the last few years have run with the same basic idea — what if, instead of buying and selling homes as agency brokers, a real estate agent came along that would provide liquidity and immediacy?

Like bonds but worse, houses are illiquid, and the process of buying and selling is stressful and unpleasant. Both buyers and sellers should be willing to pay to buy or sell without the drama, so in theory there’s a bid-offer spread that could be captured.

Assuming you can accurately price homes and housing markets are stable (pretty big assumptions!), the main issue, as it is in a bank’s trading business, is the cost of balance sheet — are you getting paid enough through the bid-offer to cover the costs of financing a substantial home inventory?

That effectively means debt funding of some sort. Even in the balmy days of 2021, venture funding for the startup platforms is not an efficient way to fund a lot of housing inventory — you need lots of dough, and not the kind of money that’s looking to 10x, but the kind that’s secured on a long list of properties.

In the US, this business model has had a spectacular blowup, in the shape of Zillow, which shut down its instant buying service in the autumn last year — it had built up a huge inventory of some $3.8bn in homes, but its “AI-powered” service had seemingly overpaid for many of these, and Zillow was forced to dump some of the inventory. But it hasn’t stopped competitors like Opendoor from continuing to buy properties.

The bit we’re interested in is the funding — Zillow used a couple of semi-private ABS transactions, as well as bank lines from Goldman SachsCiti and Credit Suisse to fund its programme, and this kind of thing, you’d expect, is squarely in the securitisation wheelhouse. Opendoor does not appear to have issued capital markets notes, but has $2.9bn of senior asset-backed facilities and a further $449m of mezz to fund inventories (only $479m in total was drawn at the end of last year).

The UK’s version never achieved the same kind of dominance. The startup golden child was Nested, which blitzed the country in advertising around 2018, and secured funding from a group of VCs, with senior debt from Lakestar. But it’s since pivoted away from buying homes outright, and now presents as a friendlier full service traditional estate agent.

Securitisation still has a role to play in funding the UK’s homebuying services — but it’s pretty small time. “WeBuyAnyHouse.Co.Uk” funds its properties piecemeal using loans from Together Commercial Finance….as does its competitor “WeBuyAnyHome.Com”….so there’s a fair chance these loans are being securitised in Together’s private or public facilities.

At institutional size, though, a far juicier prospect is Italy’s Casavo, which operates instant homebuying platforms in Italy, Spain, and Portugal.

Goldman has been providing senior debt, and in decent size — €150m last year, extended with a mezzanine tranche from DE Shaw, and an additional €300m this year to finance the expansion to Spain, with Intesa Sanpaolo and Viola Credit joining in the senior debt.

Spain is not greenfield territory though — Deutsche Bank is providing a hefty €400m to Madrid-based Clikalia, which offers a similar instant home-buying service. Given that we’re talking about southern Europe in mid-August, it hasn’t been easy to get hold of some of the principals in these deals to talk through this sector, but it’s clearly a meaningful source of demand for securitisation-style financing.

Strip away the tech gloss, though, and we’re talking about something not a million miles away from bridge lending — property secured mortgage finance for the short term, covering a period of intermediation. Flexibility is paramount for the platforms; their growth (and their VC equity story) depends on being able to finance a broad range of properties. They need financing that allow them to say “yes” as much as possible. Trad bridging is also a sector that’s seeing some buzz (we talked about Elliott’s involvement last year), but the instant buying sector, if it takes off, promises a large-sized opportunity for securitisation capital.

Me, talking about securitisation

DealCatalyst, a conference company that’s launching a series of new securitisation events, has one running on September 7 on UK Mortgage Finance.

It has many good qualities (several of my esteemed readers are speaking), and also features me as moderator for the session on “Fintech and the Future of Mortgage Finance”, if that were not incentive enough to come.

We’ve got representatives of Auxmoney, Habito, Proportunity, MQube and Clifford Chance on board, hopefully it will be a good one, and I’m keen for any question ideas or thoughts to put to the panel. I believe it’s possible to attend virtually as well, though I couldn’t tell you how at this point. Hope to see you there!

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