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Private Credit 

Owen Sanderson

Some of the excitement has disappeared from ESG in CLOs. Perhaps you were always a cynic, perhaps a true believer, but it certainly feels like most of the big, innovative moves are now in the rearview mirror for Europe. Basically every transaction has some kind of negative screening, with increasingly nuanced language. More and more managers have screening plus scoring; sophistication is increasing but it’s moving by increments.

The negative screens, however, are getting more baroque. Thermal coal is bad, but should you measure its badness through revenue percentages, expansion plans, carbon intensities or some combination of them all? Is it sufficient to incorporate global guidelines like the UN Global Compact, or do you need to be more direct?

The majority of CLO investors don’t care much (they want to know that ESG is being performed, but the details don’t matter much). But a few accounts care very much and will negotiate line by line.

One particular sin about which CLO docs are usually sanguine is the booze. We have enjoyed an ale or two with many market participants over the years, so it’s nice to see personal and professional values align here.

But the new Permira Credit deal, Providus IX, includes an unusual and highly explicit no alcohol provision, added in the drafting process — “any obligor which derives any revenue directly from the manufacture of alcoholic beverages, including distillers of hard liquors, brewers and vintners”.

It’s not totally unheard of to have some alcohol language in the docs — Barings Euro CLO 2019-1 had an alcohol 10% revenue limit bundled in with prohibitions on tobacco and e-cigs — but it is rare, and the drafting here gives very little wiggle room. Market speculation suggests this came from a Middle Eastern investor with a particular religiously-derived approach to ESG, but Permira and arranger Jefferies are staying tight-lipped.

At first sight, brewers seem more plausible LBO candidates than other challenging ESG cases — how many pornographers or nuclear arms makers are in the ELLI? — but there are surprisingly few firms caught, even by this highly explicit language.

Stonegate, a UK pub chain with euro FRNs in a few CLOs, is one of the few big pubcos without its own brewer, while competitors Greene King, Marston’s, and Mitchell & Butlers, which do brew, have sterling fixed rate capital structures that don’t trouble CLOs much.

Campari would be an outright no, of course, but its term loan was not widely syndicated and its fixed rate bond doesn’t appear to be in many CLOs.

Australia’s Accolade Wines, proud makers of the Echo Falls and Lambrini brands, would be a straight red under this language. But with looming 2024 and 2025 maturities, leverage with an 8 handle, and a Caa2 rating, it’s not going to be on many new issue CLO model portfolio lists.

Tereos (with fixed rate bonds) is basically a sugar processor, but makes a ton of alcohol. It’s mostly not for drinking (bio-ethanol), but with some “beverage” end markets for the sugar beet hooch it is turning out.

There are closely related credits in the levfin universe. Guala Closures basically puts tops on wine bottles and premium corks in fancy spirits, Verallia does bottles; Dufry sells duty-free and the supermarkets shift plenty of liquor, but these wouldn’t be caught under the provision. One shouldn’t be too legalistic about these things though. When the investor in question feels very strongly about a particular ESG topic, managers don’t really want to go right up to the line. 

If you find yourself saying “don’t worry this is fine, only 4.9% of revenues currently come from white phosphorus and land mines”, you have already lost the ESG argument.

The only large (and surprising) problem we could find was Refresco, a much-loved levfin borrower with €4.5bn outstanding across euros and dollars. It’s mostly a soft-drinks bottler, but has a few little drinks manufacturers knocking around (Tru Blue Beverages and Avandis acquired last year). 

There are 44 CLO managers in the €1.53bn euro TLB, most of whom presumably don’t have an alcohol problem (in their documentation), but language like that in the Permira deal would cut out this much loved and widely held credit. Not all ESG limits are a freebie.

We make some good calls around here, and some less good ones. 

The call over the summer where we suggested sponsors wouldn’t be keen to obtain CMBS financing more expensive than the asset yield seemed like a no-brainer at the time, and yet here we are. 

The same sponsor, Blackstone, with the same asset class (logistics/light industrial) has brought the year’s second European CMBS to market, Stark Financing 2023-1, on economic terms which also seem hard to parse, if rather less extreme than those in Last Mile Logistics 2023-1.

Backing the deal is a senior loan paying Sonia+285bps, with Sonia initially capped at 325bps, stepping up to 450bps until the August 2026 interest payment date. So 6.1% out of the gate, compared with a 7% gross initial yield (6.5% net). 

It’s not actively money-losing like Last Mile Logistics 2023-1 was, but wouldn’t you rather get paid 6.1% for a senior loan with an LTV in the low 50s than 6.5% for owning a whole load of buildings? That surely suggests the CMBS is a screaming buy, and it appears to have gone well; only a portion of the senior loan, provided by Bank of America and Deutsche Bank was securitised in the CMBS, but this was increased during bookbuilding from £250m to £275m, with books 1.6x / 3.4x / 2.9x at guidance.

This is fine for the banks, who derisk at a decent level, and it’s fine for the CMBS investors, but still, the sponsor is paying away basically everything to finance the purchase. 

What gives? Why is everyone pretending like this is a normal thing to do?

Well, in commercial real estate, it kind of is. I write about securitised products here, and the disclosure is miles better than in the private market, but there is nothing particularly special about the securitised format; it’s happening right across commercial real estate finance.

One question you can pose is “why pay away everything you get in asset yield in financing”, but it’s the wrong question. The right question is “what are you gonna do” — if you’re in the business of buying or owning commercial real estate, you certainly don’t want to do it with your own money, you don’t want to stop doing deals, and you don’t want to sell and crystallise a value decline. 

“If you have an asset in hand, and the cost of financing is high, there’s not an awful lot you can do about it,” said a head of CRE financing we grilled about this sort of thing. “You might have an asset that produces five or six in annual cash flow, and formally paid one or two of that in interest…now you pay virtually all of it away, and you can’t send a dividend to your LPs, but is it a good idea to sell that asset now? Might the prospects be better in a year or two? You never want to be a forced seller, and the lifespan of these funds is long compared to the standard term of a CRE loan.”

They were talking about existing portfolios, while the new Blackstone CMBS is a recent acquisition — it funds and refinances the portfolio of Industrials REIT, taken private by Blackstone earlier this year. The offer for the company was all equity-funded, but with the provision that it might be relevered later on; this deal is part of the relevering.

But still, if you have raised a fund to do CRE deals, you need to do some deals. Waiting until the financing environment suits you is not what you’re being paid for. Better to get assets you think are good in the door in the first place.

They say that bad news sells papers, and they’re right. But it’s always a little delicate discussing a deal that’s struggled. 

Whether it’s a trade where 1x covered is enough, a deal which took a full month of syndication, or deals which lean heavily on preplacement, the salient point is generally that the deal got done. Still, this stuff does matter; syndicate don’t earn the big bucks (please don’t write in disabusing me of this) because they put any old rubbish on screen and just sit back and see where it clears.

So how to parse the challenging trade for Tesco Bank last week, Delamare Cards 2023-2? IPTs in the mid-80s, priced 1x done at 92bps. A deal got done, but clearly the level was dictated by the marginal buyer. Textbook execution this ain’t.

My old shop put it down to the reports emerging that Tesco Bank was up for sale (Bloomberg ran a story on 17 October, one day after announcement of the deal. This can’t have been helpful; the deal was basically a funding trade, and redemption in a timely fashion does somewhat depend on the strength of the sponsor.

But it can also be overdone. There’s been plenty of M&A across the specialist lender / challenger bank space in the past few years, some of it covered in these pages. Charter Court / OSB a few years back; Kensington; Fleet-Starling; Shawbrook / TMF / Bluestone; Metro / RateSetter off the top of my head, without even considering the various large and strategic portfolio sales. Generally these entities have continued to fund through the process without noticeable difficulty. Tesco itself stopped mortgage lending in 2019 and sold its portfolio to Lloyds; the first reports that it was up for sale filtered out in February this year.

This is just part of investing in securitisation. It’s possible the sponsors of a deal will change, whether it’s a senior-only funding deal or full stack, and possibly they will have different incentives. Mostly it’s fine, calls are exercised, nothing much happens. There are occasional wrinkles, for example: Pimco stopped replenishing one of the Finsbury Square deals when it bought the Kensington back book, squeezing the spread going to the X note.

But, “Tesco Bank might be in play” should be in the price. 

A different take is that there still isn’t really a natural end-account buyer of senior. This was the weak spot even of the halcyon September days. 

In the case of Tesco, this weakness is exacerbated by a couple of factors. Sterling is one (it was only a £250m trade, but sterling is narrow and notoriously clubby) while asset class is another. An STS senior tranche should be going to treasuries, but credit card seniors, even with a three year tenor, are less appealing than RMBS, and fully out of scope for the building societies

One can sort of discern this in the deals announced since Tesco — prime UK RMBS transactions for Bank of Ireland (Bowbell No. 3) and Atom Bank (Elvet Mortgages 2023-1). Both of these were announced with some diffidence about how much senior would actually be placed, with Bank of Ireland signalling only that it would do “benchmark size” and Atom Bank with a “may retain a portion”. But if the Tesco transaction had a broader read-across to prime sterling securitisation, these would simply not have been announced.

Tesco was cheap to prime RMBS (but it’s unsecured), but you could just as easily argue it’s expensive to BTL or non-conforming, or indeed to subprime cards like NewDay. 

If you’re looking at senior tranches, the considerably better quality of the Tesco book doesn’t matter much; it’s baked into the structure, with NewDay’s 30% credit enhancement (in the last Partnership deal) vs 11.5% for Tesco. If you squint, Tesco could be seen as a stronger sponsor than Cinven, but securitisation (and indeed, credit card origination) is far more marginal to Tesco. No securitisation means no more NewDay, so NewDay really cares about its relations with the market.

Speaking of treasuries, there’s a couple of moves we wanted to highlight — headline-grabbing UK challenger Monzohas hired Chretien Harmeling, who has been buying ABS since the early 2000s, most recently at Schroders, as head of treasury markets. This suggests a new account potentially coming online for prime UK collateral?

Currently missing out on executing a prime UK deal is Bank of Ireland’s Alan McNamara, former head of global balance sheet management and execution, who is joining Howden Broking as executive director, balance sheet advisory and structuring. This is likely a role drawing on McNamara’s SRT experience, hoping to draw more insurance investors into unfunded SRT transactions — specialist credit insurance brokers are increasingly involved in that market, and it’s looking set to grow….as we will see below. But suffice to say, he’s not doing the investor calls for Bowbell.

“Last year, finally, the US stirred for real, with a deal between JP Morgan and PGGM hopefully firing the starting gun on a major market expansion” — that was, um, me in 2021, discussing the US SRT market, which has been the big prize SRT investors have been eyeing for the best part of a decade? Matters have slowly improved in the last couple of years, with JP Morgan now a semi-regular issuer, and Goldman Sachs and Morgan Stanley doing the odd transaction. 

US regional banks have also accessed the market, following the trail blazed by Texas Capital Bank in 2021; there have been deals from PacWest, and several from Western Alliance Bank. I think this year regional bank CFOs have had other things on their mind than establishing SRT shelves, so perhaps some plans have been put on hold. But really, any minute now the US market is going to blossom into majestic life. 

Per Bank of America: In recent years the deal flow, it was noted, was predictable with occasional flashes of new activity (Canada, HK), but that may not be the case in 2024 as volume surges across geographies and particularly from the US given recently emerging clarity about US regulations and US regulators’ positive, albeit lukewarm, endorsement of SRT. In the US, the combination of a banking stress and a positive regulatory change create the conditions for a rapid development of the SRT sector. Some panellists even ventured a guess about $16bn of notional volume in 2023 in the US to be followed by a multiple of that in 2024. The high cost of issuing equity, the need for equity build-up in light of the BIS III endgame, the expected M&A wave among regional banks, CRE loan portfolio concerns, etc. are pointing towards the need for SRT across the banking sector.

The US market has been slow to take off for a combination of economic and non-economic reasons. 

Historically big US banks have generally been better capitalised than their EU peers, and keener on finding ways to pay out capital surpluses than ways to drag on P&L for incremental capital. They’ve held less on balance sheet than EU banks, doing more movement and less storage, and they’ve had access to a more diverse suite of hedging instruments. US banks could use CMBX or CMBX tranches to hedge CRE exposures; in the EU banks would probably be bodging it with Crossover, the index for all seasons.

But the non-economic reasons have been real and awkward as well. The US has a rich and diverse range of regulators to go with its rich and diverse capital markets, and SRT deals touch the Federal Reserve, the Office of the Comptroller of the Currency, plus potentially the SEC and the CFTC depending on the structure. And that’s before we consider state regulators! If US banks wanted to use SPV structures for SRT deals, these could be caught by the Investment Company Act or commodity pool rules. Here’s a rundown from Clifford Chance.

For all the undoubted faults of EU financial regulation, since the establishment of the Single Supervisory Mechanism, the EU approach to SRT deals has basically been transparent and somewhat industrialised. Supervisors have become more experienced and comfortable with the structures, improving certainty and ease of execution.

Anyway, the latest change which might herald a wave of US activity is the Fed revising its rules on credit-linked notes, in an FAQ released last month. 

Basically it says that credit-linked notes (in which the guarantee or credit derivative referencing the notional portfolio is embedded in a bank bond) do not automatically work as a mechanism to transfer credit risk.

That’s a shame, as this is pretty much market standard for big bank SRT transactions, but what’s interesting is that the Fed explains its reasoning. Reason one is that direct credit-linked notes are not necessarily executed under standard industry credit derivative documentation, and reason two is apparently that “financial collateral implies the existence of a security interest in some form of collateral, and the Federal Reserve staff believe that the cash purchase consideration for direct CLNs is property owned by the note issuer, not property in which the note issuer has a collateral interest” — see this excellent piece by Mayer Brown for more.

This seems incredibly obtuse and pointless — why does this matter, and why should this stop a given CLN working as a risk transfer mechanism? — but it is good that the Fed got it out there publicly, and it offers a workaround, which is banks asking for supervisory discretion.

Per Mayer Brown: “In the FAQs, the Federal Reserve staff effectively put into writing the views that many believe they have been communicating informally to banking organisations for the last several years. The FAQs indicate that notwithstanding these concerns, Federal Reserve staff recognize that direct CLNs can be an effective way to transfer credit risk.”

Mayer Brown also noted that the day after this FAQ was published, the Fed announced it had approved a request from Morgan Stanley to treat some CLNs as synthetic securitisations.

So ask first, but let the market finally blossom.

I’ve been working with conference group DealCatalyst ahead of its European Specialist Lender Finance event on 16 November, getting some video interviews in during the run up to the event. 

The first one in the series was with Richard Evelyn, chief capital officer at Oodle Car Finance — find it here. We talked about the balance of public and private financing, whether the market environment has turned, how Oodle has coped with the rising rates cycle, market timing, and much more.

There’s more to come, from the issuer, investor and sponsor side — rest assured I will be enthusiastically promoting them and hoping to see you all at the event!

Related, my colleague Will has a great interview with Ares alternative credit head Joel Holsinger, also done in collaboration with DealCatalyst, and we’d also shout out the latest Ares Alternative Credit Newsletter; some strong views on the challenges for fintech in the current environment.

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