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Private Credit 

Owen Sanderson

That’s the two hottest markets of the moment, right? Everything from credit card lending to fund finance is getting a private credit themed rebrand these days, and even if LBO pricing has swung back in favour of the syndicated loan markets it doesn’t look like it’s going away any time soon. The rise and rise of SRT is a little more under the radar but it’s still been growing 18% per year since 2010, it’s larger than European CLOs, with total placed tranches of around $54bn, meaning portfolio notional of 10x than or more. Here’s a paper from Olivier Renault and the Pemberton risk sharing team making the case that total tranche placed size could reach $255bn by 2030

It’s not an aggressive assumption that requires faith in the US market opening; all you have to do is assume that banks already active in the market will extend their use of the tool. If every medium-large bank in Europe, never mind Japan, Canada and the US used SRT to the same extent as a Barclays, BNP Paribas or Santander, this thing will be spectacularly large.

So why mention private credit and SRT together? Because the advent of the US majors as regular SRT issuers could fundamentally reshape the market as we know it. 

Contradictory rumours are flying so I can’t tell you definitively what the new US trades look like; I hear there are at least five big banks deals doing the rounds, and some strategic hints to the papers of record on both sides of the Atlantic suggest it’s going to be big.

Most people with knowledge of the US bank trades agree, however, that the minimum ticket sizes on some of these deals are going to be enormous (we are hearing $250m for one of the deals). If you have a brand new $25bn+ SRT programme to spin up as quickly as possible, minimising the number of counterparties helps. SRT deals can be quite bespoke and negotiated, so each account can add a lot of pain.

But this size requirement effectively cuts out a lot of the traditional SRT-specific funds. If you’ve raised and partially invested a $2bn fund, there’s a lot of concentration involved in putting in $250m at a time. Even Christofferson Robb, which practically invented the market and claims a market share around 30%, said it invested a record $2.2bn in 2022, so a $250m ticket is doable, but still very large! PGGM, the pension fund of the Dutch healthcare system, regularly does multiple hundreds of millions at a time, while Elliott Advisors has been recently active (doing the Klarna deal for example) and has deep pockets.

So who’s going to step in instead? Well, first watch my video with Dan Pietrzak, head of private credit at KKR, done in collaboration with conference company DealCatalyst. Bank risk transfer trades are a top opportunity for the private credit arm of one of the world’s largest alternative asset managers. KKR’s latest asset-backed fund raised “only” $2.1bn, but the private credit group manages north of $76bn total. Blackstone has been sighted in the market, Areshas been discussed. Apollo dabbled in SRTs many years ago, doing some CRE trades (I believe with Barclays) and presumably can dabble again.

The big US banks have been receiving considerable inbound from these sorts of funds since the media coverage began; we’re hearing anecdotes from several securitisation investors that their LPs are pushing them to get involved in this “risk transfer” market, whether or not they’re already active.

SRT first loss is manifestly very different from doing sponsored unitranche for LBOs, but the private credit megafunds all have flexible mandates, and plenty of smart people who can understand the structures. US large cap corporate credit is fairly uncontroversial, even if it’s levered 8x to make it interesting. From a risk-reward perspective it’s certainly in the right place, and to borrow a truism of SRT pitchbooks…..where else are you going to get access to the core lending books of the world’s top corporate and investment banks?

If these funds do become the SRT first loss investors of choice, this marks a further way that private credit is eating the world. The risk-bearing capital of choice for IG corporates is not big bank equity any more; it’s private credit funds.

There’s a definite spring in the step of Lloyds since Miray Muminoglu and co arrived to put some pep in the UK clearer’s step, following the disastrous donut decision in 2020/21which decimated the investment bank. It’s always going to be a sterling house, but it’s been doing more varied deals across asset classes and more work with specialty lenders and financial sponsors. 

Lloyds has always had a strong line in self-arranged deals as well — there was a flowering of securitisation shelves in the immediate post-crisis period, with the HBOS and the Lloyds securitisation vehicles active at the same time, plus various standalone transactions too. 

As with other big UK banks, the number of securitisation funding trades dwindled more recently, to the point where earlier this year, all the Permanent RMBS transactions had (ironically) been redeemed. Penarth, the credit card shelf, is in a similar state, which may, like Perma, prompt some spring-cleaning.

But the number of risk transfer deals accelerated sharply, with semi-public deals like the Syon Securities shelf jostling for room with deals referencing CRE, agricultural loans and other asset classes. 

This year brought a monster portfolio sale in the form of Bridgegate Funding 2023-1, the year’s first asset-backed deal. This was backed by the incredibly beaten-up mortgage portfolio of “The Mortgage Business”, which had been hanging around on the Lloyds balance sheet since the HBOS merger. Many of the mortgages in question had already passed maturity, so it was more like an NPL/RPL transaction than a performing securitisation, and, because Lloyds can’t really be a part of kicking British homeowners out of their homes, the servicing didn’t move. 

But it was a major derisking transaction for Lloyds, a competitive process we’re pretty sure was won by mortgage monster Pimco. Before year-end, there could be further de-risking to come, we understand, with a big chunk of the personal loan up for sale. We’d assume the goal is to close by year end, and it’s junior and mezz for sale. We understand Lloyds is going to hang on to the senior notes, as it did with Bridgegate and as Barclays intends to do with Kensington’s new deal.

Lloyds has plenty of capital available, with CET1 north of 14% (the same level as Credit Suisse in March!) but that’s not the only regulatory measure which counts. Big banks in particular have very vigorous stress testing regimes, which can disproportionately punish certain asset classes. Mortgages with high LTVs attract high risk weights anyway, but a bank stress scenario will always come with a house price drop. So your 85% mortgages might become 100%+ mortgages, simulated default rates will spike, and that particular portfolio will get whacked. 

“Master trusts are like a nuclear power station,” according to a wise man whose phrase I was compelled to steal. There’s no toxic waste output; he was referring to the cost of setting up, the cost of decommissioning, and even the costs of shutting them down for a clean up (as per Lloyds). When they’re running, though, they should be humming along producing cheap and clean power/funding.

For the big banks and builders sponsoring these vehicles, however, they’ve like to use them as basically equivalent to covered bond funding, with a time to market that’s measured in hours or days rather than weeks or months. 

If there’s a good window, they want to print, an urge only magnified by the relative chaos of the past few years. If your structurers and ratings people were on holiday in August 2022 and you missed your September 2022 execution window, Liz Truss ensured that your execution plan was toast. The collapse of Silicon Valley Bank came out of left field and blew up what looked like a valid execution opportunity. For the small lenders access to market is existential; for the big banks, it’s about optimising cost of funds, and accessing another channel of secured funding to sit alongside covered bonds.

One option is the “Coventry structure”, on display last week with another Economic Master Issuer transaction. This strips out a layer of SPV from the pre-crisis master trusts, simplifies the docs and makes it easier to draw down a new deal.

But in some ways, the approach adopted by Nationwide is simpler. This week brought a retained Silverstone RMBS transaction with £1.7bn of bonds across three tranches. Citi was the arranger, but there were six banks on as “dealers”; you could call this overkill if this deal was intended as central bank collateral.

It does, however, give Nationwide the flexibility to remarket these notes whenever it likes. Call dates are January 2028, April 2029 and July 2029 for £600m, £600m and £500m each. The big banks tend to do their term funding in whole numbers, often threes and fives. A simple man might therefore read the funding plan next year as a four-year right out of the gate, a five-year in the Q2 window and line up the final five-year after the Barcelona conference. The beauty of selling the bonds whenever you like, though, is it doesn’t have to be like that!

As everyone knows, Three is a Trend, so it is a fine thing to have a third European CMBS deal for 2023 on the screen this week, Brookfield’s Magritte CMBS, privately placed via Morgan Stanley this week. This deal doubles the numbers of active sponsors in the market, and most excitingly, it is an office-backed deal, rather than the trendy light industrial/logistics portfolios Blackstone has brought to market in the other two transactions.

Office matters because office properties are generally the focus of greatest CRE worry right now. Everyone has a view on how the CRE shakeout will happen; some firms are getting ready to back up the truck for a bonanza of distressed opportunities, others are nervously eyeing over-extended exposures and bloated bank balance sheets.

But office provokes the greatest worries — the aggressive levels at which prime offices were purchased pre-pandemic plus the structural decline in the demand for office space as WFH refuses to die are a potent combination. The numbers only stack up if you can count on sustained upwards rental reviews, and it doesn’t seem like landlords have much pricing power today. And probably the world’s largest tenant of office space is now in Chapter 11?

Magritte, to be fair, seems to be backed by some of the best offices going, with 98.7% occupancy, and 88.7% of contracted rent from government tenants — the European Parliament, the regional government of Wallonia etc.

One could still argue that it doesn’t quite wash its face, from a sponsor point of view. Net operating income is €22m, the senior debt is costing c. €13.6m out of the gate, thanks to a slightly off-market swap (>€15m without). There’s going to be a mezz loan taking it from 55% to 67.5%, on undisclosed terms. If the mezz costs 12% or so, that’s going to take out about €6m pa….leaving Brookfield earning €2m on a €123m equity commitment. The number is positive in nominal terms, so it’s not nothing, but it’s not an obvious slamdunk either out of the gate.

The deal structure did handily derisk Morgan Stanley, with the coupon spread passing straight through to the cost of the loan, but the CRE concerns aren’t really about the debt, and especially not the banks involved; there have been some big writedowns booked by US banks but not that big give the scale of CRE lending.

The basic problem is that the debt provider, where bank, debt fund or CMBS investor, is getting almost every bit of cash coming off the asset. Who’d buy a building in these conditions?

The Eurosystem added a new rating agency last week, the first such move since 2008, when DBRS joined Moody’s, S&P and Fitch in achieving this designation. There’s a curious mismatch in European regulation of rating agencies, between those which meet the requirements of the securities regulator (29 in total, though several of them are separate Moody’s entities) and those which the ECB will accept for purposes of its collateral framework (four until last week, now five).

The two designations (CRA vs ECAF, if you care) do serve different purposes; the ECB is interested not just in credit quality when considering collateral, but also in marketability and general acceptance. This requirement is honoured more in the breach than the observance, given the huge volumes of whole loans accepted as collateral in the easy money era, but that’s the theory, at least.

There’s also a bunch of stuff about systems, pricing and operational achievements (see here for more). Being an ECB-eligible rating agency should, in theory, be a massive boon; if the ECB will accept a given agency’s rating for collateral management and monetary policy, that should mean more investors do likewise, since the ECB’s backing guarantees a certain amount of liquidity in the underlying bonds. For a European bank treasury, an ECB-friendly rating is a must-have on an asset-backed instrument (well, two, actually).

The downside of becoming ECB-eligible is that it’s a fantastically large amount of work. The ECB lays out its minimum coverage requirements here, and it’s rough.

Most of the smaller agencies on the ESMA longlist have some kind of specialist niche; trade credit, monolines, insurance, fund finance, factoring, local capital markets. To get from there to 10% of bank bonds, corporate bonds and covered bonds in the euro area is a massive job, requiring a huge investment in providing unsolicited ratings, for which the agency will receive no recompense (because the issuer didn’t ask them for it). So it’s a massive investment to get to this level. Per this FT story from 2020, Scope had -€14.3m EBITDA in 2018, presumably partly because it’s paying people to rate entities which don’t ask for ratings. I haven’t seen a more recent figure, Scope being a private company.

Also, despite this week’s news, it’s not quite all the way there — per the ECB, “the ABS ratings issued by Scope are at the current juncture not compliant with the Eurosystem eligibility requirements, which renders them ineligible for Eurosystem monetary policy purposes for the time being”.

It does, however, have some friends in high places; the “Scope Foundation”, which “guarantees the rating agency’s independence, its entrepreneurial spirit and the long-term preservation of its European identity” reads like a list of central banking luminaries. Jean-Claude Trichet, Pier Carlo Padoan, Lorenzo Bini Smaghi, Yves Mersch, and most recently Basel Committee chair Stefan Invges are all involved.

It’s clearly a big step, but it comes at an inopportune time — with the demise of the asset purchase programmes and extraordinary liquidity facilities, the boom times in ECB-targeted retained issuance are surely coming to an end. For an agency yet to achieve full investor acceptance but with a central bank stamp of approval, new retained collateral assets are the sweet spot. Scope has another journey ahead now to convince the private market to accept it.

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