That could mean more mortgage portfolios, infrastructure loans, direct CRE loans, structured CLO-style vehicles, and much more — and the UK bulk purchase market continues to flood life insurers with liabilities to be invested.

Sivakumaran joined Morgan Stanley in 2019 from the buyside — he was head of European structured credit at Sculptor Capital Management, having worked there since the financial crisis. One of Sculptor’s most notable post-crisis trades was buying residual notes in the Lehman Brothers non-conforming RMBS deals Eurosail, which had broken hedging structures following the collapse of the investment bank.

Morgan Stanley declined to comment.

Street cred

To much fanfare, Blackstone priced its “private credit CLO”, BCRED CLO 2023-1, last week. The firm placed double-A and triple-A notes for a blended 237bps DM — tighter than a middle market CLO (Guggenheim’s latest deal was a blended 262bps down to double A) but at a considerably lower advance rate, with 39% par sub versus 32%.

Much ink has been spilled over the potential differences between private credit CLOs and middle market CLOs — is it branding, is it a new asset class, evolution or revolution etc. Basically the difference seems to be that the loans are larger and the portfolio is more diverse compared with a standard US middle market CLO. The FT article cites Zendesk and Mimecast as part of the collateral, which were $5bn and $2bn unitranches, large cap lending even by the standards of the BSL market, but presumably more levered and with more restrictive documentation than your common or garden TLB.

BCRED, the world’s largest Business Development Company (BDC) is genuinely an absolute monster, with $43bn of first lien loan investments, ranging from tiny tickets to the truly enormous — it has the scope to carve out incredibly diversified portfolios, and indeed has already issued more than $3bn of BSL and MM deals. So it can add another route to market with the “private credit” brand, and access untradeable large cap secured debt to secure more leverage.

It can also borrow fairly cheaply in its own right — as an investment-grade borrower, BCRED issued a $500m five-year at 315bps over Treasuries just last week (7.59%). Tapping the CLO market for secured funding at SOFR+240bps (7.71%), when you’re offering a secured AAA/AA blended tranche with 39% par sub, doesn’t seem on the face of it to be very desirable from Blackstone’s perspective.

These are different pockets of funding, with different structures, so it offers some funding diversification — BCRED has $7.995bn of bond debt, $3.361bn of CLO debt across BSL and MM deals, and $10.3bn of bank debt.

The new deal most likely substitutes for bank debt — and here we can pore over the comparables. Blackstone is, uh, extremely well banked, and there’s a debt facility from basically every investment bank out there.

But many of them step up quite substantially in the year ahead, according to the Blackstone prospectus. BNP Paribas’ Bard Peak margin will step up from 155bps-215bps currently to 305bps from March 2024. Citi’s Castle Peak margin is currently 170bps-220bps but will add 100bps from January. Bank of America’s Bushnell Peak will step up from 160bps-185bps to a 210bps-245bps range from December next year.

There are 17 different “peaks” so I’m not going to go through them all, but I think this illustrates the point. However much the investment banks of the world might love Blackstone, they won’t lend at margin that’s through the market forever, so it’s time to open up a new capital source.

Residual value risk still exists

The past few years have brought a flowering of new ways to get mobile. Instead of buying or leasing some wheels, you can now join a car club, you can get a car subscription, or you can Uber everywhere in town for often less than the cost of car ownership. The intuition that most cars spend most of their time sat in one place has encouraged entrepreneurs of all sorts to figure out ways to thin-slice the total cost of auto ownership.

But cars still come with a problem — once you drive them out of the dealership, their value plunges and they continue to depreciate fairly rapidly. So what’s the car worth when the lease/susbcription/car club/rental agency has finished with it? That’s residual value risk right there, and it’s a pretty well known and well understood problem — lease contracts bake it into the price, leasing securitisations either carve it out or include it; it’s a risk that can be priced and it shows up in deal structures and pricing levels.

The newest business models and the newest car technologies, however, are still struggling with it, and that’s nowhere more obvious than in the case of Onto, the UK electrical vehicle subscription business, which filed for administration in September. Teneo, the administrators, have recently filed their statement of proposals, giving us an idea of how the company got into difficulties and who’s likely to get hurt.

Pollen Street Capital and CDPQ are the largest providers of secured funding to Onto — here’s a release from January announcing a new £100m funding commitment. Other funding comes from HSBC Equipment Finance and specialist asset-based lender Lombard North.

The particular problem Onto faced came from plunging prices for used electric vehicles. According to a Fitch Ratings report last month, used electric vehicle prices have fallen nearly 25 percentage points since September 2022. As the agency noted, Tesla’s “aggressive price cutting on their new vehicles” drove the decline. The agency said that this “could be creating pockets of increased voluntary terminations, due to the higher likelihood of negative equity in EV financing agreements”.

Following the valuation decline, Onto was in breach of the loan-to-value covenant on its secured facilities, so equity backer LGIM stepped up to inject £31m in convertible loans between April and June this year. But it pulled the plug in July, declining to inject further capital, and Onto was in breach of its £10m minimum liquidity covenant.

Lenders then agreed a standstill while Deloitte marketed the company for a sale. According to Teneo, there was one solvent offer for the firm, though this was withdrawn on 31 August, with the firm filing for administration two weeks later.

The SPVs holding the vehicles (which receive the subscription benefits) are now contributing some of the costs to keep Onto’s holding company trading while Teneo runs a further marketing process. The administrators said they had 15 offers for parts or the whole of the company.

According to the statement of administrator’s proposal, Pollen Street and CDPQ should be made whole, though the administration experience (and dripfeed of capital into the holdco) can’t be particularly fun. CDPQ’s capital solutions strategy was just ramping up in Europe, and hadn’t announced many large deals before proudly unveiling Onto.

Part of the selling point for subscription businesses is giving customers flexibility — they aren’t necessarily tied into term contracts, and some arrangements allow them to change cars midway through. In financial terms, the subscription businesses are short the option on residual value, and may well be mispricing this option — the incentives for startups have tended to encourage rapid scaling and customer acquisition, and one way to achieve this is by underpricing residual value, and underpricing optionality.

So where will the next shoe drop? Octopus Electric Vehicles is one of the largest electric vehicle providers in the UK, and offers integrated packages including charging infrastructure, solar panels, battery storage and more.

But most of its business is basically traditional leasing, using the UK government’s salary sacrifice scheme, which gives an extra tax sweetener to customers. That’s far less risky, because it gives customers less free optionality. Pollen Street has also financed Octopus, and we hear there’s a bank deal in the works.

Specialist finance firms may also concentrate some pockets of EV risk. WeFlex is a UK business targeting PCO (minicab) drivers who want a vehicle so they can drive for Uber or its various competitors.

EY was running a fundraising process last year, and the company appears to have signed a facility with a non-bank vehicle called Solo Asset I (potentially linked to LCM’s SOLO strategy). WeFlex gives a four week termination options after the first three or six months — and aims to keep the RV risk with customers via rent-to-buy contracts — so hopefully the fallout from the price drop should be contained.

There’s competition for free money

My excellent CLO-focused colleagues have reported that Chenavari Investment Managers is getting into the risk retention financing business which has been historically dominated by Nearwater Capital.

Risk retention financing in general is almost as old as the risk retention rules themselves; maximising leverage is a principle very dear to the hearts of the securitisation industry, and it was clear from the start that thinly capitalised CLO managers and non-bank originators would struggle to find the cash to fund 5% pieces themselves.

Until Nearwater came along, though, the basic structure was a repo — bonds would be pledged with a haircut and mark-to-market language. Nearwater’s solution remains a repo, but it gives 100% financing without marking to market, for the lifetime of the deal. This has historically been funded by simply recycling the bonds into the market straight away.

The originator doesn’t need to find any actual cash to cover the 5% risk retention, but it still has skin in the game, as the repurchase agreement is full recourse. Locating rehypothecated deep mezz or junior tranches isn’t easy, but the beauty of risk retention financing is that Nearwater doesn’t have to do this — the repo financing unwinds when the deal is called.

This is a great trade for the originator, and a great trade for Nearwater — it solves exactly for the regulatory issue at hand in the most convenient way possible. One could object that the spiritual intention of risk retention was not to allow originators to put in no money whatsoever, but multiple lawyers have mused on the structure and given it a clean bill of health. The spiritual intention in the hearts of European lawmakers is basically irrelevant; the law says what it says.

Risk retention is a ridiculous idea, especially in CLOs which do absolutely no origination themselves but it does seem to be something certain European lawmakers are very attached to, so it’s going to stick around for a while.

That leaves the status quo in an awkward position. The law makes little sense, there’s a solution which minimises the costs and pain, but it involves paying a stream of fees to a hedge fund — the surprising part is that nobody else has come along to scoop this up until now.

Parlour game

Whole business securitisations were a great way to add extra leverage at low cost to UK businesses — as with other forms of secured debt, they traded flexibility for cheap financing. The benefit of the cheap financing / high advance rate comes up front, but the loss of flexibility is a pain for years to come afters. Decades, really, since many of the deals have ludicrously long bond maturities to match the appetites of the UK real money industry.

The last new WBS was breakdown repair firm RAC in 2016, but most were pre-GFC, and have been hanging around troubling treasury teams long after the CFO who signed off on it has retired. They’re a useful tool, but the tight covenant packages have a tendency to require cash to be fed into the structures, and built-in deleveraging through scheduled amortisation tends to further squeeze free cashflow.

So breaking these deals up might be desirable, if difficult. Bondholders don’t have much incentive to agree to collapse a WBS, even if their bonds have been downgraded, so treasurers might have to pay make-whole — or present some other compelling economic argument.

Anyway, Dignity, a funeral home business, is indeed looking to dismantle its Dignity Finance WBS at some point in the next year. On Monday it launched a consent process, looking to pave the way to redeem the class A notes at par and the class B at 84.25 (NatWest Markets is dealer manager).

This follows Dignity’s take-private earlier this year. Various investment vehicles linked to Direct Line founder Sir Peter Wood bought the company, having been longstanding shareholders, and have been reviewing operations, tightening belts and so forth. The company’s £32.5m EBITDA goes pretty much entirely on debt service (it’s FCF negative), of which £11m is amortisation on the WBS, and the new owners have had to inject money into it to cure a covenant breach.

The problem is….what comes after it? The WBS bonds cost a blended 4.3%. Even with a discounted buyback of the bonds, and some improvement in the underlying business, if you want to beat that rate you’re trying to solve for a way to finance a >10x levered business flat to Gilts. A challenge!