Market Wrap

Excess Spread — What’s in the box, off-ramp, Run DMC

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


We’ve spent most of Thursday, when I usually write this, at DealCatalyst’s excellent “Specialist Lenders’ Forum on Private Credit Finance”. The title’s a bit of a mouthful, but it’s essentially “all about speciality finance lenders in Europe”. The rooms are packed, the energy is high…but all is not well in the sector, as we have discussed extensively in Excess Spread passim.

The best line of the day at the time of writing was from JP Morgan’s Ben Tucker, who invited all the lenders present to have DMCs (deep meaningful conversations) about DMC (defaults margins and capital)…..preferably involving JP Morgan if there was capital to be raised.

Basically, this three letter acronym (we love ‘em in securitisation) refers to the challenges coming up in the year ahead.

Let’s start with the C.

Lenders which are basically in the originate-to-distribute business need to ensure they have the capital strength to carry on doing the originate part. Maybe this means plentiful VC funding (hard to come by, if it’s not already in the bank). Maybe this means another deep-pocketed partner with a more profit-focused PE approach (also hard to come by now).

More likely, it means monetising the assets they originate, perhaps selling portfolios, perhaps originating into forward flow arrangements rather than tying up capital in the junior piece of a warehouse.

One large originator of UK consumer assets, which has traditionally warehoused assets for regular securitisation takeout and provided its own junior capital, signalled that 2023 might bring forward flow partnerships instead; we’re hearing rumours of one UK mortgage lender working on a multi-track situation, shopping some portfolios but also looking to either raise equity or get itself bought. We’d say who, but still crossing all the Ts.

Capital providers, though, are more complex. Securitisation takeouts are very expensive, but that has a pretty straightforward read across to leveraged investors. Forward flow providers that are tied to the capital markets have to price to a term takeout, and hope is not a strategy.

Pension fund capital (especially UK defined benefit money) has been spooked by recent events, and rising rates across markets have made illiquid assets less attractive relative to liquid markets.

On the other hand, we sat down with a PM at a major overseas pension fund, who said (paraphrasing), they’d been backing up the truck on forward flow, stepping into a market rich in opportunities. If you’ve got the capital (and this institution has oceans of it), then get out there and sign some agreements.

The economics of forward flow are all about balance - does the originator or the buyer get the sweetest slice of the profits on the business? How do you strike a level that creates happy long term partnerships? If the supply-demand picture favours the funder, how hard should one push?

Moving back to the M (that’s margin)….that’s been the issue all year, especially in mortgages, and most of all in buy-to-let, as swap rates surged. Poorly hedged facilities led to lenders writing loans that were instantly underwater; lenders scrambled to tweak their forward-starting hedges and match them careful for completion models.

Then the LDI unwind blew things up spectacularly…and now the problem in the UK is almost reversed. Swap rates may well fall, and lenders could face another hectic steeplechase in the other direction, trying to keep pricing keen. The rise in absolute mortgage rates make this more crucial than ever; all mortgage origination is price sensitive, but the differences between a prime rate at 1.4% and 1.6% might easily be papered over through better relationships, brand loyalty, customer experience and other soft factors.

When the spread between providers gets into the 80 bps-90 bps type area though, for customers which are already facing some refi sticker shock, then the pricing competition is going to be truly cutthroat.

Preserving margin also means keeping hedges cheap (easier said than done), and, as in any business, costs growth. If you’re a “blitzscaling” tech platform who needs to show your VC backers some numbers….you’re going to be writing loans at silly levels.

Defaults is the final piece of the puzzle. There’s no great mortgage panic, but the lenders in other products, who have less reason to worry about margins (still a ton of excess spread coming off the book for a NewDay or an Oodle) have every reason to worry about the state of the macro picture, and what happens to subprime credit when energy bills and mortgage hikes slam into disposable incomes. Even in buy-to-let….well, your mileage may vary, but there’s an argument that rent controls are becoming more likely.

Anyway, the conference threw up much other material besides, but I’m there right now, there’s places to be, people to see and cold beverages to find, so I will sign off for this week.

Off Ramp

Is it better to burn out or fade away? Revealed preferences indicate most people definitely prefer fade away, though burn out remains the cooler option.

Applied to CLO management in 2022, “burn out” is what you do when you pull a deal, traditionally reckoned an embarrassment for sponsor and arranger alike, while “fade away” might be applied to the practice of issuing deals you know will have lousy equity returns and hoping there’s some kind of rally to bail you out down the road.

By this measure, KKR are the rockstars, preferring no deal at all to a poor quality one, and deciding to put Avoca XXVII on the back burner last week. This I can respect, but it may not be a decision open to every manager. Warehouses need emptying, platforms need growth, AUM has a quality all of its own. It takes confidence and presence to insist on quality deals only, rather than “fade away” with 50 bps running on another €400m. Revealed preferences of late suggest a fair few managers fall into this camp, especially if they don’t have to keep third party equity happy.

KKR brings its own equity to its CLO programme, but it may have had other partners that needed keeping happy as well - perhaps the rapidly rallying loan market caused some cold feet?

Unrelated no doubt, but KKR Credit also published a widely circulated, and provocative note entitled “The Hunt for Yield is Over”. Here’s a few points…

The first is the provocative headline point….”we think the opportunity in leveraged credit is better than any time since the end of the Global Financial Crisis — but we also know it can’t last forever”.

The piece surveys the landscape across high yield, loans, IG, looking at the US and EU, and concluding “there are risk-return profiles to please nearly all comers. Those investors seeking 7%-9% returns on relatively high-rated debt for 8-10 years can do so. Those investors seeking higher returns while avoiding single-name concentration or triple-C exposure have that option. We think total return investors can find opportunities in short-dated capital structures. This is why we call it a yield buffet: The opportunities come in many flavors.”

Perhaps. But digging into the CLO point highlights the issue — KKR points out that triple-A CLOs, the safest possible leveraged credit exposure, are to be had at 6%.

Put another way: The most secure leveraged credit is available for yields 2% higher than a B-rated leveraged buyout credit yielded last year”.

Neuberger Berman also has a note out advocating for the value in CLOs (US-focused, double Bs but still), and plenty of other buyside shops share the view, in public or private, that you’re getting much more value playing CLO tranches than loans directly.

But that’s basically just a “glass half full” way of saying the arbitrage is still lousy — for a healthy CLO market with lots of supply and decent equity returns, you want loans to be cheap to liabilities.

Anyway, back to KKR — it certainly looked like there was a deal on the table. Avoca / KKR Credit is a pretty top shelf manager with a decent following, and the price talk looked in line to somewhat tighter than recent prints — but the issue, most likely, was the rally in loan prices, capped off by the relief rally following Thursday’s CPI print. Ramping a deal against this backdrop would have locked in poor performance.

Related to this, we were struck by some stats this week in Bank of America’s CLO research, which require some reflection. Of the 22 European CLO tranches that have defaulted, 17 were managed by just three managers (of which Avoca accounted for eight). The other major offenders were M&G and NIBC.

The first point is — 22 tranches is not bad at all! BofA was pulling S&P’s stats, and the 22 tranches were from a 1.0 universe of 1500 tranches (or total of 4500 including 2.0 deals). All were rated BBB or below at issue. This is the kind of stat which CLO folks, especially those in the regulatory lobbying business, need to carry around and beat anyone that will listen over the head with. Next time there’s a “oh no look at how big Norinchukin’s CLO book is” article, wheel out this one front and centre.

The second is the ability of CLO managers to turn around a reputation and atone for past performance. Avoca, under KKR’s ownership, is now in the managerial elite; M&G’s plan to relaunch a CLO business will presumably seek to move on from the performance of the Leopard transactions, while NIBC has also carved out a reasonably successful niche in the 2.0 era, partly by pushing the boundaries of ESG in the CLO universe.

This far down the road from the 1.0 era, it’s a bit of a “Ship of Theseus” (or Trigger’s Broom, for fans of old UK sitcoms) issue. To what extent is a CLO manager the same if it has different owners, different portfolio managers, analysts and credit committee and looks at a different leveraged finance universe? Culture? Office? Vibes? Is there anything at all left?

The KKR decision suggests we also need to rethink the ‘stigma’ around pulling primary deals. Nobody wants to see a lot of hard work go to waste, but the idea that it’s a problem for the brand at either arranger or sponsor level should have been comprehensively put to bed this year. Markets are difficult, and plenty of transactions have taken a softly softly approach to lining up key accounts ahead of a public syndication to finish things off.

But on the other hand, if you accept that sometimes a public deal will fail and that’s ok, surely a fulsome widely distributed deal announcement gives the best chance of unearthing incremental demand?

What’s in the box? Pain?

Credit Suisse dribbled out for the details about the spinout of the securitized products business this week, giving the plebs that didn’t get a look in the data room a couple of little hints about what’s actually going on.

First off, the headline levels — Credit Suisse SPG had around $75bn of assets globally. I suspect that was buried in some past investor disclosure, and was certainly in line with what I’d heard, but it gives a sense of scale.

It seems that this figure does not include CLO origination, which seems to be, unfortunately, stuck with legacy CS. Dimitris Papadopoulos, who ran European origination and syndicate, is apparently out, and, in unsurprising follow-up news, Creditflux says CS is pruning its client list. If you’ve got nobody to execute deals, probably a good idea not to offer a ton of new warehousing either.

The leveraged finance teams, on origination and sales and trading, are also having a pretty tough time with mass layoffs — it looks like CS is dumping the whole value chain.

This could have a knock-on impact on the origination effort which Apollo is buying….Credit Suisse does lots of business with other sponsors (take the KKR music securitisation as one example). If it’s not covering these clients properly for their PE-classique LBO activities, surely it’s less relevant overall?

The first bites into SPG will take total assets at CS down from $75bn to $20bn (the Apollo/Pimco split has yet to be revealed), through “a series of transactions to be completed by mid-2023”. We think Pimco is probably more of a passenger here, with Apollo driving the bus, and Pimco just scooping up whichever assets don’t work for the return hurdle at Athene, Apollo’s captive insurer.

This bit is harder to parse, though: “The approximately $20bn of remaining assets, which will generate income to support the exit from the SPG business, will be managed by Apollo under an investment management relationship with an expected term of five years to be entered into at the first closing.”

Possibly these represent short-term asset portfolios, which will mostly self-liquidate during the period, with the profit thereon allowing CS to avoid taking various restructuring charges. Maybe Apollo gets paid enough on these assets to cover the costs of any layoffs, though, per the announcement, “Apollo is expected to hire the majority of the SPG team and will receive customary transitional services from Credit Suisse following the closing of the transaction in order to maintain a seamless experience for clients”.

“Majority” is doing a lot of work here — Apollo suggested the other week it was all about the assets, not so much the distribution…so are we talking about a 51% majority or a 95% majority?

Credit Suisse said that selling down the $55bn of assets to take SPG down from $75bn to $20bn should free up around $10bn of risk-weighted assets. Using the magic of simple arithmetic, that suggests a risk intensity of 18.8%. Risk weighting is a dark art at the best of times, and doubly so when it’s a whole mix of asset types across multiple massive global portfolios, but that’s a figure that suggests these are pretty good quality — probably, as one would expect from a bank, senior investment grade secured facilities.

The announcement says that CS will provide financing against some of these assets, but again, there are few terms out there — are we talking about repo-style leverage? Are some of the SPG traders being tapped to hang out at legacy CS and risk manage these probably quite complex positions? What would it cost to persuade you to hand in your new Apollo badge and hang about in the rapidly shrinking CS investment bank?

Homework for the holidays

The CLO market is likely to pack up early this year, unless there's a serious Santa rally to close things out — everyone's keen to put 2022 behind them, and late November/December is rarely the window for executing more difficult projects.

We'd suggest that the CLO community spend a bit of time in self-examination during any mid-winter downtime.

The slow pace of CLO execution has repeatedly put the CLO market at a disadvantage this year, with loan prices lurching lower or higher more rapidly than primary CLOs can hope to respond.

Crossover blows out, Loan prices dive, and print and sprints are on the table, but by the time they’re ready the window is closed. Credit rallies, loans get squeezed, but CLOs lag and can’t ramp at a level that makes sense. Some of this comes down to technicals (CLOs ramping all together; the LDI unwind), but surely there are some bits of market practice which can be tightened up.

The US market is dabbling in electronic platforms for auctions and for resets; that sounds like a reasonable step, though it’s not really the manual syndication or trading which makes CLOs slow.

Standardisation and transparency tend to cut time to market across all financial products, but CLOs sit in an awkward mid-ground — they’re levered exposures to similar loan names, with similar tranching, similar docs mechanics, similar optionality. Similar, that is, but not standardised….there’s a whole world of complexity built into to the ostensibly simple business of levering loan portfolios.

But can similar become standard? Not on the portfolio side, obviously, but surely there’s a way to tighten up the plumbing.

Some kind of streamlined issuance shelf? Ditch 144A? Standard reps and KYC? Maybe the rating agencies could be smarter and faster about pre-positioning portfolios and deals; offer a mass produced product rather than bespoke each time. Could big anchor senior accounts keep a terms grid out there? Any deal which hits the following characteristics, we’re in for €100m at 220 bps? Strip back the optionality, standardise the docs terms. Price to an index.

Probably there are sound reasons why the market doesn’t do all of these things — in most halfway decent market conditions, deal sponsors would rather optimise for optionality, capital efficiency and the last five basis points rather than than time to market. It’s all trade offs at the end of the day.

But that doesn’t mean the clever people involved in CLOs have yet hit a panglossian best-of-all possible markets. There must be scope for some improvements; strip things back, and ponder what a market would look like if you reinvented it today for maximum efficiency. Then email me your ideas because I’m super interested in this stuff.

Another answer is probably to pay your friendly local investment bank for immediacy. If a term CLO has to come NOW, can the banks simply take it down on the trading book? It’s not without precedent (that used to be what investment banking was all about), and trading desk underwrites have been used during troubled times for consumer ABS. It costs money, but would it cost more than screwing up a precious issuance window? A smart investment bank could surely find ways to get paid extra, and getting a warehouse termed out means it can probably trade €300m of loans in quick succession…..that’s got to be worth something?

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