Excess Spread — Bad marks, the Black Knight, closing time

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Excess Spread — Bad marks, the Black Knight, closing time

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

The Black Knight?

What are CLO managers thinking as we enter the last weeks of the year? That they’d like to watch some football, go out for some lunches and try to forget about the year that’s almost over?

Most probably, but that’s not an option for everyone. Our friendly rivals at Creditflux pointed out that Bridgepoint, in the market at the moment, will be the 43rd manager to print a deal in 2022 when it finally clears. That’s a big number, both as a proportion of the European manager universe (just this side of 60 I think?) and as, well, an absolute number of deals to come to market. Some managers printed three transactions!

Given that the market has been somewhere between bad and worse for most of the year and the dealflow has kept coming, what conclusions can we draw about next year?

Is the CLO market effectively unkillable? New issue volumes aren’t even really down on long-term averages. Is the market like Monty Python’s Black Knight, limbless and bleeding but still shouting defiance? Tis but a scratch!

The market has a reason to exist, and fulfils its ecosystem role (providing term leverage against leveraged loan portfolios) very handily. Maybe that ensures its survival on a five or 10 year horizon (Europe saw five years between 2008 and the dawn of the 2.0 era with the Cairn deal in 2013).

But over the next one-to-three years, the market depends (like every other market) on the allocation of equity capital.

In this respect, there’s reason to feel optimistic. Lots of the equity capital allocated to CLOs is “sticky” — risk retention funds, specific CLO strategies, specialists in warehouse equity, specialists in control equity, long-term partnerships to print CLOs, capitalisation of new CLO businesses. Sometimes these funds will prefer secondary and sometimes single-B over new issue equity, but they’re sticking around. They’re staffed with CLO specialists and they’ve raised money to do CLOs.

Hard to unpick the numbers, but I think much more of the market’s equity capital falls into these categories than into an opportunistic bucket — money which comes into CLO equity and out again when there’s something else compelling (private debt? special sits? Distressed?) to attract attention.

Long term, all money has to come from somewhere and multiple years of rubbish CLO equity returns at a time when, say, distressed funds are knocking it out of the park will hamper fundraising. LPs won’t show up forever. But the stickiness has some distance left to run, so there’s still time for a CLO uptick.

One can split the market into at least five distinct manager categories — most of which point towards doing deals whatever the weather.

1 — All AUM is good AUM

The subsidiaries of big alt asset managers have plenty of capital, and those firms generally seem to like the idea of investing in leveraged loans. Here’s Ares and here’s KKR for a flavour. Of course, all asset management “research” has a tendency to conclude that whatever the current fundraising strategy happens to be is Good and Right and Profitable, but maybe there’s something in it?

Better to get capital deployed, get loans under management and figure out the economics of the capital structure later. Print now and refi later.

2 — Print to prove a point

If you’ve just started a CLO business, or expanded to Europe, or hired people or allocated capital to it, you need to issue CLOs.

Maybe they aren’t the CLOs you want to issue, maybe they aren’t going to shoot the lights out, maybe the term structure isn’t ideal, maybe you got hauled over the coals on docs…..but regardless, CLOs need to happen. If you’re below three deals or so, you’re in the startup phase and you need a steady cushion of fees from a handful of CLOs under management just to balance the books. Validate the business model, for a certain value of “validate”.

3 — Print when there’s a window

Maybe you’ve got a triple-A in at attractive levels, maybe loans look cheap, maybe there’s a nice book of ready to ramp loans sitting on a trading book somewhere, maybe the stars have aligned in some other way. If you’ve got some optionality, pre-existing warehouses, pre-positioned collateral, you can try to be nimble in a market like 2022 and jump in selectively.

4 — Print because it’s been too long

As far as we’ve heard, arranging banks have been pretty chill about their CLO warehouse exposures, despite the long hangover since the Russian invasion of Ukraine. That makes sense — even if warehouse docs allow banks to force their clients to market or to liquidation, it’s not good business to get that kind of reputation. Roll over and keep the relationship. Still, at some point everyone’s (equity, manager, arranger) patience will run out. Squeeze out a static, hit the market bid, do whatever you need to clear out the optimistic end-2021 warehouses. It’s nearly 2023; nobody needs these facilities hanging around.

5 — Don’t print

Why would you, the market has been terrible and excess spread / arb is at multi-year lows? A manager like Fair Oaks, which was an equity fund first and a CLO manager second, has probably seen much better opportunities this year in secondary equity than in staking its own potential new issues. And hence no transaction since November 2021.

Anyway, it doesn’t seem like there’s much of a catalyst for all this to change.

Tis the season for CLO Outlook pieces. Barclays jumped early with a note on November 4 estimating €25bn for 2023, and we’ve seen Bank of America this week with a slightly more modest call of €22bn (€3bn of reset / refi thrown in for fun).

A statistic that jumped out from the BofA piece is ratio of European CLO outstanding to leveraged loans in the ELLI — essentially, a big picture proxy for the supply-demand imbalance in European leveraged finance.

According to BofA, this is now at 73%, compared to 68% in December 2021 — the highest level since the restart of the European CLO market in 2013.

That’s a brutal fact for CLO arbitrage going forwards….whatever clever liability structures or targeted placement approaches can be made to cut the cost of the CLO capital stack, there are simply too many euros chasing too few leveraged loans.

Haircut this ratio even further in practice, since it’s unlikely CLOs are going to be actively chasing the 4.6% of the ELLI which is triple-C rated, and there’s likely to be caution around the 20% that’s B- rated, given the inbound recession.

The leveraged loan market is showing some signs of health this week — Ekaterra, one of the year’s biggest overhangs in Europe, is now cleared (albeit at 82, gulp), and banks have even begun chipping away at their forced TLA exposures (KronosNet is now out with an add-on for this purpose).

But that’s a long way from a fully firing new issue LBO market pumping new supply into the syndicated market. Direct lenders are sniffing around some of the largest situations in the forward pipeline, and will win at least some of the meagre supply coming down the tracks. The balance will take a long time to bring back….

Bad marks

We talked a few weeks back about Intrum’s big writedown on its joint NPL venture with Intesa Sanpaolo, Project Savoy. We were cautiously advancing the theory that this portfolio might be a pretty good indicator for broader conditions and valuations in Italian NPLs — it’s geographically diverse, massive, and Intesa is a solid originator. Solid originator of NPLs sounds like an insult, but it’s unlikely that Intesa will have some idiosyncratic issue that makes Intesa loans drastically worse than market.

Judging by the time of the original announcement (11pm on a Friday), Intrum’s finance team must have been pushed into updating the market at that time, but even then they warned that more trouble was coming, saying that “any sale to a third party of the stake in the Italian SPV currently held by Intrum’s co-investor would be considered as objective evidence and could potentially lead to a further adjustment of the book value”

CarVal was a minority co-investor with Intrum, and did not announce that it was looking to exit, but we surmised that this was likely — it’s been in the position since 2018 and it was probably time to realise.

CarVal’s sale triggered the next round of writedowns, a further SEK 4.3bn (€384m) off the last Intrum mark. The CarVal sale (of 37.5% in the jointly managed Italian SPV holding 95% of the portfolio) came in at SEK 109m (€9.98m)....which is pretty savage. Intrum’s remaining 62.5% is therefore marked at around €17m.

That’s pretty punishing — the portfolio was a massive €10.8bn gross book value when it was sold, and valued at €3.1bn in total. Intrum’s end was initially €1.43bn.

But most of this was borrowed through a GACS (government-wrapped) securitisation, in a vehicle called Penelope SPV. Leverage will tend to maximise your downside!

Penelope is a sequential pay deal with €750m of the senior tranche left and €143m in the class B….and so, according to Intrum, no cashflows are coming to the junior until at least 2025.

CarVal evidently doesn’t want to hang around and wait.

The presence of the Penelope financing also stopped Intrum itself exercising its option to buy out CarVal, which would presumably have been at a slightly more attractive level, in line with Intrum’s own revaluation in September.

Intrum boss Andres Rubio said: “We did not acquire the stake as the senior secured debt attached to the underlying portfolio was not compatible with restrictions on our balance sheet. Consolidation or acquisition would have led to an increase in our aggregate debt load, but we are hearing loud and clear that this is not what the market wants us to do, we want to remain on our deleveraging path.”

Another highlight (not from Intrum’s perspective!) of the release was the cost of unwinding a derivative transaction with CarVal, which appears, from the outside, to be a contract of truly face-ripping savagery — Intrum has paid SEK1bn (€92m) to get out of it.

Intrum described it as a “clean up obligation to buy out [CarVal] at a formulaic price in the future.”

This was struck at “a different time, with different macro conditions and different macro expectations”......but to be clear, CarVal sold its actual exposure for €10m or so, and made NINE TIMES THAT FIGURE letting Intrum out of its future cleanup obligations.

Reassuringly, Intrum told investors that the new co-investment contract doesn’t have this kind of embedded option, and nor do any of its other JVs.

Well done CarVal, I guess, for protecting its own downside so comprehensively.

The actual investor taking over CarVal’s stake is “Kistefos”. Nope, me neither, but a quick google shows it’s basically the family office of Norwegian billionaire Christen Sveaas. The team slides show no particular NPL or loan portfolio expertise, and most of the disclosed investments are of a mid-market PE or VC  nature, with a bias to Nordics.

This isn’t entirely without precedent — Geveran, the family office of John Fredriksen, another Nordic businessman, has a big stake in Axactor, a Nordic debt collector which competes with Intrum. Why should he be the only billionaire that gets a look in?

But presumably the auction was competitive — CarVal likes money — and it is noteworthy that this family office won rather than, say, Fortress, Cerberus, Pimco, Bain Capital or DK.

Exercise for the reader — what does the NPL investing universe look like if everyone re-marks their securitised Italian GACS (state-guaranteed) NPL books by a similar proportion?

Closing time

The end of the year is a strange sort of time. Those with risk that don’t want it are keen to ship; those who usually buy risk are keen to close books. It’s a time of unusual bargains, private placements, side deals and all manner of house cleaning ahead of year end balance sheet dates.

That’s not the case in the SRT market, of course, which is driven by bank balance sheet considerations, and tends to see its busiest period in the run-up to year end, as banks and their advisers scramble to lock down transactions before December 31.

We’re interested in how pricing holds up in this busier and more liquid environment; one theory cautiously advanced but the excessively tight risk transfer market as other risk assets slid in the spring was that a couple of new dedicated SRT funds (M&G and Chenavari) were out there trying to get deployed in a market without a lot of dealflow.

The number of issuers accessing SRT capital has grown fairly swiftly, and the deal sizes and asset classes used by established banks have also increased….potentially at a pace that runs ahead of SRT fundraising by the buyside, despite the aforementioned new funds (Pemberton has also been on the funding trail this year).

It’s a private market of course, but Santander has kindly given us a level for Motor 2022-1, an auto loan-backed SRT deal for Santander Consumer (UK), which it has got rated by Moody’s and KBRA, presumably suggesting a slightly different marketing effort from the usual bilateral SRT distribution.

This happens to be 1475 bps on the £30m class D, attaching and detaching at 1.5-6.5% of the portfolio, and 725 bps on the £24m 6.5%-10.5% class C. Consumer assets aren’t always a great benchmark for the broader SRT space, since they attract interest from the sorts of regular securitisation funds that buy cash residuals and stake forward flow — so the competition can be a little keener than in the more off-the-run SRT asset classes.

That’s wide compared to the equivalent deal in 2021 — at 900 bps and 300 bps respectively — and a widening that’s roughly in line with other subordinated exposures in the structured credit universe. CLO single Bs aren’t a close comp, but they were also printing at 900 bps-950 bps at the back end of last year, and are now somewhere in the mid 1400s range (but no longer printing very much at all in primary).

Perhaps the SRT repricing is now fully underway?

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