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Banks have the money

JP Morgan and Quilam Capital announced their joint venture a couple of weeks back, but in my view it didn’t get the attention it deserved. Quilam is very well known in UK specialty finance circles but it’s not got the headline-grabbing potential of an Apollo or a Blackstone.

But it might be one of the most significant developments in European asset-backed markets this year. It has the potential to reshape the financing landscape for specialty lenders, turbocharge Quilam’s fortunes, and fire up the pipeline for the JPM securitised products group.

The deal looks like this: Quilam lends asset-based corporate loans to fintechs, going down to “stretch-senior” advance rates, for tickets sizes of roughly £50m to £250m. These are sold into a securitisation vehicle in which JP Morgan is the senior noteholder, leaving Quilam with effectively mezz exposure.

It’s crucial that these are recourse loans backed by assets, and not securitisations — otherwise this would be a resecuritisation and everyone would be in big trouble. But avoiding securitisation treatment is a positive benefit for a smaller fintech, many of which lack the regulatory appetite to get involved in even a private securitisation, and may also lack a permanent funding or capital markets function. They want money to be able to lend, with minimum brain damage.

JP Morgan gets to lend potentially large amounts of money (the facility has “multi-billion” ambitions) to a client base which might otherwise be too small for JPM to bank, but which has attractive risk-reward characteristics.

When a lender becomes big enough, or has the regulatory appetite, it can refinance out into a private or public securitisation, and one particular American bank will already be familiar with the assets, business, processes, underwriting and have a very warm intro to the management team. It’s an incubator for the future JPM pipeline as well as a nice facility to deploy today.

Quilam, meanwhile, gets another tool in its specialty finance toolkit. Much of the firm’s business currently takes place deep down in the capital structure, in the form of growth debt, 100% advance rate facilities with warrants attached, equity stakes and mezz credit. Adding senior debt with the JP Morgan firepower behind it means smaller lenders, somewhat underserved today, get access to the monster balance sheet of one of the world’s biggest banks.

Quilam portcos are significant clients across the asset-based world; consider Raylo’s facility with NatWest, or Updraft’s forward flow with Jefferies (financed by Santander) or Momenta Finance’s senior facility with Barclays, or ThinCats (up for sale) with Citi and Barclays, or many many more.

But Quilam itself has not had the cost of capital to serve specialty finance companies as a senior lender itself before.

Below the investment bank-sized facilities, the funding universe shrinks. Few of the big securitisation shops have the cost base to lend tickets of £50m at a time, though some (such as NatWest) have made a bit of a niche in financing earlier stage companies.

At this kind of size in the UK, the dominant players are certain of the challenger banks, such as OakNorth, Paragon Bank, Aldermore or Shawbrook, the alma mater of the Quilam co-founders. A few funds also play here, for example BCI Capital or Foresight.

It is in theory possible for a fund to write a senior facility, then use back-leverage in turn to fund it, giving an economically similar exposure to that which will be delivered by the new JV — but this is much harder to execute, and the Quilam-JPM tie-up is designed around ease of execution.

The idea is for Quilam to do much of the origination, including the hard yards of data cleaning, diligence, negotiation and structuring, while JPM will shadow-underwrite the transactions and provide senior funding.

The securitisation facility presumably has some hard-wired eligibility criteria, but the alignment goes beyond this; there are template termsheets and agreements and extensive discussion between the firms, the idea being that it’s absolutely clear to Quilam and its potential clients what can be offered.

We think this is very cool, for a couple of reasons.

First, it reworks the traditional arrangements in financial services.

From 38,000 ft, there are some analogies to the Atlas SP Partners deals — essentially, Atlas SP Partners (the old Credit Suisse SPG unit) writes warehouse facilities at more aggressive advance rates and more flexible terms than most traditional investment banks or commercial banks can manage, funding this up to 90% with great slugs of fund-finance type money from those same banks.

The banks get to lend a lot of money at spreads they find attractive, without doing much of the heavy lifting on origination; Atlas is left with a mezz-like exposure and the actual client relationships.

The legal mechanics are the other way around to that of Quilam-JPM. In the Atlas trades, the underlying assets are securitisations while the leverage is basically in fund finance format (now increasingly in bonds), while in Quilam the underlying assets are corporate loans and the leverage is a securitisation.

There are now dozens of different private credit-bank partnerships across different asset classes. Some of these are deconsolidation trades or portfolio sales press-released to look more attractive, others are genuine ongoing business partnerships. Others are in-between.

There are sound bank-capital reasons for this, but there are also economic and cultural reasons behind it.

If a firm is an entity to minimise internal transaction costs, investment banks are a particularly odd beast. They are generally designed to have quite high transaction costs associated with working with different divisions, and even at a well-run place like JP Morgan, there will no doubt be perennial internal fights about revenue attribution.

In any sub-division of an investment bank’s business, there may well be more natural affinity between the bankers inside the division and a separate private credit fund focused on the same area.

A corporate private credit fund will generally be staffed by professionals who cut their teeth in the leveraged finance division of an investment bank; infrastructure debt funds tend to be staffed by former infra bankers. Same story in CRE, aviation, specialty lending and everything else. They talk the same language and think about credit the same way.

The transaction costs and cooperation across the boundaries of the investment bank may very well be better than the transaction costs and cooperation across an investment bank’s different divisions. Maybe it is better to share revenue and slice exposures between a bank and a fund than between LevFin and coverage. Maybe it’s better to outsource origination to a fund with strong alignment of interest than to M&A bankers in the same firm with their own separate P&L and reporting lines.

The second way it’s interesting is because it rewires the competitive landscape in the UK. Quilam might be hunting smaller facilities than the mainstream clients for securitisation businesses, but high-growth fintechs taking asset-based loans are the securitisation clients of tomorrow. It’s not like they will all end up funnelled to JP Morgan once they’re at scale, but it’s undoubtedly an arrangement which benefits both sides.

Quilam is targeting double headcount and has already moved into new premises, and has received commitments from backer InterVest for the new strategy. It may not win deals on pure price against commercial bank balance sheet money, but that’s only one element in the competitive picture for this market segment, and being able to speak for size in a quick and flexible manner is a huge advantage.

The first deal is already on the board — Reward Funding raised a £360m debt package, of which £150m is from Quilam/JPM, alongside a £100m traditional private securitisation from Deutsche Bank, and £110m in new funding lines from Foresight and RMB.

We’d expect the structure to be quickly copied. Just as in corporate private credit there’s been a whirlwind of partnerships signed, how many funds or serious securitisation banks can afford to be a wallflower?

Credit funds will want a bank partner that can be flexible, sizeable and efficient, while banks will want partners that share their risk appetite and approach to origination. Let the matchmaking begin!

Hopcroft or notcroft?

Last month, UK SME lender Funding Circle's share price took a 20% dive, on the back of an article in The Times about a court case. Fans of the efficient markets hypothesis should note that there was nothing really new in it; the hard info was that a judge in a 2024 court case had said that it was worth proceeding to full trial, which will come sometime this year.

The case concerned two directors of a company in voluntary liquidation, which had borrowed from Funding Circle.

When the loan went bad it was sold to Elliott-backed unit Azzuro Associates, which went to court to enforce the personal guarantees given by the directors. This personal guarantee is essential to Funding Circle's business model, and indeed to much small balance SME lending; absolutely nobody is building DCF models and EBITDA forecasts for cake shops, plumbers and market stalls.

The defence offered by the directors concerns assignability of the guarantee; to what extent can this travel with the loan?

The legal technology here is not usually complicated: a guarantee is usually made for the benefit of the lender or its successors in title or assignment. Assign the loans, guarantee follows, not a problem.

But even if it’s well understood, there might be hiccups along the way. If “lender” is badly defined, or the terms of the guarantee aren’t well drafted, this seamless mechanism might be interrupted.

The worst (but very unlikely) case is that there’s some broader issue with assignment of guarantees, which would be a huge and terrifying result for SME lending in general and securitisation of SME lending in particular. Non-bank structures of any kind don't work properly if the guarantees aren't designed in such a way that they can follow the loans to wherever they do. Portfolios cannot trade or be financed, NPL sales don't work, the market grinds to a halt.

If there has been a Funding Circle-specific screwup, the question goes to how extensive it is. Is it a specific portfolio of seasoned FC loans, or the whole FC origination universe?

The firm is a major client in securitised products, the originator of the only true SME ABS shelf in the UK (Capital on Tap is SME credit cards) and sells loans to various top tier firms, including Waterfall Asset Management, sponsor of the SBOLT securitisations, Angelo Gordon and Barclays, who have a joint forward flow, and Bayview Asset Management.

These are smart people with good legal teams and more than a passing familiarity with guarantee structures (who have doubtless reviewed the loan terms again as the court details dribbled out). If they’re confident, there’s probably little to worry about in the front book.

Pulling the trigger

My colleague Celeste continues her deep dive into the details of SRT transactions with a story about JP Morgan’s Valeria SRT deal and the collapse of French IT services group Atos.

Negotiations over triggers and loss determinations are the very heart of the SRT product; anyone with the right analytics software can take a view on default correlations across a portfolio of loans, but finer points of structuring come to the fore in figuring out exactly what a workout or loss determination looks like and how this translates into an SRT deal.

Anyway, loss determinations in the JP Morgan transaction started from the relatively unusual (but more transparent) point of the public CDS auction for contracts referencing Atos, though this loss determination (which came out at 3 cents, or 97% loss), was likely modified further by the SRT documents.

Where a public CDS market exists, it’s an attractive starting point because it takes loss determination entirely out of the hands of the bank in question.

If we skate over the long history of hedge funds manipulating auctions to benefit their own positions, the auction mechanic provides a transparent open forum to clear the market for a potentially illiquid distressed credit and light on a final price.

Everyone can see what happened, it’s right there on the internet, unambiguous.

It isn’t necessarily a perfect match for SRT transactions though. Public CDS auctions are geared to price around the “cheapest to deliver” debt obligation of said credit — the CDS payout is supposed to match the expected loss on the cheapest eligible instrument, which will generally be unsecured debt, rather than the bank loans or RCFs usually referenced in an SRT transaction.

CDS auctions might also be triggered earlier in the lifecycle of a debt restructuring than is strictly desirable. CDS contracts expire, so some protection buyers have an incentive to get moving and ask the question to the Determinations Committee, triggering the auction process. In Atos, for example, the Credit Event date was considered to be July 18 2024, when the company entered the court’s accelerated safeguard procedure. The auction took place in October, but the restructuring wasn’t fully baked until 19 December.

SRT investors, who might have a five or seven-year position, might be better served by waiting, though of a course the bank buying protection might prefer a quicker outcome.

Other methods of determining loss, such as bank estimates of LGD, are more open to challenge and less objective, or might require truing up later on in the lifetime of the deal. On the other hand, they might give better recoveries.

It’s not like one approach is better than another — it’s a commercial negotiation, with different triggers serving different interests, and it isn’t even obvious a priori which approach yields better (for which party?) results.

Large cap restructurings almost never look like a clean writedown of debt principal, which is easiest for CDS contracts and SRTs alike to handle. Instead, they’re some mishmash of early bird, consent fees, reinstated debt, extra liens, PIK facilities, new money participations and equitisation.

As these plans start to swirl, the pricing of existing debt reflects not only the economic value of the company and potential for repayment, but the opportunity to benefit from the economics associated with the workout. CDS outcomes depend on the trading of illiquid, potentially locked-up instruments; SRT outcomes depend on a bank’s workout approach and restructuring decision tree.

But we think it’s an interesting approach — especially as more multi-asset credit funds become active in SRT markets. These funds might be exposed to distressed credits in multiple formats. Maybe they have loans, bonds, credit indices (or tranches), credit options, inventory financings, working capital lending as well as SRTs. Pure play SRT funds would have no truck with any of this.

If a fund has multiple exposures, it may also have an interest in consistency of recoveries, and consistency of hedging. Other funds might be playing the relative value between index tranches, packaged single name CDS and SRT transactions; for this to work properly, there needs to be some connection between the products, and a public trigger is one way to tie it together.

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