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Excess Spread is our weekly newsletter, covering trends, deals and more in structured credit and ABF.

I have two small children, and I often struggle to explain to them what I do for a living. Borrowing money they just about get, but tranching leaves them baffled and they are totally uninterested in my tirades about the ever-expanding definition of private credit and the fine-grained distinctions between mortgage trading and forward-flow investing.

So it’s with considerable gratitude that I saw Ares has explained the SRT market in terms of a squirrel gathering nuts for the winter.

Sara the Squirrel stands for a bank, while Kevin the Wise Owl stands for the investor community, its wisdom doubtless reflecting the wisdom of Ares itself.

I showed it to the children, and while the two-year-old simply said: “squirrel”, the six-year-old had more substantive criticisms.

“Daddy,” she said. “Why is the squirrel regulated? Squirrels don’t plant trees except by accident, they bury acorns in order to eat them later? Why are they trading with beavers?”

When I pressed her on her concerns, she had other important comments.

“Don’t owls eat squirrels?” she said. “Why would a respectable asset management firm like Ares implicitly cast itself in the role of predator vis a vis its counterparties? Surely that’s not the message they’d like to convey?”

This is not the only piece of enjoyable content out of the Ares ABF team.

We linked this video before — it tells the story of Alex, who finds she is “connected to the world of ABF in ways she never imagined”.

Squirrels aside, the rest of the SRT paper is actually packed with good info — neat explainers, good data, mostly repackaged from the IACPM, a survey of regulatory and market trends, including the expansion of SRTs into a broader range of asset classes.

As the paper notes, SRT markets demand both innovation and restraint — while that might be true for actually investing, let’s make sure investment writing remains free-wheeling, unconstrained, and full of woodland creatures.

In other woodland news, one UK reperforming loan deal might appear much like another, but under the hood these are deeply complex transactions — as with most reperforming loan transactions, there’s a ton of detail around the servicing and structuring which really matters.

RPL deals generally see servicing stay with the seller, but usually need to solve for deconsolidation treatment, which means convincing accountants and auditors that the loans are really gone.

That in turn means proving that the risks and returns of the assets have been passed off for good, and cannot flow back, and that the selling institution isn’t involved in the ongoing management of the pool (feel free to write in with more scholarly takes, but that’s the basic idea).

So servicing standards have to walk a fine line between a servicing approach that’s basically applicable to front-book performing assets (and treats the struggling borrowers in the RPL pool gently) and a servicing approach which is attractive to potential investors and aligns interests effectively — and walk this tightrope with an eye on solving the accounting conundrum.

For example, potential buyers of a pool of sub-performing assets might want to incentivise servicers to act in their interests by backloading servicing fees such that optimal recoveries on the assets get the servicer the best fee (this might mean fast recoveries or fulsome recoveries, depending on the pool).

But if the design of this fee is too high and too backloaded, the seller/servicer basically ends up exposed to the performance of the pool, so a strict accounting opinion might conclude that it retains risk-reward and should consolidate, negating the whole point of the asset sale. Potential sellers must juggle the price improvement they gain from an attractive servicing structure against the constraints of the accounting rules.

Other servicing tools give rise to other complexities — product switches, transferring eligible borrowers onto a new loan, could be seen as a form of control.

Product switches in general have been on the increase in RMBS, driven in part by rising interest rates; borrowers may not be able or willing to refinance away from their original lender, and lenders want the flexibility to give them a new loan and keep the customer, and fund this through their securitisation shelf.

Lots of the UK non-banks now have 15% buckets for product switches in their deals, and while investors might grumble, they see the rationale. Again, it’s all about the details. If the new loans coming in are much like the original portfolio, it’s easier to swallow the flexibility.

This point in particular marks a big difference between some of the superficially similar portfolios the UK clearing banks have sold down.

Lloyds has a long-running programme of deconsolidation transactions, beginning with 2023’s Bridgegate Funding (a closed book of loans originated by The Mortgage Business), but also taking in Barrow Funding (Bank of Scotland loans from pre-2008), Performer Funding (front book consumer loans) and Valley Funding (Halifax and Birmingham & Midshires loans from 15 years ago).

Santander has done two such exits, and we’ve discussed them already here — they were sold as whole loan books and securitised into Hazel Residential and Frontier Mortgage Funding, sponsored by Morgan Stanley and Bank of America, respectively.

Both are post-crisis books, but Hazel is a little longer in the tooth, being mostly pre-2014 (mortgage market review) origination and Frontier being on average nine years old, and therefore mostly afterwards.

The rationale for these trades is complicated but stress tests and accounting treatment have a lot to do with it — generally these loans are IFRS stage 2 or 3 (which requires credit institutions to take a provision based on their lifetime expected loss). These portfolios are also treated poorly under regulatory stress tests, which basically ask banks to imagine a big macro downturn and report back on how their asset portfolios behave.

Borrowers already struggling to pay their mortgages, in an imagined high-unemployment scenario, might stop paying altogether, so the banks have to take (imaginary) provisions. These provisions feed into pillar 2 capital requirements, and, this week’s news on cutting UK capital requirements notwithstanding, they don’t like holding onto assets which make them look bad.

So it was that NatWest joined the deconsolidation party this year, launching Project Antler, a £2.5bn sale of subperforming mortgages. You’d have read about it here first, naturally. This deal sought to sell down assets which were dinged by IFRS 9 and by regulatory stress testing.

We kind of assumed it was a similar deal to the Santander and Lloyds trades, but it’s actually pretty different under the hood, being mostly subperforming front book portfolio (3.7 years average seasoning) across a smorgasbord of origination categories.

There’s a lot more first-time buyer exposure than average (48%), for example, but these are not clean mortgages — the book has 21% arrears, according to Fitch. The rating agency describes the resultant securitisation, Antler Mortgage Funding 1, as a prime RMBS, noting that origination standards are in line with those of a prime lender, but points out that it is not, in fact, a prime deal.

“The portfolio’s performance is not comparable to that of other prime pools of recently originated collateral rated by Fitch…this portfolio represents a negative selection of NatWest’s mortgage book”.

Still, it matters that it is basically the recently bad stuff from NatWest’s new origination, rather than the skeletons hanging around an old closet labelled “Royal Bank of Scotland”. The cap stacks are pretty different — Antler had 22.13% credit enhancement at triple-A, versus 28.4% for Valley. The Santander-originated deals, Hazel and Frontier, had 12.5% and 11%, respectively.

But back to servicing. How different will servicing behaviour be when a deal contains relatively recent loans rather than older vintages?

The product switch mechanics, certainly, are very different — Antler allows “Retained Product Switch” mortgages to remain in the pool, with the prospectus warning that “Fixed Rate Mortgage Loans which become part of the Mortgage Portfolio after the Closing Date (for the reasons set out earlier in this paragraph): (i) may exhibit lower fixed rates and / or margins compared to the Fixed Rate Mortgage Loans in the Provisional Portfolio; and/or (ii) experience a delay to the reversion to the Seller’s Standard Variable Rate.”

Contrast this with the Lloyds deals, which have a robust stipulation that the seller buys back the loans if there’s a product switch. Valley, Barrow and Bridgegate all state: “In each case, no new Loan will be sold to the issuer” when outlining their product switch mechanics.

In Hazel and Frontier, the two Santander deals: ”For the avoidance of doubt, any new Loan created following the Product Switch shall not form part of the Portfolio sold to Issuer under the Securitisation Mortgage Sale Agreement.”

If there are a lot of product switches offered by any of these UK banks, the Lloyds and Santander deals pay down more quickly than might have been anticipated, and that’s a mostly good thing for investors — the old loan is redeemed out of the pool at par. In Antler, a lot of product switches might mean shrinking yields from the same borrowers.

We’d hazard a guess that this makes the deconsolidation arguments easier, as the issuer takes the loans under a broader range of conditions. Santander and Lloyds presumably have to thread the needle of control while also offering investors a robust buyback commitment if they do offer switches.

Depending on the buyers, this might not matter too much. Investors will always prefer more yield to less yield, but an unlevered buyer might be content with “enough yield”, and appreciate the chance to gain access to assets. For levered buyers, it’s a more serious problem, as their junior positions would be highly sensitive to such changes. Caught on the horns of a dilemma in UK deconsolidation, you might say.

Marta has been writing about the shifting sands of the European servicing landscape, as the sales of two big beasts in Spain and Italy, Hipoges and Zenith, respectively, have just been announced.

This marks the end of an era. KKR bought Hipoges in 2017, when bank asset disposals were at their peak. In the same year, Santander sold a €30bn portfolio, Project Quasar, to Blackstone, and BBVA sold its €12bn real estate business to Cerberus.

At that time, alternative asset managers were furiously snapping up servicing platforms. Blackstone acquired its Aliseda unit as part of the Quasar purchase, KKR acquired Sistemia in Italy, Davidson Kempner agreed to purchase Prelios, Fortress, which had merged Italfondiaro and doBank in 2016, listed the combined business as doValue in Milan. The merger of Intrum and Lindorff, announced in 2016, also closed in that heady year — as did Arrow Global’s takeover of Zenith.

This was really the second wave of servicer acquisitions by alternative asset managers (generally conducted at richer valuations than the first).

In Spain, the first wave might include the following: Apollo bought Altamira from Santander in 2013, while Lone Star bought Neinor from Kutxabank in 2014, rebranding the property development side of the business Neinor Homes and floating it in 2017. Cerberus’s Haya Real Estate platform, sold to Intrum in 2023 after a debt restructuring, was first created from the servicing platform of Bankia in 2013. Blackstone still owns Anticipia, the servicer it carved out of CataluynaCaixa as part of the Project Hercules buyout in 2014.

Throughout this period, the theory was that there was a natural synergy between servicing and asset acquisition. Servicing is by far the largest cost related to NPL investing, and successful follow-through of a servicing plan is crucial to the IRR of any portfolio purchase, and the terms available for any associated financing.

It’s perfectly possible for an investor to buy a portfolio and hire a third party to service it, constructing contracts to make sure interests are aligned and the servicer is incentivised to take decisions which help the investor in question.

But it still involves paying hefty fees out to a third party (and potentially a competitor).

While incentives are partly aligned when the servicer and fund are under one roof, in another respect this sets up a tension — the servicer will increase in value only if it has sufficient assets under management. Feeding the servicing beast adds an incentive to buy portfolios which is separate from the portfolio’s credit characteristics itself.

The new wave of Spanish asset disposals involves much less intensive servicing activity. As Marta also wrote this week, a maturing market skewed more to RPLs (or even performing transactions, as in Santander Residential 1) is a market with a different structure and incentives. Originators generally retain the servicing of RPL portfolios, until a loan hits a specific threshold (somewhere between one and 180 days delinquent, depending on the loan).

Stronger macroeconomic conditions in Spain, and the workout of the first wave(s) of NPLs, have also changed the nature of the primary disposals on offer — less beaten-up CRE and development lending, more impaired mortgages. Servicing the latest wave of asset sales means more payment plans and less enforcement of collateral, a less confrontational (but less lucrative) proposition.

The buyers for Hipoges and Zenith are Pollen Street Capital, via Finsolutia, a smaller competitor, and Astorg-owned IQ-EQ, which is known primary for its corporate services and SPV management businesses.

In neither case is there an obvious NPL buying synergy. Pollen Street’s various business lines include, in theory, NPL investing, and it has several senior staff members with relevant experience, plus investments in German debt collector PAIR Finance and leverage on a book of Italian public sector receivables.

But it hasn’t really shown up around most of the big Spanish processes we’ve come across, despite its broad footprint in financial services equity and credit investing.

IQ-EQ meanwhile isn’t an investor at all. Previous Zenith owner Arrow Global is one of the largest and most successful buyers of bad debt in Europe, and has successfully pivoted from NPL buyer to broad-based private credit shop. IQ-EQ is more about corporate administration (also a business line for Zenith), with expertise in management of fund structures and securitisation SPVs. The actual servicing has much less natural synergy with its acquirer.

Six months ago, DK’s sale of Italian servicer Prelios to ION Group closed, and the group sold its first high-yield bond, offering a chance for us to look at the bigger picture for servicing, and to ask what the future value is for this kind of business. ION is also more of a technology player than a loan buyer (it competes with 9fin through the Acuris group publications).

The big element has to be data. That was part of the rationale for the asset management firms to own servicers. Knowing how thousands of borrowers across dozens of asset classes behaved through decades of credit cycle was and is hugely valuable as an investing tool. Very few of the first-wave asset sales included good quality portfolio data — the firms which could model or proxy it had the best chance of pricing this risk appropriately.

With fewer portfolios up for sale, this data might seem harder to deploy economically.

But the overall business of servicing is ripe for disruption, and the servicing market for consolidation. Servicers have been investing in technology, as all companies have, over their decade or so under the ownership of fund managers. But there’s still a huge number of manual processes which could be streamlined, and enormous capacity to extract further insights from the masses of data held in servicer systems. Servicing certain asset types — lumpy, legally complex CRE NPLs, for example — will still remain fairly manual, but granular asset classes should see further efficiency gains, if servicers can spare the cash for appropriate capex.

In other words, the play now is more like old-fashioned private equity — operational improvements, investments in automation, cost-cutting, streamlining, gross margin improvement — not servicing as an adjunct to distressed debt investing. At the end of this cycle, expect to see fewer, larger servicers, with more technology and better margins.

Big firms set to win ABF fundraising frenzy

Conference firm DealCatalyst has a strong presence in asset-backed markets, with events on SRT, ABF, specialty lending, digital infrastructure, and mortgage finance. They’ve had a few mentions in these pages, and been kind enough to invite me to moderate some of their events lately.

They’ve also used this market reach to dig up some unique data, surveying LPs, GPs and borrowers across the asset-based finance landscape on their allocation, fundraising and borrower ambitions to create the inaugural ABF Capital Flows survey.

DealCatalyst gave 9fin an early look — though see here if you’re interested in digging through it yourself. The survey population included 47 GPs, 33 LPs or allocators, and 48 borrowers or specialty finance platforms, roughly 50:50 Europe/US.

Unsurprisingly given the sample set, it’s pretty bullish on the market in general. 24% of the LP sample intended to allocate more than $1bn to ABF in the next 12 months, and a further 21% between $500m and $1bn. GP ambitions seemingly stretch higher with nearly half of respondents targeting ABF capital in excess of $1bn. AUM, as we sometimes say round here, has a quality all of its own.

The survey finds that two-thirds of LPs intend to allocate only to established managers, with 60% targeting managers with AUM over $1bn, and roughly a third only intending to allocate to firms with AUM over $10bn. Just over 10% of LPs will consider new fund launches.

That roughly matches the anecdotal fundraising evidence we hear. $1bn isn’t a huge AUM bar by any means, but when you’re starting with zero, and fighting fellow startups for attention from only 10% of LPs, it’s a huge barrier to entry.

Other notable data points — only 28% of GPs want to take equity stakes, and just 10% of borrowers are willing to give equity. Perhaps the platforms represented here are more established, or perhaps revealed preferences might play out differently; a genuinely greenfield startup might not want to dilute its early stockholders, but it will give warrants if it’s desperate enough for the institutional funding that will let business accelerate.

Anyway, it’s an interesting snapshot into an undercovered market — take a look!

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