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Inside the IG factory

We think manufacturing risk for insurers is pretty much the biggest thing in credit now (here’s me on a podcast discussing it with DealCatalyst’s Todd Anderson). It was also much discussed at Opal’s Private Credit and ABF forum on Monday this week, with fund finance and private credit CLOs operating as two routes to basically the same destination.

Insurers (especially lifers) want lots of duration, and are happy to harvest any complexity and liquidity premium that’s available, as long as they can get something investment grade. UK and EU insurers have the additional layer of complexity provided by the matching adjustment, which provides substantial capital benefits for insurers if they invest in instruments with fixed cashflows which can be ‘matched’ to insurer liabilities.

Corporate private credit is a promising raw material to work with, since it starts off with plenty of yield (incorporating plenty of illiquidity premium), and it’s hard to access in off the shelf format.

But there’s an unusually wide range of formats available.

Private credit CLOs haven’t really taken off yet in Europe (at least in publicly rated format) — only Barings and Ares have issued so far, but these were both deals structured to insurance-friendly format. Golub Capital, a massive middle market CLO issuer in the US, has launched a long-dated dollar CLO with four times the normal call protection.

Outside the public market, insurers may be able to take participations in bank-provided private credit leverage facilities, or even offer these directly.

If CLO structures don’t work, there’s fund finance.

Rated feeder structures are a way to get direct fund participation in rated, insurer-friendly format, and have been growing rapidly — though some investors, especially those used to a robust CLO document, find the flexibility granted to fund managers to be distasteful.

Private equity, private credit or other asset classes are available according to taste and risk appetite. Insurers could also participate in NAV lending (which kind of looks like a private credit CLO) or packaged fund stakes in CFO format.

These instruments all have different legal and regulatory advantages, but the big structuring lift is figuring out maturity transformation. Corporate private credit takes its cue from the syndicated loan market, with limited call protection and floating rates — which ideally needs reworking into long-dated fixed rate format for maximum insurer appeal.

This in turn introduces originator risk — to manufacture a long-dated exposure out of a portfolio of private credit assets means relying on the fund manager / originator to keep writing new private credit loans as old deals are refinanced out. Stepping back one layer can help; secondaries funds spread the originator risk over more institutions, while financing long-dated continuation vehicles can also help extend the lifetime of the insurer investments.

The other way to manufacture investment grade, insurance-friendly transactions is just to lend to IG companies — an increasingly popular and lucrative activity being heavily promoted by all of the big alternative asset managers, led by Apollo.

We dived into this trend and some deal structures this week, since the real essence of these trades is that they’re generally accounted as equity by the ultimate ‘borrowers’. Apollo or its peers generally buys into a joint venture or SPV, which might contain a chip fabrication plant, an air miles programme, a pipeline, a port, some real estate exposures.

The alternative asset managers then lever their stake in the joint venture, carving out a suitable investment grade instrument (rated privately) for their captive insurers and other lenders. This is debt, but it’s not an obligation of company receiving the money; it’s not on-balance, there’s no cross-defaults or cross-collateralisations.

It’s not totally clear what will happen if and when these deals go wrong. The retranching process is no doubt robust, even if it’s carried on in private, and clearly satisfies the rating agencies providing the private ratings. But will the debt holder (a captive insurer) be willing to enforce security when the equity holder is an affiliate?

Proving a negative

The FCA unveiled its consultation on motor commission compensation on Tuesday, with headline numbers that were more or less in line with where it guided; immediately after the Supreme Court decision it gave a range of £9bn-£18bn, noting that £18bn seemed high and in the middle was more likely; on Tuesday it estimated £8.2bn in redress payments (based on 85% take-up of the scheme) with a £2.8bn cost to implement, for £11bn total.

If you want to know the broad background, read this and this, if you want a thorough legal rundown look here, and if you want to know the actual mechanics of the compensation scheme, the FCA has you covered here.

The Supreme Court and the FCA decision are widely seen as bringing some relief to the industry, giving certainty and allowing business planning and wholesale funding to start firing again. Certainty is good (though it’s just a consultation, nothing is officially settled etc etc) but this is still a heavy blow for the industry.

The largest provision in the industry is Lloyds for Black Horse, at £1.2bn.

The big players, such as Lloyds, Santander and the captives, can absorb the pain. It’s unwelcome, but big UK banks are used to being cash cows and coughing up for past misdemeanours, and have the capital base to absorb it.

More worrisome is the smaller players. The FCA highlighted the risks to these firms in its announcement of the scheme, saying: “We have heard concerns about the impact of paying redress on non-bank, non-captive lenders focused on non-prime markets.”

It said “Access to funding for such non-prime lenders had been a challenge even before the motor finance commissions issue became prominent” (this might come as a surprise to anyone who’s been in a bunfight trying to lend them some private mezz) but the difficulty these players will have with the scheme is that they must demonstrate they did not do various categories of unfair lending which give rise to compensation.

The three behaviours giving rise to a compensation claim are high commissions (over 35% of total credit cost or 10% of loan), unfair relationship (such as a contractual tie giving right of first refusal), or discretionary commission, banned from 2021 in any case.

Per the FCA, “some non-prime lenders have told us they did not engage in discretionary commission or tied arrangements. If that is the case, they are less likely to have to pay redress under the scheme.

That would apply to, for example, Oodle, the largest non-bank issuer of auto ABS in the UK market, which did not use discretionary commission, but there’s still some difficulty in proving it.

Lenders can rebut the presumption of unfairness if they can show there was evidence of adequate disclosure of commission, or, if there was a discretionary commission, if they can prove that the broker selected the lowest rate at which they would not have made any additional commission, or if they can provide evidence that the consumer was sufficiently sophisticated to be aware of the arrangement.

There’s also another potential get-out down the road:

“These lenders may also be able to rebut the presumption of loss or damage proposed at the liability assessment stage if they have clear evidence that the consumer would not have secured a better offer from any other lender the broker had arrangements with at the time of the transaction. If the presumption of loss or damage is rebutted, the lender would not have to pay any redress to the consumer.”

Having clear evidence that the consumer would not have secured a better offer from any other lender the broker had arrangements with at the time of the transaction sounds difficult.

Most lenders have good understandings of the product offers of their competitors. But it’s quite a step from “we know roughly where a competitor would lend for this kind of business” to “clear evidence”, and it’s still potentially very administratively burdensome to get there.

If the FCA’s basic assumptions hold, 25% of the total cost to lenders is likely to be implementation (£2.8bn out of £11bn). A significant portion of this cost is likely to be incurred early, handling and assessing complaints and managing customer communications, and would therefore be incurred by firms irrespective of whether they actually did any of the bad things.

Highly levered specialist lenders who only do auto finance don’t necessarily have the capacity to absorb this kind of burden. They run lean, don’t have a big capital base, and they’re fighting for margin. Even if they have to clear potential mezz lenders off the doorstep every morning when they come in, that doesn’t mean funding is actually abundant; their equity capital source is PE or VC money with high return targets.

Don’t worry though, the regulator is on it:

While these non-prime lenders represent a small share of the overall motor finance market, we will remain vigilant to the effect on them as the consultation progresses and as we make final rules.

Ambassador, you’re spoiling us

After a decade with only one non-bank credit card master trust issuing in Europe, that total has DOUBLED and is set to TREBLE, as Capital on Tap launches the first term issue from its London Cards Master Issuer vehicle, and Jaja Finance puts together Falcon Master Issuer to handle its own asset-backed activities (the vehicle was originally filed at Companies House in April, but according to Jaja’s accounts, this arrangement, as well as revising its existing warehouse facility, is expected to complete early October).

It’s generally reckoned the best way to fund a credit card issuer, whether bank or non-bank; the point of the master trust construction is to manage the revolving balances which are an inherent feature of the credit card product, and it’s always going to be awkward to jam this into a standalone term deal (you need some kind of VFN feature to absorb the variability, which sit better consolidated into a master trust rather than spread across standalone transactions).

The ideal format is one funding platform which handles public and private funding alike, or, if the collateral is sufficiently different, funding platforms distinguished by product rather than by issuance format. NewDay Funding and NewDay Partnership Funding is the paradigmatic example (and I guess the only example, being the only UK non-bank credit card master trust issuer for a decade).

So it’s not surprising that other credit card firms have adopted the technology, but it’s taken a while to get there.

Scale is one obstacle. The ideal master trust has staggered maturities / amortisation, smoothing repayments. That means the collateral pool has to be large enough to support multiple term transactions and private facilities, as well as absorb volatility. There just aren’t that many non-bank credit card issuers with that kind of portfolio.

Time and effort is another. Startup lenders run lean, and treasury teams are generally focused on solving today’s problems. A master trust is the ideal solution, but it’s not the easiest or cheapest to deliver right now. The lead time is long for structuring and legals, a panel of banks must be recruited, and even then it won’t hit maximum efficiency with the first deal.

Still Capital on Tap has built a very impressive business. Plenty of firms do small business lending, in a variety of formats. But very few do business credit card lending, though it’s hard to see why not on the basis of these figures; yields are in NewDay Funding territory, with charge-offs in NewDay Partnership Funding territory. For the avoidance of doubt, that is a very good thing.

A lot of this gross yield comes from interchange fees. Unlike consumer credit cards, where these are capped, in business credit cards they can be generous (unless you’re a retailer), allowing a healthy rewards programme for business owners as well as substantial interchange making up for the relatively high proportion of borrowers paying no actual interest.

This gives rise to the deal’s main structural tweak vs NewDay — given legal uncertainties over the treatment of interchange fees, CoT is wearing the risk, and selling receivables into the structure at a discount to create “synthetic interchange”.

There’d be a rich irony if, just as CoT comes out and Jaja fires up, NewDay shut down after the KKR portfolio acquisition. Happily, though, as we discussed a couple of weeks back, KKR is planning to keep the structures in place and indeed, expand lending wherever possible.

We think there must be some extra leverage in the background though. NewDay’s only HY bond has now been called, but surely KKR isn’t going to settle for a structure that’s less levered than Cinven and CVC. Capital on Tap has a corporate facility with Blue Owl / Atalaya, at the time one of the largest private mezz pieces offered in Europe. KKR isn’t buying the company, so can’t do a combo corporate/mezz structure with no corporate underlying, but perhaps it can raise a massive chunk of mezz elsewhere.

Crossing the Ts

Even if Trump family crypto schemes are apparently A-ok, some corners of the financial markets are still focused on crossing the Ts of US regulation, and nowhere is it more important than for SRTs.

Regulation has always driven SRT issuance and structures — banks are motivated to do deals because of their regulatory capital requirements, and generally need to colour within the regulatory lines to actually claim the benefits.

This has historically dampened issuance in the US market. There’s an awkward patchwork of banking regulators (Fed, FDIC and OCC plus the states) with slightly different preferences and approval approaches. There’s also an awkward treatment of derivative structures. Superficially similar structures can end up as either security-based swaps under SEC jurisdiction or commodity pool swaps under CFTC jurisdiction, triggering the Dodd-Frank ‘commodity pool operator’ status, which you don’t want to trigger.

The really big moving target has been the actual level of required capital, with the Basel Endgame proposals delayed (but now on by year-end). With plenty of deregulatory mood music playing around Washington, US banks have been unwilling to commit to stepping up their SRT programmes to the kind of levels that would fully prep them for fully loaded Basel. They’ve issued shorter-dated deals and in lower volumes than the Europeans, unclear if they’ll end up overcapitalised under a new regime.

Celeste has an excellent rundown of the main issues in US SRT regulation right now. The industry would like to see a more straightforward regulatory regime, with fewer cooks in the SRT-approving kitchen; this might improve a little, but it’s unlikely to reach the heights of unified efficiency seen in the PRA or ECB’s Single Supervisory Mechanism (both of which are trialling methods to further streamline SRT approvals).

Easing up on the commodity pool operator issue would also help, and there is a potential path forward — an exemption for certain categories of private fund, which was repealed in 2012. That would help not just SRT markets, but a whole range of credit funds, private equity and hedge funds, which may draw more water in Washington than the SRT market.

Also on the wishlist is approval for insurers to provide unfunded protection. Insurers are not currently viewed as eligible guarantors for SRT transactions in the US, for reasons which have a lot to do with the AIG bailout in 2008. A change here could add massively to the US investor base for SRTs, but that’s still arguably a niche issue — don’t expect much in the near term.

Excess Spread is our weekly newsletter, covering trends, deals and more in structured credit and ABS — subscribe to this newsletter here.