SRTs (significant risk transfers) are a rapidly growing market allowing banks to hedge parts of their loan portfolios, by selling off the junior risk to a fund. Using a credit default swap, financial guarantee or insurance contract, banks are protected against a tranche of initial losses, and can then claim capital relief from their supervisors, cutting the costs of holding these portfolios without transferring the loans themselves.

These can reference any class of debt obligations, from mortgages to project finance, ship loans or commercial real estate, but corporate lending is common, both investment grade credit lines and leveraged finance or middle-market lending.

In leveraged lending and sponsor financing particularly, transfer restrictions have been tightening, with features like restrictive whitelists increasingly prominent. These have heavily affected trading and restructuring processes in cases such as GenesisCare and Accell.

The purpose behind these lists is to give sponsors control of who their ultimate lenders are, and specifically, to exclude distressed debt and loan-to-own specialists for as long as possible (whitelists typically fall away following a material event of default, but not before, and the definition of default can vary).

Transfer restrictions can also cover sub-participations, a common structure allowing a fund to assume the economic risk and responsibilities associated with owning a loan, but without becoming a lender of record as far as the loan agent is concerned. Transfer restrictions may differ depending on whether the sub-participation brings voting rights, or not.

The use of sub-participations is particularly common when banks seek to transfer risk on revolving credit facilities, which are more rarely traded than TLBs and where a bank wants to demonstrate its commitment to a sponsor relationship (by remaining lender of record).

Ambiguities in the language, though, can potentially restrict these facilities from inclusion in an SRT trade, since these give the end-investor some kind of risk participation in the loan. No physical transfer takes place, but the drafting is too woolly to rely on.

That’s unlikely to have been the intention behind the inclusion of this language; sponsors generally have no problem with banks actively managing their balance sheet and using a variety of hedging and capital management techniques.

But they may have simply opted for the best docs available in the market at the time, with the greatest flexibility for themselves and greatest limitations on their lenders. 

The LMA has started working on ways to solve this problem. The LMA ran a Credit Risk Insurance & Significant Risk Transfer event for the first time in September 2024, discussing this rapidly growing market.

The event was closed to media, but the organisation wrote up key takeaways from the sessions, noting challenges included “liquidity bottlenecks created by restrictive provisions in (often leveraged) loan documentation, impacting both information disclosure and asset transferability. These latter issues are caused, however, at a much earlier stage in the loan life cycle by borrowers and sponsors unable to see their relative importance as drivers of liquidity”.

Disclosure and confidentiality, as the LMA notes, can also constitute a problem for the SRT market. Investors in leveraged loan SRTs typically want to go line-by-line and assess individual credit exposures in a deal (in contrast to mortgage or SME SRTs, where a statistical approach is more common). But disclosure provisions allowing information to be passed to lenders of record can be too restrictive to encompass potential end-SRT investors, forcing them to look elsewhere for the relevant information on their leveraged finance exposures.

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