Moral fibre ABS

CLO investors lose money, fibre ABS draws closer, and Balbec buys a UK bridging lender

Transcript

SPEAKER_01 0:06

Hello and welcome to another fine matter. I'm George Smith, local capitalist securitisation editor, and I'm joined by only one Tom this week, Thomas Hopkins, our CL Reporter. Hello.

SPEAKER_00 0:17

Hi there, George. How are you doing?

SPEAKER_01 0:19

I'm very well, and it's good to have you back on another fine mass.

SPEAKER_00 0:22

Yes, well, I was in Scotland last week. You're currently in Scotland, and I'm wishing I was still in Scotland because it is horrifically hot in London. And uh yeah, I think basically most people in sort of the southeast of England have just been in a terrible mood all week because of the horrendous heat. But yeah, so I'm very envious of you still you know of you being in Scotland.

SPEAKER_01 0:43

Yes, I'm feeling very smart. I mean I did actually do it tactically. I got on the first tube on or the first train on Tuesday morning when I saw the red alert. And um as we record this on Friday, I'm getting the train back this evening, so I've pretty much avoided the red alert.

SPEAKER_00 1:00

Yes, it it it will be a shock to the system though, I think even just one evening. But yeah, you are fortunate in that the heat wave is uh set to end this weekend, so you've missed most of it.

SPEAKER_01 1:10

Yes, indeed, indeed. Um let's talk about the the market. CLOs have sort of kept taking away, haven't they, since since Global ABS, a few more deals printing this week, at least I think I've seen.

SPEAKER_00 1:23

Yes, in fact, so it was quite a slow start to the week. Um, but sort of later on we've actually had quite a few. Um so I mean at the start of the week we had a refinancing um of sort of harvest CLO32, and then sort of moving on a bit, we yeah, we we've had um a new issue from Bridge Point, you know, we've also had a Capital Four reset, we've had sort of OCP uh Euro CLO 2017 refinancing, and then sort of yesterday evening there were sort of three um new issue deals that came through Reading Ridge, Palmer Square, and sort of ICG. So it's actually been it was as I say a slow start to the week, but it's really kind of picked up. Um and certainly from what I'm hearing from the market, you know, while we haven't got spreads that are say at 2020 levels, they are still reasonably tight by the standards of the last few years and are almost back to sort of pre-w Iran war levels, not quite, but almost, and there's a lot of positivity in the market, and so it seems to be moving at quite a quite a pace, really.

SPEAKER_01 2:29

Well, that's all good news that there's positivity in the market despite the topic of your weekly story, which I understand. Exactly, yes. I'm not allowed to call it a default, but some tranche buying investors have lost some of their principal for the first time since the financial crisis. Is that the legal way to phrase it?

SPEAKER_00 2:54

Yes, yeah, exactly. We have to be we have to be careful, in fact, not to call this a default because there was no technical default on the uh on the tranche in question. I want to make that quite clear. Uh that's how we've described it. But uh, but yes, what we have seen is the first impairment to a CLO liability tranche in the CLO 2.0 era. Uh, that obviously dates back to sort of 2013 when CLOs were relaunched after the financial crisis. So this is kind of the first impairment really since you know um the GFC. But there were impairments to, uh and this is only in Europe, I have to make very clear as well, because we have seen impairments to some US CLO liability tranches uh since the GFC. There were also impairments in the CLO 1.0 era in um in Europe, which was obviously sort of before and sort of including the financial crisis, uh, but this is the first time it's happened. So, in the sort of the 13 years of the of the new CLO product that was kind of launched after the financial crisis in Europe, um, it's happened. And the deal in question was the Bain Capital Euro CLO 2018-1 deal, is obviously managed by Bain Capital Credit, and the impairment happened on the class F notes. You know, in CLO land, we often refer to things by uh their rating because you know, when they're when the CLOs are issued, you know, you'll you'll sort of reuse that rating to refer to the particular tranch. It's a little bit more complicated here because the class F notes were originally the single B's, but by the time the impairment happened, they'd been downgraded a couple of times by Fitch. And so, yeah, we're sort of calling them the class F's, but you can think of them as kind of the single B tranch, so the lowest tranche kind of at the bottom of the capital stack in you know, in terms of CLO liabilities. So, yes, George, essentially you're right. So there was kind of essentially the note holders received a kind of lower sort of principal kind of payout than they would have done. So they kind of consented. Uh so when the deal was called, essentially, the the an agreement was reached with the note holders, and they received 7.4 million euros instead of the full par amount of 11.2, and they did consent to sort of lowering this sort of par, but it's a sort of outstanding principle balance, which made calling the deal possible because generally in CLO documentation, if you're going to call a deal, you know, you have to be able to sort of re repay all the outstanding balance and interest as part of that. So kind of calling the deal was sort of made possible by this uh agreement being reached with no holders, but because it was reached, you know, and and the and the balance was lowered, there was no technical event of default uh because they had agreed to that and that's uh and that that's what they'd received. So so yes, but it is still an impairment in the sense that investors did not receive the full original par balance of the notes.

SPEAKER_01 5:49

So what's already gone gone wrong here then? Because presumably nobody this isn't the outcome anyone would have wanted.

SPEAKER_00 5:56

Exactly. It really has a lot to do with the kind of deterioration of the CLO's collateral pool sort of over kind of a number of years. So uh a source close to the deal did tell me that one thing was that the the CLO had sort of a meaningful exposure to mid-cap issuers, uh, and the source kind of identified this as a key issue of Bain's strategy at the time. The source did note, though, that uh Bain has now changed this strategy and has sort of shifted to kind of more diverse and liquid portfolios. Additionally, though, you know, it's sort of this is a deal that obviously was first priced in 2018, and so it's gone through a number of things like, you know, the the pandemic and the war in Ukraine, the Iran war, which has been rather a shock to many CLO's kind of collateral pools. But then the most important thing I think to consider is that this deal exited reinvestment in 2022 and has kept running since then. Now, the longer you keep a deal out of reinvestment, you know, you don't call it or reset it, the more likely you are to end up with kind of par losses in your portfolio and a kind of just a deteriorating, weakening portfolio because inevitably over time any CLO will pick up kind of lower quality credits. And, you know, if you're going to keep a deal running after its formal reinvestment period, you have to keep meeting the CCC and OC tests, meaning that basically your your share of CCC rated assets can't exceed 7.5% of your portfolio. And so to keep the CCC threshold lower than that, if you're just continuing to run the deal after reinvestment, you have to keep selling triple C assets, and you often have to sell these at a discount, and that doesn't raise enough to replace them with higher quality assets, so you get a deteriorating portfolio. You will also accumulate some defaults over time. So there was some strategy-specific factors with the with the CLO about um, you know, where where it had been invested in sort of the mid-carechases, there was some macro level shocks, and then there was just the fact that this deal was kept running for so long after reinvestment. Almost any deal will eventually start to get to a point where it has accumulated, as I say, lower quality credits if you haven't had like a fresh equity injection to clean up the portfolio, as you would if you reset the deal. And ultimately, then when looking to call the deal, I think it became clear that if the assets in the portfolio were sold, it was kind of unlikely that the sale of all the assets would repay the notes in full, and that's sort of where the impairment kind of you know comes about in the end.

SPEAKER_01 8:38

Is isn't it quite standard practice in the CLO market to just reset deals once they get kind of towards the end of reinvestment or just after like what happened here? Why was there no reset?

SPEAKER_00 8:48

So yes, you're quite right. Most managers will reset a deal within kind of nine to twelve months of reinvestment ending. The reasons for this is, well, A, it's quite complicated to keep a deal running after reinvestment, as we've just sort of noted. Secondly, when the reinvestment period ends, you you know, if you don't manage to meet certain conditions, like those tests we were mentioning, amortization can start. And if amortization starts, the AAA's are paid down first and the cost of capital in the CLO goes up. So most managers don't keep deals running for ages and ages after reinvestment. They will sort of reset them or call them within about nine to twelve months. But the reason that this deal was kept running, it seems to have a lot to do with the fact that Bain did not hold the majority of the equity in the deal. This was held by sort of third-party investors. Now it's very important to note that third-party investors, if they hold the majority of the CLO's equity, they control really when the deal is called or reset. So Bain didn't really have any control over that. Uh, in fact, I know from a source, you know, with sort of familiar with the matter, that Bain tried to call the deal last year and the majority equity decided against this. But there are also reasons why it would have appeared quite attractive for the third-party equity investors to keep this deal running, because like a lot of deals in 2018, it priced with incredibly tight spreads. I mean, the triple A's had a spread of 78 basis points. I mean, now you're talking sort of mid-120s for triple A's. Uh, similarly, the transactions single B's, the tranch that eventually was impaired, um, had a spread of just 629 basis points. Most marriages are not getting anything sort of far below 800 at the moment. So these incredibly tight spreads would have, I think, made for quite an attractive arbitrage. And ultimately the arbitrage funds cash on cash distributions to equity. So at no point was there really much of an incentive to sort of accept higher spreads and a lower arbitrage by resetting the deal from the third-party equity investor perspective. So it may have been attractive for them just to keep the deal running and running and running and getting these quite healthy cash distribution cash-on-cash distributions, even though eventually when the deal's called, I mean, it you know, it's it's sort of very it's quite unlikely that they will receive anything from the event eventually calling the deal on the basis that you know, if the single bee tranche is impaired, it's very unlikely equity gets anything because equity is below the single bees in the waterfall. But it's it's an interesting illustration of how in some ways the interests of the note holders and the interests of the third-party equity investors were a little bit different. And you know, the deal, I think, was called now rather than being reset. You know, that this may have been because ultimately, you know, the third-party equity would have had to in the third-party equity investor would have had to put in quite a lot of capital, you know, in in sort of additional equity to reset the deal. And it may have just been more attractive to just call the deal and invest somewhere else or in a in a in a new deal rather than you know reset it. So there were sort of specific circumstances I think that may have led keeping the deal running to look a bit attractive to third-party equity.

SPEAKER_01 12:06

Yeah, that is interesting. People talk quite a bit, you know, NCLOs about having equity and debt in the same vehicle kind of can create tension, but it's it's very interesting to have this practical example of kind of how that can play out.

SPEAKER_00 12:20

Well, exactly. You know, I mean I think like to some extent, you know, equity and debt can have an alignment of interests because neither of them really want lots and lots of defaults in a portfolio, generally speaking, because it does affect both of them potentially. But in this specific instance, when you had those really tight spreads, you know, it may have been attractive to keep the deal running for third-party equity, even though that that was sort of ended up posing a risk to the note holders.

SPEAKER_01 12:48

Yes. Um then I guess you know that this presumably has something then to do with this vintage where the liability spreads were so tight. Um, and presumably there's at least kind of a few other deals out there in a sort of vaguely similar position to this one. Do you think this is something that investors should be thinking about or worried about by the by what's played out here?

SPEAKER_00 13:08

Yeah, I mean I certainly, and from some conversations with investors that I've had, you know, there does seem to be at least a little bit of a change in sentiment about CLOs, but I would say it's a little change, because you know, I think it will give them pause, but I mean, one has to remember that this was one impairment to one CLO liability tranche, you know, because obviously all none of the other tranches in the Bain deal were impaired, it was just those class Aps. So this is one impairment to one CLO liability tranche in 13 years. That's not the worst track record, really. Uh, and it was sort of in some ways bound to happen eventually. But yes, I think investors may be a little bit more wary now of deals that have been left out of reinvestment for a long time, particularly when those deals, you know, have the sort of very tight spreads, like the 2018 deals. I think if you look at so that there are about near there are nearly 40 deals that are rated by Fitch that have been out of reinvestment since 2024 or earlier. Now, obviously, it's very important to say that many, or indeed probably most of these deals, will just be reset or called completely successfully and you know, with no issues. But I think investors might just think a little bit more carefully about deals that have been out of reinvestment for quite a long time because it just means that you're just a little bit more likely to have this sort of slowly deteriorating collateral pull. And if that is the case, you know, you know, unless the manager or equity investor decides to reset the deal, there could be an issue if if you call the deal. And so that's probably something to be aware of. I I think another thing maybe that they might think about is also kind of whether or not the manager sort of has control of the equity in the deal. I mean, say what you like about sort of captive equity funds, but um, you know, which we've discussed at some length on this on this podcast, and you know, at least if the manager does sort of have a controlling stake, they can intervene to reset or call the deal. I mean, they don't have to, but ultimately there's sometimes that you know there can be a little bit more of a kind of alignment of interest there in the sense that I think few managers really want their deals to record impairments. I mean, it doesn't mean it's impossible, obviously, but you know, they do at least kind of have the ability to intervene. Whereas, you know, in in if you have third-party equity controlling the deal that doesn't want to reset or call, you you can have your hands tied a little bit as a manager, and uh this can obviously you know make an impairment a little bit more likely. So, yeah, I mean in short, I would say I think it's very unlikely we're gonna see a wave of impairments to CLO liability tranches, but also I think it would be you know wrong to say that this Baying deal is you know is going to be completely unique and there could not be any other examples that might come along. So it's certainly something that investors will think about, but I don't think it's gonna provoke a radical change in their kind of confidence in the sort of CLO 2.0 product.

SPEAKER_01 16:10

Well, your story on the impairment is called Bane Impairment Shines Light on CLO Liability Investor Risk, and that is on the website for subscribers. And there are more of your exact thoughts about what to make of all this, which is and this one is is free for all, so do give it a read. First Euro CLO impairment since GFC is a wake-up call for investors.

SPEAKER_00 16:33

Yes, indeed. I've uh argued that essentially that uh the reason that the investors are paid the sort of juicy spreads you might get paid on a uh on a single B CLO note is precisely because there are actually very real risks. Um but yes, please do give that a read on our website if you're if you're interested. But George, uh, we should talk now about the ABS markets. Do you want to give us a little sort of flavor of what's been going on in the market this week?

SPEAKER_01 16:58

Yeah, so in the absence of Tom on uh Wednesday, Thursday, and today Friday, I've I've had to uh try to keep track of things. There's a deal out from Ford Bank, which is a more sporadic issue, but I think it does price quite tightly, at least when I was looking through our asset-backed monitor at its um at its past transactions. Other than that, you've got kind of various deals now drawing towards the finish line. So Paratus had a bite let RMBS that I think was priced on Thursday afternoon. Um and United for with its French consumer loan deal also priced Thursday afternoon and Hadock. Um I wrote in the another fine mes column at the start of this week that I thought one of the interesting things is both Paratus and uh Hadock had STS stamps for the first time. So clearly something that issuers are at least taking more of an interest in and thinking about whether they can they can get that on their deals. The big transaction of the week was obviously that one Tom spoke about last week, the Roth C securitization of HSBC mortgages. Uh we're recording fairly early on Friday and it's not yet priced, so we'll have to keep an eye out for that. It'll probably be done by the time this podcast goes on air.

SPEAKER_00 18:16

Yes, I did like Tom's initial story on that deal precisely because he used uh a sort of a photograph of the story that sort of had the cricket, basically, which is sort of sponsored, I think, by Roth is the test cricket that's going on right now. So uh it's nice to see cricket making its way into global capital. But uh George, you have been sort of very industrious in producing um a couple of uh very interesting uh articles over the last couple of days, almost sort of two kind of weekly length pieces. But I think one of the things you've been writing about is uh sort European fiber securitisation and you know whether or not we're going to see most of that. I mean you've uh you sort of said that it could arrive within within about 18 months. I mean, why do you think we haven't seen fibre securitization really in in Europe yet?

SPEAKER_01 19:09

I mean, you used to be a uh project finance reporter, so I guess you're probably partly to blame. Uh I think Europe has just a very deep kind of bank lending market, um, is one thing. So there's there's just not like as much pressure to like find kind of capital market solutions to financing fiber as as there might be without that that bank finance market. And then the other thing is just the kind of maturity of the networks and like whether I mean securitization, you you need like a sort of stabilized long-term cash flow that the rating agency can get its head around and investors can get comfortable with. And so you can't really finance any capex, you can't really like deal with networks where there's a lot of kind of customer churn or anything like that. So it's sort of a question of like A, there's a lot of bank money, and B, there's not that many suitable assets yet, although more and more are kind of reaching that point of maturity.

SPEAKER_00 20:09

Yes, I mean I do remember from you know my my project finance days of long ago that ultimately this fiber rollout in Europe hasn't actually been going for all that long. I mean, we we started seeing fiber project financings, I think sort of 2019, 2020, and you know, a lot of these deals, I think, you know, that that was project financed initially, you know, sort of had like five-year maturities, and then there was a view that these would be kind of refinanced through the capital markets, potentially, I think, through, you know, the sort of ABS structures. But ultimately, I think some of as you say, some of the some of this might still be kind of working its way through the system. I mean, just in terms of like a stable cash flow and and raising agents being able to get comfortable. I mean, did you sense from talking to the market that you know that that fiber just kind of isn't really there yet in Europe, that there are sort of risks that raising agencies or you know investors might be very seriously concerned about if they try to do a fiber securitisation?

SPEAKER_01 21:08

I think it's a bit case by case. So these are likely to have the like as we've seen in the European data center securitization market to kind of copy the US structure of having like a very long final maturity and like a a post-ARD like cash sweep basically to amortize the the principal balance, but be like soft bullet basically maturity to say five years of the anticipated repayment date, which is ARD. That's a US thing. I think we tend to call it the first optional repayment date in the European market, but the even the use of the term ARD suggests the kind of US influences on this market. So for that you you need to sort of be able to say thirty years into the future, like people will still want to pay for my fiber. Um and you generally won't have them like tied into a lease or or tied into a deal for thirty years like you know, consumers, I think you can only tie in for two years in in most of Europe. And businesses, again, like you probably yeah, that is also the credit quality of the of the business that you have tied in for if even if you have tied them in for 30 years, which is unlikely. So you need to be kind of confident that your fibre is going to be able to be re sort of leased or re another deal will will be able to be done for you to supply fibre to the same kind of premises.

SPEAKER_00 22:26

Yeah, we've also seen some issues with sort of an abundance of competition between fibre developers. You know the UK is particularly falling foul of that.

SPEAKER_01 22:35

I think you were saying in some of the conversations you were having that people are rather skeptical of the UK market particularly because you you have quite a lot of risk of of churn between different companies and just of uh of almost of this some of this infrastructure being kind of overbuilt with different developers carving up almost street by street in bits of London it feels like yeah overbuilt came up a lot I think uh I think the UK and Germany are the two jurisdictions particularly in the fibre to the home like retail market basically where there's less regulation and there and there's been a lot of kind of immediate like speedy construction which which means as you say if there's a lot of churn then that just makes it difficult for the rating agencies to get comfortable and presumably investors as well. So yeah you need to find suitable assets and and it it may be that they don't come from certain markets.

SPEAKER_00 23:25

How advanced is fiber securitization in the US? Because often with securitization we see a trend emerge in the US and then eventually it comes to Europe.

SPEAKER_01 23:33

I mean I think that's starting to happen with data centers for example but is the US kind of way ahead of Europe on this or yes uh it it's accelerating now I mean I think last year there was quite like a sort of roughly three times growth in the market. It's kind of similar to the the data centers. That's the one for 144A market uh which is like the public US securitization market. I think it's similar to what we saw with data centers where like a couple of deals were done and then a few more deals were done and then suddenly like wow everyone's doing this. And this year I think we'll be big again. From what I've heard and and the conversations I've had with Chad who's our US ABS reporter like the data center deals are if anything like performing slightly kind of sluggishly now compared to the fiber deals where people are enthusiastically still still kind of participating for the diversification from data centers.

SPEAKER_00 24:27

And so it would it would seem that in the US they've managed to sort of establish areas where you have kind of a reasonable kind of amount of penetration of the sort of fiber network to a sort of quite a large area that that kind of provides a stable kind of cash flow essentially over a over a long time. Is this sort of been the case for some of the US deals which has made them sort of able to move forward or do you think there are other any other factors that mean that the US is sort of ahead of Europe on this?

SPEAKER_01 24:58

I think that's right. I mean at least a good part of it is like having suitable assets. And then the other component is just that US capital markets are like a lot deeper and US investors are like more kind of willing to to do kind of deals where there's a bit more of an underwrite but the investor base is much bigger and then therefore like that there's more people willing to look at it and establish the market and then also to take down the kind of scale of deal like it like US data center and fibre securitization has come to be like an extremely substantial part of the whole total US securitisation market now. Whereas like it's hard to believe that European securitisation in its current form would be able to support like a dramatic increase in the total size of them of the market. Although obviously regulatory efforts are ongoing to to change things.

SPEAKER_00 25:45

Of course um well that story I which I absolutely commend to you know global capital readers it is available to global capital subscribers it is called first european fiber securitization could arrive within 18 months so do do give that a read but Georgia as I said earlier you have been you you seem to have worked very very hard yesterday and produced um another story of considerable length and this is about Baalbeck um sort of buying funding 365 do you want to tell us a little bit about the you know that acquisition yeah I've worked far too hard um this is I think this is the story of the week if you're in the kind of specialist lending market.

SPEAKER_01 26:28

So funding 365 is a is a UK bridging lender. Baalbeck is a big US um alternative asset manager I guess with a focus on kind of real estate of of some description. They're a big big issuer of US R and BS they hit they you know they have assets they securitize in the US and they've done a couple of deals in Europe um there was the Spanish RPL deal that we also I assume talked about on this podcast but I wrote a story about that as well last year. But this is I think at least one of the first times that I can recall them buying a lender and I guess what's interesting about this is it comes you know the UK bridging sector has not had the most joyful time in the last few months since Market Financial Solutions which was a competitor I suppose collapsed in in February.

SPEAKER_00 27:21

Exactly and I mean I I know this might not sort of apply directly to this specific acquisition but I think you've sort of said somewhere in the story that you know there might be a kind of window of opportunity if some of these sort of smaller kind of specialist lenders don't have access to the same funding lines that they might once have had sort of following MFS. Is that right?

SPEAKER_01 27:43

Yeah so this was sort of the talk of Barcelona that banks are sort of retreating from lending to small specialist lenders um in the wake of the of what's happened with MFS. I think yeah in theory if you're a big fund with uh like lots of relationships with the banks it kind of makes sense that you could buy one of these lenders and use that relationship to kind of extend their funding right while others may be struggling but but to be clear if it it's maybe just a happy coincidence if anything for for Baalback here like they they've been interested in in bridging in the UK for a long time and and we're looking to get into this space already so it's you know prior prior to the collapse of of MFS. So it shouldn't be read as like an opportunistic trade from Baalbeck it's it's clearly a her sector they have kind of conviction about um it's just if anything a kind of if anything kind of helpful that the situation with MFS has played out.

SPEAKER_00 28:42

Why do you think we don't see more of these acquisitions of some of these sort of specialist lenders you know particularly given that you know that some of some of the assets they hold are kind of very popular and are kind of fought over. I think you you might logically ask well why isn't there just some buying up of the various lenders because that would give you access to the the the the assets they hold.

SPEAKER_01 29:02

Yeah this is a this is a great question. This is the question I think in the um in the asset financing market at the moment like as you say the the the market for assets the forward flow market is very competitive but then like seemingly the sort of MA market for specialist lenders is is much more subdued. And people have been sort of saying there's there's this trade where you literally just buy a lender and that gives you kind of proprietary access for your funds to the assets and I think that is definitely part of the motivation for Powerback here to get those those assets kind of flowing into their funds. And we have seen a few other deals um for specialist lenders KKR bought New Day and Cerberus bought Lend Co recently again we we can't be sure of those of the motivations for those transactions but one would have thought at least partly it's it's together the asset flow.

SPEAKER_00 29:57

It's part of the challenge here that you know some of these funds don't actually have mandates to buy up you know lenders.

SPEAKER_01 30:04

Yeah I think that's exactly the challenge like the the mandate flexibility question like you know a lot of the shops that have done it successfully are like big private credit and private equity shops where they can buy from one arm the the the lender and from another arm like buy the assets and then that kind of works in tandem but that's not the case for um for Baoback like as I say I think this is the first game I can recall of them buying a European lender. I had luck on company's house and the the owner of funding 365 or at least owns the more than 75% of shares is is Baobek Capital Limited which to me it doesn't look like a fund so it's perhaps they've they've just bought it directly.

SPEAKER_00 30:47

Well thank you very much George and I do commend that article to listeners it is called Baalbeck buys funding 365 as banks look to fund sponsor packed lenders and if you want to find out a bit more about the possibility of public bridging securitizations in the article you should definitely give it a read. It is available on the Global Capital site to global capital subscribers.

SPEAKER_01 31:09

And with that we shall say thank you very much for listening and goodbye.

SPEAKER_00 31:13

Goodbye