New one-tranche structures avoid punitive CMBS capital charges, reports Lauren Parr
Very slowly, structuring in the European debt market is becoming more sophisticated. Eighteen months ago products started to emerge that sit somewhere between straight loan syndications and fully structured CMBS deals, with “a few more being done” today, according to one investor.
The market for this ‘middle product’ is still very new and there is no universally agreed term for it. Some investors call them loan notes, structured notes or pass-through notes. Others – incorrectly – call them single-tranche securitisations.
Their most distinguishing feature is that they are one-tranche deals, so there are no separate classes of subordinated notes. This means they are not defined as securitisations by European regulators.
Splitting loans adds complexity
In the most basic form, a single loan is put into a special-purpose vehicle that issues a single tranche of notes. Additional levels of complexity can be added by splitting whole loans into senior and mezzanine loans, then putting one, or both, into separate SPVs, which each issue a single tranche of notes.
Patrick Janssen, ABS fund manager at M&G Investments, explains: “A £60m loan on a £100m shopping centre, with a 60% loan-to-value ratio, would currently be rated single A. If it were tranched into two pieces of 0-40 and 40-60%, and bonds issued on each, that’s effectively a securitisation.
“In the eyes of regulators, under Solvency II, the bond with a 0-40% LTV ratio all of a sudden becomes a lot more risky than the loan with a 60% LTV ratio. So while risk is actually lower on the bond, you have to hold three to five times more capital against it. It doesn’t make sense.”
But, Janssen adds:“If, instead of a single issue tranched into two classes of notes, you cut a loan in two pieces, with one note referring to one piece of the loan and the other to the other part, it’s not necessarily a securitisation any more. It’s a slight nuance, but you get more sensible capital charges.”
Under Solvency II the capital charge for an institutional investor such as an insurer or pension fund buying and holding a five-
year, triple-A rated CMBS bond is 62.5%, compared to just 15% for loans.
All CMBS falls under what the European Commission calls “type 2” securitisation, against which a 12.5% annual minimum capital ratio must be held. This is many times more expensive to hold than “type 1” (high-quality) securitisations, against which the annual capital ratio can be just 2.1%.
This punitive regulatory treatment of CMBS is one push towards devising new ways of holding real estate debt at lower capital charges.
Mezz issue from JP Morgan
In a classic A/B securitisation structure, typically the senior A debt gets tranched and securitised and the subordinated junior B debt is sold as a loan. But, for example, JP Morgan recently structured a loan note as part of its refinancing of debt secured against the UK Mint Hotel portfolio, owned by Blackstone. In this case, around £95m of mezzanine debt was converted into a single tranche of notes and sold. The senior debt remains a loan.
One issuer says: “The concept works well for mezzanine, as it has a more attractive coupon than senior. There is substantial interest in buying junior exposure and in security form. It ticks the boxes for bond-buying debt funds and hedge funds, which are not constrained by regulatory capital in the same way as banks, for example.”
While one securitisation analyst says a loan note format “is just packaging”, it does get around higher capital charges associated with CMBS and could expand the investor base for structured debt.
Matthew O’Sullivan, M&G’s head of commercial securitisation credit research, says: “Potentially, as loan notes become more common and liquidity is generated in those, they’ll become more attractive to investors.”
Loan notes may take off in the next couple of years, but meanwhile, a potential change in regulations for-high quality securitisations (to be incorporated in Solvency II and Liquidity Coverage Ratios) could cap the capital charge for senior securitisation bonds to the same level as the underlying whole loan.
If CMBS is included, this would make real estate loan notes relatively less attractive from a capital efficiency position.
Loan notes slip out under the rating and marketing radar
The genesis of a real estate loan note is that “it has to be an opportunity not easy to syndicate in the loan market, but where it does not make sense to use CMBS to get it out into the capital markets”, says Matthew O’Sullivan, M&G’s head of commercial securitisation credit research.
“But without regulatory reform to make CMBS capital charges less punitive, loan notes could become the efficient way for capital markets to invest in commercial property.”
Although publicly listed, they are not widely marketed. “Loan notes are under the radar and only pop up once they’re sold,” one issuer says. So far no loan notes have been rated. “For that feature you pay up; investors command a higher spread than on rated products.”
Since deals often comprise small positions in larger loans — perhaps £100m or less — it makes no economic sense to get rating agents involved, given their flat fees and the time and trouble taken over the rating process.
The Mint hotel debt was prime material for this type of issue as hotels are an asset class that does not often feature in European securitisations. “In this case it can be easier to team up with a group of investors that are happy without a rating,” says the issuer.
The £100m Midas Funding UK deal was part of a £330m loan, issued as a single tranche of unrated notes. “The deal looks like a loan syndication, with syndicate members preferring to invest in bonds rather than a loan format,” according to a Bank of America Merrill Lynch research note.
Because of their listed status, loan notes also provide more disclosure than for syndicated senior loan positions. “Some investors prefer to have an instrument with an international securities identification number,” says the issuer. “Particularly for debt funds and hedge funds, it’s about tradability, transparency and better liquidity than loans can provide.”
This makes the product not only attractive to traditional CMBS buyers, but could tap into a new investor base — funds that can only invest in public securities.
“The benefit for both arranging banks and sponsors is that they may get access to a bigger investor base, therefore getting more certainty in execution and better pricing,” says O’Sullivan.
Morgan Stanley issue has the Midas touch
Morgan Stanley has issued £100m of floating-rate notes secured against 10 mainly office properties, including three at St Katherine’s Dock, in a loan note called Midas Funding UK.
The issue is part of a £330m whole loan, with a 69.1% loan-to-value ratio, Morgan Stanley wrote late last year to refinance debt held against assets Blackstone acquired from its purchase of Max Property Group last July.
Knight Frank valued the 1.29m sq ft portfolio, which is 80% let and also includes a few retail and residential assets, at £477.5m last November.
The £100m single tranche of unrated notes, with a 2019 maturity, was priced at 205bps over Libor, which matches the loan margin, according to a BAML analyst’s report.
The notes were listed on the Irish Stock Exchange and do not appear to have been publicly marketed, suggesting the deal was put together for an investor or investors that prefer to hold bonds rather than direct loans.