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CMA
January 13, 2017  

Deutsche, Citi, KKR Mapping L-Shape Deal

Deutsche Bank, Citigroup and KKR are working on what could be the first commercial MBS deal to use the “L-shape” option under new risk-retention rules.

The three shops are “well on their way” to agreeing to terms, according to a person familiar with the matter. The conduit transaction (CD 2017-CD3) could surface within several weeks.

Meanwhile, as previously reported, Goldman Sachs and Rialto Capital are also weighing whether to use the L-shape on a pending conduit offering (GSMS 2017-GS5).

CMBS issuers initially focused on the two other permitted structures for risk retention, but interest in the L-shape option has mushroomed over the past couple of months. Some market pros now think it could become the preferred way to comply with the rules, at least initially.

The regulations require CMBS issuers to keep “skin in the game” by retaining long-term exposure to 5% of their deals. They can hold a vertical bond strip consisting of 5% of each class, a horizontal strip at the bottom 5% of the capital stack, or an L-shape strip that combines the other two options. An issuer also has the option of passing off all or part of the retention responsibility to a B-piece buyer, which must retain a horizontal strip or the bottom portion of the L-shape strip. For a conduit transaction, the risk must effectively be retained for the life of the deal under any scenario.

In the CD3 transaction, Deutsche and Citi would hold the vertical component of the L-shaped piece — likely equal to about 2% of each class. KKR, a B-piece investor, would take down the horizontal 3% strip at the bottom of the capital stack (except for the 2% sliver of that piece retained by Deutsche and Citi).

Likewise, in the GS5 deal, Goldman would hold the vertical portion of the L-shape strip, and Rialto would hold the junior 3%. However, it’s still possible that Goldman might use a different option, retaining a 5% strip itself.

Being the first to market would carry some bragging rights. It’s unclear which offering might come first.

In the second half of last year, three conduit issuers conducted test runs of the vertical-strip option, both to iron out the mechanics and to get an indication of whether investors would pay up for bonds floated by lenders willing to “eat their own cooking.” The deals generally fared well at pricing.

But issuers ran into problems with the horizontal-strip and L-shape options. They are insisting that B-piece buyers guarantee they will fulfill the risk-retention responsibilities. But issuers and B-piece buyers have had a hard time agreeing to mutually acceptable indemnifications.

Deutsche, Citi and KKR evidently are making progress on that point. It may be that KKR’s size and clout as an investment firm allows it to skirt one of the tougher parts of that dispute. To ensure that B-piece buyers have enough heft, issuers want a purchase to make up no more than one-third of the assets of the acquiring entity — typically a fund operated by a B-piece shop. “So if you want to buy the $30 million horizontal piece of an L-shape deal, that means you need to have another $60 million of assets in that fund. I guess for KKR that’s not an issue. But if you’re setting up a brand new fund that only has commitments at this point, then you might have a problem.”

The L-shape option is attractive to both issuers and B-piece buyers because it limits the amount of junior bonds subject to the long-term hold requirement. A horizontal risk-retention piece must amount to 5% of a deal’s proceeds. That could extend from the unrated class up to the triple-B notes — all subject to the long-term hold. But with the smaller 3% B-piece under the L-shape option, issuers could sell the triple-B notes in the open market at higher prices, and B-piece buyers would not be required to hold the lower-yielding triple-B paper.

Some believe the L-shape structure will appeal to investment-grade bond buyers because, on the one hand, issuers will keep some skin in the game by retaining the vertical strip and, on the other hand, a significant slug of junior bonds subject to the first losses on the collateral pool will be retained by a B-piece buyer. By contrast, with the 5% vertical option, an issuer retains a much smaller amount of below-investment-grade bonds.

There was some talk that an upcoming deal led by Barclays and UBS might also use the L-shape option, with Rialto buying the junior bonds. But it turns out that transaction will use the vertical option. Rialto will serve as retaining sponsor and hold a 5% vertical strip. It will also buy the 95% chunk of the below-investment-grade bonds that aren’t subject to the hold requirement.

The buzz is that Rialto plans to put financing on some of the senior retained bonds. The rules allow for recourse financing to be used on the vertical structure.