Half of Issuers Retaining Single-Borrower Risk
In a surprising development, issuers held on to the risk-retention portions of half of the single-borrower offerings that priced from January to June, instead of selling the bonds to high-yield investors.
Many observers had expected the 5% retention slice of such deals to find strong investor demand, especially from insurance companies. But for the 22 transactions during the first six months under the new regulations, dealers handed off the risk-retention responsibility to third parties only 11 times.
“It took a lot of people by surprise,” said one Wall Street lender. “Everybody had expected this to be this straightforward lifeco trade, but it didn’t turn out that way.”
The reason? A combination of thin yields and complicated sales contracts, which require buyers to indemnify issuers from losses if the buyers are later found to have violated the retention rules.
“It has become too difficult to try to sell a retention strip on a lot of these deals,” groused one senior lender. “The lawyers mucked it up. And there’s no way to fix it. The majority of these strips are going to continue to be [held by the dealers].”
In the first half, issuers addressed risk retention in one of two ways — either by retaining bonds themselves (typically 5% of each class) or by selling the junior 5% of the deal structure (a “horizontal strip”) to an investor.
The 11 horizontal strips sold in the first half generally range in grade from single-B to double-B. Five carry fixed rates and in most cases have weighted average lives of 7-10 years. Five carry floating rates and have weighted average lives of 2-3 years. And one was divided into fixed- and floating-rate tranches.
The yield hovered around 6% on the fixed-rate strips and Libor plus 600 bp (or roughly 7% initially) on the floating-rate strips. Those were disappointing levels for investors that had expected yields to reach the high single digits or low double digits, according to a handful of pros.
“There were guys who went out and started raising funds to buy these bonds, but the returns came up short,” said one sellsider. “There was a disconnect between what they had promised to their investors and what they could actually deliver.” Such fund shops were forced to move to the sidelines, he said.
The returns are roughly in line with yields on mezzanine loans backed by institutional-quality real estate, which usually attract a mix of insurers, pension funds and sovereign-wealth investors. A big difference is that buyers of retention bonds are required to hold them for the long term.
The horizontal strips were acquired by Prima Capital (four), Blackstone (two), Oxford Properties (two), BlackRock (one), Oaktree Capital (one) and Square Mile Capital (one).
Notably absent were insurers. “If we’re going to try to get yields like that, it’s easier to just go and get mezz — and the mezz is liquid,” said one insurance executive.
For some, the indemnifications required by issuers were a stumbling block. Generally, issuers want the retention buyer to have a minimum amount of assets under management, including a prescribed amount that can’t be subject to any liquidity restrictions.
“They want to know that you have enough assets that they can get at to compensate them for whatever losses you cause them if you break the rules and get caught,” said one investor.
It’s unclear if a significant proportion of issuers will continue to take on the risk-retention portions of their single-borrower transactions, which are backed by one or more large loans on real estate with an individual owner. Some dealers said they could keep doing so indefinitely. “We’ll continue on the way we’ve been going, and it’s no big deal,” said one.
Others said that investors will probably resume fund raising with lower yield goals and surface as retention buyers later this year or next year. “The market will catch up to raising the right money for this, and you’ll start to see more [third-party] trades in the future,” predicted one investor.