FFA Blog Day 2: What’s keeping sub lines from the capital markets?

The market is in need of a supply solution, but is it fit for one?

I’m a little late with our blog covering day two of the Fund Finance Association’s Global Fund Finance Symposium in Miami Beach, but there was so much to talk about with market players, it was hard to find time to write! Here goes:

Only a year or so ago, there were anecdotally some 75-80 banks active in the subscription credit line market. Now, the number thrown around last week was 50-60.

Demand is high for sub lines. Sponsors are pursuing all kinds of investment strategies in the new economic environment.

But balance sheet and resource constraints, concentration limits and, generally, higher borrowing costs are causing banks to either hold off on new lending or to concentrate on their most profitable clients – those who draw their lines frequently and/or have lucrative ancillary business with their lenders.

To make matters worse, Basel III reforms (commonly referred to as Basel IV) will further increase risk-weighted asset capital requirements globally systemically important banks. Proposals for US banks are expected in a month or so, according to Wes Misson, partner at Cadwalader, followed by a 60-day comment period. A final implementation date isn’t yet known, but as of now, year-end 2023 appears to be the goal.

Some banks are, according to attendees, turning to non-payment insurance and synthetic risk transfer deals (otherwise known as credit risk transfer deals) to free up balance sheet space and ease concentration limits.

And while insurance companies and other asset managers may be taking down portions of bank syndications themselves (insurance companies are also lending in both the sub line and NAV space, often with attractive terms), freeing up capacity a bit, it is clear that a capital markets solution is needed to satisfy demand and keep the market growing.

“Historically, this was a buy-and-hold product,” one panelist at the Miami event said. “I’ve been hearing a lot about distributing in order to… deploy more capital.”

But what could that solution be? Some banks and law firms are hard at work standardizing their documents as part of a push to make transactions more efficient and, perhaps, take steps toward some form of capital market solution.

Alongside (and depending on the breadth of acceptance of) standardization, the entrance of ratings agencies into the space (Fitch is getting ready to release a methodology for sub line ratings in a matter of weeks, followed by a NAV ratings methodology, according to an employee at the firm) bodes well for a capital market in sub lines.

Perhaps the most obvious solution would be securitization. With the historical performance of the market, one panelist suggested that sub line assets should be priced like prime auto – historically a large securitization market.

This is purely my own speculation, but it seems realistic that banks could pool loans together (in the commercial mortgage-backed securities market, two or more banks sometimes do this), perhaps even including both large, established managers as well as riskier, smaller ones) tranching the debt into different risk profiles. Done right, there should be natural buyers for the senior AAA-rated slices from the likes of insurance companies, pension funds, and Japanese and South Korean buyers active in the CLO market (Norinchukin comes to mind). At the base of the capital stack, hedge funds and credit managers might be the obvious buyers. Although, should the structure take the form of a collateralized loan obligation, the equity piece would need to be juicy enough to attract higher-yield seekers, while spreads at the top would need to remain relatively low.

Banks could then retain a Basel-compliant slice – I believe that still stands a 5 percent of the overall credit risk, either vertical (a piece of ever tranche) or horizontal (taking down a big piece of the AAA slice themselves).

But an array of costs and other complications make the feasibility of that kind of structure unclear. Not all banks need or even want ratings for their sub line debt, and given the low relative yields on the facilities, it may be difficult to find a way to make it worth anyone’s while. Some GPs, funds, and even their LPs may not wish to contribute to the transparency a securitization would require, even for a private deal under SEC rule 144A.

And, of course, correlation risk would need to be considered. After all, private equity stakes, secondaries stakes, leveraged loans, CLOs and now collateralized fund obligations all represent cogs in the global private equity machine.

Meanwhile, other capital markets develop

Private Funds CFO’s Tom Auchterlonie reports from Miami Beach that there is express interest in growing a secondaries market for private credit, though, again, there are hurdles.

And the collateralized fund obligation market appears to be taking off. Some speculated that pension funds may begin issuing this year – a “game changer,” according to one attendee.

And capital regulation of the market for insurance investors, one of the bigger buyers in the CFO market, may not be as onerous as it was once thought to be.

“In the middle of December it was gloom and doom,” said a lawyer on how clients initially reacted to the release of a proposal to regulate insurance holdings of CFOs from the National Association of Insurance Commissioners. However, that feeling has since “dissipated largely,” the lawyer said. In March, the NAIC released an exposure draft that law firm Mayer Brown said could “facilitate rated feeders, CFOs and other structured investments.”

Another lawyer summed up what the proposal entails, saying it affects when and whether CFO notes can be treated as bonds by insurers for reporting and statutory accounting reasons. He said it also covers applicable risk-based capital charges for those bonds.

Another speaker, who works for a large asset manager, predicted the NAIC’s scrutiny will lead to a push to diversify the mix of institutions investing in CFO notes beyond – thus helping the product gain wider traction.

“Because these transactions have largely been siloed with a specific buyer group, it hasn’t exploded as an asset class, right? This is a footnote within the asset-backed securities market globally,” he said.

The NAIC claims it is only going after regulatory arbitrage on the part of insurers. One lawyer clarified that buying a “vertical slice,” or holding multiple tranches in a CFO, gives the same economic benefit as regular fund investing, but with more favorable capital treatment for insurers.

With additional reporting by Tom Auchterlonie.