The market for commercial real estate CLOs expands

They may not be as old as houses but commercial real estate CLOs have been around since the early 2000s and, whilst this category of CLO fell out of favor after the crisis, it looks like they are finally back with a vengeance.

2017 was a very good year for CRE CLOs with nearly $9 billion of issuance, and market specialists at the Opal conference in December 2017 predicted significantly higher volume levels in 2018. In 2017, well-known issuers such as Arbor and Prime Finance closed multiple deals and new issuers such as Blackstone Mortgage Trust (BXMT), Greystone, Benefit Street Partners, Hunt Mortgage Group and Ladder Capital launched their first 2.0 deals.

Indeed, BXMT 2017-FL1 was not only the inaugural issue for BXMT but a post crisis record-breaking $1 billion CRE CLO with a portfolio comprising office, multifamily and lodging across 12 U.S. states.

The CREFC conference in Miami in early January was well attended and expectations are that several additional new entrants will enter the market in 2018, with some of those deals already underway, and annual volume expected to reach $12 billion to $14 billion.

TPG Re Finance Trust has begun marketing their $932.4 million debut CRE CLO, and we are assisting with this and with other new entrants. Although static transactions are more common, clients such as Arbor, the most active issuer in the market, have shown that actively managed CRE CLOs are possible and successful.

US CLO Market Review

The volume of issuance in 2017 for the U.S. CLO market far exceeded the predictions that were issued at the end of 2016 when U.S. risk retention rules came into play.

In fact, at $118 billion of new issuance, it was the second highest year since the credit crisis, nudged out of the top spot by the $124 billion issued in 2014.

Fear that risk retention would reduce issuance and lead to a reduced manager field did not materialize. In fact, a number of new managers as well as one new arranger entered the market.

New managers on the broadly syndicated side included Assurant, CBAM, Ellington, Marble Point, NCC, Pacific Asset Management (Pacific Life) and Rockford Tower Capital Management (King Street). Antares and MidCap entered the fray in the middle market space while existing BSL issuers, such as Barings and KCAP, moved into the middle market as well. Other CLO managers launched new CMVs and CMOAs which issued deals.

Amherst Pierpont priced a Z-Capital refi as a debut arranger in December. If you also add in the heady volume of refis and resets we saw in 2017, there was barely time to catch a breath during the usual August and post-Thanksgiving lulls. Deals were even closed between Christmas and New Year in a year-end rush we have not seen the likes of since 2007/8.

A few days into 2018 and the U.S. market kicked off again. By mid-January, early indications and pipelines suggest we are heading into another strong and fast-paced year, with new warehouses closing and both resets and refis, and resets of prior refis and resets, moving ahead. Our pipeline alone shows several managers with three or more warehouses open, lining up their deal flow from the end of last year into the start of 2018.

Below are some of the highlights of 2017:

  • $118 billion from 212 deals compared to $124 billion from 235 deals in 2014 and $72.3 billion across 156 deals in 2016.
  • Refi and reset activity accounted for another $177 billion in issuance from a staggering 335 CLOs, some of these were deals that refinanced and later reset. The numbers broke down at approximately $125 billion in refinancings and $52 billion in resets.
  • AAA pricing started the year at L+130-140 and ended the year at around L+112-120.
    Over 95 managers issued a US CLO (BSL or MM) in 2017.
  • Ares, Carlyle, CIFC, CSAM, GSO/Blackstone, MJX, Octagon and PGIM were the most active managers, each pricing five or more new issue deals apiece.
  • Middle Market issuance at $14 billion reached the highest levels post credit crisis.
  • At the time of writing we estimate that there are about 75-80 warehouses open in the CLO pipeline.

2018 outlook

With the U.S. court ruling in favor of the LSTA4 on Feb. 4 that BSL CLO managers are not subject to risk retention requirements, 2018 is set to be another interesting year.

While U.S. government agencies have 45 days to appeal the case, initial indications coupled with the fact that the Republican government was already broadly in favor of some sort of risk retention relief for CLOs, suggest that the agencies are unlikely to appeal. Whilst this may bring some short-term uncertainty to the CLO market there has certainly been a sigh of relief from smaller CLO managers who have been grappling with risk retention strategies.

For managers who implemented risk retention strategies, it remains to be seen if they will keep their risk retention structures in place. On the one hand these structures lock in longer term capital and provide a pipeline of equity for new deals but, on the other hand, they raise the cost of doing transactions. Whether we see two tiers of manager now emerge – a top tier of managers who still comply with the now defunct risk retention rules and whose cost of funding is slightly cheaper as a consequence, and a second tier of managers who retain very little or no equity and have to pay a slightly higher coupon on the debt they issue – will remain to be seen.

What this means for U.S. and European dual-compliant CLOs is also not yet known. To get a sense of managers’ plans following the ruling, Maples Fiduciary is aiming to carry out a Risk Retention Survey of U.S. CLO Managers – Part III once the time period for appeal has passed.

Risk retention aside, all signs for 2018 point to it being another bullish year with $6 billion from 10 primary issuance transactions being issued in January and over 25 transactions being refinanced or reset. The conservative predictions suggest a year similar to 2017 in terms of volume for both new issue and for resets/refis, although the ratio for the latter category is predicted to flip in favor of resets (60 percent) over refis (40 percent).

BAML project around $110 billion in new issuance and Wells $125 billion, exceeding the 2014 post crisis record year, while others are more conservative predicting less than 2017 at around the $100 billion mark. Morgan Stanley estimates that around $68 billion of CLOs issued between 2013 and 2015 have passed their non-call dates and have yet to refi or reset and, with AAA pricing expected to drop well below 100 bps in 2018, it is not unreasonable to expect many of these deals to take advantage of the market conditions and reset in 2018 off the back of even lower spreads.

The rise of the Korean and Chinese CLO investor base looks set to continue in 2018 with predicted growth in investors from these countries set to expand. If they are not already, these destinations should be key stops for any managers looking to roadshow in Asia.

Ironically, the concern of many market participants in 2017 that risk retention would damage the market and lead to a contraction of managers and investors has proved unfounded. If anything, the opposite appears to have been the case. The market will undoubtedly take a breather to digest the ruling in the LSTA case but, once it has done so, issuance levels look set for healthy and robust volumes for the remainder of 2018.

European CLO Market Review

Records are there to be broken, and in 2017 the European CLO market did exactly that on several fronts. 2017 saw primary issuance in the European CLO market hit a new post crisis record level of €20.5 billion from 50 transactions. This represented an increase of over 20 percent on the primary issuance levels of 2016 which was the previous post crisis record holder with €16.8 billion issued from 41 transactions.

In addition to this impressive level of activity in the primary issuance market, there was extensive activity refinancing and resetting existing CLO transactions, which contributed an additional €25 billion plus of issuance.

Furthermore, November 2017 set the record for European CLO transactions pricing in a calendar month with €4.74 billion from 11 transactions. The downward pressure on European CLO spreads, which started in 2016 when AAA spreads on European CLOs fell from a starting position of 150 bps to 95 bps by year end, continued unabated in 2017 with AAA spreads falling to a new record low of 72 bps. In 2017, 31 different managers issued one or more primary CLOs, with European debuts for a number of new CLO managers, including HPS, Brigade Capital and Onex Credit Partners. 2017 also saw extensive issuance activity from the usual suspects in the European CLO market, including CVC, GSO/Blackstone, ICG, KKR and Oak Hill.

Regulations – finally a form of STS regulation we can work with…

2017 saw the finalization of the text of the long awaited STS Regulation. On Nov. 20, 2017, the Council of the European Union announced it had adopted the final text of the STS Regulation, which had been previously approved by the European Parliament. It was signed into law on Dec. 12, 2017 and published in the Official Journal of the European Union on Dec. 28, 2017. The STS Regulation shall, when it comes into effect on Jan. 1, 2019, implement a new risk retention regime applicable to European securitizations, replacing the disparate sets of risk retention provisions contained in, inter alia, the CRR5 and will be applicable to all securitizations with securities issued after Jan. 1, 2019 – so it will be applicable for re-issues and refinancings of existing CLO transactions that take place after that date.

While the STS Regulation has gone through a variety of forms throughout its extended legislative development, the final text closely resembles that of the original European Commission proposal from 2015. Many market participants will breathe a sigh of relief that a number of the proposed amendments put forward by various arms of the European legislature during the regulatory approval process have not been implemented through the final text of the STS Regulation, including: (a) Increasing the economic interest in the securitization to be retained by the risk retention holder from 5 percent to 20 percent; (b) requiring that the retention holder (originator, original lender or sponsor) be a regulated entity; and (c) requiring that only institutional investors be permitted to invest in securitizations.

Generally, the methods and retention levels applicable under the existing risk retention regimes have been largely untouched under the STS Regulation. In addition, there have been amendments to the definitions of “originator” (an entity cannot be an originator if it has been established for the “sole purpose” of securitizing exposures) and “sponsor” (widened to incorporate the possibility of including non-EU entities).

However, the precise effects of such changes will depend to a large degree on the clarifications to be provided under regulatory technical standards, once finalized, and the accepted market practices that may develop over time.

2018 outlook

The level of activity in the European CLO market in 2017 has resulted in analysts predicting that 2018 will surpass the expectations they had for 2017, with primary issuance levels expected to achieve volumes of between €20 billion to €26 billion. The market should also benefit from the removal (finally) of any uncertainty around the STS Regulation and the risk retention requirements that will take effect next year.

The steady stream of new managers entering the fray in Europe, particularly those with experience in the U.S. CLO market, the increased level of investor appetite that impacts European CLO spreads, which hit 70 bps by late January 2018, and the ongoing refinancing and resetting activity, including, more recently, “re-issue” transactions, all point to another busy year in the European CLO market.

Nollaig Murphy, Stephen McLoughlin and Callaghan Kennedy contributed to the European CLO Market Review and Jarladth Travers from MaplesFS contributed to the CRE CLO segment of this article.