Here at Dechert, we have market-leading practices in CRE CLO as well as corporate CLOs, including broadly syndicated and middle market structures. So, every day that I peer into these two alternate universes, I’m astonished at how different these two fundamentally similar leverage technologies really are. Certainly, even at a modest remove, they look pretty much the same. A sponsor is looking for match term leverage and has developed a healthy disquietude about the mark to marketness of the repo market and has read CrunchedCredit assiduously and understands that portfolio lenders need multiple modalities of leverage. Said well-educated sponsor conveys financial assets into a securitization vehicle which issues time and ratings tranched debt to a wide range of investors seeking exposure to the space in a more liquid and more focused risk/yield return way. Tada!
So why are CRE and non-CRE CLO structures so weirdly different? Okay, there are some differences because of disadvantageous tax rules around commercial real estate and a certain amount of 40 Act uniqueness, but that doesn’t really explain it. These are the same fundamental technologies and have ended up so different they could probably get married in West Virginia.
Why so different? As a habitant of the CRE world, I might observe (okay, I will) that at least in a commercial real estate deal, if everything goes castors up, the investors actually own real estate…real stuff. Not so much in the corporate space where, when things go pear-shaped, you might end up with a potpourri of largely useless whole business assets and UCC claims. So ours is a safer bet! Not treated that way.
If the length, specificity and granularity of the offering materials are a cypher-like measurement of investor risk tolerance, then the CRE CLO investor marketplace is indeed different. And indeed scary. Don’t go down to the woods today…there are bears there!
Just look at our offering documents! At a very superficial level, a CRE CLO offering circular will easily run 400 pages with over 70 pages of risk factors conveying such shocking warnings as that investing in commercial real estate involves risk and the offering notes might not be a suitable investment for everyone (and we’re only talking QIBS and IAIs!). Our books contain reams of detailed information about the financial assets conveyed into the structure at the closing and frankly, about almost everything else, even better, in duplicate. (My reaction to our zaftig risk factors is that if you actually need all that to understand what you’re investing in, you probably shouldn’t invest in the first place.) The turgid, bloated condition of our offering documents is a bit embarrassing. Who’s getting paid by the word? Can’t we afford punctuation? Why the love affair with subjective clauses, double negatives and Russian doll embedded definitions? Apparently, during the Soviet era, the Russians published maps in Europe that were intentionally wrong so that come the invasion, NATO couldn’t find Moscow. It comes to mind.
A middle market corporate CLO offering document is svelte by comparison. It is significantly less bulky with significantly less – no duh – risk factors (arguably more focused on the actual risk) and certainly less granular information about the assets that are in the structure when the transaction closes. Why? Because everyone knows that the vehicle will recycle its capital into new assets regularly throughout the life of the vehicle. And that’s not a problem? Seems not. Why is that not for us? The corporate investor apparently focuses on management and criteria. In our space, it’s all about the assets. It shouldn’t be.
Well, that’s a riff about me just being annoyed, as my desk is groaning under offering documents.
Actually, I’m not on a mission here to fix all the flaws of our process and disclosure in the CRE space, albeit it’s pretty clear that the whole thing could use a good spring cleaning and rethink. What I want to focus on is why can’t we take a page from the actively managed CLO and develop vehicles with better ability to recycle capital? We’re already gently legging into this as ramps get bigger and capital is more easily recycled with exchange mechanics, replenishment mechanics and the like, with the addition of significant modification provisions that allow the issuer to keep loans in the deal that would otherwise get refinanced away, but we seem almost sheepish about all of it. And it comes with a premium to static deals. Dear Lord, what will the investors think! Given the enormous cost of launching a CRE CLO, instead of wallowing in a malaise of structural apathy, shouldn’t we refocus on engaging with the investor marketplace, show the investor community how an actively managed CRE CLO in the hands of a competent and experienced manager is a good thing? If the same investors buy corporate middle market CLOs, why in heaven do they balk at such structures in the CRE space? (Okay, I get HERF and loan count, but really? If the loans are good…)
So, to reiterate, I’m not here to suggest we make corporate CLOs more difficult or more expensive to close, God forbid, but wondering whether we might be able to take a page from their book and make CRE CLO transactions more efficient and felicitous.
And while we’re at it, given the times, let’s get really ambitious for the moment. Let’s not just look at the corporate CLO market but look at the equity market as well. How about a mortgage SPAC? The newest thing in equity land, of course, is the SPAC, or the Special Purpose Acquisition Company. These must be really good and surely safe investments because sports figures and Hollywood stars are shilling for them and everyone knows that advice from famous entertainers on financial products is a sound investment strategy, right? These are blind pools. Let me say that again: These are blind pools. Management important? Much diversity? Not. Do market investors trust management? Apparently so. So why not a mortgage SPAC? If need be, we could enhance our eligibility criteria, add rigor to what is already an extremely rigorous set of protocols and other guardrails. We could add de-levering features, stagger par value and income tests and provide for a finite life and diminishing reinvestment later in the vehicle’s life. We could even consider giving an investor populated advisory committee some rights to turn off reinvestment (gasp!) in the future. The technology is all there to make this sort of thing work. (We’d have to come up with a really good name for though.)
Like horses for courses, the SPACs CRE CLO seems purpose-built for this time and place. Why? Because we are likely to see enhanced asset mobility. We are likely to see enhanced asset mobility in the CRE space over the next year or so. Numerous alternate lenders are under scale and will be hard pressed to continue to successfully grow businesses which will result in the disposition of orphan portfolios. Mortgage assets are clearly going to be in need of repricing and even though we are recovering from post-Covid blues, no matter how excited we are about finally getting back on planes and eating at restaurants, there will be mispriced asset and broken toys looking for a new home. The tide is going out as the pandemic recedes and as Mr. Buffet famously said there will be those left without bathing suits. Here, it’s assets in need of repricing. Moreover, it’s likely that the prudentially regulated banking community will be under increasingly intense pressure under the Biden administration to trim and right-size exposures to commercial assets and real estate assets. The percentage of banks’ balance sheets invested in actual loans has been dropping and is likely to continue to drop and likely accelerate as the institutions compete for “Atta boys” from the regulators.
With all that happening, owning a vehicle that is positioned to bid aggressively and close rapidly makes the case for an open-market CRE CLO. And note, as the cherry on the sundae, these structures will not require risk retention as they will not involve transfers of financial assets from a sponsor to a securitization vehicle.
Many of you will remember back in the lee of the Great Recession the construction of the liquidating trust and other distressed debt hoovering technologies which could be somewhat repurposed here. In the day, we were late to the game building structures awash in the sea of assets needing repricing and hence the opportunity went away too quickly. Now we have a chance to get this right. Now, we have a chance to build the technology and catch the wave.
A purpose-built structure for the world in which we live. What a great idea. Come on, give it a shot!