Corporate securitization: Back to the future

SECURITIZATION OF THEIR property portfolios has been a no-brainer for corporates in recent years. From supermarkets to pubs, company treasurers swiftly realized that the leverage they could achieve by monetizing their real estate was far higher than anything on offer elsewhere. The corporate securitization market therefore morphed into a hybrid CMBS market, with tenant quality and operating cashflows taking a back seat to ballooning property values. But UK commercial property has had a catastrophic start to the year, and this logic has been turned on its head. “In this environment it may well be the case that you can get higher leverage through a whole-business securitization than through an opco/propco deal,” says a CMBS banker, with an air of weary resignation.

This is a complete reversal of the dynamics that have driven the corporate securitization market for the past five years. “Previously, corporates with real estate assets could use them to repeatedly refinance the business,” says Andrew Currie, managing director at Fitch Ratings. “Sentiment has now completely switched. On the basis that it is a hard asset, real estate should be as good a form of collateral for corporate finance as anything else. Using commercial property as collateral for corporate loans should not, therefore, be closed – but in practice it probably is currently.”

So where does this leave securitization as a corporate financing tool? The technique now has a serious image problem (see “The S Word”, Euromoney November 2007) so the assumption is that any corporate securitization would be a very hard sell at the moment. Traditional whole-business securitization almost disappeared over the past few years and presumably opco/propco securitization will now do the same.

Back from the dead?

But if this part of the market is anything to go by, the securitization market’s reputation for reinvention looks as if it might be well deserved. Far from being despondent, bankers involved in corporate ABS seemed enthusiastically upbeat in mid-January. It seems a very long time since Euromoney has spoken to a securitization banker with a bulging pipeline of deals and a positive story to tell. However, for those in this niche sector of the market, what has happened over the past six months could be all good.

“We have a strong pipeline going into 2008 but the key for 2008 will be distribution,” says James Miller, head of corporate securitization at RBS in London. “We have seen a lot more interest in corporate securitization generally as a funding option and- people want to know what can be done again. The last few years have actually been tougher for capital markets, given the liquidity available in the banking markets. But this has to change, and refinancing risk is much higher on the agenda for a number of asset owners we have met recently.”

Easy credit made it difficult for corporates to be persuaded to undertake the cost and expense of a whole-business securitization. Instead they embraced opco/propco structuring with gusto – lured by the much higher leverage that was on offer. By splitting the operating company from its real estate, this technology boosted potential ebitda multiples from around six times under a traditional whole-business structure to more than nine times in some cases. Not surprisingly, the advent of opco/propco saw many firms unwind their existing financing arrangements and take advantage of the boost in funding available.

One of the most high profile instances of this was ABN Amro’s acquisition of the Priory healthcare group in 2005. Previous owner Doughty Hanson undertook a £207 million ($403 million) whole-business securitization in 2003 but redeemed it just two years later in 2005 with the same assets reappearing in a hybrid CMBS deal. The £375 million trade, via ABN Amro’s CMBS conduit, Talisman, involved notes being issued down to triple-B in an A/B note structure. The £200 million B loan pushed leverage in the structure way above anything that could have been achieved in the whole-business market. A more recent example is that of the General Healthcare Group, which was acquired by South African healthcare group Netcare in April 2006 – a process in which its outstanding whole-business securitization was redeemed and replaced with a hybrid CMBS transaction in early 2007. Pub operators Mitchells & Butler and Greene King were also both looking at opco/propco financing structures before last summer. This decision proved particularly painful for Mitchells & Butler, which had put an interest rate hedge in place before its £4.5 billion opco/propco plan was scrapped. This decision has now left M&B nursing a £391m loss and it now faces the prospect of being sold.

But just because an opco/propco structure would be very difficult to push through in the present market, are structurers being over-optimistic that corporates will automatically re-examine the value of whole-business securitization? “Whole-business securitization is now a much more efficient alternative than it was before,” admits a banker at a European house with a large CMBS conduit programme. “The last few years have witnessed a blurring of operating risk and property risk in these structures and, given sentiment towards commercial property, the two now need to be separated again. As a result, you might see whole-business securitization coming back as a financing technique.”

Ganesh Rajendra, managing director at Deutsche Bank, says: “Legacy whole-business securitization will probably make a comeback. It was squeezed out by the banks’ capacity and appetite to lend in the longer term. That has now changed dramatically and the capital markets will come back as a key source of long-dated finance.” For any corporate, the two things that matter when considering any form of securitization are cost of funds and leverage. The cost of the structure was not competitive in an environment of very cheap bank lending but in the present environment of zero bank lending it begins to look very attractive indeed. This is because the fixed-rate, long-term deals are priced to gilts, which have come in sharply as they have benefited from the flight to safety over the past six months. The yield on three-month UK gilts was 5.45% on January 21 2008, compared with 5.35% on January 29 2007. But the six-month yield was down to 4.38% in 2008 from 5.55% in 2007 and the one-year yield was 4.3% in 2008 compared with 5.5% in 2007. Most whole-business securitizations incorporate both fixed-rate and floating-rate tranches. “On the back of the credit crunch we have also seen underlying yields rally, the 20-year gilt yield has tightened 70bp since June for example, which has largely offset the widening credit spreads we have also seen,” explains Miller at RBS. “So for a whole-business -securitization the cost of funds may not be vastly different on an all-in basis, yet this is not often the perception,” he says.

Although the movement in gilt spreads clearly works in whole-business securitization’s favour, this might not be enough to counter-balance what has been going on with credit spreads. The changes in Libor rates since the summer clearly affect the bank and bond markets to the same degree, as both are priced off the same Libor rate. But, because of their size and tenor, corporate securitizations have traditionally relied on monoline wraps – and the monoline insurance companies are now in utter disarray.

Unless the monolines are in a position to participate, the optimism over a revival in whole-business securitization could prove to be short lived. No amount of gilt rallying will be able to make up for an environment where investors have no trust in a monoline wrap. At a recent briefing in London, one investor expressed a view that is probably shared by many: “I am far more concerned about my portfolio’s exposure to monoline insurers than I am about my exposure to their underlying credits.”

As long as this sentiment prevails, the sale of any sort of wrapped corporate securitization will be impossible. When Fitch Ratings downgraded Ambac on January 18 a series of corporate deals were immediately downgraded in line: Punch Taverns, Mitchells & Butler, Spirit Group, Channel Tunnel Rail Link and Tube Lines. This was never supposed to happen, and it will take a very long time for investors to get comfortable again.
The situation in the corporate market is enormously frustrating for the monolines. Many had assumed that a deterioration in the credit markets would play into their hands, and had been anxiously waiting for the market to turn. When the whole-business market evaporated in the face of opco/propco competition, a very nice stream of business for them went along with it (See The end of the monoline? Euromoney March 2007). Now that corporate securitization could be sufficiently competitive to be on the agenda again, the insurers are bogged down in the consequences of their CDO exposure and unable to take advantage of the situation.

But it is not only the monoline insurers that have been watching the negative rating agency actions in this sector with dismay – corporates that have bought a monoline wrap could be facing a serious problem as well. When a monoline guarantor agrees to insure a bond, the agreement is irrevocable, and cannot be rescinded even if the monoline is downgraded. Thus those corporates that have paid the premium for a triple-A wrap will have to continue to pay that premium but in Ambac’s case get a double-A wrap in return (at least in the near future). This state of affairs is unlikely to endear many corporates to the concept of a wrap at the moment either.

But regardless of the monolines’ ability or otherwise to wrap issuance, their involvement will remain academic as long as spreads on their paper remain at their present wides. The monolines have only been so integral to the corporate securitization market because there were clear cost advantages to paying a premium for a triple-A wrap. That is quite obviously no longer the case. When the Ambac-wrapped triple-A bonds issued by BT’s Telereal vehicle were trading wider than its unwrapped double-A bonds last November many viewed it as a bizarre overreaction. But it now looks like slightly unnerving prescience.

Waiting for a deal

In the UK there is a £15 billion hangover of corporate issuance from deals that were expected to close last year but have not. The vast majority of this is accounted for by the refinancing of Ferrovial’s acquisition of BAA. The securitization – expected to be around £8 billion in size – has been dogged by delays but sources close to the situation insist that the deal will still go ahead this year. It is, however, very difficult to see how this will be achieved if the two principal monoline insurers, MBIA and Ambac, continue to wrestle with their difficulties. Neither will be in a position to take the kind of exposure to BAA that the structure would have originally envisaged, and it is hard to see what alternatives are achievable in the present environment. “Single-limit risks for the monolines will certainly be impacted by what has happened,” admits a corporate ABS expert. Could such a deal be attempted with far more limited monoline exposure?

That all depends on the level of appetite for unwrapped corporate ABS paper. “We have often had investors not wanting a wrap,” -muses a banker. “A lot of them have simply become full up – and fed up – with monoline paper.” Certainly, for small, niche deals where an investor is prepared to do the credit work it would make much more sense to take unwrapped exposure. But for BAA? Unwrapped appetite could never be sufficient to facilitate that kind of issuance.

As with most aspects of securitization, any discussion of where bonds might clear or what structures might be possible remains largely academic while the market’s lengthy hiatus continues. The BAA securitization is now nearly a year overdue, and other plans, such as those for football clubs Manchester United and Liverpool, will presumably need a rethink given current market conditions.

But many corporate deals – particularly those from the UK government’s PFI programme, are on a strict timetable. One large deal caught up in the hangover is the £1.7 billion facility to finance the FSTA contract between the UK Ministry of Defence and the -AirTanker consortium to provide aircraft, infrastructure and support services to the Royal Air Force. This deal was supposed to have been signed in 2007 but is now slated to close by the end of the first quarter this year. It involves a mixture of bank and bond debt. Rumour has it that at one stage one monoline insurer had been willing to wrap the entire bond portion on its own – but that seems a far-fetched prospect now. Shareholders in the AirTanker consortium include Cobham, EADS, Rolls-Royce, Thales UK and VT Group.

While the outlook for the monoline insurance sector remains so unsettled, it is very difficult to make the case that corporate securitization in the guise of whole-business structures will resurface. Any issuance that is priced to gilts must be attractive to the floating-rate alternative, so previous candidates for corporate securitizations might opt for straightforward index-linked bond issues. According to Miller at RBS there could also be interesting opportunities in the LBO market for corporate ABS – as a restructuring option for deals that are underwater. “For the right asset class it can still be possible to achieve attractive investment grade debt levels with the right structure with a substantial pick up in pricing benefit and this has to offer a number of benefits to PE owners,” he says.

Real estate’s Achilles heel

Given the lower leverage on offer, any renaissance in whole-business securitization is contingent on opco/propco securitization ceasing to be a feasible proposition for corporates. “Whole-business and opco/propco are both useful items of technology but the fallout in commercial property means that opco/propco deals are far more exposed to what has happened than whole-business deals are,” says an asset manager. Opco/propco deals usually incorporate LTV covenants, which will come under pressure as asset values continue to fall. Whole-business structures involve operating covenants, which are under considerably less pressure – so far.

Although not that many opco/propco deals were actually done, their impact on the market was substantial. “There are certain areas where opco/propco has worked very well – those in which the real estate is very strong and the tenant is weak,” says a CMBS investor. “Some pub groups have privately admitted that they just viewed opco/propco as a way to up their leverage – nothing more.” But given sentiment in the commercial real estate sector, that avenue must now be closed. “Highly leveraged opco/propco transactions would be very difficult to execute now,” agrees Damian Thompson, head of property capital markets at RBS. “But the term opco/propco became attached to very highly leveraged structures, and this was not always the case.” Indeed, the supermarket deals that were done (for Somerfield, J Sainsbury) were at reasonably conservative leverage. But a deal at any leverage would be a challenge now. “Pubcos were used to seeing their real estate valuations rise by 20% a year whereas now if they did a deal they would probably have to write down their real estate portfolio,” says an investor. “That would be very painful and they would rather not raise finance than have to do that.”