Whatever happened to Northern Rock? That’s easy — it collapsed and had to be bailed out by the government. If you pressed a little further, some people might remember that much of it ended up as Virgin Money, and, with a new lick of paint on the branches and bracing “challenger” status, is back writing new loans and securitizing them again.
But a part almost as large as the bit that went to Virgin ended up in the hands of the world’s biggest bond fund, Pimco’s $250bn Income Fund complex, as the West Coast investor bought some of the largest privatisations in recent years from the Northern Rock ‘bad bank’.
In buying these assets, it had to win auctions against some of the world’s biggest private equity firms.
The first sales of Northern Rock mortgages went to CarVal Investors, a distressed debt specialist. Subsequent deals went to the likes of Blackstone and Cerberus, investors with return targets well into double digits.
But since 2018, Pimco has dominated. It won the £5.3bn Project Durham, in April 2018. A year later, it won the £4.9bn Project Chester. It bought control rights for the very first block of Northern Rock mortgages from CarVal, financing them in September 2019.
Tot up the fund’s UK mortgage exposures, and you have a figure that would make it one of the UK’s largest challenger banks. For big portfolios of performing prime mortgages, Pimco will probably win the bidding.
But Pimco, in winning Project Chester, also had to beat M&G, the asset management firm originally set up to manage the investments of insurer Prudential, while in Durham it worked alongside M&G.
M&G has a long track record in buying securitization bonds, largely at the senior end of the capital structure, but just over two years ago, it hired Jerome Henrion and Vaibhav Piplapure, both senior Credit Suisse bankers, to set up a private equity-style operation within M&G, known as M&G Specialty Finance. One fund was seeded by Prudential, while the other raised pension fund money.
This unit has enough firepower to tackle the likes of UK Asset Resolution’s £4.9bn Chester portfolio (with external leverage), as well as taking, alongside Pimco and Barclays, the €4bn sale of Lloyds’ Irish mortgage book, Project Porto. Just like a financial sponsor, M&G’s unit kept just €36m of residual notes on its €1bn piece of the deal — on which, according to the fund’s marketing documents, it expects to make a 9.5% IRR.
The funds are also investing in the equity tranches of already-issued RMBS, in capital relief transactions, cash risk transfer, and student loans.
“It used to be a pure PE market, but we have taken some share away from the PE funds, who have refocused a bit more on platforms and NPLs,” says Henrion.
“It’s a function of risk and return targets, which pushes them towards different asset opportunities, away from the performing space.”
Market split
The rise of these asset manager-sponsor hybrid strategies is part of a cause and part of a symptom of a split in the market. Four or five years ago, when European banks started to sell what they called “legacy assets” in earnest, the buyer base was similar, whether these assets were Italian non-performing loans (NPLs), German shipping loans or UK mortgages — predominantly US-based private equity firms which raised money specifically to target these opportunities.
Now, there is a wide gulf between performing loans in creditor-friendly jurisdictions, and harder-to-solve non-performing assets. Handling assets that aren’t performing means a very different investment style, requiring much more control over the entity that collects the money.
Servicing a performing portfolio can be as simple as collecting the direct debits, but servicing loans that aren’t performing is much more intensive and expensive. NPL servicers can therefore command up to 30% of collections, in some circumstances, and are often bought up by the major sponsors looking to maximise their control over NPL investments.
Lone Star, for example, services its NPL books through its Hudson Advisors unit, while KKR bought Pepper’s European operations. Fortress Investments owns Italy’s doBank (the former UniCredit Credit Management).
Even a market such as Italian NPLs is becoming saturated, and the funds that were first into the market are now exploring the likes of Greece, Cyprus, the Balkans, and even Turkey.
That’s not the approach favoured by the asset managers, and comes with its own risks, which LP investors demand they get paid for.
“If you buy a platform, you need to sell it at some point, and you need to sell it at a higher price than you bought it,” said Henrion.
“At some point you might become a forced seller. If you buy platforms and buy NPLs, you get higher returns if everything is going well, but you are taking more risk — not just credit but operational risk too.”
If you are buying performing loans from originators that are still in good shape, it can help to be a part of a large investing institution such as M&G or Pimco, with a lot of relationships up and down the capital structure. M&G’s regular bond funds own capital instruments, covered bonds, unsecured bonds and everything else from banks across Europe — giving a range of strong institutional relationships with treasury teams.
“Being part of a several hundred billion asset manager like M&G gives us a competitive advantage,” says Henrion.
“We have a lot of broad and deep relationships with institutions. We might be shareholders, corporate bondholders, covered bondholders, and ABS holders for a single institution.”
Some of the hedge funds active in the market might not meet such a positive reception from bank management teams — but can get around this by purchasing institutions outright. Elliot Management still owns a large chunk of Charter Court Financial Services, recently buoyed by its merger with OneSavings Bank, originally a JC Flowers investment.
Chenavari Investment Managers, started by former Calyon credit head Loic Fery, owns Belgium’s Buy Way and Italy’s Creditis, both consumer lenders, and has a large stake in Ireland’s Dilosk — all of which lever their portfolios in the securitization market.
But M&G, for example, is more likely to hold bonds or offer warehousing than to buy institutions outright. In Ireland, the specialty finance unit is funding Finance Ireland’s expansion from commercial into residential lending, for example.
Making the journey early on from bond buyer to bond issuer was TwentyFour Asset Management, the fixed income boutique formed in the depths of the crisis. It listed its UK Mortgages closed-end fund in 2015, and has been sponsoring securitizations ever since, levering the fund’s purchases of performing mortgage portfolios.
But in 2019 the asset manager has had to go back to its investors and ask to add more leverage. UK Mortgages was initially able to sell only senior tranches to the market — now it can sell down the structure to a maximum of 20 times levered.
Bargain deal
Like M&G, the fund’s relationships extend from bond buying to capital instruments and future originations — Coventry Building Society sells some of its buy-to-let loans to UK Mortgages, while TwentyFour’s other funds were able to lock in a bargain with a privately placed AT1 note from the UK lender in March.
Being an asset manager focused on performing credit, rather than a hedge fund focused on a quick return and aggressive management of portfolios, helps these relationships flourish.
“Every originator has its own approach to servicing — for Coventry, it’s important to take a conservative, customer-focused non-contentious approach,” says Rob Ford, partner and portfolio manager at TwentyFour in London. “They wouldn’t want to be involved with a more aggressive institution. From our perspective, we want them to manage the servicing with that type of approach. Their customers shouldn’t know or notice a difference whether their mortgages are in an Offa bond, in a Godiva wrapper or in one of the UKML vehicles.”
Diversification play
Being sponsor as well as bond buyer is a specialist model, but that hasn’t stopped other asset managers from eyeing up the business, especially if they have a track record in buying securitization debt.
“The risk return is very interesting, it’s a good diversification play,” says Henrion.
“A lot of real money investors have exposure to real estate, to corporates, to infrastructure, but very few have an exposure to consumer assets.”
Hermes Investment Management, which began as the British Telecom pension fund, has been building out its securitization business, hiring Andrew Lennox and Stephan Michel in 2018. Their mandate was partly to build out the public ABS business — but also to explore illiquid loan portfolio opportunities.
However, this isn’t easy. Henrion says: “The barriers to entry are pretty high. Even if you build the teams out, every deal can take months to do, and you need the expertise to do it properly. There’s also tons of historic data you need — not just the data on the portfolio to be sold, but on the rest of the seller’s origination and comparable assets. We have that, other portfolio buyers have it, but not every asset manager has it.” GC