European commercial real estate (CRE) lending markets face a difficult environment, resulting from a higher than usual cost of debt and declining property valuations. In the face of such uncertainties, we examine how private credit funds with a real estate debt strategy might nonetheless take advantage of funding opportunities and what considerations might shape how back leverage providers choose to participate.
The commercial rationale for using back leverage in CRE debt deals is straightforward. Credit funds typically use leverage provided by commercial banks to enhance returns on their real estate debt investments at a cost lower than that of direct (equity) investments into the fund. Back leverage providers, in return, obtain indirect exposure to illiquid assets as well as additional asset-backed structural and contractual safeguards.
Notwithstanding the additional operational and structural complexity, in our recent experience, banks providing back leverage may prefer more structured solutions instead of a direct lending exposure to private credit funds. This is because most funds are unrated, triggering a 100% risk weighting for the financial institution. By offering back leverage in a more structured manner, for instance through repackaging the CRE loan into a note, a private securitisation—also known as “private-label” commercial mortgage-backed securitisation (CMBS)—a master repurchase arrangement, a loan-on-loan or a derivatives-based financing such as a total return swap (or a combination thereof), back leverage providers can apply a lower risk weighting, which in turn reduces the amount of capital the back leverage provider is required to hold against the exposure. As a result, back leverage providers in structured deals should be able to provide cheaper pricing to private credit fund borrowers.
Back leverage providers tend to fall into one of two camps: those approaching financing with a credit mindset (wanting discretionary approvals and vetoes on eligibility, haircuts in respect of each underlying loan and control over a negotiated set of material decisions in respect of the underlying loans) and those with more of a fund finance mindset (who do not approve or veto individual positions, instead relying on detailed diversification and eligibility criteria, combined with complex partial haircut mechanisms to set the available borrowing base).
We have seen a range of structuring options emerge to allow private credit funds to diversify their funding sources and potentially tap cheaper funding, while also sharing risk and increasing liquidity in the CRE lending market.
The CRE lending market underwent significant changes after the global financial crisis (GFC). Before the GFC, bank originators of CRE debt could avail themselves of a number of bank syndication and funding options, including selling sub-participations and mezzanine loan pieces to other financial institutions.
Alternatively, banks could tap the debt capital markets to sell exposure to CRE assets through commercial mortgage-backed securitisations (CMBS 1.0), which flourished as an off-balance sheet funding tool during a time of cheap and abundant debt with no regulatory requirement to retain risk. Other options included CRE-backed collateralised loan obligations (CRE CLOs), although this was (and arguably remains) primarily a feature of the US CRE debt capital markets.
After the GFC, a more restrictive regulatory environment coupled with “slotting” rules and capital allocation to risk weighted assets led to a certain amount of retrenchment by the banks from parts of this sector, giving way to a rise in private credit. Since the GFC, we have seen something of a role reversal when it comes to originators of CRE debt and the funding options available to them.
CRE loans are now increasingly originated by private credit funds, with banks and insurance companies providing financing by gaining exposure to senior positions in such CRE loans through the abovementioned range of bespoke financing structures, each offering distinctive advantages and disadvantages in terms of risk, tax, and regulatory treatment. The EU and UK Securitisation Regulations and their US equivalents have added risk retention to the list of structuring considerations.
When structuring a back leverage trade, deal teams might evaluate different structuring options in terms of the returns achievable through leverage, the control private credit funds can retain vis-à-vis the back leverage provider over the underlying CRE loan assets and whether the senior piece is also marketable to non-bank institutional investors (such as pension funds and insurance companies).
Throughout 2022, we saw greater complexity with structures being combined (such as repack-to-repo structures, repo-to-repack structures, and repack-to-repo-to-private securitisation structures) to optimise the abovementioned features as well as to achieve the desired regulatory treatment. Aside from regulatory capital treatment, the key structural drivers in these transactions include maximising tax efficiency and achieving the required accounting treatment within a fully cross-collateralised structure for the private credit fund sponsor. Where the financing takes the form of a repack-to-repo structure for example, back leverage providers have shown a preference for cleared notes which are (at least in theory) more liquid and rehypothecable, with a non-EU listing venue for the notes preferred by private credit sponsors due to European Market Abuse Regulation considerations.
As the public debt capital markets have largely stalled in the second half of 2022, bespoke private funding solutions remain particularly attractive. They also allow larger private credit funds to ramp CRE loans ahead of an eventual return of longer-term public capital markets financing solutions like CMBS (CMBS 2.0) or the much-touted European CRE CLO. In the short term, we expect more bespoke private structured credit solutions to continue to thrive given the disruption in the public markets and the prohibitive costs, due diligence, and timing considerations associated with structuring and marketing public CMBS 2.0 and CRE CLOs.
Present market conditions raise important questions concerning fluctuations both in the cost of borrowing and the valuation of underlying CRE assets. Such market moves can trigger funding shortfalls, particularly when banks use margin calls to demand partial repayment to compensate for material declines in the market value of the underlying CRE assets. The prospect of being margin called on one or two business days’ notice is particularly unattractive for smaller private credit funds, that, absent a capital call from the fund’s limited partners (which might take up to 10 business days), may not have access to other funding lines or the option to voluntarily de-lever the facility to avoid the margin call and who might thus be easy prey for back leverage providers in a market downturn.
Mark-to-market provisions in CRE back leverage facilities are, in the eyes of private credit funds, fundamentally unfair, on the basis that such provisions borrow from technology used in liquid repo markets where quotation sources and reference points are well defined and usually readily available. Applying a variant of such methodology where the asset subject to the mark is (or is backed by) a unique, illiquid asset can, if not well negotiated, accord undue discretion to the back leverage provider and an imbalance in the lending and structural protections afforded to them. These same imbalances can trigger liquidity concerns for private credit funds—that will need to find other ways to inject the necessary cash.
Despite such additional challenges, our experiences with market participants suggest that the benefits of achieving healthy returns (for both parties) and favourable regulatory capital treatment (for bank lenders) will likely continue to outweigh the scourge of increased borrowing costs and additional liquidity considerations. While market participants may structure transactions with lower overall levels of leverage, thereby seeking to balance the concerns of lenders and credit funds alike, back leverage—in its different forms and variations—is likely to remain an effective means for private credit funds to enhance returns and increase market share.
In our next publication in this series, we will compare and contrast some of the typical features associated with different European back leverage finance structures.
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