Commercial real estate has taken a battering from the financial crisis. While some classes of asset-backed securities have seen signs of recovery, with improving prices in the secondary market and an increase in primary issuance, commercial mortgage-backed securities (CMBS) remain in the doldrums. With the assets underlying many CMBS deals expected to deteriorate further in 2010, investors continue to shun the sector.
Despite this hostile environment, UK supermarket Tesco issued two transactions backed by commercial property in June and September last year, worth close to £1 billion combined. The deals were over-subscribed and promptly received media acclaim for breathing life back into the CMBS market in the UK.
However, the success of the deals was dependent on one key element: investors had credit risk exposure solely to Tesco. This required Tesco to take an unprecedented role as swap counterparty to the special-purpose vehicle (SPV) that issued notes to investors. Fulfilling this role – traditionally undertaken by financial institutions – required a high calibre of creditworthiness, an understanding of the risks involved in the transaction, and the ability to manage those risks effectively.
“We wanted to make the credit analysis as easy as possible for the bond investors. The bond is amortising over 30 years, so investors only have to satisfy themselves about Tesco’s ability to pay the rent, not the value of the underlying properties at maturity. With Tesco as the swap counterparty, investors also don’t have to worry about bank default risk. In effect, they can view the issue as an equivalent credit to a Tesco PLC bond,” says Alistair Clark, UK treasurer at Tesco in Cheshunt, Hertfordshire.
Tesco Property Finance I issued £430.65 million of 30-year fixed-rate bonds on June 17 to finance the sale-and-leaseback of 14 properties. The notes were given the same rating as Tesco: A- by Standard & Poor’s and Fitch, and A3 by Moody’s Investors Service. The deal, arranged by Goldman Sachs, was priced at 330 basis points over UK Treasury bonds and was 3.1-times over-subscribed, with more than 50 investors buying the notes.
Tesco Property Finance II was issued hot on its heels on September 16, again arranged by Goldman Sachs. The issue was similar to the first: 30-year bonds financing a sale-and-leaseback on 17 properties. The size of the issue was slightly larger, at £564.5 million, but the notes priced tighter at 220bp over UK Treasury bonds. The deal was over-subscribed 2.3 times, with 53 accounts in eight countries investing.
Identifying the features that would lure potential investors into buying the notes was a key element of the first transaction on June 17. “We entered into a good deal of dialogue with potential investors, as well as some non-deal roadshows. The things investors didn’t want were taken out and certain key characteristics were built into the structure. For example, the deal was fully amortising and the cashflow structure was kept as simple as possible, hence only the one tranche. Investors are very focused on transparency, so everything is published on Bloomberg, and detailed reporting will be provided on a quarterly basis,” says Ben Green, managing director in the structured finance team at Goldman Sachs in London.
The structure of both transactions took broadly the same form. Rent for the properties involved in the sale-and-leaseback is paid to a UK limited partnership, an SPV established to hold the interests of the securitised properties and their occupational leases, with increases in rent payments linked to the rate of inflation.
So far, the transaction appears similar to most sale-and-leasebacks. However, for the SPV to lay off the inflation risk, it would need to enter into a hedge with a swap counterparty in which it would make limited price inflation (LPI) swap payments and receive annuity swap payments. Usually, a financial institution would act as swap counterparty. Instead, Tesco took on that role in the two deals. Initially, it hedged this position in back-to-back swaps with Goldman Sachs, and assigned the swaps to other banks after the close of the transaction.
Tesco’s willingness to take on the role of swap counterparty was crucial. By doing so, the structure created a pure credit linkage to Tesco, rather than exposing investors to the risk of a bank swap counterparty defaulting. “Tesco was initially surprised when we proposed this structure to it. However, it is extremely sophisticated in risk management and was quick to understand the benefits of such a structure,” says Green.
Tesco will have to manage its own credit exposure to the banks. However, Clark says this does not present a major concern due to the nature of the transaction. Tesco will receive a fixed amount from the counterparty banks under the swaps and pay LPI. These exchanges mean Tesco is likely to receive from the bank counterparties on the swaps for the first 15 years of the bonds’ life, then pay out on the second 15 years, provided inflation does not rise sharply, he says.
“The bank has credit exposure to us rather than the other way around: we’re getting cash in from them for a long time before we start paying cash back out again, assuming inflation stays at a reasonable sort of level. So it’s not a significant concern for us in terms of credit exposure,” says Clark.
This structure helped to appease investors unwilling to take on exposure to banks – a fear that had become acute since the collapse of Lehman Brothers in September 2008. The cost of five-year credit default swap (CDS) protection on Tesco was at 100bp on the date of the first deal. This compares with 91bp for CDS protection on UK sovereign debt and 153bp for Goldman Sachs at the same point in time. Under the terms of the deal, Tesco guarantees swap payments to the SPV issuer. If Tesco gets downgraded, the notes will see their credit ratings lowered to the same level.
Observers say the structure should be successful in insulating investors from third-party credit risk. “Tesco taking on the role as swap counterparty marries up the lease covenant with the hedging covenant. And, as inflation risk is inherent in the structure, there is no reason why it should pay somebody else to take that risk. If you have the right credit rating, self-hedging is cost-effective relative to shipping it out to a bank counterparty. Moreover, bringing in a bank creates additional counterparty risk, which investors are more acutely aware of post-Lehman,” says Andrew Vickery, partner at law firm Linklaters in London.
Investors have been particularly wary of using bank swap counterparties in structured finance transactions following a series of lawsuits filed on behalf of the Lehman Brothers estate in both London and New York during 2009. In these lawsuits, Lehman litigators have looked to test contractual and bankruptcy laws in an attempt to access potentially hundreds of millions of dollars worth of collateral tied up in various SPVs to which Lehman acted as swap counterparty.
Lehman Brothers was the arranger of various structured finance programmes worth billions of dollars. In many instances, Lehman Brothers Special Financing (LBSF), a Delaware-incorporated subsidiary, would act as swap counterparty to the SPV issuing notes to investors. Meanwhile, a trustee would hold collateral purchased using the proceeds of the money invested by note-holders. When Lehman Brothers filed for Chapter 11 bankruptcy protection on September 15, 2008 (followed by LBSF on October 3), issuers of the notes declared a credit event had occurred and terminated the swap agreement. In some cases, trustees began to liquidate collateral as a result.
Ordinarily, the swap counterparty would be senior to the note-holders in the priority of payments following an event of default. However, rating agencies often insist flip-clauses are written into the trust deeds, which reverse the priority of payments if the swap counterparty defaults, making it subordinate to the note-holder.
This has been the main point of contention: whether these flip-clauses are legally valid, and which party should have first call on the collateral in these deals. Of the numerous lawsuits filed on both sides of the Atlantic, only one case had been settled at the time Risk went to press. On July 28, the chancellor of the High Court in London, Andrew Morritt, ruled in favour of Perpetual Trustee, representing Australian investors, and Belmont Park Investments, an Australian investment firm, which were note-holders of issuances from the Dante Programme – a multi-issuer secured obligation programme set up by Lehman Brothers International (Europe) in 2002. The ruling deemed the flip-clause legally valid, granting investors first access to collateral. This decision was upheld by the Court of Appeal on November 6.
Nonetheless, it is still unclear what will happen in the US, where the US Bankruptcy Court for the Southern District of New York is still considering several similar cases.
Lawyers and analysts agree the structures of Tesco Property Finance I and II achieve the aim of leaving note-holders only exposed to Tesco credit risk, despite the fact Tesco entered into back-to-back inflation swap hedges with banks.
“Tesco’s hedging counterparty is completely immaterial to note-holders: they are only facing Tesco. If the counterparty was to default, Tesco will still have obligations vis-à-vis the securitisation issuance. It’s just behind the scenes that it won’t be covered for that exposure, meaning it will have to close out and re-hedge its swaps,” says Vickery at Linklaters.
“Assuming no change in Tesco’s creditworthiness, any arrangements Tesco enters into to deal with its exposures as swap counterparty are separate to the transactions and shouldn’t impact their performance in any way. All the swap payments under the transactions are guaranteed by Tesco, so exposure to any back-to-back counterparties doesn’t really exist here,” say Gioia Dominedo and Emmanuel Baah, CMBS analysts at Fitch Ratings in London.
Investors can feel safe. In contrast, the role of swap counterparty presents Tesco with a more challenging risk management position than a corporate might be accustomed to. However, Clark indicates most issues in this respect are relatively minor. For example, its treasury systems aren’t designed for indexed-linked annuity swaps, and as a result the swaps will have to be rate-set manually for retail prices index changes. Also, Clark says he will need help from the banks for the mark-to-market valuation of the swaps. Otherwise, though, he does not envisage the risk management of the position being overly onerous going forward.
“Once you have it up and running, it’s a back-to-back position so it all cancels out. There is a counterparty risk if the swap becomes in-the-money, which would be monitored as part of our normal risk management processes,” says Clark.
Undoubtedly, the sophistication of Tesco’s risk management capabilities, the size of its balance sheet and investment-grade credit were vital to the deal. These traits will limit the number of corporates able to replicate the structure. Nonetheless, analysts believe investors will remain wary of bank counterparty exposure on long-dated deals for a while to come.
“Last year, we saw two or three comparable transactions where people were grappling with this issue: creating a structure with hedging that is purely credit-linked to the tenant, as, by definition, hedging with a different counterparty gives you another credit exposure. I think the Tesco structure is innovative in that sense, and it is likely to be followed by companies of appropriately high creditworthiness,” says Vickery.
The week on Risk.net, July 14–20, 2017Receive this by email