HYH Interview - Risk Transfers

10 Questions in 10 Minutes with a Private Credit Risk Transfer Professional

Author

HY Harry
May 06, 2024

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Welcome Back!

We’ve got an exciting interview this week. This interview piece is more short-form oriented and getting right to the heart of an increasingly popular slice of private credit.

I previously wrote about the private credit strategy of “risk transfers”, where private credit funds are able to purchase pools of assets from banks at attractive valuations. While Banking remains pressured by capital constraints and high capital charges, Private Credit has significantly fewer regulatory pressures.

There’s been some timely examples of investing in the space, such as the following:

Given all the buzz in the space, I sat down with an anonymous private credit professional in the risk transfer space.

In this “10 questions in 10 minutes” styled piece, we’ll hear about this subset of private credit directly from an anonymous first hand source.

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Without further ado, let’s get into the interview 👇️ 

1) Can you give us a vague sense of your background?

I spent a few years at BB in structured credit. Eventually moved to a HF where I pivoted to CLOs. Then went distressed debt and finally ended up in PC (SRT specifically). 

2) What are the characteristics of a risk transfer fund and loans. Does Loan-To-Own ever happen?

The funds themselves are usually set up with anywhere between 5-9 years of lockup. Given some of the workout characteristics of the loans you are generally given a lifespan of 9 years max on each deal. The loans themselves can vary depending on lender, region, and regulatory requirements but generally the fund will take junior exposure into a pool of loans held by a bank. The banks issue CLNs to keep ownership of the credit while issuing protection to the fund. 

The idea of these transactions are to generate cash interest payments as the loans amortize. In some rare cases you can take a loan to own approach but almost exclusively you are looking at a term loan w/ little expectations on owning the underlying credits.

3) Can you talk about the return profile and lien of risk transfer assets?

In the current environment, we are looking at deals with ranges of SOFR+700 to SOFR+1400 depending on the portfolio. This equates to zero loss expected yields of 12-17, and loss adjusted expected yields of 10-15. Generally we have seen 1-3% default rates in portfolios, so that’s the default rate you should be expecting. Meanwhile, the structure of the deals that are junior tranches are usually in the 0-11% range.

4) How do banks benefit from risk transfer deals?

There are quite a few reasons why banks benefit from these transactions. 1) the reduction of the risk-weighting of loan portfolios, 2) meeting ever increasing regulatory capital thresholds, 3) migrating risk from the bank to the fund (or buyer of portfolio) in a way to pass on risk to end buyer while paying a reasonable premium (that we assume is baked into the initial lender’s deals). 

5) Has the environment cooled off post the regional banking crisis? Is there cyclicality within the strategy?

I would say if anything, the regional banking crisis has sparked the market for a few reasons. 1) It has caused banking institutions to look more carefully at their loan portfolios and ways to mitigate their risk in a more sophisticated manner. 2) Whenever there is any type of failure the regulators come in (too late) to restructure the field which will lead to more volume from banks trying to meet growing regulatory guidelines. Although this market has been around for decades, it is still rather new so it is hard to gauge whether there is a true cyclical nature to the market. Obviously with rising rates and more scrutinous regulatory environments you can see an uptick in deal flow. 

6) Obviously there have been some notable deals in the space with Ares buying Pacwest loans and KKR buying RV loans from BMO. Any thoughts on these types of transactions? 

Having larger and relatively new players coming into the arena (lol), can be positive and negative. 1) Positive because it brings more LPs to market and can lead to better fundraising cycles for new launches with smaller dedicated shops. 2) Negative because like everything these guys touch it will eventually be controlled by them on their terms since they have endless dry powder to throw at dealflow. We could start to see smaller funds being left out in a space they were usually participants in.

The KKRs, Blackstones, Ares, etc are now starting to have dedicated teams to this space. Before, they would buy the actual credit portfolios of banks, but now with the SRT market taking off they are starting to take a synthetic approach. I believe this will saturate the market and start to make competitive terms provided by banks less likely given the amount of folks in the space.

7) Are there warrants attached to risk transfer assets or is there any other type of seller financing mechanics we should be thinking about?

Since the deals themselves are usually some form of a CLN issued by the bank, we don't generally see any warrants. In some cases while a specific credit is being worked out at the end of the portfolios life there can be agreements in place between the bank and lender on how to finish up the life of the deal.

8) Do you broadly think the biggest credit firms are getting “too big”?  Arguably, every steerco in public credit and every direct lending club deal is the same group of guys.

I think I have made it clear in my ramblings above that as we start to see further ballooning of assets of the same 7-10 credit shops the ability to find favorable deal terms for buyers of SRT deals will continue to become difficult. Thankfully, since there is nothing the government likes more than adding regulatory guidelines to the banking industry, there will a growing need for this space. 

9) What’s your general view of Private Credit over the next few years?

As long as rates remain high, Private Credit is not going anywhere. What was once a niche industry has obviously exploded over the last decade. I think we will continue to see growth in the market especially with private companies not wanting to give up equity pre-ipo, in favor of paying yield to get access to capital. But, like every industry, there will be a time when exposure is too high and deals have become some synthetic that there will be some sort of crisis of sorts. If rates go down, anyone holding floating rates without downside protection will see returns diminish.

10) How do people break into this industry? What’s the typical background? What does the career path look like?

There are really three possible career paths within this space: Portfolio manager, credit research, and structuring. Portfolio Management and Structuring usually come from some of structured credit background (CLO, CDO, etc), while credit research can come from either public or private credit research. 

This concludes my 10 question interview with an anon risk transfer professional.

Until next time,

Harry

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