One day last November, Barclays bankers and salespeople sitting on a second-story trading floor in the firm’s Manhattan headquarters received an unexpected perk. A Taco Bell feast.
The spread included over 120 tacos, including many that were Nacho Cheese Doritos Locos, not to mention nachos, Cheesy Gordita Crunches and Cinnabon bites.
Why Taco Bell? It was the celebration of a Wall Street deal expected to become more commonplace this year. The transaction — $1.5 billion in bonds backed by royalty payments from thousands of Taco Bell franchises that Barclays helped sell — is known as a whole-business securitization.
It’s one type of transaction in a growing part of the bond market known as esoteric or non-traditional asset-backed securities. Other esoteric deals involve cash flows from assets such as aircraft leases or rail cars, but bundling entire businesses like fitness centers or fast-food chains is among the fastest growing and most complex parts of the market. About $7 billion of whole business securitizations were done last year, according to figures compiled by Guggenheim Securities.
The broader esoteric ABS market almost doubled in the past four years to $62 billion in issuance in 2018, according to data provider Finsight. Right now that’s enough to comprise around 20% of the total ABS market. One banker estimates it could account for as much as 50% of the total ABS market in the next few years.
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“There are other emerging asset classes that could be eligible for securitization,” said Benjamin Fernandez, a managing director at Barclays who runs the esoteric ABS group. “If issuers continue to get credit from their investor bases for adding structure and security, I think we could certainly continue to see more growth.”
In ancient Greece, where the root meaning of “esoteric” first arose, it referred to belonging to an inner circle. For centuries, the term was used in philosophical thought as a catch-all category for beliefs held outside the accepted canon, including freemasonry, the occult, and magic, according to historian Wouter Hanegraaff. An early instance of esoteric being used for Wall Street investments was in 1979, when the New York Times quoted an investor who owned a hodgepodge of businesses like pinball arcades, a footwear product maker, and a refrigeration company. “We specialize in the esoteric,” he said.
These days on Wall Street, esoteric is defined almost more by what it’s not — bonds backed by credit-card receivables, auto loans, mortgages, and student debt — than what it is. Among the many types of assets that underlie deals in this category are airplane leases, tech-enabled consumer loans, cell-phone payment plans, tax liens, and whole businesses.
The last category is most commonly made up of franchise food deals like Taco Bell due to franchisee fees seen as predictable revenue streams. Arby’s was one of the earliest adopters and its sale of nearly $300 million in bonds backed by franchise royalty fees in 2000 launched the industry.
Dunkin Brands followed with a $1.7 billion issuance in 2006. Others include: Applebee’s, Cinnabon, Church’s Chicken, Domino’s Pizza, Five Guys, Hardy’s, Hooters, IHOP, Jimmy John’s, Sonic, Wendy’s, Wingstop. A notable exception is McDonald’s, which is large enough to raise efficient, investment-grade financing at the corporate level.
The way the deals are structured should be known by anyone familiar with how mortgage bonds work. In this case, a company sells an asset, be it a fitness center, intellectual property, or a tug boat, to a shell company. The shell then issues debt to investors, using the cash to repay the corporate parent for the asset, and servicing debt with cash flows from the businesses it now owns. The assets are structured so that they’re protected from a bankruptcy of the corporate parent, at least in theory.
For the banks that sell these deals, it’s another way to scale the securitization machinery they pioneered in the 1970s. Within Barclays’ securitized products origination group, for example, revenue from non-traditional ABS grew more than that of any other business in 2017 and 2018, according to a person familiar with the performance.
While Guggenheim and Barclays typically lead the esoteric ABS league tables, Goldman Sachs and Deutsche Bank are also very active.
For the issuers, it’s a cheaper way to access the bond markets, sometimes by multiple percentage points and often with an investment grade rating that they can’t get otherwise. And for the insurance companies and mutual funds that invest, the deals usually offer more yield than similarly rated corporate securities.
Critics worry that in their haste to grab yield, investors may be overlooking some significant risks. Few transactions have historical data showing how the underlying asset has performed during multiple economic cycles. Not all the structures have been tested in bankruptcy court. And some varieties of whole business securitizations get pretty complicated.
“A legal structure diagram of the deal can sometimes span two pages,” said one investor, who declines to invest in whole business deals and asked for anonymity to preserve relationships in the market. Making matters worse, some of the newer whole business deals involve most or all of a company’s assets, raising questions about whether creditors of the parent could seize them in the event of a bankruptcy, the investor said.
“Will the bankruptcy court agree that these assets sit outside the parent?” asked one investor, adding that for some of the more complex securitizations, it’s still an open question.
Paul Norris, a managing director at investment management firm Conning, argues that whole business deals lack the history and simplicity that he finds in aircraft leases and container deals, which bring decades of performance data and have structures that are easier to understand. Add in the fact that whole business deals are opportunistic for the issuer and the underwriters and Norris says he won’t touch them.
“All of it adds up to something that is extremely complicated, not all that liquid, and has not been proven,” Norris said.
Even the deals that Norris invests in require careful underwriting due to the idiosyncratic nature of different types and ages of airplanes or rail cars.
Defenders of the whole business model point to almost two decades of history wrapping restaurant franchises into bonds, and suggest that many securitizations in the sector follow similar structures. One note: prior to the 2008 US financial crisis, the deals were backed by bond insurers and assigned AAA ratings. When the financial crisis hobbled those insurers, bankers began to sell the deals without insurance. Now many, including Taco Bell’s, hold a BBB rating, one notch above junk.
“This is a market that a number of us have been developing since before the financial crisis,” said Katrina Niehaus, who leads Goldman’s esoteric ABS business. “Historically, ABS, which takes more work up front and has more controls, was generally viewed as being a safer asset class. We didn’t see that in the last crisis, because mortgage ABS was at the epicenter, but the hope is that we revert to that historical logic.”
Ron Joelson, the chief investment officer at Northwestern Mutual, is more optimistic about the broader esoterics market even though he hasn’t done many whole-business deals either. In his view, yields are high enough to compensate investors for their added risk. And as predictions for a recession mount, it’s also nice that the deals are secured, he said.
“There is something appealing about hard assets as we approach the latter part of the cycle,” said Joelson, who said he plans to more than double his allocation to esoterics in the next couple of years to $3 billion. He oversees a $200 billion investment portfolio. “We generally have expertise to analyze those transactions although, because the historical track record isn’t that long, you have to do your homework.”
Recent deals have tested the market’s growth. Barclays had to postpone a deal last year for the parent of IHOP when investors grew wary of the credit, while Guggenheim’s deal for $455 million in bonds backed by tug boats and barges later ran into trouble. The tug boat bonds, for a firm called Harley Marine, were downgraded after higher-than-expected operating expenses cut into investor returns and allegations of CEO fraud frightened investors.
Despite those hiccups, investors don’t yet seem to be souring on the broader esoterics space.
“What we’re hearing from some investors is that there’s a preference for structured finance over corporates or high yield,” Barclays’ Fernandez said. “They see it as a defensive play in a volatile market.”