Preston Hollow Brings Back CDOs for Municipal Debt Funding

Preston Hollow Brings Back CDOs for Municipal Debt Funding
2023-03-16 16:01:34.428 GMT


By Martin Z. Braun
(Bloomberg) — Preston Hollow Community Capital, a firm
that finances hospitals, universities and real estate
developers, has found an unusual way to raise money: packaging
the funding it provides into municipal securities. 
Since 2018, Preston Hollow has largely financed itself
through banks, which were willing to lend to the firm for years
at fixed interest rates. With rates having risen, those lenders
are less willing to provide that kind of funding, said Jim
Thompson, chairman and chief executive officer at Preston
Hollow. 
Now the firm is switching to the bond market, where it
might be able to find regular financing at a lower price,
Thompson said, adding that “We expect it to lower our cost of
capital.” 
Preston Hollow lends to projects like building dormitories
at universities. It provides that financing in the form of a
municipal bond, often unrated, which it might buy from a public
agency issuing securities for the project. 
The firm is taking 18 of those muni bonds, worth $371
million, and selling them to a local Wisconsin government
agency, the Public Finance Authority. PFA is in turn selling
municipal securities backed by the portfolio of debt. Wells
Fargo & Co. and Hilltop Securities Inc. are the underwriters.  

Key Differences

It sounds a little like collateralized debt obligations,
the complicated financial products that helped crater the
banking system in the 2008 financial crisis. But there are key
differences here. For one thing, the securities that the Public
Finance Authority is selling have a relatively straightforward
structure, where the cash flow from the underlying tax-exempt
bonds goes straight to the investor. CDOs, in contrast, often
had a series of slices with different levels of risk. 
The $371 million of underlying debt is backing $237 million
of senior certificates. That difference, known as
overcollateralization, means there’s a margin of error if the
portfolio that Preston Hollow sold ends up souring. 
Preston Hollow, founded in 2014, is one of the only direct
lenders in the muni market for riskier borrowers, building a
$2.5 billion portfolio at the end of 2022. Thompson, the former
CEO of Orix USA, founded his current firm with $100 million of
his own money. The company has raised more than $1.2 billion
from private equity investors Stone Point Capital and
HarbourVest Partners, according to a preliminary offering
statement for the certificates.
Preston Hollow will retain about $134 million of
subordinated certificates in the transaction. The firm will be
the first to take losses if the underlying borrowers default.
Moody’s Investors Service estimated the credit quality of the
pool backing the senior certificates to be consistent on average
with a Ba2 rating, two levels below investment grade. 
The rating company assigned a Aa1 rating to the debt being
sold now, its second highest grade, in large part because of the
magnitude of the overcollateralization. The portfolio’s
diversity by region and sector also makes it less likely that
multiple bonds would default, said Al Remeza, a Moody’s
structured finance analyst. The 18 bonds in the pool are from 15
issuers in 10 states and Washington DC. 

Avoid Losses

Almost 40% of the pool are backed by special property tax
assessments for development projects and another 23% is
nonprofit hospital and nursing home debt. The portfolio also
includes municipal bonds issued for student housing, colleges,
hotels and schools.
In the worst case, 36% of the bonds in the pool could
default without any recovery, before the senior lenders take
losses, according to Moody’s. In reality, those bonds are
expected to return a percentage of principal. The certificates
are structured with other features that would enable senior
lenders to avoid losses if even more bonds defaulted.
The senior certificates have a final maturity of 2059 and
an initial remarketing date of 2029. The underwriters are
marketing the securities at par with a coupon in the low to mid
4% range, according to people familiar with the matter. If the
certificates aren’t refinanced in six years, that will step up
to 5.5% and all principal payments from the pool will be used to
pay down the senior certificates.   
“This is a structure you would not necessarily see in the
municipal market,” said Oksana Yerynovska, a Moody’s analyst. 

To contact the reporter on this story:
Martin Z. Braun in New York at mbraun6@bloomberg.net
To contact the editors responsible for this story:
Elizabeth Campbell at ecampbell14@bloomberg.net
Dan Wilchins, Michael B. Marois