How to structure, manage and protect securitisation investments
Securitisation is a financial process that involves pooling assets, such as mortgages, loans, and other receivables and repackaging them into interest-bearing securities that can be sold to investors. The investors who purchase these securities receive principal and interest payments from the original assets. It offers opportunities for investors and frees up capital for originators, both of which promote liquidity in the marketplace. In essence, a typical securitisation transaction involves the following steps:
- Setting up a special purpose vehicle (SPV) to issue debt securities to investors;
- The SPV then uses the funds raised through the debt securities to purchase securitisable assets, for instance receivables, which are financial obligations owed to a creditor by a debtor;
- The securitisable assets are usually owned by a financial institution or company before being sold to the SPV;
- The investors' repayment is ensured by the securitised assets, and the SPV's payment obligations can be secured by security interests;
- When the SPV receives payments from the securitised assets, those payments are used to pay the investors and meet other costs in the structure;
- The securitisation structure allows the originator to obtain the funding for a pool of securitisable assets without incurring liability and allows investors to receive a return on their investment without being exposed to the credit risk of the originator.
Investors who consider investing in securitisation vehicles shall be aware of the enhanced protection that is a big benefit in Luxembourg, as well as understand the structuring approach, due diligence, key risk factors and dispute resolution aspects.
Enhanced protection for investors
The bankruptcy remoteness of the securitised assets held by the SPV aims at isolating them from any bankruptcy risk linked to the originator and any party involved in the securitisation transaction. In case of bankruptcy of the originator (entity initially owning the securitisable assets) or the servicer (party in charge of collecting the cash flows produced by the securitised assets for the SPV), the SPV is entitled to claim the transfer of ownership of those cash flows without being affected by the bankruptcy of such a party.
Furthermore, the Luxembourg legal framework ensures that the SPV is protected against individual interests of the parties involved in the securitisation transaction by the legal recognition of the following provisions contained in the issuing documents of the SPV:
- Limited recourse: limits the amount that investors can claim to only the amount that can be found in the SPV or in its relevant compartment. This means that in case of any default on the underlying assets, investors will not be able to seek additional compensation from the SPV or the originator beyond the available amount.
- Non-petition: prevents investors from initiating bankruptcy proceedings against the SPV, which could lead to the forced sale of the underlying assets and potentially lower returns for investors.
- Subordination: ensures that the claims of certain creditors are prioritized over the claims of other creditors.
As further developed below, the creation of compartments within the SPV aims at segregating the pool of assets and liabilities preventing the insolvency contamination of one compartment to the other compartments.
Moreover, for transparency purposes, the articles of association of the SPV shall carefully foresee the way that the securitised assets can be transferred by the management body of the SPV.
Finally, any collateral arrangement shall be considered to secure the investors. Any rights in rem (for instance pledge agreements) as opposed to rights in personam (for instance, guarantees) should be considered by investors in order not to be affected by the remaining risk of an insolvency scenario.
Investors can invest in securitisation vehicles through securitisation funds or securitisation companies. Investors shall be cautious about the compartmentalisation of their investments within the SPV to avoid risks of other investors trying to recover the assets in their compartments. On the other hand, investors who invest in SPVs can benefit from the compartmentalisation of the investment that can protect them from the distressed situation of other SPV compartments.
Advanced due diligence
Investors shall conduct thorough due diligence to understand the risk factors linked to the securitisation transaction. Advanced due diligence should cover the issuer's jurisdiction, regulatory compliance, historical performance, credit quality and the underlying assets' quality and liquidity.
Key risk factors
Investors shall appreciate the risks associated with securitisation vehicles in terms of bankruptcy, default, and tax. If the structure is not tax-efficient, the two main risks that could affect the profitability of the investment are tax leakage and the interest limitation rule with ATAD regulations. Moreover, the risks should be appreciated in the jurisdiction of the issuer and the investor, which might require a cross-border tax analysis. In addition, default and insolvency shall be considered. Default risk refers to the risk that the securitised assets may not generate enough cash flows to make payments to investors. Insolvency risk refers to the risk that the originator or the SPV may go bust, which could lead to the loss of the investor's investment.
Securitisation vehicles can be quite opaque and are only subject to a certain level of disclosure if they offer their securities to the public if the securities are listed or for compliance with certain EU rules and regulations for transparency and standardisation purposes which is not always the case. As such, in case of abuse or fraud, SPVs could be found insolvent. To recover any damages, it would be necessary to trigger the directors' liability and/or its parent company if no orphan structure was used. It is important for investors to be aware of the risks associated with dispute resolution in securitisation vehicles and to ensure that they have appropriate legal representation to structure and protect their interests.
To conclude, investing in securitisation vehicles can offer attractive returns, but it is important for investors to thoroughly understand the enhanced protection that is made available, as well as the structuring approach, due diligence, key risk factors and available recourses in case of a loss of the investment.
If you are interested in learning more about these considerations and how to structure, manage, and protect your securitisation investments from an investor perspective, we invite you to attend the PCS Securitisation Symposium co-organised by DLA Piper on 7 March 2023 held at the European Investment Bank in Luxembourg. There, we will delve into these topics in greater detail and provide insights from industry experts. Do not miss this opportunity to enhance your knowledge and make informed investment decisions in securitisation exposures.