Esoteric asset-backed securities (ABS) are not for the fainthearted. They require significant due diligence to build comfort with the underlying assets' future revenue streams and investor protections. On the plus side, the bonds pay a premium, and investors work closely with the issuers and bankers, giving them keen insight into future financings in a potentially growing asset class.
Orrick, Herrington & Sutcliffe, a San Francisco-headquartered law firm, has long helped facilitate those transactions with insights into the unique risks they pose. Originally focused on public finance, today the global law firm specializes in the technology, energy and infrastructure, finance and life-science sectors. Firm veteran Leah Sanzari, based in New York, is a member of Orrick's board and co-leader of its 80-strong structured finance team that works across all asset classes, including esoterics. She and Houston-based Jonathan Ayre recently discussed trends and developments in esoteric ABS with Asset Securitization Report. Ayre focuses on the energy markets and has helped pioneer several first-time securitizations of assets including operating and nonoperating working interests and Bureau of Land Management leases.
ASR: How does Orrick define esoteric ABS?
Sanzari: Esoterics generally comprise offerings not securitizing residential mortgages, credit cards, auto loans, and other traditional assets. They tend to be placed privately with a small syndicate of investors who are at the table and working with the company to learn about the assets and help structure the transaction. As certain assets become more familiar to ABS investors, like those stemming from Commercial Property Assessed Clean Energy (C-PACE) legislation, they may be distributed more widely under Rule 144A.
Proved developed producing (PDP) oil and gas assets are getting there. In 2019, when we did the first PDP deal for Raisa Energy, we had one investor and one issuer at the table and we created the transaction together with the bank. Since then there have been about 25 deals.
Ayre: The universe of investors expanded from those willing to do the first deals to a much broader investor base.
ASR: Why the expansion?
Ayre: The theme applies to esoterics more generally: disruption and innovation create market opportunities. In oil and gas, a number of factors resulted in traditional financing becoming less available, but there was still a lot of demand for energy. So securitization provided a solution to allow the ABS market to provide financing while other sources were retreating.
ASR: Who are the investors?
Sanzari: Esoteric investors include traditional ABS investors, such as the largest insurance companies and investors participating in the 144A deals—they each tend to have desks specializing in the different markets. In private placements (under the Securities and Exchange Commission's Item 402 of Regulation S-K), investors are generally at the table getting familiar with new assets and negotiating structures, hoping to grow long-term partnerships with the issuers. Rule 144A deals are generally broadly syndicated with the use of offering memorandums.
We've seen an expansion of energy ABS, including a focus on renewable energy such as ground-lease deals, data centers, and cell towers.
ASR: Since the assets are new to the ABS market, how does Orrick get involved?
Sanzari: We work with the investment banks who lead in bringing transactions to market. Banks such as Guggenheim Securities, Cantor Fitzgerald, Barclays, Jefferies and others have played an active role in creating esoteric markets. They see where ABS can benefit corporate clients with financing needs. Similarly, we consider when our own clients could benefit from the use of ABS financing.
Ayre: We represent companies and their investors across a wide variety of transactions: M&A, finance, regulatory, litigation … the whole gamut. At Orrick, we often have a broad understanding of the potential underlying assets. So when we're looking at esoteric transactions in a new space where there are risks associated with how the assets operate, we bring knowledge about those risks and how to mitigate them. We work with the investment banks on their models and make sure the legal risks are understood and mitigated to the extent possible.
ASR: What new esoteric ABS assets have you seen?
Ayre: We've seen an expansion of energy ABS, including a focus on renewable energy such as ground-lease deals, data centers, and cell towers. The energy space is rapidly expanding, and one reason is data centers and the energy they require. That's causing demand for energy assets of all types, including renewables and nuclear, as well as oil and gas because of the immediate need from today's expansion of artificial intelligence (AI). AI and data centers, in particular, are and will continue to be a big focus of the ABS esoteric market.
Sanzari: Intellectual property backed by TV, music, trademarks, and copyrights is another area. For example, Simon Cowell securitized his America's Got Talent platform in 2023.
Acquisition finance is another area. In more traditional ABS structures, a party owns the assets and issues notes backed by the assets to investors. Over the past 12 months we've seen ABS issuers increasingly using securitization proceeds to simultaneously acquire the assets. So instead of what generally has been a two-step process, issuers can now, if they get the timing right, acquire the assets using the securitization proceeds. We've worked on multiple acquisition financings in the last 12 months.
ASR: What types of assets have used acquisition financing?
Sanzari: Many, including energy-related assets, intellectual property assets and other deals that have master-trust mechanics. We think expansion will continue.
Assets must have reasonably predictable cash flows that can be analyzed and structured, with risks that can be understood and managed.
ASR: How have market participants responded to the expansion of esoterics?
Sanzari: It has been very well received. Issuers get access to a different capital base from their traditional lenders, and investors are happy because they get access to new assets, new structures and sometimes higher yields. They also spend a lot of time with issuers learning about the assets and the companies, and hopefully they're building long-term relationships.
ASR: Are there certain features of never-before-securitized assets that make them appropriate for esoteric ABS?
Sanzari: Assets must have reasonably predictable cash flows that can be analyzed and structured, with risks that can be understood and managed. The assets ultimately need to allow for structures that provide the traditional markings of an ABS transaction, including ratings, bankruptcy remote features, cash accounting measures, and debt for tax.
Ayre: The oil and gas cash flow profile has been fairly defined over years, but you have to be careful about understanding and defining the cash flow when considering an asset for the ABS market. There's a lot of price volatility with oil and gas. So to structure a deal for ABS investors requires hedging the market risk to ensure the steady revenue stream investors want. Typically, you hedge with futures contracts such as West Texas Intermediate (WTI) to fixed-price hedges, and sometimes you'll have basis hedges, depending on local market prices.
ASR: Those futures contracts are well established; what about for newer asset classes such as intellectual property (IP)?
Sanzari: IP doesn't have the same price volatility issue as oil and gas. With IP, you often run into chain-of-title issues related to the age of the assets and the documentation involved.
ASR: What are the biggest challenges structuring esoteric ABS?
Sanzari: Many esoteric deals are deals of first impression, so there are always new issues that have to be considered and resolved. We work with the banks to figure out the issues and adapt structures accordingly. All the normal ABS protections the rating agencies and investors would have in more traditional ABS have to be built into esoteric deals to make them marketable.
Being a part of the esoteric market has been a rewarding experience, because we truly are creating new markets.
