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October 26, 2016  

Ellington Preps CMBS Risk-Retention Fund

Ellington Management is seeking to raise $250 million for a fund that would expand the firm’s role in commercial-mortgage securitizations as risk-retention rules take effect for that sector.

The firm aims to launch Ellington CMBS Sponsor Retention Fund in January. With support from that vehicle, the $5.8 billion fund shop plans to act as a sponsor to issue commercial MBS deals. It would retain 5% of each class of bonds, while also purchasing the first-loss “B-pieces” of the deals.

Holding the “vertical” 5% strip would satisfy a requirement, stemming from the Dodd-Frank Act, that transaction sponsors retain “skin the game” as a way of discouraging risky lending. The risk-retention piece must be held long-term — in most cases, for the life of the deal, typically 10 years.

The rules, which take effect for CMBS issuers on Dec. 24, alternatively allow sponsors to delegate the risk-retention responsibility to B-piece buyers. But the capital required per transaction could be as much as double the current amount, and the buyers effectively would have to hold that “horizontal” strip of high-yield bonds for the duration of the deal. Ellington sees that as unworkable, and predicts that the industry will move to a vertical-retention model.

“As the implementation of these new risk retention regulations come into effect toward the end of 2016, we believe this presents a unique opportunity set to participate in investment grade credit risk while potentially offering a mid-teen return profile,” Ellington managing director Brian Rice wrote last week in an email to prospective investors.

Ellington traditionally has invested in the B-pieces of CMBS deals. The new fund also would hold lower-yield paper. Indeed, the firm estimates that 77% of the vertical strip in a typical transaction would be triple-A rated. But the fund also would take the remainder of the B-rated and unrated bonds at the bottom of the capital stack, which would be treated as a traditional B-piece.

“Ellington will act as a CMBS sponsor and retain a vertical interest while also purchasing higher yielding, lower rated tranches with the flexibility to sell them to manage our risk profile,” Rice noted.

The fund would have a two-year investment period and a term of at least 10 years after its last transaction. It could use leverage and hedge against interest-rate and other risk. The management fee is 1.5%. Investors get a preferred return of 8%, after which the manager will keep 20% of profits.

Ellington to date has invested in the B-pieces of 23 CMBS deals, including four issues this year, according to the CMBS Database maintained by sister publication Commercial Mortgage Alert. The firm’s CMBS strategy had annual returns of 21-24% in 2012-2014, 7.9% last year and 5.1% year-to-date.

The team is run by senior portfolio manager Leo Huang, whose 23-year career also includes a stretch as co-head of Goldman Sachs’ commercial real estate lending business. Another key professional in the strategy is Wendy Pei, head of commercial real estate credit.

Ellington, an Old Greenwich, Conn., firm founded by chief executive Michael Vranos in 1994, runs a mix of structured-product, equity, futures and global-macro funds.