Preston Hollow Brings Back CDOs for Municipal Debt Funding

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 over collateralization, 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 [email protected] To contact the editors responsible for this story: Elizabeth Campbell at [email protected] Dan Wilchins, Michael B. Marois