The rating actions are as follows:

Class A, GBP 836.3m: assigned new rating of AA-_SF

The rating reflects the expected loss for investors associated with the payments contractually promised by the FITZROY 2018-1 CLO DAC class A notes on a particular payment date or by their legal maturity, as outlined in the terms and conditions of the notes.

Transaction overview

FITZROY 2018-1 CLO DAC has issued six classes of notes, which each reference the credit performance of a corresponding tranche defined in a credit protection agreement that the issuer has entered into with Banco Santander London Branch S.A (Santander). Classes B to F remain unrated. Scope also assigned ratings to tranches A to G of the credit protection agreement that the issuer entered into with Santander, leaving tranche F unrated. The transaction closed on 27 September 2018.

The reference asset of the class A notes is the most senior tranche of a GBP 1.12bn synthetic risk-transfer agreement of project finance loans originated in the UK and other EU countries by Santander and its affiliates in the ordinary course of business. The risk transfer is achieved through the execution of a credit protection deed and is in accord with Basel III (CRR) and European Banking Authority guidelines regarding significant risk transfers. The legal maturity date is 15 June 2045 or earlier if triggered by events.

The reference portfolio will be revolving for three years and currently comprises 92 senior secured, first-lien project finance loans. The projects backing these loans are mostly related to renewable energy, public-private partnerships/private finance initiatives, utilities, and infrastructure. They are primarily located in the UK and up to 20% of the balance may be located in Jersey, the Republic of Ireland, Sweden, Finland, Norway, Denmark, France or Germany, as per the replenishment criteria.

Foreign exchange risk for the transaction is well mitigated because non-GBP reference obligations are converted to GBP at a fixed rate. All reference obligations are scheduled to repay three years before the transaction’s maximum legal maturity.

Credit event definitions for the referenced assets include: failure to pay after the longer of 90 days or the contractual grace period, bankruptcy-like events, and the completion of restructuring due to credit deterioration which resulted in a loss. Initial and realised losses will be verified by an independent agent.

This is a synthetic transaction with no synthetic excess spread. The class A notes benefit from credit enhancement of 25%, provided by first-loss protection.

Premia will be accrued on the effective balance of the notes, i.e. referencing the non-written-off balance of the reference tranche under the credit protection agreement. Losses are strictly allocated to the classes of notes in reverse sequential order (i.e. from F to A). Defaults, and losses realised after restructurings, increase the loss balance; realised recoveries offset any accrued loss balance.

The structure releases credit enhancement when performance is good, due to the pro-rata allocation of reductions in guaranteed exposure (i.e. the reference portfolio’s scheduled and prepaid principal amortisations, and recoveries). Risk at the final stages of the transaction is mitigated by the sequential amortisation triggers. Conditions which would make the structure sequential include cumulative losses in excess of 1.6% of the initial balance, and the concentration-weighted number of assets falling to less than 15.

Santander will be holder of the cash collateral account, holding all funds to repay the class A principal. Moreover, the bank is payer of i) the credit protection premium; and ii) the interest on the cash collateral, together the only source of interest payments on the class A notes.

Rating rationale

The rating reflects the legal and financial structure of the transaction; the quality of the referenced collateral as constrained by eligibility and replenishment criteria considering macroeconomic conditions in the UK and continental Europe; the experience and ability of the originator and servicer, Santander; and the counterparty credit risk exposure to Santander as protection buyer, premia payer and collateral account holder.

The class A notes benefit from the credit quality of the assets in the reference portfolio, with low single-asset concentrations compared to most project finance portfolios. Scope expects an attachment of class A to be relatively unlikely, as the agency assumes losses of 1.0% over a weighted average life of 10.0 years for the reference portfolio at issue date.

The rating also reflects class A credit enhancement in the form of first-loss protection. Class A is strongly protected by its senior position, as well as the 25% subordination and performance triggers that would change the amortisation profile to strictly sequential.

The counterparty risk exposure to Santander constrains the class A notes’ rating at the bank’s credit quality as assessed by Scope. The bank is the payer of the risk premia and holder of the collateral cash account.

Key rating drivers

Senior secured exposures (positive). The senior nature of the exposures, together with the fundamental economic value of the underlying projects, most of which are operational, and the strength of the counterparties involved, result in a portfolio of mostly investment-grade exposures to projects. Scope calculates low expected losses from the revolving portfolio of senior project finance loans (i.e. 1.0% equivalent to an A- quality portfolio over a weighted average life of 10.0 years at issue date). This reflects a high weighted-average expected recovery rate of 88%, typical for senior project finance exposures.

Experienced originator (positive). Santander’s risk appetite is low. The originator generally targets senior exposures to projects with strong counterparties known to the bank. Santander is an experienced project finance lender in Europe with a longstanding track record and well-tested processes and models.

Limited revenue risk (positive). A significant segment of the initial portfolio balance (69%) is directly or indirectly exposed to the UK government under strong revenue contracts (i.e. production-based, take or pay, availability-based, and/or contracts for difference).

Credit enhancement (positive). Credit enhancement from the subordination provided by the financial structure reduces expected losses for the class A notes.

Counterparty risk (negative). All funds available for payment to the class A note holders are exposed to the credit quality of the bank. The bank holds the cash collateral paid in by the class A note investors, which is the only source of class A principal repayment. The bank is also the payer of the guarantee premium and collateral account interest, which fund the interest on these notes. The bank has high credit quality, but there is no risk mitigation.

Long revolving period (negative). The transaction is exposed to portfolio migration over a revolving period initially set at three years. This risk is mitigated by the origination and underwriting experience of Santander and its limited risk appetite. Furthermore, replenishments will require investor and rating agency confirmations.

Country and sector concentration (negative). This transaction is mainly exposed to the UK (96% of initial balance) and highly exposed to renewables (50% of the initial balance). Concerns about the UK economy in the context of Brexit are offset by the strength of its finances and the dynamic nature of UK markets, supported by excellent property rights and the rule of law. Renewables exposure is somewhat diversified across offshore wind, onshore wind and photo-voltaic solar.

Volume risk (negative). The significant exposure to renewables results in exposure to volume risk, despite the general absence of price risk. This risk is mitigated by the long tenor and seniority of the exposures.

Pro-rata structure (negative). The class A notes will remain exposed to the risk of losses for a long time because the amortisation of synthetic exposures reduces the classes of notes pro-rata. Realised losses reduce the effective balance of the subordinated notes sequentially, starting with the most junior class F. Portfolio profile and performance tests mitigate the class A notes’ exposure to potential underperformance and portfolio concentrations.

Rating-change drivers

Positive. Strong portfolio characteristics at the end of the revolving period could support marginal positive rating actions. There is limited rating upside because pro-rata amortisation prevents the accumulation of credit enhancement when the transaction performs well.

Positive. An upgrade may result if Santander’s credit quality improves or if the bank is replaced as collateral account holder with a counterparty with stronger credit quality.

Negative. An unexpected deterioration of the macroeconomic environment in the UK could trigger the review of Scope’s default and recovery assumptions for this transaction, which could result in downgrades.

Asset analysis

Class A reflects the credit performance of tranche A under the credit protection deed, which references the credit performance of a project finance loan portfolio, accounting for 25% credit enhancement. The initial portfolio comprises 97 senior secured, first-lien project finance loans backed by projects relating to renewable energy (50% of exposure), public-private partnerships/private finance initiatives (30% of exposure), utilities (13% of exposure), and other infrastructure (8% of exposure). Projects in the UK represent 96% of the initial balance; with the remainder located in Denmark, Ireland and Jersey. The portfolio will have a weighted-average life of 10.0 years or less. Any individual reference obligation will not represent more than 3% of the initial reference portfolio balance.

Reference obligations benefit from solid covenant packages and structural features such as cash sweeps, which will further reduce asset-level leverage if projects underperform. Most projects in the initial portfolio benefit from stable and predictable cash flows, directly or indirectly linked to the UK government for 69% of the initial balance, used to service the reference obligations. Project cash flows are often underpinned by long-term revenue contracts and sound fundamentals. For example, cash flows are protected from demand risks if the project’s output serves an essential necessity. A number of projects rely on payments which are exposed to significant revenue risks, such as wholesale electricity prices or traffic volume fluctuations. However, less than 5% of the initial portfolio balance is exposed to strictly demand-based revenue.

The reference portfolio’s exposure to construction risks is limited. However, this could increase to up to 20% as per the replenishment criteria if such exposure is approved by the protection seller and does not compromise the outstanding ratings on the tranches at that time. Over 96% of the initial reference notional is linked to fully operational, cash-generative projects.

The reference portfolio is diversified across 18 sub-sectors, with concentration in onshore wind, photovoltaic, education, offshore wind, and smart meters. These five subsectors jointly represent approximately three-quarters of the total initial portfolio balance.

There is sufficient diversification regarding key agents involved in the projects underlying the portfolio, with the exception of the UK government, which directly or indirectly supports the revenue of almost 70% of the initial portfolio. The correlation framework applied to the transaction captures the exposure to the UK government as ultimate revenue counterparty in this transaction.

Santander is an experienced originator in the European project finance market. The bank has a prudent origination strategy, a low risk appetite, and strong operational and risk management. Santander’s net economic interests are aligned well with those of investors through material risk retention in the reference portfolio. Santander has specific internal policies governing communications between front office origination and work out teams, and the CLO structuring and portfolio management teams, which mitigate conflicts of interest. This supports independent and consistent loan servicing because the servicing teams do not know which projects have part of their risk covered by this transaction.

Scope’s analysis of the assets in this transaction consisted of: i) using asset-by-asset fundamental data points to produce a probability-of-default estimate for each reference obligation; ii) producing rating-conditional recovery rates by incorporating the average leverage employed by Santander in the UK and Scope’s analysis of project finance recovery rates as per Scope’s General Project Finance Rating Methodology.

Quantitative analysis and assumptions

Scope analysed the reference portfolio loan by loan and built a mapping to estimate each asset’s probability of default given the portfolio’s good granularity. Scope then simulated portfolio performance using a single-step Monte Carlo simulation implementing a Gaussian-copula dependency framework, extending the risk horizon to account for revolving risk.

Scope produced a measure of the expected loss and the expected weighted average life for the class A notes, which was then benchmarked against Scope’s idealised expected loss curves. Scope’s analysis incorporated the transaction’s capital structure, guarantee reductions, premia payments, and amortisation trigger to test the structure’s mechanisms and their impact on expected loss for the class A notes. Scope did not consider the impact of a termination option at the discretion of the protection buyer, upon the reference portfolio balance dropping below 10% of the initial balance.

Scope assumed an 8.0% mean lifetime portfolio default rate and an 88% weighted-average portfolio recovery rate, based on its analysis of the portfolio using mapped loan-by-loan input assumptions. Scope also assumed a maximum pair-wise correlation of 44.5% (excluding the top exposure correlation stress of +20 pp). The non-parametric default-rate distribution resulting from the simulation exhibits a 90% coefficient of variation.

These metrics reflect the reference portfolio’s expected credit quality of A-, the concentrations in UK assets, and relatively good diversification across 97 reference obligations with no single-name synthetic exposure exceeding 3%.

Scope mapped the bank’s individual internal risk measures in order to assess the default risk of each reference obligation for the transaction. The mapping is based on a loan score that Scope assigned to each reference obligation. The loan score incorporates: i) fundamental data points that provide key information on the reference obligation’s credit risk, including: country, sector, revenue type, project stage, and key credit metrics; and ii) Santander’s internal assessments. Scope then created a regression model that considers the most significant characteristics of each project: its operational status; sector; type of revenue risk; weighted-average life; and its debt-service coverage ratio. The mapping was back-tested by conducting complete credit estimates on a targeted selection of 10 projects covering a range of different characteristics.

Scope assumed an average recovery rate for the portfolio of 50% under a AAA scenario for operational projects. The AAA-conditional recovery rate assumed for projects not yet fully operational is10%. These recovery rate assumptions reflect the seniority and leverage of the underlying assets, as well as the general characteristics of the projects in the portfolio. Scope applied rating-conditional tiering to its recovery rate assumptions, which reflect the characteristics of the assets in the initial portfolio. These recovery expectations consider the findings from the recovery study which Scope performed for its project finance methodology.

Scope applied an asset correlation framework that it deems appropriate for the analysis of multi-sector project finance assets in different countries within the same region. The maximum correlation can be split into: a minimum 2.0 pp for all loans; 5.0 pp assigned to asset pairs sharing the same country; 15.0 pp to pairs sharing the same sector; 7.5 pp to pairs sharing the same country and sector; and 15.0 pp to pairs which both have the UK government directly or indirectly supporting the revenues of the project.

Scope also applied stress to the largest exposures, consolidated by project, by applying a 10% haircut to rating-conditional recovery rates, and increasing the pair-wise correlation among the largest exposures by 20 pp. Five reference obligations exposed to four projects (11.4% of the initial portfolio balance) were selected, based on their relative size and contribution to the portfolio’s expected loss.

Rating sensitivity

Scope tested the resilience of the rating against deviations in the main input parameters: the portfolio mean default rate and its coefficient of variation, and the portfolio recovery rate. This analysis has the sole purpose of illustrating the sensitivity of the rating to input assumptions and is not indicative of expected or likely scenarios.

The following shows the number of notches that the results for each rated tranche move when: i) the portfolio’s expected default rate increases by 50%; ii) the portfolio’s expected recovery rate decreases by 50%; and iii) the portfolio default rate’s coefficient of variation increases by 50% (respectively):

The class A rating is not affected by the sensitivity scenarios given the constraining factor of Santander’s credit quality.

Stress testing
Stress testing was performed by applying rating-adjusted recovery rate assumptions.

Cash flow analysis
Scope has primarily analysed the distribution of portfolio losses and its impact on the rated instruments, with the use of Scope Portfolio Model (Model) Version 1.0.1.
Scope performed a cash flow analysis of the transaction with the use of Scope Cash Flow SF EL Model Version 1.1.0, incorporating default and recovery rate assumptions over the portfolio’s amortisation period, taking into account the transaction’s main structural features, such as the notes’ priorities of payment, the notes’ size and coupons. The outcome of the analysis is an expected loss and an expected weighted average life for the notes.

Methodology
The methodologies used for this rating were the ‘General Structured Finance Rating Methodology’ and the ‘Methodology for Counterparty Risk in Structured Finance’. The analysis also considered the analytical principles of the ‘General Project Finance Rating Methodology’. All documents are available on www.scoperatings.com.
Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definitions of default and rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale.

Solicitation, key sources and quality of information
The rated entity and/or its agents participated in the rating process.
The following substantially material sources of information were used to prepare the credit rating: public domain, the rated entity, and Scope internal sources.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.
Scope Ratings GmbH has not received a third-party asset due diligence assessment/asset audit. Scope has performed its own analysis of the data quality, based on information received from the rated entity or related third parties, which is not and should be not deemed equivalent to the performance of due diligence or an audit. The internal analysis was considered when preparing the rating and it has no impact on the credit rating.
Prior to the issuance of the rating or outlook action, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds on which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Regulatory disclosures
This credit rating is issued by Scope Ratings GmbH.
Lead analyst Sebastian Dietzsch, Director
Person responsible for approval of the rating: David Bergman, Managing Director
The rating was first released by Scope on 1 October 2019.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
© 2019 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5 D-10785 Berlin.

Scope Ratings GmbH, Lennéstraße 5, 10785 Berlin, District Court for Berlin (Charlottenburg) HRB 192993 B, Managing Directors: Torsten Hinrichs and Guillaume Jolivet.