Prytania Quarterly Update - Q2 2024
Commercial Real Estate (CRE)
Introduction
This quarterly update will explore aspects of the commercial mortgage backed securities (CMBS) market, including transaction structure and collateral characteristics. It will also cover some of the key differences that we see between the US and European markets and where we see the best relative risk-adjusted value.
Commercial Mortgage Backed Securities
CMBS offers an investor the opportunity to gain exposure to commercial real estate (CRE) without the need for direct investment in the physical “bricks and mortar.” This brings many advantages over direct investment, including much quicker transaction times and greater potential liquidity.
The nature of commercial property also means that, as an asset class, CMBS can open up a highly diverse investable universe to the savvy investor. With diversity comes a level of complexity though; commercial real estate has unique characteristics within subsectors spanning the archetypal industrial, retail, and office designations to more specialised property types such as data centers, hospitality, student accommodation and many more.
As already suggested, the CRE market is very diverse, resulting in an almost infinite number of ways property portfolios can be constructed, exposures driven as much by the nature of the underlying investor as the property investment made. Financing such portfolios is, fortunately, a little more straightforward, from sponsors who utilise personal wealth to third party private capital to CRE lending.
CMBS is the method utilised by that last category, CRE lenders, to transfer credit risk from their balance sheets to third parties and / or term out financing. As securitisation generally isn’t a viable option for smaller lenders, loans that end up in CMBS transactions are almost exclusively originated by larger, well capitalized and well-regulated entities.
For ease, CMBS investors tend to classify transactions as:
Large Loan: a single CRE loan backed by either a single property or portfolio of properties all ultimately owned by the same sponsor (sometimes called single asset / single borrower [SASB] transactions)
Conduit: a portfolio of CRE loans originated to a range of sponsors, with each loan again backed by a property or portfolio of properties. Usually, loans are not cross-defaulted, so each loan needs to be reviewed on its own merits
Sale / Lease Back: a hybrid whole business / CMBS transaction as the securitised properties were previously owned by the business, which now occupies them via lease, with rents paid from their operating activities
CRE CLO: not a true CMBS as this uses a CLO structure to finance a pool of CRE loans rather than corporate obligations
Similar to other securitisation transactions, CMBS are structured as bankruptcy remote vehicles, using the cashflow from the underlying collateral – in this case, commercial property backed loans – to support a debt structure typically comprising senior, mezzanine and junior debt. Unlike most other securitisation structures though, CMBS transactions don’t generally have equity tranches, rather they rely on the equity in the property to provide the “first loss” protection for the junior debt holders. Outside of the securitisation, a mezzanine facility may be provided by a third party, which will sit between the sponsor’s investment and the securitised senior debt.
Chart 1: CMBS Structure
CRE investment requires a flexible approach to risk assessment, given the varied and often unique characteristics of the underlying collateral. Below, we briefly highlight some key criteria we review as part of the initial investment process. It is worth stressing that these criteria are not analysed in isolation, instead each parameter is assessed to form a blended view of the overall viability and performance of the structure. As an example, a high day 1 LTV need not be a concern if there are other positive factors such as a long lease term or modern, energy-efficient build.
Loan to Value: changes in property valuations are invariably headline grabbing so investors almost always consider this to be the “key” risk metric on which to focus. Whilst LTV is important, a low LTV is by no means a guarantee of a smooth transaction, nor does a high LTV necessarily represent a high-risk investment. As an example, a new-build modern property with a long lease to a high-IG rated tenant and some loan amortisation may well warrant a much higher day 1 LTV than a portfolio of secondary properties let to private tenants on roll-over leases. The exit LTV at loan maturity remains a key credit consideration as this will drive the ability to refinance the loan and return the lent amount to the investors.
Property: obvious, but important, is the actual property. On a very basic level, we see any commercial property as simply a box that generates a cashflow. The success or failure of that box to do this will depend on a wide range of factors, many nuanced, but ultimately, all come down to supply-side and demand-side drivers. A high demand for the space offered will support a more consistent and potentially better quality cashflow, enhancing valuation.
Lease Profile: the tenant-landlord relationship can be complex, and detailed lease information is rarely communicated to noteholders for commercial reasons. However, basic information covering such things as unexpired term to maturity and first break, gross annual rent and any fixed rental uplifts gives investors enough to assess the cashflows available to meet senior loan repayments. Ideally, we want to see stable rental for at least two years after loan maturity, which we see as sufficient to allow a controlled workout of a stressed situation.
Tenant Profile: hand in hand with the lease profile is the quality of the tenant base from which cashflow is derived. The more diverse the tenant base, the less weight each tenant has in our overall risk assessment, although an assessment of the “top 10” is common where these combined typically generate in excess of 50% of total rental income.
Loan Profile: CMBS notes only get repaid if / when the underlying loan gets repaid. In an ideal world, every senior loan would be amortising from day 1, thereby mitigating tail risk by reducing the loan to value at maturity. Sadly, this is not the case. Whilst some loans have notional amortisation profiles of 1% p.a. for example, the base profile is a senior loan with bullet repayment which can leave noteholders exposed to market value risk. Other features that need to be considered include any call protection and extension options. Basically, we don’t want to do a lot of work on a new deal only to see a loan refinance six months later. Equally, we wouldn’t want to be tied into a loan that allows the sponsor to cheaply extend at maturity rather than face a more expensive refinance.
Combining information on the lease / tenant / loan profile is, therefore, important as we try to avoid investments where lease runoff is around the same point as the loan maturity. Setting aside cashflow concerns, the uncertainty around vacancy rates can impact the borrower’s ability to secure suitable terms to refinance the facility, leading to a default.
Sponsor / Mezzanine Loan Provider: CMBS securitisations are established as non-recourse vehicles, which means that there is no contractual obligation of the sponsor, or any subordinated lender, to support a transaction under stress. That said, where loans have failed to refinance, many sponsors have stepped up to provide additional capital as part of a consensual restructuring of the existing facility. A strong sponsor with a high day 1 financial interest in the property and financial wherewithal to add future capital can be a very strong albeit intangible factor in the investment decision. To a much lesser extent, a mezzanine loan provider can offer similar intangible support. Mezzanine loan terms usually allow the mezzanine lender to rectify senior loan covenant breaches in order to protect their own loan position. Any new capital injected ranks pari-passu with the existing mezzanine facility, so it is below the senior loan but above the sponsor for any recovery.
Financial Covenants: although a range of financial covenants may be included in the loan documentation, the most common are loan-to-value (LTV) and debt service coverage (DSCR) tests and, occasionally, an interest coverage (ICR) test. The LTV covenant is always a simple pass / fail, whilst the DSCR and ICR tests can have a tiered element, but a breach of any test usually initiates a cash trap process that diverts cash away from the equity sponsor until the test is cured.
For us, there is always a balance when looking at covenants, as an established sponsor with a good track record will negotiate looser covenants. This can be problematic, as an effective covenant package can incentivise a sponsor to support a stressed loan, but equally, a weaker sponsor may not have the ability to inject further capital. Is it, therefore, better to have a strong sponsor and forego a decent financial covenant package or a weaker sponsor with good covenants?
Transaction Structure: on the surface, different transactions may look very similar, especially note tranching, loan terms and LTV of the senior loan. However, we continue to see a wide variation in the non-financial covenants contained in the Offering Circular, which differentiates the servicer / sponsor / noteholder relationships in the event a loan becomes stressed. We also see variations in the way scheduled and unscheduled loan repayments are treated. Whilst pure sequential is the normal model, we have seen pro-rata, modified pro-rata and even reverse sequential structures.
US CMBS Market Dynamics
The most obvious starting point when comparing the US and UK / European CMBS markets is their relative sizes. Data from JPM indicated that the balance of distributed transactions still outstanding as of 31 March 2024 was c. €19bn for the UK, €6bn for Europe, and around €650bn for the US.
The US CRE market has many similarities to its European counterpart, including the approach to the underwriting of loans. Loan providers are also very similar, with a range of banks, private equity, insurance and pension companies lending against CRE assets. Unlike Europe, though, the US market also has a large number of public and private real estate investment trusts (REITs) providing finance, as well as two Government Sponsored Entities (GSEs) in the form of Freddie Mac and Fannie Mae.
Given the absolute size of the commercial real estate market in the US versus the UK / Europe, it will be no surprise that the US CMBS market is more active than its UK and European counterparts and offers a wider range of specialist transactions. A prime example is Data Center transactions, which are still considered a “new” collateral class in Europe compared to the US, which is now a recognised collateral sub-class.
One of the other predominant features of the US CRE market versus the UK / Europe was the use of longer dated, fixed rate finance, especially fixed rate conduit transactions, to provide longer term finance on stable, well-let assets. These loans typically comprised the collateral for Large Loan (SASB) CMBS transactions.
Post-pandemic, the dynamic changed somewhat as US investors looked to shorter dated, floating rate loans in order to boost absolute returns whilst mitigating duration risk. These loans have usually been associated with bridge finance for ‘transitional’ properties i.e., real estate, where some level of active management is required to achieve a stable cashflow.
The risk for investors is that the sponsor needs to successfully execute the turnaround / stabilisation business plan in order to refinance into a cheaper, longer term facility. So, whilst bridge loans offer high running returns, credit risk is usually demonstrably greater than that of longer dated fixed rate alternatives.
There are ways real estate investors can mitigate default risk, such as taking exposure via conduit CMBS and CRE CLO structures, which give investors exposure via diversified portfolios, whilst the tranched debt stack offers rising levels of structural enhancement. Care still needs to be taken, though, as loose reinvestment criteria can leave debt investors exposed to negative selection, as good loans repay and weaker ones may not.
2023 saw issuance in the US of around $20bn in each of the Conduit and SASB categories, which was a 14-year historical low for the Conduit side. This year witnessed a rebound in demand from CMBS buyers, driving the Conduit and SASB issuance to, respectively, $11bn and $29bn YTD
Chart 2: Annual US CMBS & CRE CLO Issuance
Source: JPM issuance data, 2006 to 2024
Another trend has been in the mix of properties supporting public, non-specialised CMBS transactions. Pre-pandemic, these types of transactions were backed by mixed pools, with around 50% of the collateral being office and multi-family residential properties – both being considered by investors as safer given the perceived stability of cashflows. Since the pandemic, there has been more focus on lodging and industrial assets.
A growing concern in the US is that many US financial institutions are over-exposed to shorter dated CRE backed loans written at very low (post-pandemic) fixed rates. With loan maturities on the horizon, speculation is mounting that a further wave of CRE loan defaults over the next 2-3 years could drive banks’ capital buffers into the ground. This is potentially problematic for regional banks and some credit unions where capital buffers are thinner than “systemic” banks who are similarly over-exposed.
Although this should not directly impact CMBS transactions, which are bankruptcy remote and generally have no forced sale penalty if loans extend, a freeze in bank (and other) CRE lending could hit property valuations, driving risk for junior, mezzanine and even potentially senior noteholders. This scenario has already mostly played out in the UK / Europe, where the CRE market is now seeing a rebound in finance.
CRE CLOs
Commercial Real Estate CLOs utilise the same structuring “technology” as the more well-known Leverage Loan securitisation (CLO), but the underlying collateral typically comprises a diversified pool of between 10-30 shorter dated, floating rate CRE loans.
As issuance volumes show, even in the US, the CRE CLO structure isn’t that popular, with just $6.7bn publicly placed in 2023 vs $22.8bn CMBS (Morningstar / Fitch).
In the US, floating rate, shorter-dated CRE loans are also more likely to be backed by transitional assets, i.e., bridge finance on properties two to three years away from income stabilisation, with loans with maturities between three and five years.
A typical CRE CLO pool would comprise anywhere between 10 and 30 loans, which arguably mitigates risk via granularity whilst structural enhancement rises as you move up the debt stack, especially for more senior note classes. However, DSCRs are usually below 1.0x, which indicates that, on day 1, the revenue stream is unable to service debt, putting more onus on the sponsor to deliver the business model.
Similar to corporate CLOs, the CRE CLO manager can exit loans and reinvest returning principal proceeds for a period of time so an investor must rely on the manager to correctly analyse each new loan exposure. For us, this does not sit well, as we like to be in a position to underwrite each loan when assessing an investment. Even “static pool” transactions will not automatically preclude managers from reinvestment as terms may allow “unscheduled principal receipts” - i.e., prepayments - to be reinvested.
As CRE CLOs follow the corporate CLO model, transactions come with additional tests not seen in CMBS structures, including par coverage and market value tests. Failing these tests usually diverts cash away from junior notes, so whilst beneficial for senior investors, the CRE CLO comes with a further layer of risk for a mezzanine / junior debt investor. Positively though, most actively managed CRE CLOs also come with portfolio level covenants such as weighted average life, minimum floating rate, and diversity tests, which ensure diversity during any reinvestment period but usually fall away once that is over.
Despite a concerted push by a number of US banks to bring the CRE CLO format to Europe, the structure never caught the interest of investors. In addition to our concerns around re-underwriting risk, the lack of a diverse pool of suitable, lower risk loans from which to build a portfolio was a key issue.
US vs. EU CMBS
Detailing key differences between the US, UK and European CMBS markets would prove a very lengthy process, not least because drivers for each are heavily influenced by macroeconomic factors such as interest rate policy to softer issues such as hybrid working.
We then need to consider specific collateral focused factors such as the availability of finance, competing space, changing trends, etc. Circumstances may also be positive for some properties and negative for others: will inflation drive rents up or tenants out?
Although we have made the point that the US CRE landscape is not the same as the UK or Europe, the basic drivers are sufficiently aligned to allow some generalities to be offered up.
Competition: in the UK and Europe, highly regulated banks still dominate the CRE loan market, even if their desire to lend is currently limited. In the US, smaller regional banks, which already benefit from lighter touch regulation, have had to compete with less regulated private wealth, insurance and pension companies as well as REITs and the GSEs. As such, some suggest that the basic loan quality of US CRE finance is weaker than their European counterparties. Whilst we have no direct view on this, it has been widely reported that the value of delinquent loans tied to US CRE held by US banks hit $24.3bn in 2023, up 116% in 2022 (source: Financial Times / FDIC data).
Liquidity: it may not feel like it, but evidence suggests that UK / European CRE lending is starting to recover whilst the US is still on a downward trajectory. The ability of a sponsor to obtain attractive financing, not just the rate but also leverage (LTV), has a very strong influence on sentiment and ultimate deal execution. A sponsor looks at the capital they can commit, so greater leverage means they can pay a higher price for the property, whilst cheaper funding maintains the expected equity return.
Return from Home: this is harder to quantify given the wide dispersal of office properties, but generally, the hybrid work / home model adopted across Europe is much more office-centric than that in the US, usually involving 3 – 4 days in the office.
Stranded Properties: property investors and tenants alike are re-evaluating the environmental impact of the properties they own and / or occupy. There are clear benefits in pushing environmental standards, but one of the key risks has been called “stranded property syndrome.” This is where a policy, e.g., drive to “net zero,” results in uneconomic costs in order to comply. If the owner decides to walk away, the loan provider must either meet the costs themselves or face selling at a heavy discount – either way, resulting in a potential loss.
Regulation: diverse regulatory environments across the US make tracking risks trickier. Something as simple as a zoning law can impact value: a weak / zero zoning policy can allow a sponsor to build new, competing space next door to an aged unit more cheaply than actually doing up the old unit. UK / European planning tends to be more restrictive, especially where land is at a premium.
CMBS and ESG
Since the pandemic, the investment community has placed an ever-growing weight on Environmental, Social and Governance (ESG) factors in the decision-making process. Companies perceived to have weaker ESG standards generally find it harder to raise capital than those that score well and are, rightly or wrongly, perceived to be lower risk and / or better placed to handle future developments. Therefore, it should be no surprise that those corporates wanting to improve the “E” in their ESG scoring look to their building(s) as a logical starting point.
Landlords wanting to attract / retain tenants are, therefore, under growing pressure to make their property stand out. The most obvious changes are focused on energy efficiency and carbon offset through the use of renewable energy sources. The retrofitting of solar panels, heat pumps and modern insulation are popular “fixes” but requires capital expenditure to complete.
New build properties are easier to “futureproof,” using modern technology and building materials to maximise energy efficiency whilst also reducing carbon emissions linked to the building process.
Finally, we are starting to see landlords, especially those managing campus or estate type locations, i.e., multiple separate properties on a single site, pay more attention to the “S” in ESG. Examples range from the simple widening of pathways, improved external lighting, installation of EV charge points, and the creation of communal indoor / outdoor spaces.
Although we, as CMBS investors, are unable to directly influence a landlord’s decisions around ESG, we can indirectly play a role by avoiding transactions backed by clearly polluting properties. As an example, we have not and will not consider petrol forecourt properties as suitable collateral.
We also consider ESG risk as part of the property assessment, treating it as a supply side driver. This can be as simple as understanding that, given a choice, a tenant will prefer an energy efficient property over one that is not. More complex considerations come around older properties, which may require additional capital expenditure to bring them up to modern standards, and whether the cash is not only available to cover this, but that the sponsor is minded to undertake the improvements.
Market Stress
Like other securitisation structures, a CMBS Note Issuer is an SPV whose only asset will be the rights accruing from the underlying CRE loans it purchased during the transaction process. Repayment of the noteholders, therefore, ultimately relies on repayment of the underlying loans, which in turn requires the sale or refinance of the reference property portfolio. There are various terms and structural tweaks that can be built into the transaction documents to mitigate risk, but all things being equal, this loan repayment / note call cycle follows a natural rhythm, and noteholders never get involved.
As recent history proves, though, this cycle can be disrupted for property specific reasons (e.g., extreme dilapidation, obsolescence), to issues in the wider real estate market (e.g., falling valuations) to difficulties in financial markets (e.g., the post-GFC pullback in bank lending), or a combination of one or more of these.
The reasons behind one loan becoming stressed whilst another does not are, therefore, just as diverse as the nature of the CMBS transactions themselves. What rights a noteholder has if a loan defaults, or indeed the influence they may have on the resolution process, will be set out in transaction documents.
So, what happens if things go wrong? The answer, surprisingly, is generally nothing – at least not immediately!
In the event that a financial covenant, such as maximum LTV, is breached during the term of the loan, the “worst” that usually happens is excess cash is retained in the transaction and becomes available to help amortise the loan if the breach isn’t cured. There are nuances around this, but the loan will not be classified as defaulted at this point.
Should a loan default, generally by failing to repay at maturity or, less commonly, missing an interest payment, it will become specially serviced. This basically means that a specialist third party is appointed to work with the Sponsor (loan obligor) to resolve the situation. Given the specialist nature of commercial real estate management, the existing servicer usually takes on the Special Servicer role for the defaulted loan.
The Special Servicer technically works for the Note Issuer, and hence noteholders, under a broad framework referred to as “the servicing standard.” Whilst this is part of the legal service level contract agreement, the idea of “servicing standard” itself is pretty nebulous as it just requires a servicer to “…service the applicable loan or loans in the same manner and with the same care a similar servicer would apply…” This makes it very difficult for noteholders to simply push a Special Servicer into a specific course of action, e.g., enforcement of security, when viable alternatives exist.
Despite the imprecise nature of the servicing standard, the Servicer / Special Servicer still has to abide by the specific clauses in the transaction documents. However, as we have noted before, these terms can differ materially across transactions, resulting in very material differences in the leeway granted to a Special Servicer to manage a distressed loan.
The Opportunity
Headlines around the impending collapse of various property markets alongside more general credit market stress made investors wary of CRE linked investment, leading to the widening of CMBS spreads and an opportunity to purchase good investments offering outsized returns.
Since the start of 2024, dislocation opportunities in the UK and Europe have been harder to source as some have already played out whilst others, including legacy positions in our own funds, remain closely held to allow for the potential upside to be realised.
Even without market dislocation though, the additional complexity associated with CMBS investment means that opportunities in this space usually offer a material spread pickup compared to other securitised collateral classes with similar credit ratings. As such, we believe that a multi-asset portfolio should have some allocation to CMBS.
The investable universe of CMBS is wider in the US, but the market also sold off less than the UK and Europe, which currently limits opportunities to make oversized returns. Unlike the UK and Europe, though, the US seems more exposed to contagion risk across markets, given the very high exposure banks and other financial institutions have to CRE lending. Should this come to pass, there may well be a wider US CMBS selloff, which will create good entry points for those willing to do their analysis.
Even without the crystallisation of any contagion risk, yields around US mezzanine and junior CMBS risk, i.e., A to BB rated debt tranches, have widened as investors become warier, and a reversal in US property assets may be just around the corner. Balancing risk and reward will be critical, but it feels very much as if the US CRE market could easily see the stresses brought on by declining property values and a freeze in the finance markets seen across the UK and Europe as interest rates started to rise in the post-pandemic period.
Summary
As discussed in this report, investing in CMBS transactions offers investors the ability to gain exposure to a diverse set of real assets without having to invest directly in the asset. However, risks are diverse, and therefore, there is a need for in-depth analysis of each individual credit rather than simply assessing the overall asset class.
Even when looking at similar deals, a multitude of factors, such as location, accessibility, nature of tenants, energy efficiency and the track record of the sponsors, among others, can influence whether an investment will perform well compared with another that has the same features on the surface. For example, although there have been instances of stress in the CMBS markets, specifically given the first AAA default in the US, there are other CMBS opportunities that we have come across that we believe could offer compelling returns.
To learn more about the commercial real estate markets, please visit our website – www.prytania.com, where we have published the recording of the Prytania Webinar Series II, The Commercial Real Estate Plunge – Is this the bottom? In this webinar, our portfolio managers, Andrew Burgess and Michael Husemann, who have a wealth of experience investing in this sector discuss the current market landscape, the differences across the US and European markets and answer questions on ways to capitalise on the rebound. We also welcome you to reach out to us at investorrelations@prytania.com to arrange meetings for more in-depth discussion on the commercial real estate market as well as the broader structed credit market.
APPENDIX
Relative Value
1. Opportunities in the US mezzanine sub-sector
As shown in Chart 3, since 2022, spreads on the lower rated, mezzanine segment of the capital stack, BBB and below, have widened significantly and at a greater pace than the senior part of the capital stack. Due to broader investor concerns, we have not yet seen the same level of tightening.
Chart 3: US Conduit CMBS Spreads to Swap
Source: JPM Spreads, March 2019 to June 2024
2. US CMBS offers spread pick-up against similarly rated US CLO opportunities
Chart 4: AAA US CMBS Spreads against US Secondary CLO Spreads
Source: JPM Spreads, February 2016 to June 2024
Chart 5: A US CMBS Spreads against US Secondary CLO Spreads
Source: JPM Spreads, February 2016 to June 2024
Even when compared with CLO spreads, US AA & A CMBS spreads have been trading wider despite significant spread tightening since the latter part of 2023, whereas in the past, CMBS spreads have typically traded at around similar or tighter levels to CLOs, as shown in Charts 4 and 5.
Chart 6: US CMBS Spreads against EU CMBS Spreads
Source: JPM Spreads, September 2011 to June 2024
It is also notable that the returns for Europe AAA CMBS are now similar to that of US A CMBS. The European CMBS markets have shown a greater degree of dislocation over the same period and have also continued to trade at wider levels. Although at a macro level, the EU showed more signs of weakness, which led to a rate cut by the ECB sooner than in the UK and US, CMBS spreads have not followed suit. Therefore, when we look at opportunities across the US and Europe, there still tends to be a higher degree of relative value in European deals at the moment.
Chart 7: AAA EU CMBS Spreads against EU BSL CLO & RMBS Spreads
Source: JPM Spreads, February 2016 to June 2024
Taking a step further, European CMBS has remained wider than CLOs as well as RMBS in the region, as shown in Chart 7.
While this does not mean that every opportunity in the European CMBS market presents a promising investment, we see greater value in selective high-quality deals in Europe.
Our Views
Due to the additional complexity associated with CMBS investment we have typically found that even “vanilla” investments can offer a material spread pickup compared to other securitised collateral classes with similar credit ratings.
Significant market dislocation opportunities in the UK / Europe are largely played out
We have some seasoned positions across our open-ended funds which have yet to realise the expected recovery upside
Current levels still offer good relative value versus other collateral classes
There is very limited new issue in Europe currently. At present, some one or two more transactions are expected in the rest of 2024
The opportunity set is wider in the US, but the market also sold off less than we anticipated and then rallied more quickly in many cases, so lower absolute spreads are available in secondary. Parts of the mezzanine segment of the capital stack, BBB and below, have widened more materially than the senior part of the capital stack, which can present an opportunity for investors to capture outsized returns when taking exposure to highly selective risk.
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This document has been prepared for discussion purposes only by Prytania Asset Management and its subsidiary, Prytania Investment Advisors LLP (“Prytania”), a limited liability partnership (OC305343) incorporated in the UK and regulated by the Financial Conduct Authority (FCA). Prytania is registered as an Investment Advisor with the US Securities and Exchange Commission.
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