Category: CLOs Regulation
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The re-proposed US risk retention rule (SCI 29 August) favours larger CLO managers and could result in a two-tiered loan market. Issuance is also expected to drop after the regulation takes effect, potentially raising borrowing costs for below-investment grade corporates.
The minimum 5% risk retention requirement for CLOs is unchanged under the re-proposed rule, but is now based on fair value at closing. The standard retention options are: an 'eligible vertical interest' of all classes, an 'eligible horizontal interest' or any combination of the two.
The re-proposal has special language for two types of CLOs - 'open market CLOs' and 'balance sheet CLOs'. The former includes an option for retention of 'CLO-eligible' loans, to be satisfied by lead arrangers of the original loans rather than the manager.
However, CDO strategists at JPMorgan note that it's unclear if the loan lead arranger option for open market CLOs will be received favourably. The broader question is whether it makes sense for banks to retain loans to underwrite CLOs.
Adoption will depend on business practices, cost of capital/balance sheet usage, operational complexity and so on. "Loan arrangers may well retain some of a broader credit facility's revolver, but little - if any - of the term loans typically sold to institutional investors/CLOs, given the capital requirement," the JPMorgan strategists explain.
Deutsche Bank CLO analysts suggest that a two-tiered loan market could emerge - of 'CLO-eligible' loans and non-CLO-eligible loans. "To minimise the amount necessary to retain, the loans would most likely be broken into 'CLO-eligible' tranches that would be sold to CLOs explicitly and tranches that would not qualify as CLO-eligible and would be sold to other leveraged loan investors, such as mutual funds, exchange-traded funds and hedge funds," they note. "But the issuance of the CLO-eligible tranches would still be more costly for banks and so one can imagine that the pricing of those might have to change to compensate for the increased cost. Conceivably these tranches could be sold at a lower spread to investors, but would incorporate a higher underwriting fee."
A mixed market with both options employed could potentially develop, where bigger CLO managers would retain the risk under the general risk retention requirement and could invest in non-CLO-eligible loans, while smaller CLO managers would have to accept lower yielding CLO-eligible loans. "Under these proposals, there will therefore be significant value in the ability to marry capital to asset managers, and returns to providing the capital into such a marriage could be great," the Deutsche Bank analysts add.
Another potential wrinkle is that, if a manager retains 5% in the form of the standard horizontal first-loss option, it may end up being the majority holder and thus crowd out potential investment from other CLO equity investors. Although the sunset on transfer and hedging restrictions may seem to offer some flexibility, difficulties could arise if the retaining manager's strategy is to call the transaction.
Of 35 CLO managers surveyed by the LSTA last month, just over a third said they would be able to raise funds to satisfy the general risk retention requirement (SCI 5 August). Consequently, the CLO manager industry may further consolidate to the extent the rules constrain business models with limited capital to put towards the retention requirement. Since the CLO market re-opened in 2010, about 45 US CLO managers - just fewer than 50% of the universe - have issued three or more CLO 2.0 deals.
The comment period on the re-proposal expires on 30 October, with the rule taking effect two years after being finalised. Although CLOs issued up to the rule adoption date are grandfathered, the re-proposal is expected to negatively impact issuance well before then as the market adjusts to the new - more costly - environment.
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