There are the five stages of grief, and there’s an analogous process that financial institutions go through when confronted with new regulations. First, they predict the industry’s demise; then they fight the regulation tooth and nail. The third phase is an attempt at a compromise, followed by acceptance. Last, firms figure out the least painful way to comply. U.S.-based firms managing collateralized loan obligations (CLO) are now in stage five, with an impending risk retention rule.
The rule, which goes into effect at the end of 2016, requires managers of CLOs to own a 5 percent stake in each one they manage. Despite the year-and-a-half time frame until the rule becomes real, firms already have had to grapple with compliance. The reason: CLOs can typically refinance after two years. “If you do a deal today, and two years from now you want to refinance, you will have to be risk retention compliant at the time of the refinancing,” says John David Preston, head of CLO and commercial asset-backed securities research at Wells Fargo in Charlotte, North Carolina.
Given that most CLOs fall in the $400 million to $600 million range, the risk retention rule generally translates into a commitment of $20 million to $30 million. If a CLO management firm doesn’t have that much money lying around, it must seek financing to meet the requirement. The most straightforward way of doing that is by eliciting a direct investment in the firm managing the CLO. If the firm is a public company, which most CLO managers are not, it can raise funds through public debt or equity issuance. The private option is known as a capitalized management vehicle (CMV), which is an entity set up for the sole purpose of taking on the 5 percent risk retention requirement.
Of course, who wants to put up the entire 5 percent if they don’t have to? To that end, CLO management firms are exploring another strategy called the majority-owned affiliate (MOA), which allows a related entity in the form of a fund to hold the risk. Because a majority owner can own as little as 51 percent of an affiliate, the CLO management firm can reduce its risk retention obligation in each of its CLOs by as much as half.
Say a manager has a $500 million CLO to issue. The MOA would hold a $25 million stake to fulfill the 5 percent requirement. As the majority owner, the manager would be on the hook for just over $12.5 million.
That said, there appear to be some advantages to the CMV. “As of now, it looks to us as if the CMV is the substantively stronger solution,” says one manager. Granted, that is the more time-consuming option, even though, says the manager, it is one more likely to withstand the scrutiny of regulators. “There’s less of a chance that the regulator says, ‘That affiliate that you set up just doesn’t hold water, and we think the entity to hold the risk must be the parent company,’” the manager says.
Those using the CMV route may find it easier to issue CLOs compliant in both Europe and the U.S., according to a January 2015 report by Philadelphia-based law firm Dechert.
Another question facing managers is whether to hold the 5 percent risk retention requirement in the form of a so-called vertical strip, which includes a piece of each of the tranches, or in a horizontal strip, which would mean retaining a large chunk of the equity — the riskiest part of a CLO.
CLOs are structured in tranches according to risk, from the safest triple-A-rated slice, which is always the largest piece, down through B-rated tranches to the equity. Because the equity generally makes up around 10 percent of a CLO — say, $50 million of a $500 million deal — a horizontal strategy would mean retaining roughly half of it.
Here things get tricky, because it may be easier to finance a vertical solution to fulfill the risk retention requirement. When it comes time to raise the rest of the CLO, however, the manager still has to find investors for the remaining 95 percent of the equity. Not only is the equity the most difficult part of the CLO to sell, but equity investors also demand the most compensation.
“That’s really the interesting conversation looking ahead,” says Oliver Wriedt, co-president of CIFC Asset Management in New York. “Many managers might be able to solve for risk retention by retaining a vertical slice of the capital structure, therefore minimizing their initial capital outlay.”
The problem with that approach, he adds, is that it ultimately is not feasible in terms of costs, since the CLO manager would still have to meet the 95 percent equity threshold and lose much of any return by having to pay fees.
Preston at Wells Fargo and others agree that it’s still too early to know if one strategy will become more common than another. Most likely, the CLO market will see a mix of structures. “The solution for each firm is going to depend on the nature of that firm, its relationships and its size,” he says.
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