While lawmakers continue to press regulators to exempt collateralized loan obligations from Volcker Rule restrictions, managers of these deals have found another workaround and this one allows them to invest in bonds.
CLOs that contain any securities are “covered funds,” and banks are not permitted to hold “ownership interests” in covered funds under the Volcker Rule.
Most CLOs issued before the publication of the final rule in December have the ability to invest in bonds as well as loans. And owners of senior debt securities issued by these CLOs typically have the right to remove the deals’ managers “for cause” and so could be considered to have an ownership interest.
To avoid running afoul of Volcker and putting themselves off limits to banks, most CLOs issued since the rule was published restrict themselves to investments in loans. There have also been discussions about making existing deals compliant by selling bond holdings or limiting the noteholders’ ability to remove or replace the manager.
But there is another way to avoid being classified as a covered fund: relying on Rule 3a-7 of the Investment Company Act of 1940 to avoid registration with the Securities and Exchange Commission. Most CLOs are issued under a different exception allowed by Rule 3c-7 of the Act. (This is the same exception used by many hedge funds and private equity funds and the reason CLOs got ensnared in the Volcker Rule.)
Since CLOs issued under Rule 3a-7 aren’t covered funds, banks can hold the senior debt issued by these vehicles, regardless of their ability to remove the manager or whether the CLOs hold bonds or other securities.
It sounds simple, but Rule 3a-7 comes with more restrictions than Rule 3c-7. Notably, the rule prohibits investment vehicles from making trades for the “primary purpose of recognizing gains or decreasing losses resulting from market value changes.”
Although most CLOs are actively managed, recognizing gains or avoiding losses isn't necessarily the primary reason that managers buy or sell assets. Managers also make trades to comply with various covenants and compliance tests, improve or adjust a deal’s rating profile, diversity score, weighted average life or maturity profile.
And there’s plenty of precedent for using the 3a-7 exemption. “We’ve seen a lot of the balance sheet deals involving middle-market loans that have historically been 3a-7 compliant, and some managed broadly syndicated transactions that have as well,” said John Timperio, a partner at the law firm Dechert LLP.
In a February report, Wells Fargo analysts listed a number of legacy CLO 1.0 deals that appear to have been issued under Rule 3a-7, from managers such as Silvermine Capital Management, Highland Capital Management and GSO/Blackstone Debt Funds Management.
Timperio says that existing CLOs could theoretically change their status from 3c-7 to 3a-7 with an amendment, though the ability to do so varies from deal to deal. He believes it’s more likely that we’ll see Volcker-related use of the 3a-7 exemption among new CLOs, however.
“In the past it’s been driven by the manager wanting to rely on 3a-7 for its own internal reasons,” Timpero said. The difference here is you’ll have managers setting them up in this fashion due to constraints around the noteholders. Because of that difference, you’ll probably see some protective provisions for the investors worked into this new group of 3a-7 deals.”
In other words, even if a manager issues a deal under the 3a-7 exemption, unless there is wording to guarantee that the manager’s future trading activity won’t put the deal at risk of Volcker noncompliance, these banks may balk.
“Some banks are conservative and worried, so they may be hesitant to rely solely on the 3a-7 exemption,” said Wells Fargo CLO analyst Dave Preston. “From a bank investor’s point of view, the concern is that the manager could do something to push the deal out of Volcker compliance. So a lot of banks are looking at it like belt and suspenders—in other words, it may not be enough but it might help.”
Indeed, at least one recently marketed U.S. CLO that was issued under Rule 3a7—the $746.04 Madison Park Funding XIII managed by Credit Suisse Asset Management—also eschews bond investments, according to a presale report by Fitch Ratings.
The transaction documents for the deal state that it will not invest in bonds or other securities unless none of the senior securities issued by the deal are considered to be an “ownership interest” under Volcker or it is exempt from registration under the Investment Company Act by Rule 3a-7.
A representative from CSAM declined to comment.
Preston believes that 3a-7 deals may become a preferable option for European CLOs. That’s because the limited supply of European corporate loans makes bond allocations more valuable for these deals. The size of Europe’s loan market may also limit managers’ ability to conduct trades that might put deals in conflict with the rule.