The European CLO market may be headed in an uncertain direction as regulators and participants map out how they would accommodate UK collateral managers in a post-Brexit European Union.
International corporate law firm Cadwalader, Wickersham & Taft issued a client update this week warning that the UK’s vote to depart from the EU could result in a host of problems for London-based asset managers if the separation from the EU comes to fruition (a process that may take up to years).
That could not only be a market exclusion problem for UK firms, but a threat to the structure of the existing EU CLO market as a whole, since the bulk of Euro collateralized loan obligation sponsors (and consequently the chief risk-retention holders) are London-based.
“Of key concern will be how UK collateral managers will be regulated within Europe and how that impacts their ability to hold risk retention and manage an EU CLO,” the report stated.
The greatest concern over a British departure from the EU could pertain to whether UK firms would remain legally able to hold CLO collateral if they are outside EU regulatory jurisdiction.
UK firms today manage the bulk of CLO portfolios across Europe through special purpose investment vehicles (SPVs), operated under the EU’s Markets in Financial Instruments Directive (MiFID) regulation. Those SPVs are “generally” established in Ireland and The Netherlands, but are operated and sponsored by UK collateral managers.
But upon exiting the EU, British managers would need a reciprocal agreement in place to continue as legal sponsors of CLOs. Cadwalader and others speculate that the remedy could be through the UK obtaining an extension of its “passporting” rights extended to non-EU members like Norway and Iceland as part of the European single market, or the European Economic Area.
While those passporting rights permit the UK financial services industry to operate across borders in EEA member states, it presents with it stipulations for which the victorious “Leave” ballots were seemingly cast in opposition – such as the UK having to agree to free cross-border movement of immigrant labor from across the EEA.
CLO collateral managers aren’t the only ones out of luck if UK institutions cannot extend EEA passporting privileges or fail to negotiate working agreements with the EU. “Other transaction parties, if they are UK entities, including investors, may also be unable to be involved for similar reasons,” Cadwalader noted.
Another alternative, Cadwalader notes, is for CLO risk-retention compliance to come under the originator method, whereby the 5% “skin in the game” stake is to be held by the structural agent behind a CLO transaction instead of an off-loaded SPV. European regulators have been exploring new regulations that could limit SPVs, believing that it better aligns securitizers’ interests with investors.
Under the originator model, UK collateral managers would have to originate a portion of the assets for each CLO. “The key here is that there will be no change to the entity holding the retention, which is generally not permitted by the EU risk retention rules, but it will solely be a change to the capacity in which such UK collateral manager is eligible to retain.”
The risk-retention concern is heightened by new proposals to extend further restrictions on CLO sponsors, originators and lenders under the EU’s “STS” (Simple, Transparent and Standardized) securitization change initiatives.
Under the proposed STS changes, an originator, sponsor or lender of a CLO would be required to be a regulated entity – namely, a MiFID designated institution. In additional, EU-regulated institutional investors would be the only parties permitted to invest in asset-backed securities governed by STS standard, potentially cutting off UK buyers for CLOs. (CLOs lack an exemption to the STS proposed changes due to their actively managed status).
European issuance of new primarily CLOs is at €6 billion, through 15 deals that have priced year-to-date. Just over €13 billion in new CLOs were issued in 2015.