US CLO managers are pretty evenly split on how to comply with an impending requirement to keep “skin in the game” of their deals.
A survey of some 50 managers of collateralized loan obligations by Fitch Ratings indicates that just over 40% plan to hold on to the most subordinate trance of their deals, giving them the first-loss position. This is known as the “horizontal” strategy. And nearly 35% plan to hold on to a slice of each tranche of their deals, known as the “vertical” strategy.
Another 7.7% of managers polled might do both.
In fact 50% of the respondents indicated their choice between vertical or horizontal might change on a deal-by-deal basis, as well.
“U.S. CLO managers do not appear to have a one-size-fits-all preferred approach to meeting U.S. risk retention requirements,’ said Fitch senior director Gioia Dominedo. “Not only are multiple approaches being considered, but half of the managers stated that they plan to vary their approach on a deal-by-deal basis.”
One option managers view nearly unanimously as unattractive is establishing of cash reserve accounts with a trustee, which could be released to meet shortfalls on an equivalent horizontal (first-loss) position, according to Dominedo.
(In an April CLO investor conference, panelists hosted by the Information Management Network speculated that it might be possible to finance the retention of either a horizontal or a vertical slice held for risk-retention purposes. These are stakes that cannot be securitized or hedged).
U.S. risk retention standards will go into effect in December 2016, but are already having an impact on how CLOs are being structured. Much of this has been caused by uncertainty about whether existing deals that would otherwise be grandfathered will trigger compliance if they are refinanced Some recent deals have had unusually short periods where the notes are non-callable, so as to allow refinancing before December 2016, for example.
Other managers are structuring deals with delayed draw tranches.
Beyond which securities to hold, CLO managers are considering how to hold them. Again, Fitch’s survey wide variations in plans: 41.2% plan to use a majority-owned affiliate with the capital stakes to handle the U.S. requirement that a “sponsor/arranger” hold the risk-retention piece. But 29.4% of existing managers plan to maintain the sponsorship themselves; another 13.7% plan to bring in a new manager as sponsor on U.S. deals; and 11.8% plan a new manager sponsor in order to be dually compliant with the differing U.S. and European risk retention regulations.
Again, nearly 30% plan on varying their approach on a deal-by-deal basis.
Less than half (44.2%) of the managers surveyed by Fitch indicated that some of their new CLO structures are compliant with European’s risk-retention standards, allowing them to be marketed on both sides of the Atlantic. Another 15.4% always ensure their CLOs are compliant in Europe, whereas 40.4% have not constructed a domestic CLO with European compliance in mind.
None of the managers surveyed indicated they would be getting out of the CLO market, with all respondents indicating they will issue new CLOs in the next two years. None plan to sell their U.S. CLO management contracts in the next two years, either.