THE THICK OF IT: Clifford Chance's Steven Kolyer has advised managers on deals with delayed draw tranches and other kinds of potential work-arounds.


It’s one of the biggest regulatory hurdles the market has faced since the financial crisis, and promises to bring wholesale changes to the structures of transactions as well as to the business models of managers, particularly those that also want to comply with separate risk retention requirements already in place in Europe. 

After December 2016, any sponsor of a new U.S. CLO will be required to hold 5% of the notional value of the structure on its balance sheet, for example, $30 million of a $600 million CLO. That’s a tall order for firms that manage funds for clients, but have little of their own money to put to work.

CLOs issued prior to the cutoff date are exempt. However, there are mounting concerns that otherwise exempt CLOs may end up triggering retention requirements when they are refinanced or repriced, as often happens at the end of a two-year non-call period.

The Loans Syndication and Trading Association, the industry’s main trade group, thinks that refinancings and repricings would be exempt under the spirit, if not the letter, of risk retention rules.

Some CLO managers, including Apollo Global Management and Carlyle Global Market Strategies, are trying to exploit this ambiguity. They have been structuring new deals with delayed-draw tranches that serve as placeholder securities for eventual refinancing of the existing notes -- or possibly a mechanism for additional issuance that could carry the exemption. 

Steven Kolyer, a capital markets partner with law firm Clifford Chance and an industry veteran, is in the thick of things, having advised managers on a number of deals with delayed draw tranches and other kinds of potential work-arounds. He is also working with managers on ways to comply with risk retention.

In a recent telephone interview with ASR's sister publication, Leveraged Finance News, Kolyer discussed his concerns about the impending regulations, as well as other pressing market concerns such as the slowdown in primary loan issuance and the quest for CLO “super structures” that comply with both U.S. European risk retention requirements.  

Leveraged Finance News:  Is the introduction of delayed-draw loan tranches a trial balloon to send before regulators, or is it primarily a new refinancing strategy?

Kolyer:  As a practical matter it amounts to both. There are bona fide structural benefits, in terms of facilitating the ease of adjustments to funding later, to having these up-front features…as well as perhaps achieving [risk retention] compliance without being limited by a grandfathering period.

If you view a refinancing as merely adjusting an old financing that was already in place, you would say it wouldn't have to follow retention rules as a new securitization. When you think of securitization, definitions of securitization often include the notion of a transfer of financial assets to a bankruptcy-remote vehicle and the issuance of securities to investors supported by payments on those assets.

There's the view that post-December 2016 these QUSIP-numbered unfunded notes have already been issued and when funded fully would not constitute a new securitization. That is supported not only by their already existing but also by the notion that the assets aren't being transferred, they're staying in the same vehicle.

So this has been done many times in other asset classes?

Yes it's been done in a variety of contexts, where a rating agency will rate the credit quality of an exposure that may not be fully funded at the outset. If you go back to the CDO market prior to the credit crunch, there are a lot of derivatives and unfunded note classes, such as in synthetic CLOs, that had no up-front funding. Not only in CRE CDOs and 1.0 CLOs, but asset-backed commercial paper as well. If asset-backed commercial paper can't be rolled over on a given day, then there are liquidity facilities in place to be drawn down to replace the CP with potentially longer term loans. Those loan facilities are available to be drawn days or months later and when they are drawn they aren't considered new securitizations.

In these delayed draws, are issuers specifying which tranches they are associated with?

Yes, an unfunded class is linked to a funded class. Most of the refinancing features in the CLO 2.0s provide that the subnote or equity tranche remains constant…and it's about the refinancing of the debt classes that lie on top of that.

Have issuers applied specific amounts to these delayed draws, and what is their percentage to the notional value of the CLO?

I can't speak to specific deals. We have worked on multiple deals. When there is a partial refinancing, there are structural features to insure that the other ratings will hold up. You may have a refinancing after a two-year non-call period where the portfolio has reached its fully ramped up size.  But ostensibly you could have a situation where a refinancing could occur much later, even after four years when the portfolio starts to shrink and contract.

Most CLOs limit the maximum size but stop short of hardwiring replacement principal amounts upfront because you could have a refinancing after the deal has started to contract in size. And therefore the principal amounts may have changed.

In a Moody's report issued on delayed-draw terms, the agency stated this brought a new level of complexity to the CLO structure.  What complexity do these add?

From a credit perspective, the rating agency would have difficulty pre-committing to a credit rating structure not yet certain. That's what Moody's seems to be getting at. The fact is that if they're being asked to agree upfront to more specificity to what these to-be-funded classes will look like later, it becomes trickier for Moody's to run a model.

But it's a matter of degree.  Like everything in CLOs, if there's a complexity for which there is a consistent approach, then that complexity becomes more familiar. Even though in absolute terms it is complex, in market terms it's not difficult to consume.

If regulators come out in near-term that they will exempt these delayed-draws from risk-retention, what's to prevent CLO managers from overloading their pre-2016 issues with these delayed draws?

Let's remember that all the CLOs that are to be issued between now and December 2016, if not refinanced, have a tenor in terms of maturity that is 10 years. So they're still out there. You're not increasing the aggregate amount of CLOs that are out there by the simple fact of refinancing. All you're doing is changing the funding costs and the actual tenor may be getting no longer.

The whole idea is that if you refinance three or four years from now, and you're only refinancing for another three or four years, not eight or 10 years, it's not really a floodgates issue, it seems, from the standpoint of regulation.

Now, if you take all the deals right after the effectiveness of risk retention, and somehow found a way to refinance them to add 8 years to their life, that's a little harder to say that's completely consistent with what the regulators must have thought was OK.

How would these delayed draw term loans jibe with European rules?

There have been several different aspects to the transition to risk retention in Europe over the last several years. No. 1, there's been no grandfathering of deals. No. 2, there have been deals done that participants thought complied, but about which the regulators disagreed, and said we're not only interested in whether you complied with the letter, we're interested in whether you can comply with the spirit of the EU rules. That letter vs. spirit warning was reiterated as recently as December.

There are aspects of the European rules that are ambiguous. For example, how much ownership of a loan, on the part of someone who's trying to be characterized as an originator, is needed? How long do you have to own something? 48 hours vs. a month?There are issues the regulations are silent on addressing specifically, so the market has had to figure out where to point the needle, where to draw   line.

"Super structures" for dual U.S. and European CLO compliance are going to be a topic of discussion at the upcoming IMN conference.  Is it even possible, and how will that impact their business?

We have one or two in the pipeline that would be dual compliant. In some ways, having a risk retention structure that complies in the EU jurisdictions makes it easier to then layer in the U.S.-risk retention compliant structure as well. But only for certain U.S. managers – I don't want to say that categorically across the board.  The "holy grail" solution certainly is feasible.

A lot of alternative asset managers in the United States have ambitions to spread their asset management and advisory businesses in the alternative space into Europe. We see certain large managers lament the fact that the way they're structured makes it potentially more difficult to re-sort themselves to this. The large institutions each have their own special circumstances. Some of them have their credit platforms glued into their overall structure, mutual funds, etc., in  such a fashion that it's not that easy to put a CLO asset-manager entity into a convenient place in a risk retention structure – because they are already glued into parts of a broader organization.

When you're talking about risk retention, now you're talking about how you're setting up your business with permanent equity capital and that's a whole wider angle view. In the mortgage REIT space, that's what people do. What we spend a lot of time researching and talking with the SEC from time to time about is issues on how it may work for assets like corporate loans.

Permanent equity capital is a different dimension than the CLO market has been considering through its long and robust life.

So organizational structure could be fundamentally altered?

I've used the examples of the mortgage REIT. If you invest in a mortgage REIT and say, I trust you to set up CDOs from time and time and I'm not going to look at each one, you also want liquidity for your equity for the New York Stock Exchange, which means public equity.

So the holy grail idea in the U.S. is to set up a permanent capital vehicle that has just not equity fused into it in a nice little box-and-arrows diagram, but one that will see this vehicle do an IPO and end up with publicly-listed equity and liquidity so that the equity investor can be at ease.

It's not realistic to raise private placement equity in the U.S. and assume you're going to easily have equity investors be able to simply write you a blank check for CLOs for the next 10 to 20 years. A lot of those equity investors will want to know there's liquidity in the form of some sort of public market outlet at some point.

Regarding the slowdown in loan issuance – what's the impact on CLOs, and are CLOs considering alternative investments to fill the pipeline of demand?

Many believe that the chances of the regulators clearing up issues in the current Volcker Rule that would enable a loosening up of the bond bucket restrictions are dubious. We're left with the supply of loans in the market and the primary market origination pace fuels a lot of this.

The last two years, every time has market started to pause or have a hiccup, the market has so far shrugged off these things and kept going. There are a lot of dollars piled up with banks and insurance companies looking for safe paper.  Currently we have new AAA buyers coming in and spreads are coming down.

It is tempting to remain optimistic in all this and say this will all sort itself out.  The U.S. market has to issue like $70 to $80 billion just to replace the funding of the deals that are running off.

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.