Risk retention rules created some big hurdles to creating new collateralized loan obligations. Yet they also opened up new avenues for investing in the market, as many managers serving as fee-for-service agents were compelled to raise the capital necessary to keep “skin in the game.”
Four months in, investors are getting more comfortable with the complicated structures used to put managers into compliance. This helps explain why issuance is picking up steam after a slow start to the year, though there has also been a pickup in issuance of leveraged loans used as collateral. An unexpectedly strong April, when $10 billion of CLOs were issued, prompted S&P Global Ratings to boost its forecast for full-year issuance to $75 billion from $60 billion previously.
“The refreshing thing has been the amount of capital that’s come into risk retention structures from entities who traditionally have not been CLO investors,” said Sean Solis, a partner at law firm Dechert. “We’re hopeful that’s going to be positive for the CLO market overall.”
Solis spoke with Asset Securitization Report in April about the evolving structures that managers are using to raise capital, including creating a stand-alone business buoyed by third party investors, known as the capitalized manager vehicle (or CMV); using a lower-cost, single-purpose and self-capitalized investment unit, known as a majority-owned affiliates (MOA); or a hybrid option that brings some investment capital into an MOA, known as a capitalized MOA (CMOA).
How did the choices between CMV and MOA models evolve?
Each manager had to identify how they were going to structure their risk retention solution and some managers came to the realization they wanted to create a stand-alone business and create something that could be monetized and taken public in an IPO. They were therefore attracted to the CMV model – a complete spinout of the business, a formation of an independent manager legally and operationally separate from the legacy manager.
Forming and raising capital for CMV is an expensive undertaking, both in time and effort, and forming a new operating company like this usually involves raising significant amounts of capital from third-party investors, and such third party investors are attracted to the structure due to the fact they have a direct say on who and how the company is run and operated.
On the other hand, the people who choose to do an MOA model usually have access to internal capital, which in that case is very simple: just do a majority owned affiliate, acquire the requisite retention securities and you go from there. For those managers that want to solve for EU risk retention we have the CMOA option, which involves setting a manager that is an MOA for US risk retention purposes and an entity of substance for EU risk retention purposes. This is an attractive option for many investors as such investors who are materially interested in investing in a manager, even if it’s controlled by a legacy manager. The CMOA checks that box.
There is an option for lead arrangers to take the reins of risk retention, so why has that not been widely adopted by CLO managers?
That’s one where the regulators – notwithstanding the industry’s comments that it’s never going to work in practice – allowed the lead arranger agenting the loans to hold a certain percentage of them and act as the risk retainer. Given that most of these loans are agented by large bulge-bracket banks, such banks are not in the business of managing CLOs. The last thing they would want to do is retain securities in those CLOs that they do not manage. It was never a really natural fit, and they would never want to hold something that illiquid; in fact, they get awful capital treatment under the bank regulatory rules.
It’s never been seriously considered by anybody to my knowledge, and I seriously doubt it gets considered in the future.
Have some unforeseen complications arisen with any of the options, especially regarding costs?
It depends. I don’t think there is anything unforeseen, but the cost and complexity is a byproduct of the investors that are exploring and negotiating the applicable structure. The refreshing thing has been the amount of capital that’s come into risk retention structures from entities who traditionally have not been CLO investors. We’re hopeful that’s going to be positive for the CLO market overall.
Where is that financing coming from?
You mostly see large institutional investors, insurance companies, pension funds, sovereign wealth funds, investors of that type.
So it mirrors the investor classes for the CLO notes themselves?
It mirrors them, but they’ve been different actors. You see those types of entities invest, but my point is we’ve seen those entities that have not traditionally invested in CLOs.
Is the manner in which these managers finance the risk-retention piece driving the decision on which vehicle structure to use?
There’s not any really financing for the horizontal structure. But for the vertical, financing is very much driving the strategy. In order to attract third-party capital to a vertical-strip strategy, you need to be able to source financing for that because you likely need it to make the returns work. Long story short, if you’re doing a vertical strip strategy and you’re trying to raise third-party capital, it’s likely you’re going to need to contemplate financing to make the whole structure fit together.
Why are financing providers not interested in retaining equity stakes in the horizontal structure?
It’s obviously the riskiest tranche in terms of being the most subordinate, and it’s not rated. So the people who provide the financing often need investment grade collateral, and therefore CLO equity just does not fit that bill.
What types of managers prefer CMV to those that choose MOA or hybrid CMOA structures?
The nice thing about these structures is they’ve proven to be adaptable to managers of all shapes and sizes. As they become more commonplace and the investor community understands them better, even the smaller middle-size managers will have success in effectuating them and raising capital.
There may be a better opportunity for some investors to go with a smaller manager because they are willing to give up certain economics or be more flexible in certain terms. The nice thing is some of the bigger guys have come out and put structures in place and everyone’s gotten familiar with it and given the opportunity for smaller managers to adopt those new structures and attract significant capital.
So is the variety of these options showing that risk retention is not the roadblock to CLO creation that some had feared?
Obviously the constraint is the amount of capital out there. There’s been a decent amount of capital raised, but managers are going to be conservative on when they deploy such capital as it is valuable and it is finite.
My feeling is that once we get through this infancy stage of the risk-retention cycle, and the market fully gets their arms around all of the issues of first impression that are being worked through in each new deal, that the main focus will shift back to where it always should have been and that is mutual beneficial outcomes that abound when the market is functioning optimally.