With less than a year before risk retention rules take effect, many CLO managers are still trying to decide how they plan to comply.
One of the latest proposals comes from investment bank Jefferies, which is lining up banks, insurance companies and other kinds of third parties to finance the 5% stakes that managers of collateralized loan obligations would need to hold on deals completed after December 2016.
Jefferies doesn’t manage CLOs, but it arranges these transactions on behalf of managers. So helping managers comply with risk retention could bring in more business.Sources familiar with the plans say that details are still to be worked out, and it’s still unclear whether it would pass muster with regulators, which have provided little guidance on how financing might be structured.
A Jefferies spokesman declined comment to Leveraged Finance News about the investment bank’s financing program.
The firm is not alone; others, including CLO arranger Natixis and CLO investment firm Eagle Point Capital Management, are also exploring retention financing plans, according to sources.
And third-party financing is far from the only option.
CIFC, one of the largest CLO managers, has raised its own capital through the sale of private placement bonds in anticipation of completing its first risk-retention compliant CLOs sometime next year. Octagon Credit Investors in October decided to put its $12.8 billion in CLO, bank loan and high-yield bond assets under management within a larger umbrella organization, agreeing to takeover by Cathay Financial Holding Co. asset manager unit Conning that will provide it the necessary risk-retention capital to back new CLO issuance.
The retention rule has been controversial since its proposal phase, with many in the industry complaining that smaller CLO managers and arrangers could be forced out of the market since their function as investment managers – not originators – means they do not have the capital on-hand to meet the standard. An issuer of a $500 million CLO, for instance, would be required to retain $25 million of the portfolio.
In addition, holding on to a 5% stake would require CLO managers to hold at least a 50% stake in the equity-tranche portion of a CLO – and then be exposed to potentially an outside share of potential losses, according to Ariel Kronman, a partner in the law firm Weil Gotshal & Manges, in a client briefing he penned last spring. That’s because payment defaults are concentrated in the lower tranches, and have never been recorded in the top-level AAA- or AA-rated tranches of a U.S. CLO.
But as the deadline approaches, it appears some are finding a cost-effective way of staying compliant is more difficult than anticipated. In October, Regiment Capital Advisors chose to exit the scene by selling off its $1.6 billion in assets across four CLO portfolios to Bain Capital’s distressed debt and CLO/high yield investment unit Sakaty Advisors.
Some are expressing optimism that the risk-retention structure as constituted could be workable. Dayl W. Pearson, president and chief executive of business development corp. KCAP Financial, said in a third-quarter earnings call in November that the risk retention won't impede its new CLO issuance of middle-market loans on their books.
“I actually think the way risk retention is structured, it's probably going to need less of an investment from KCAP and new funds because you are going to be buying a strip which is financeable as opposed to equity starting in 2016, and there are also some other ways of dealing with risk retention,” Pearson stated. “So we think we have capital that would be redeployed and continue, assuming the market is there and assuming it makes economic sense, continue to issue CLOs.”
One of the roadblocks some managers are facing, however, is the lack of clarity in the regulations. While the 5% retention slice will be permitted to be held on the books of a majority-owned affiliate or a sponsor-arranger, for example, the regulations specifically prohibit securitizing or hedging against the funds.
The definition of “securitizer” can potentially be clouded in a financing arrangement, wrote Kronman in the brief.
For example, according to Kronman, risk-retention compliance could be tripped up if the financing agreement appears to shift the credit analytics function of a CLO’s underlying assets to a third-party – a clearly forbidden arrangement under the risk-retention standard. “What the effect, if any, of outsourcing credit analytics or any other CLO manager functions may have on a determination of who is the ‘securitizer’ and who is a ‘third party’ is not addressed in such guidance,” stated Kronman in the briefing.
While a “number” of financing options are being considered by CLO managers and arrangers, he wrote, it is difficult for them to structure a “cost-effective” solution due to the lack of guidance on financing options.
“The severity of the rules’ ultimate impact will to a significant extent depend on which of the financing structures that comply with the text of the rules are deemed to also comport with the guidance the regulators have provided and will provide regarding the rules’ purpose and interpretation,” Kronman wrote.