There's a broad consensus that exempting CLO managers from a requirement to hold skin in the game of their deals will tend to encourage smaller players to re-enter the market, boosting issuance.
Now Morgan Stanley is quantifying the impact: It has raised its forecast for 2018 new-issue volume by 10%, to $110 billion.
In a report published Tuesday, the bank cited a few constraints. For one, the Feb. 9 ruling by the DC Circuit Court that U.S. risk-retention rules under the Dodd–Frank Act do not apply to open-market CLO managers does not take effect immediately. In all likelihood, the ruling could come into effect as early as within 52 days from Feb. 9, though it can be appealed by the regulating agencies that were the defendants.
Second, additional issuance of CLOS may still be capped by constraints on the availability of supply of below-investment-grade corporate loans that collateralize them.
Nevertheless, Morgan Stanley expects that smaller managers and new managers for which the constraining factor was sourcing the capital for holding a 5% stake in their deals will likely return to the primary market.
In the meantime, the capital that has already been raised to finance risk retention “can support the market for at least another year of high volumes.”
Morgan Stanley also expects the DC Circuit Court's ruling to result in an increase in CLO refinancings and resets. “We think this will on the margin generate more refi deals than we originally argued in [Morgan Stanley’s] 2018 outlook ... “where we expected a larger share of the CLO debt repricings would happen in some form of resetting into longer terms.”
What could be increasing in supply, the report stated, are a “much larger” universe of new-issue equity tranches that could be available to investors. Across the landscape of 2017-vintage CLOs, 57% retained a horizontal slice of the equity tranche (the remainder use a vertical strategy of investing in a 5% share of each tranche of the debt notes and the equity, including the triple-A tranche).
“For managers holding retained equity tranches,” the report stated, “they also have the option of supplying their holdings to the secondary market unless otherwise prohibited by the indentures.”
The absence of risk retention would also have a secondary effect of reducing investor competition for European CLOs for which EU risk-retention requirements remain firmly entrenched. Forty percent of U.S. CLOs issued in 2017 were compliant with European risk-retention standards.
“To be clear, a US CLO manager will still have the option of complying with EU RR rules to tap the European investor base, as several did in 2014-15,” the report stated. “But we do not expect this to be common.”