Pleasing regulators on both sides of the pond is only getting harder for CLO managers.
Last week the European Central Bank and the Bank of England both indicated support for closing a loophole to requirements that originators keep skin in the game’ of collateralized loan obligations and other kinds of securitizations.
The proposal, which was first aired by the European Banking Authority in January, affects managers that were potentially violating the “spirit” of risk-retention by setting up special purpose investment vehicles to hold the required securities, as opposed to keeping them on their own balance sheets. As in the U.S., the European risk retention rule was designed to align the interests of managers with those of investors in their deals.If the EBA’s recommendation is approved by the European Commission, U.S.-based asset managers who’ve built Europe-compliant structures may find themselves back at the drawing board—or at the seller’s desk, according to Wells Fargo structured products research analyst David Preston.
“This means that three large regulators in Europe have recommended that the originator definition be narrowed,” Preston wrote in his weekly CLO Lagniappe newsletter on April 3. “This could limit issuance of U.S. CLOs to European investors; in a worst-case scenario (no grandfathering of existing deals), investors in some CLOs could end up as forced sellers.”
This new front in Europe’s regulatory landscape is just latest hurdle facing CLO issuers on risk retention.
Most of the market had already been focused on strategies dealing with forthcoming U.S. risk-retention guidelines, including the question of how regulators will treat the eventual refinancing of grandfathered CLO issues (those issued prior to the December 2016 enforcement date).
Now, with a greater interest in expanding their product to European investors, many U.S. market participants are tackling how to meet the existing European standards as well including options for a dual-compliance “superstructure” that will make portfolios satisfactory to both regulatory regimes.
The topic will be up for discussion in an April 21-22 CLO investor conference hosted by Information Management Network, in which one panel will examine how a CLO might set up a structure to meet both the U.S. and European rules that do not intersect in several ways.
John Timpiero, a partner with law firm Dechert LLP, says the dual structure is being sought simply because more asset managers want to expand their pool of investors as widely as possible. “It gives managers the ability to potentially sell their notes at lower spreads, which is what drives people to make their deals EU compliant,” said Timpiero, who specializes in advising on asset-backed securities and middle-market CLOs.
In a January report, Barclays analysts estimated the European CLO issuance would expand to 20-25bn in 2015, up from 14.5bn in 2014, driven by new deals from U.S. CLO managers drawn to Europe’s tighter liability spreads.
One of the first hoops a dual-compliant structure must jump through is meeting the definition of which entity has to hold the minimum 5% stake in the notional value of a CLO. In the U.S., the forthcoming regulations call for exposure to be held by the sponsor/arranger (usually a fund manager that does not have a need for large capital stakes of its own) or a majority-owned affiliate of the sponsor.
In Europe, by comparison, the retained securities must by an entity defined as an “originator” or “sponsor”, as well. But the flowing spring of definitions between the two regimes can make it confusing as to whether a U.S. “sponsor” meets the EU “sponsor” definition.
For example, a “majority-owned affiliate” of a sponsor/arranger in the U.S. only meets the definition as an acceptable EU risk-retention candidate if it meets the definition of “originator” as well, according to a client alert last fall from law firm Milbank.
That, so far, has not expected to amount to much of a burden for U.S. issuers. Although Wells Fargo’s Preston relayed the “worst case” for CLOs hypothetically rendered non-compliant, Barclays stated in its report that even if the EU tightens the standards on who is an “originator,” the “initial reaction of most market participants is that existing originator vehicles would not run afoul of regulatory changes based on the EBA’s recommendations. As such, additional originators are likely to surface in 2015, facilitating the further expansion of European CLO creation.”
One structured credit executive at a major international bank, speaking on condition of anonymity, said that ensuring compliance with EU standards alone is rather straightforward for managers. Unlike in the U.S., where the onus for compliance will fall directly on managers, European regulators focus the compliance on institutional investors—an indirect method of regulating CLO managers and arrangers.
If investors are buying into CLO tranches, they’ve likely vetted the deal against EU risk-retention standards themselves. ”You don’t know exactly if it’s going to work until you get out there and you have managers or you have investors buying the deal, and that’s the ultimate seal of approval,” the banker said. “Your deals are deemed to be good.”
But that, too, is under review in Europe. In the Bank of England/ECB published note last week, authorities also lined up behind an idea to more directly supervise managers, which would require them to verify risk retention-compliance, to “align the risk profile of European investors to that of their American cousins,” according to a client note from Dechert LLP.
“The proposal to place an additional direct’ obligation on the issuer to verify risk retention compliance (alongside the current “indirect” obligation placed on investors) will effectively mean a shift in the risk profile of risk retention,” the Dechert note stated. “Although the proposals will undoubtedly help to harmonize the structure of risk retention provision (and will, no doubt, be welcomed by investors in the market), it will increase the time, legal costs and risks of issuers.”