It’s official: collateralized loan obligations issued prior to Dec. 24, 2014 can be refinanced without triggering a requirement that managers keep “skin in the game.”
On July 17, the U.S. Securities and Exchange Commission published a “no-action” letter in response to a request from Crescent Capital Group, a CLO manager based in Los Angeles. Crescent’s law firm, Cleary Gottlieb Steen & Hamilton LLP, had asked the Commission whether it would take enforcement action if a collateral manager refinanced a CLO and did not retain 5% of the newly issued securities under forthcoming U.S. risk-retention standards.
The no action letter effectively means that $152 billion worth of CLOs will be able to refinance in 2017 without triggering the standard, according to a report issued Friday by Wells Fargo. Prior to the SEC’s decision, $261 billion worth of CLOs faced having to refinance before the effective date to avoid having to take on a 5% stake in the refinanced tranches, per Wells.
David Beaning, special counsel in the SEC’s Office of Structured Finance (part of the Division of Corporation Finance) responded in the negative; so long as a CLO is originally issued prior the publication of risk retention rules and refinancing is subject to the same terms and conditions outlined by Crescent, it would not trigger a risk-retention requirement.
The ruling puts to rest uncertainty that had been hounding the market since final rules for asset-backed securities were adopted by federal regulators last December. The risk-retention rule which regulators adopted under the credit risk retention standards set out in the 2010 Dodd-Frank Act do not take effect until December 2016, and CLOs issued prior to that date are grandfathered.
But it was unclear whether deals issued prior to December 2016 could be refinanced without losing the exemption. Spearheaded by the Loans Syndication and Trading Association, CLO industry officials had sought to clarify whether regulators would treat the CLO as a new security subject to the risk retention if it was refinanced after December 2016.
“We were saying from a policy perspective, nothing is changing” in a CLO refinancing, Elliot Ganz, LSTA’s executive vice president and general counsel, said in an interview with Leveraged Finance News. “It’s the same pool of assets, we’re not extending the maturity, and no one’s trying to game the system.”
"This SEC response provides important support for a large volume of CLO 2.0s exiting their two-year non-call periods having the commercial flexibility to manage their liability structures in varying funding rate environments," said Steve Kolyer, a capital markets partner with law firm Clifford Chance and CLO industry veteran, said in an email response to Leveraged Finance News.
The SEC’s no action letter does not apply to all grandfathered CLOs that refinance. These deals must meet several conditions ensuring that their structure remains unchanged.
Cleary Gottlieb listed these conditions in a client alert published this week: the refinancing must take place within four years of the CLO’s original issuance; the manager must achieve a lower interest rate in the transaction; and the CLO’s underlying capital structure, principal, priority of right of payment features, maturities and voting/consent rights must remain unchanged.
Managers will also have to show that no additional assets would be securitized in the refinancing, that holders of subordinate equity tranches remain unchanged. Managers can only refinance each tranche once without triggering risk-retention standards, although they would be permitted to refinance individual tranches on different dates.
In Friday’s report, Wells Fargo senior credit analyst David Preston said the four-year window reduces the pressure on managers and equity holders of deals issued prior to 2015 to refinance prior to 2017. He estimates that, of the $94 billion worth of CLOs become eligible for refinancing the second half of 2016, $78 billion worth can now safely refinance after the effective date of the rule and not be subject to risk retention.
“This ruling is positive for most CLO equity holders, in our opinion,” wrote Preston.
Kolyer noted that grandfathered deals aren’t entirely free from worry about risk retention. They could still come under pressure from investors to comply with the rule. "Practically speaking, this flexibility [from the SEC] may be constrained by investor pressures on CLO managers to implement risk retention for new financings even before legally-required," he said.
The LSTA had lobbied for a broader exemption for all CLOs issued prior the Dec. 24, 2016 effective date, but Ganz admitted “that was a bridge too far for the agencies.”
“Once the rules were published in the federal register on 12-24-2014, you are kind of aware that this might happen,” Ganz said, referring to regulators’ viewpoints. “Therefore, it’s not unfair to require risk retention on new issuance going forward.”
That means CLOs issued between Dec. 24, 2014 and through December 24, 2016 would no longer be grandfathered from the risk retention standards should they be refinanced after 2016.
Most CLOs have features that permit the interest rate on the secured notes that they issue to be reduced to market clearing levels. This is accomplished by issuing replacement notes with a lower interest rate and using the proceeds to redeem the original note. The replacement notes may be sold to existing or new investors. But the CLO’s capital structure is unchanged.
While risk-retention standards have been implemented for other financial sectors such as the mortgage industry (with the exception of a “qualified” mortgage), CLO managers were particularly concerned about the impact on the market. Retaining a 5% slice of a $600 million CLO, for example, would require a manager to hold $30 million of the portfolio on its own books a tall order for firms whose role is managing clients’ money and holding very little of their own.
The lack of clarity about the impact of refinancing had led many smaller CLO managers with fewer assets to reconsider their role in the market. Some have implemented work arounds, such as shortened non-call periods (which are typically two years for CLOs) to allow refinancing prior to the effective date.
Other CLO managers have issued deals with unfunded, delayed-draw tranches that would stand as placeholders for future refinancing efforts to avoid a technical creation of a new security after 2016. Many in the industry felt that was a workaround not likely to pass muster with regulators.
Ganz believes the no-action letter will likely reduce the need for such work arounds, and could also reduce the volume of CLOs likely to be refinanced in the fourth quarter of 2016.
“Absolutely, it makes it very clear what the rules are,” Ganz told LFN. “Without this relief, even though it’s only partial relief, there would be a rush to refinance prior to the effective date in order to avoid risk retention.”
“We didn’t get everything we wanted,” Ganz added, “but at least we did get a bigger slug of relief and we got clarity.”