A policy fight is threatening the recovery of collateralized loan obligations [CLOs] in Europe.
The debate is very familiar to U.S. bankers and regulators: Who should keep ‘skin in the game,’ and how much, when loans are packaged and sold?
A draft paper released by the European Banking Authority (EBA) in May calls into question what had been a common interpretation of the requirement for sponsors to retain a 5% economic interest in CLO deals. Participants understood that a third party could have this exposure, as long as the interests of this third party were aligned with those of the sponsor.
This interpretation made it easier for smaller CLO managers to bring new deals to market. Now that it has been called into question, the pipeline that some estimate could have reached $7.8 billion in volume by year-end is virtually shut, at least temporarily.
“The EBA consultation has already had a negative effect in stopping or slowing transactions in the pipeline,”says James Waddington, a partner in the London office of law firm Dechert. “This is unfortunate since these CLO transactions were beginning to provide additional liquidity to the European loan market where banks have been somewhat constrained, including lending to small- and medium-sized businesses.”
The CLO market’s performance matters to banks because they invest in and market CLOs, and CLOs also invest in loans syndicated by banks.
The U.S. CLO market has been on a roll. It hit $55 billion last year after slowing during the financial crisis, and some have said it could reach $70 billion this year.
The revival of the European market began just a few months ago. Six European managed CLOs have been completed this year, three of them before the draft paper’s publication. Predictions for more are currently being rethought.
Who Keeps ‘Skin in the Game,’ and How Much?
The current draft “casts a shadow over new European CLO 2.0 deals in the pipeline, or even recently issued ones, where risk retention regulation was set to be addressed by a third-party ‘anchor’ investor-retention mechanism,” Deutsche Bank analysts said in a May 24 report. “This avenue appears to have been blocked now. It would be significantly challenging for CLO managers to put their capital to meet the risk retention requirement given the lean balance sheets they typically operate on.”
Waddington agrees. “The problem is that most asset managers are fairly thinly capitalized and cannot purchase and hold on their balance sheet 5% of every deal,” he says. There might be a silver lining though as “the rules do allow financing, which may help to a degree.”
What exactly does the EBA consultation paper say that has put such a damper on issuance?
The May 22 draft paper essentially re-writes the current interpretation of risk retention that the EBA’s predecessor, the Committee of European Banking Supervisors, previously published in December 2010.
The EBA previously allowed some leeway in terms of who retained the risk. According to a client alert published by law firm Milbank, Tweed, Hadley & McCloy, previously, the EBA had considered that in some instances, such as managed CLOs, where the “originate-to-distribute” risks were remote, a party whose interest was seen as most aligned with investors can fulfill the retention requirement.
To accommodate this, the EBA had previously allowed the asset manager or the most subordinated investor in a CLO to be the retainer of risk, even though those entities were not original lenders, originators or sponsors.
The draft is proposing to eliminate these concessions and allow only those entities that actually meet technical definitions of “original lender,” “originator” or “sponsor” to be the retainer in a securitized transaction, with no exceptions.
CLO asset managers that are investment firms would be considered as a retaining entity, according to Dechert. However, experts say the application of risk retention to non-balance sheet CLOs is unnecessary and misguided.
“Risk retention was a policy response to perceived abuses in originate-to distribute and lack of ‘skin-in-the-game,’ leading to alleged moral hazard,” says Paul Forrester, a banking and finance partner at law firm Mayer Brown.
Non-balance sheet CLOs acquire their underlying collateral in secondary markets and do not originate, he says. If that were the case, no risk retention is justified or should be required. In syndicated credit facilities, the arranging or agent bank will often hold a material interest in the related loans and this is real risk retention, but is not considered in European capital requirements or in the U.S. counterpart proposals.
Although the EBA draft paper seems to have halted the recovery of the European CLO market, Milbank lawyers said that the European finance industry has a history of innovation and adaptation to the demands of new regulation.
Carlyle to Keep Issuing
To be sure, the market has not shut down completely. The Carlyle Group priced a $392.7 million deal at the end of May just a few days after the EBA’s draft paper was released. It was arranged by Barclays. Dubbed Carlyle Global Market Strategies Euro CLO, it consists of three floating-rate and two fixed-rated tranches rated by Standard & Poor’s.
The €180 million AAA-rated senior tranche was marketed at six-month LIBOR plus 180 basis points, according to S&P’s presale report.
In June, after the deal closed, Carlyle issued a statement saying that it planned other offerings. “We are pleased to be at the forefront of the re-emergence of the European CLO market and our intention is to be a repeat issuer similar to our U.S. CLO business,” Colin Atkins, head of European structured credit at the firm, said in a press release.
According to research published by S&P in June, Carlyle’s is the only deal that complies with retention requirements through a 5% equity retention by the manager.
In two deals that priced before the EBA paper was released, Cairn Capital’s €300.5 million Cairn CLO III and Apollo Management Group’s €325 million ALME Loan Funding 2013-1, 5% of the deals’ capital structure is held by a third-party equity provider that has a say in the portfolio’s management as well as the collateral manager’s decisions.
In a third deal, €300 million Dryden XXVII Euro CLO 2013, the manager Pramerica Investment Management chose to retain some risk directly through a 5% vertical slice of the capital structure, according to S&P.
S&P said a roughly €240 million deal priced by Goldentree Asset Management in June deal does not comply with the existing Article 122a retention rules, but because it is targeted to a non-European investor base, it is unaffected by the capital rules.
Other Managers on Hold
Other CLO managers may not have the same ability to retain exposure to deals on their balance sheets as does Carlyle, which has $16.7 billion in assets under management in its structured credit business, $5.97 billion (€4.7 billion) of that in Europe.
Prior to the release of the EBA’s draft paper, market sources had suggested that a total of 15 to 20 European managed CLOs pegged at nearly $8 billion in principal amount might have closed this year, according to Milbank. “In light of the consultation paper, this prediction now looks overly optimistic as there is certain to be a hiatus while transactions pause to adapt to, and await finalization of, the new regulatory environment.”
The EBA has requested comments on the consultation paper by Aug. 22 and will organize an open public hearing on the proposals on July 22. A final proposal is scheduled to be submitted to the European Commission by Jan. 1, 2014. — By Karen Sibayan