The Securities and Exchange Commission has made it easier for middle market lenders to tap the securitization market for funding by giving them an additional option for complying with risk retention.
While some people question whether the regulatory relief was really necessary, the fact that it was pursued at all illustrates just how eager many nonbanks are to lend to small and medium-sized companies.
Of course, securitizations of broadly syndicated corporate loans are no longer subject to skin-in-the-game rules enacted under Dodd-Frank late in 2016. A court ruling in February of this year excludes them. But the exemption only applies to managers of collateralized loan obligations that acquire collateral for deals in the “open market.”
Lenders who securitize loans that they originated themselves and hold on balance sheet still have to comply.
In theory, this should not be onerous. Essentially, it means that middle market lenders cannot borrow against 100% of the value of loans on their balance sheet, just 95%. And in practice, most were already holding on to more than 5% of the risk in deals before risk retention was enacted.
However, many nonbank lenders to small and medium-sized companies elect to be treated as business development companies, a type of closed-end investment fund, because it’s an efficient way to raise equity. And this election limited their options for complying with risk retention. Or at least some people believed that it did.
One way to comply with risk retention is for the “sponsor” of a deal to hold on to the risk. But the staff of the SEC’s corporate finance division has told lenders that business development companies cannot be “sponsors” for the purposes of risk retention; only the affiliated company that acts as investment adviser to the BDC can be the sponsor.
Another way to comply with risk retention is for the “originator” of the loans, which a BDC clearly is, to hold on to the risk. However, until last week, BDCs were unable to employ this method, either. This was the result of a conflict between the risk retention rule and rules enacted under the Investment Company Act of 1940 designed to prohibit self-dealing.
The risk retention rule requires the originator to acquire the risk retention interest from the “sponsor” of a deal. The originator can’t simply sell loans to a securitization trust and receive a portion of securities issued by the trust as part of its compensation. Instead, the originator has to sell the loans to the sponsor, which then sells the loans to a securitization trust. The trust then sells the risk retention securities to the sponsor, which in turn sells them to the originator.
However, the series of round-trip transactions described above would have put BDCs in violation of 40 Act restrictions on buying securities from an affiliated party.
So it was a no-go.
Instead, many BDCs complied with risk retention via an arrangement that is just as complicated, using what is known as a capitalized manager-owned affiliate. This involves creating a new corporate entity that is controlled by the adviser to a CLO but partly owned by a third-party investor; the capital contributed by this investor helps to fund the capitalized manager-owned affiliate’s purchases of risk retention interests.
This option is far from ideal, however. For one thing, it’s relatively expensive to set up a capitalized manager-owned affiliate. And lenders that use them have to share the fees earned by the entity with the third-party investor.
This is no longer necessary. On Sept. 7, Golub Capital, an asset manager that lends to middle market companies through two BDCs, got the green light from the SEC’s Division of Investment Management to use the originator option to comply with risk retention rules.
In a
“We believe that the proposed transactions … do not raise the concerns of overreaching and conflicts of interest by an affiliate underlying the 1940 Act's prohibitions on affiliated transactions, which were enacted to address ‘unscrupulous’ self-dealing by investment advisers and their officers and directors to the detriment of the investment companies they manage,” the letter states.
The Commission concurred, issuing a no-action letter stating that it would not recommend any enforcement against the BDCS or their adviser if they engaged in such transactions.
The upshot?
“If you have a BDC or other 40 Act originator that has the capacity sell 100% of the assets required to do a CLO to a CLO issuer, you now have a green light to allocate 100% of the risk retention to such BDC,” said Sean Solis, a partner at law firm Milbank, Tweed, Hadley & McCloy.
Solis added that the no-action letter is “purely limited to the resolution of this regulatory conflict under the ‘allocation to originator’ option under the U.S. risk retention rules.”
While Dechert declined to comment, citing client sensitivity, other securities lawyers think that the no-action letter raises some interesting questions about compliance.
In a Sept. 13
Forrester and Hitselberger also question whether any party in a middle market CLO issued by an externally managed BDC is required to retain risk, since it can be argued that there is no sponsor. Their reasoning: The SEC says a BDC can’t be a sponsor, and the adviser to BDC does not meet the criteria for a sponsor established in the DC Circuit Court’s February ruling if it never holds title to a loan.
“While the granted relief in the Golub letter is a clear path to compliance with the CRR [credit risk retention] Rule, it is not an exclusive one,” the client update states. “There are other alternative structures and differing views of whether there is a ‘sponsor’ for the CRR Rule and, if so, which entity would be considered the ‘sponsor’ in the eyes of affected parties and their counsel given the significant consequences of being a sponsor.”
Certainly the inability to retain risk on balance sheet did not stop Golub’s BDCs from issuing CLOs. In fact two deals completed over the summer suggest that the lender wasn’t even waiting around for the SEC to issue a no-action letter.
In June, Golub Capital Investment Management refinanced a $750 million transaction, Golub Capital Partners CLO 25 (M), originally issued in 2015, triggering compliance with risk retention. A majority-owned affiliate of GCIM acquired subordinate notes in order to comply with risk retention, according to Fitch Ratings.
And in August, the same BDC issued the $814.5 million Golub Capital Partners CLO 38 (M), which also relies on a majority-owned affiliate to comply with risk retention.
Golub Capital did not respond to requests for comment.
