CLO managers are receiving a small concession from regulators that will allow them to refinance most of their issues in two years without triggering risk-retention rules, sources say.
In a move that will somewhat ease the minds of holders of CLO equity tranches, federal regulators are expected to soon clarify that they will permit refinancing of most existing collateralized loan obligations after 2016, when new CLOs will be issued with forthcoming risk-retention requirements.
Sources this week told Leveraged Finance News that the Securities and Exchange Commission is poised to issue a “no action” letter this month clarifying that CLOs created prior to 2015 will retain their exempt status if they are refinanced or repriced after the Dec. 24, 2016 effective date.Uncertainty had been hounding the market since final rules were adopted by federal regulators last December.
The risk-retention standards mandating sponsors and managers to retain “skin in the game”— in the form of a 5% stake of the notional value of a CLO were to only to apply to CLOs issued after 2016, with CLOs issued prior to the effective date grandfathered from the rules.
But issuers worried that existing CLOs would lose that exemption if certain tranches were refinanced after 2016, since they might potentially constitute new securities.
Refinancings of CLOs are common since managers profit from the difference between interest earned on loans purchased for the portfolio and the interest paid out on notes issued to fund the loan acquisitions. After a two-year non-call periods, the most subordinate investors of the CLO in the equity tranche (frequently the managers themselves) seek to refinance the more senior tranches of the notes to take advantage of better interest rates by lowering interest payments on the notes.
Risk retention is already a contentious matter for CLO managers and sponsors, who would have to retain substantial stakes for example, $30 million of a $600 million CLO despite the fact that as money managers, most CLO issuers lack the assets to cover the retention piece.
The SEC and the Loans Syndication and Trading Association have been negotiating terms of the no action letter, according to sources. The industry was hoping to convince regulators to extend risk retention exemption for all refinanced CLOs issued prior to the rules’ start-up date, arguing the underlying mix of loans in the portfolio is unchanged and therefore not a new security.
But the SEC is only providing the refinancing exemption to CLOs issued prior to Dec. 24, 2014. That is somewhat of a hollow victory, given that most CLOs created before last December would reach the end of the common two-year non-call period before December 2016 anyway.
But the clarification means that older CLOs will not have to join an expected bull rush of CLO refinancings at the end of 2016 with $122 billion to $135 billion of CLOs entering their callable period in the last six months of that year, potentially disrupting pricing in the market, according to a report this spring from Barclays.
The threat of risk-retention standards being retroactively applied through refinancings had spurred CLO managers into creative workarounds, such as delayed-draw term tranches only to be filled after the December 2016 effective date, or with creating CLOs with non-call periods shorter than the standard two-year period so as to refinance the CLO prior to the effective date