This is the ninth of 10 articles taking an updated look at our most widely read stories of the year. The first eight can be found here: Servicer Advances, Europe, Cat Bonds, Marketplace, Risk Sharing, FFELP, Solar, CMBS.
Managers of collateralized loan obligations are finally coming to grips with impending rules requiring them to hold a 5% stake in each of their deals.
Much of the industry’s efforts in 2015 were focused on avoiding compliance with the regulation, which takes effect in December 2016. While that is still a year away, most CLOs can be refinanced after two years. In July, after six months of lobbying, the industry finally received some guidance on how to refinance grandfathered deals after the rules take effect without triggering a requirement to hold a stake in the newlyissued securities.
The U.S. Securities and Exchange Commission issued a no action outlining the necessary conditions, the most important of which is that the CLO must have been issued before the risk retention rule was published on Dec. 24, 2014. Also, 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.
The no action letter effectively means that $152 billion worth of CLOs will be able to refinance in 2017 without triggering the rules according to a research published 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.
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, however.
Most CLO managers are now focused on the least painful way to comply with risk retention. The average CLO has roughly $500 million in assets, which translates into a commitment of $25 million, a sum few managers have lying around. The simplest way to do this is by soliciting investments in the management company itself.
But many managers are exploring ways to retain the 5% stake through a majority owned affiliate in which they own as little as 51%, reducing their risk retention obligations by almost half.
Another decision that managers have to make is whether to hold the 5% stake via what is known as a vertical strip, which includes a stake in each tranche issued by a CLO; or via a horizontal strip, which would mean holding a large portion of the riskiest tranche, known as the equity.
A survey of 50 CLO managers conducted by Fitch Ratings in May indicated that the industry is pretty evenly split on how to comply. Just over 40% planned to employ the horizontal strategy and 35% planned to employ the vertical strategy. Another 7.7% of managers polled might do both. In fact 50% of the respondents indicated their choice between vertical or horizontal might change on a deal-by-deal basis, as well.