When it comes to rules requiring CLO managers to keep “skin in the game” of their deals, some are playing it safe.
Rather than wait and see whether deals otherwise grandfathered from the rules can be refinanced after December 2016 without triggering compliance, they are issuing new deals with shorter non-callable periods.
CLOs issued notes and use the proceeds to purchase a portfolio of leveraged loans. Managers profit from the difference between the interest earned on these loans and the interest paid out to note holders.
Securities issued by these deals typically cannot be refinanced, or called, for two years. After this time, investors in the most subordinated securities issued by CLOs, known as the “equity,” may exercise their ability to refinance more senior tranches to take advantage of lower interest rates. Doing so lowers the overall amount of interest paid on CLO notes, meaning there is more income left over for equity holders, who often include the managers themselves.
While it might be attractive to wait the full two years to refinance, any additional income earned could well be offset by triggering a requirement to hold a 5% slice of an all of the securities issued by a CLO.
Credit Suisse is a prolific sponsor of CLOs and had the second-highest volume of CLO refinancing transactions in 2014. When it comes to risk retention, the firm isn’t taking any chances. It has issued three CLOs in the past year with non-call periods that end before risk retention rule take effect, which is less than two years from now. The latest, the $521.8 million Madison Park Funding XVI, was issued in March with a non-call period that ends Oct. 20, 2016.
Brad Larson, global head of CLO origination at Credit Suisse, points out that investors are growing wary of the pitfalls of risk-retention should the rules hamper managers’ ability to reprice the equity tranches. “Some equity investors are being cautious on deals today because they ascribe value to the refinancing options,” said Larson. “If they feel they’ve lost that option, they feel they’ve lost the value associated with that option.”
Larson confirmed that the intent of a shorter non-call period is to get the refinancing done before the risk-retention kicks in. He notes that this may not be a perfect solution, however. “A lot of people believe the market’s just going to be so flooded with deals trying to get re-fied [at the same time] that it will push out refi levels to the point where they don’t make all that much economic sense,” he said.
The potential for a glut of refinancing to push spreads wider was highlighted in a February report from Barclays’ structured credit analyst Brad Rogoff and Jeffrey Meli. The analyst wrote that while shortened non-calls may appear compelling as a work-around to risk retention “at first blush,” the dollar volume of callable deals in the last six months of 2016 already stands in the range of $122 billion to $135 billion.
“We see limited value in the near-term call option,” the analysts wrote. “In fact, with triple-A spreads relatively wide today, we would not be surprised if later this year deals come with longer than the standard two-year non-call period as a means of reducing liability spreads and increasing potential equity returns to get deals done.”
Credit Suisse’s strategy contrasts with that of some other managers trying to exploit the ambiguous status of refinanced CLOs. Apollo Global Management and Carlyle Group have recently issued deals with delayed-draw notes in the hopes that, when eventually funded, they will not be considered new securities and so will not trigger risk retention requirements.
It’s not clear whether this strategy will pass muster with regulators, who may see it as a violation of the spirit, if not the letter of risk retention. Moody’s Investor Service pointed out this possibility pointed out in a March 26 report.
A credit strategist at a major investment bank is also skeptical of this workaround. “From what I can tell, that would not really be in the spirit of the rule,” said this person, speaking on conditioof anonymity. “Creating CUSIPs ahead of time to roll an existing structure into a repriced CUSIP— I don’t think that’s the thing that will go over well.”
Larson says Credit Suisse has not included delayed-draw securities in its issues, precisely due to the regulatory questions they raise.
“The deals we’ve done have not included delayed draw securities,” he said. “There seems to be some questioning of these structures people are wondering if these delayed draw notes will have the effect they want them to have on these interim CLOs.”