Collateralised loan obligation (CLO) managers will come back from the holidays with a different regulatory landscape, as the risk retention rules requiring CLO sponsors to hold a 5 percent interest in the credit risk of securitised assets will come into effect.
Firms have developed several ways of complying with these new rules, which took effect on 24 December, mainly through structures known as majority-owned affiliates (MOA) and capitalised manager vehicles (CMV), explained Oliver Wriedt, co-chief executive officer at CIFC, the New York-based CLO manager.
The MOA is the most common risk retention compliance technique. In this instance, the CLO manager creates an affiliated entity to hold the required 5 percent of equity. Firms can then sell down a portion of the equity, Wriedt said, allowing the manager to effectively reduce its own equity stake in the CLO.
Under a CMV, the firm raises capital to execute CLOs in standalone entities, typically with servicing agreements back to the management firms.
There is also a combination of the two, Wriedt said. The strategy, called the capitalised majority-owned affiliate, will let firms write a check to equitise an affiliated entity.
In early 2016, the sell-off in the secondary market for CLO securities affected managers more than the looming risk retention rules.
“Everyone expected risk retention to play centre stage in the CLO issuance dynamics. As it turns out, it was all about the CLO arbitrage in the first few months of the year,” Wriedt said, explaining it was a “horrific start” in the first six weeks of 2016, trying to price liabilities.
Despite their imminent application, some CLO managers decided not to structure deals to be in line with the risk retention rules. Many deals executed by Tier 1 managers in 2016 were not compliant with the statutes, he said. Certain managers voluntarily made their deals compliant in order to secure investor support, Wriedt explained.
“[It’s] investors that have been driving that decision,” Wriedt said, adding that there were exceptions. “There were a couple of Tier 1 managers that voluntarily made their deals risk retention compliant even though investors would have supported their issuance without risk retention compliance.”
Fitch Ratings predicted in its 2017 outlook that CLO issuance in the coming year will be concentrated among the larger managers that already have risk retention-adherent solutions set up. It additionally noted that some managers are looking for ways to fund the risk retention investments.