The February US Court of Appeals ruling in favour of the Loan Syndications and Trading Association argument that collateralised loan obligations should not be forced to comply with “skin in the game” requirements of the Dodd-Frank Act was an unusual, if not unprecedented, loss for US regulators.
“It’s not that common for a rule like this to be completely overturned by the courts, the standards to do so are high,” says Paul St Lawrence, Washington-based partner at law firm Cleary Gottlieb Steen & Hamilton. According to the lawyer it was far from clear at the outset that the industry body would succeed.
“There is a high degree of deference to the regulators from the courts, particularly when it comes to interpreting statutes and how to apply them. To win requires showing that the regulators have gone beyond the authority granted them or have been unreasonable in their interpretation of the statutory language. Everyone viewed the lawsuit as a worthy endeavour, but one that ultimately had a relatively low chance of success given that threshold.”
“Now a lot of managers are asking the question: ‘If we don’t need to comply with the US rules, is exposure to one or two EU investors on any given deal really worth us having to hold 5 percent when we don’t want
to do that?’”
Since December 2016, US CLO managers, the largest buyers of leveraged loans, have been required to hold 5 percent of risk retention capital in all securities issued as part of a broader move for increased regulatory oversight of the originate and distribute securitisation model blamed for much of the financial crisis.
The LSTA fought back with a three-and-a-half year legal campaign arguing that the unique structure was different in how it approached risk transfer versus traditional asset backed structures, such as based on underlying assets of motor insurance, or credit cards.
“Cars, or cards, of the vast number of typical securitisations, more often than not, are undertaken by a sponsor or an originator. Whereas an open market CLO is quite different because the manager is acquiring assets in the market and has not originated those assets in any way,” says Lee Shaiman, executive director at the LSTA.
In any case, according to Deborah Festa, Los Angeles-based partner in law firm Milbank’s alternative assets practice, the fee structure used by a CLO manager already aligns their interests with investors. “CLO managers get paid at three levels; their base management fee, a subordinated management fee which is paid after interest on the secured notes, but before the equity gets any payment. Then they have the potential to receive an incentive fee after the equity reaches a certain target return. That whole compensation model is designed to create incentives for the manager to perform well and have its interests aligned with investors.”
While the court ruling provides relief for managers with a US client base, it is creating a headache for those managers looking to sell their paper into the EU where risk retention rules are still in place for CLOs. According to data from Wells Fargo, 40 percent of US CLOs last year were dual compliant with European risk retention rules, and while it probably makes sense for large firms with multiple product lines into the trading block to continue doing so, other managers may reconsider.
“In a strange way CLOs have benefited from the risk retention rules introduction, and the asset class will now get another boost from their demise”
For Chris Duerden, Charlotte-based partner at law firm Dechert, the end result could be detrimental for European investors looking to get access to US CLO paper. He says that one of the initial reactions from a lot of US-based managers following the LSTA ruling, is that if they do not have to comply with risk retention rules in the US then they would rather not sell their deals into Europe because of the additional capital costs.
“Before the LSTA ruling there was likely to be more of a landscape of managers which were willing to be EU compliant because certain structures could be set up to meet both US and European risk retention rules. That meant managers could hold 5 percent against one piece of credit risk,” says Duerden.
“Now a lot of managers are asking the question: ‘If we don’t need to comply with the US rules, is exposure to one or two EU investors on any given deal really worth us having to hold 5 percent when we don’t want to do that?’ My sense is that the long-term options for EU investors will narrow.”
Duerden’s view is backed by Shaiman who says firms without strong existing relationships with the EU will be re-examining their plans to market in Europe following the court case. The executive director points to the potential for tactical issuance depending on the relative price of loans in Europe versus the US but that strategic moves will be less likely due to the issue of risk retention capital.
“Very few US managers will be European risk retention compliant in the long term following the ruling unless there is a significant difference in the cost of European originated liabilities – so in other words if it improves the arbitrage it may entice US managers in a certain number of circumstances to become European risk retention rule compliant.”
The US CLO market thrived in 2017 despite the introduction of risk retention, with total issuance hitting $117 billion, according to Thomson Reuters LPC, close to the 2014 record. Meanwhile, first quarter figures for 2018 are even higher than 12 months previously.
St Lawrence says it is difficult to increase further, even when regulators announced at the end of March they would not be appealing the ruling, but the long-term CLO market prognosis is good.
“The market was already very busy, but the ruling is certainly going to make executions simpler and keep costs down. One knock-on effect of having the rule in place for 15 months was a proliferation of all these equity funds that were setup as majority owned affiliates of the manager to raise capital to buy horizontal strips. These funds still have a mandate to purchase CLO equity.”
This point was picked up by Shaiman who says that publicity around the risk retention issue pulled in new investor groups to the sector. These investors who went on to fund the risk retention equity strips of high-profile managers such as Neuberger Berman, Seix Investment Advisors and Blue Mountain Capital Management and therefore still have “skin” in the CLO game.
“Many managers raised capital from a new investor base to fund the risk retention portion of the CLO and that capital is likely to remain in the asset class. So, in a strange way CLOs have benefited from the risk retention rules introduction, and the asset class will now get another boost from their demise,” says Shaiman.
“The end of the risk retention rules reduces the regulatory and frictional costs of issuing CLOs, as well as ending the economic cost to managers of having to put up capital. Firms now have more resources to focus on their business, which is managing credit risk in CLO structures. That is what their clients hire them to do.”