Friday letter: CLO volumes defy critics of regulation

Regulation is proving its worth to investors in CLOs, showing that it is possible to curb risks without undermining the market.

The naysayers have been proved wrong. A quick google news archive search for 'CLO' reveals a slew of 2013 articles citing a variety of sources predicting a collapse in CLO issuance. The regulatory critics complained that new risk retention regulations in Europe, and restrictions on bank investment in CLOs in the US, would kill off a market just starting to recover from the financial crisis.

The predictions have turned out to be incorrect. Already this year, US CLO issuance has totalled $106.08 billion from 198 deals as of 6 November, according to S&P Capital IQ LCD. That figure clearly outstrips the previous full year record which was over $90 billion in 2006.

European CLO issuance is on a bull run too with year to date issuance at €11.91 billion from 28 deals in the year to data, as of 6 November, according to S&P Capital IQ LCD.

Among those taking advantage were Carlyle and Apollo, which both closed European deals at the end of October. Carlyle’s €450 million vehicle brought the firm’s European CLO issuance to €1.2 billion so far this year, and the firm has also raised roughly $2.73 billion in US CLOs. The €411 million ALME Loan Funding III is Apollo’s third European CLO, a the Citigroup-arranged vehicle that will invest in leveraged loans.

Amidst the buoyancy, there are still some critics of the risk retention rules introduced first in Europe and approved by US regulators for implementation there last month. But those critics are not among the investment community, they are managers worried about being negatively affected by the regulation.

Demanding that a CLO manager to keep some exposure to the product they are selling is an eminently sensible idea. It does restrict the market to managers of a certain scale, but scale is almost always an advantage in finance anyway, and something that most aspire to.

But it was 3i Debt Management’s fifth CLO of the year that demonstrates the point – the market is adapting to the new rules, which have been beneficial. 3i’s €466.5 million Harvest CLO X is the firm’s fourth European CLO, but only its second to meet both European, and more recently, US retention requirements and comply with the Volcker rule. In August, 3i managing partner, Jeremy Ghose spoke to PDI sister publication pfm about why they have opted to raise Volcker-compliant European CLOs even though the rule does not apply to non-US vehicles.

Ghose said: “Our view is that the Volcker rule is here to stay. The US banks absolutely have to follow it and slowly and steadily banks in Europe doing any type of business in the US will also have to follow it. As a result, we are finding that the big European banks in particular are very keen to stay on the right side of the Volcker rule.”

Volcker ruled that CLOs holding securities fell under the definition of covered funds. It therefore restricts US banks from investing in CLOs not made up exclusively of loans (which fall outside the covered funds definition). Before it was applied, banks made up a large part of the US CLO investor base.

Since it came into force, however, the US CLO investor base has diversified. With banks exiting and spreads widening, pension funds, insurance companies and asset managers are all evaluating the opportunity. 

When regulation cuts risk and promotes the asset class to a new and broader investor base without damaging volumes, it must be doing something right.