With Carlyle revealing it has raised $800 million for its latest CLO fund – Carlyle Structured Credit Fund – in January, the market seems to be picking up where it left off in 2017.
By the end of November 2017, new collaterilised loan obligation issuance in the US had reached $108 billion for the year, reports Lipper Alpha Insight, just below the record issuance levels seen in 2014. This is despite new US risk retention rules coming into force in December 2016 requiring CLO managers to hold a 5 percent interest on all CLOs issued. The regulations had been anticipated to dampen the US CLO market, at least for 2017.
There are clearly market forces at work, with high demand from borrowers as economies continue to grow and from investors for CLO products in the now all-too-familiar low yield environment. Indeed, Moody’s estimates that US CLO issuance will match that of 2017. Yet the other factor in the CLO market’s rude health has been the ability of many managers to find solutions to the risk retention puzzle over the last two years.
Some have opted to use partner capital, while others have joined forces with private equity and credit houses. “There has been some consolidation in the market among smaller players seeking to align themselves with capital sources, such as private equity firms.There was some activity last year, but we saw some even before that,” says Deborah Festa, partner at law firm Milbank, Tweed, Hadley & McCloy. Pine Brook acquired Triumph Capital Advisors in 2017, while a few months earlier Marble Point Credit Management had announced the acquisition of American Capital CLO Management, for example.
Many others have sought third-party capital, including through specific risk- retention vehicles. Under the rules, managers can obtain 80 percent of their risk retention capital from third-party sources. Last year, GoldenTree Asset Management and Neuberger Berman took advantage of this, raising $600 million and $450 million, respectively, for such vehicles. Meanwhile, CIFC teamed up with Ontario Pension Plan to form CIFC CLO Strategic Partners in September 2017, a fund that will purchase majority equity positions in CIFC’s future CLO.
Around 65-70 percent of CLO managers have attempted to go down this route, according to Sean Solis, partner at Dechert, a law firm. Not all have been successful, however, as Festa notes. “Raising third-party vehicles for risk retention has been most common among CLO managers with the wherewithal to raise capital,” she says. “Some smaller players are trying to do this, but only a few have managed to close funding facilities.”
Yet for those that can raise third-party capital, the risk retention rules are proving to be something of a boon. “There are many managers that now view this as a competitive advantage,” says Solis. “There is no single view on this and it’s quite nuanced, but for larger firms that can raise capital relatively easily, risk retention has ultimately had a positive result.”
It’s a point picked up by Festa, too. “A few years ago, CLO managers had not only to secure AAA investors, but they also had to seek out risk retention equity investors,” he says. “Now, many of the larger managers have equity for the next five to eight deals already wrapped up – they don’t need to worry about it. For those managers that have achieved this, the risk retention regulations provide a competitive advantage: if they don’t have this, they may not get access to deals, because those that do can complete deals more quickly as the equity is largely in place.”
“A few years ago, CLO managers had not only to secure AAA investors , but they also had to seek out risk retention equity investors”
Added to this is clear investor appetite for these vehicles, particularly among investors that didn’t previously invest in CLOs. “For many investors that hadn’t had expo- sure to CLOs before this has presented an opportunity to invest in risk retention vehicles,” says Solis. “And because there is this requirement for capital, investors have been able to dictate some of their terms.”
These terms may, for example, include a portion of fee income, according to Festa. “They are attractive to many inves- tors because this provides another way to access CLOs and they often offer a kicker through the share of the management fees, something they wouldn’t get if they simply invested in the equity portion of a CLO,” she says.
With many larger managers and some investors apparently seeing benefits in the new rules, the publication by the US Treasury of a report on risk retention last autumn, which recommended that the regulations be loosened for CLOs, may have been met with less enthusiasm from the industry than might be expected. Few believe the report will result in wholesale regulatory reform, however.“The notion of regulatory roll-back in the area hasn’t moved on much from the idea phase,” says Festa. “It would require the co-operation of Congress or several agencies and that seems quite unlikely at the moment.”
There is also an appeal underway by the US Loan Syndications and Trading Association after it lost a court case arguing that the rules had been misapplied to CLOs. “It’s easier to see the pending LSTA litigation having some effect,” says Festa. “We are still waiting on the outcome of the appeal, but if it overturned the previous ruling, the risk retention requirements for CLOs could change.”
Whatever the outcome, however, it seems likely that risk retention-style vehicles have now become part of the CLO landscape, given the competitive advantages many larger managers believe they offer and the benefits they can provide to investors.
In any case, with updated risk retention rules coming into force in the EU in 2019, managers targeting both the US and Europe will continue to need to raise risk retention capital or put in place permanent risk retention structures, with many already putting in place solutions that are compliant in both markets.