The trouble with skin in the game

So far this year, CLO issuance volumes in both Europe and the US have been stunning. The US passed its 2007 record high of $98 billion earlier in the year and hit a total of $115 billion as of 25 November, according to S&P Capital IQ LCD.

Experts speaking to PDI in November said that more was to come in both markets before the end of the year and with several issues already lining up for pricing in the first quarter of 2015.

But although the CLO market is demonstrably doing very well, there is those in the industry who argue CLOs are over-burdened with new regulatory requirements. They complain about authorities including it unnecessarily in some measures (Volker rule) and attempting to beat it down with others (minimum risk retention requirements for managers).

Some were disappointed by US regulators ruling on CLO managers retaining 5 percent risk exposure to their vehicles – they had been arguing for a lower percentage.

“There was an element of shock for the market because I think it believed its own lobbying to a certain extent,” says Franz Ranero, a partner at law firm Allen & Overy.

It’s clear that not all managers will be able to raise the capital to meet these requirements, and narrowing manager choice for investors is a regressive move, argue those who are against the rules.

Volumes will also suffer, runs the anti-regulation line. US CLO volumes will reach no more $70 billion to $75 billion in 2015, according to some analyst’s estimates.

The anti-regulation arguments are technically correct. Both Ranero and Jeremy Ghose, a managing partner at 3i, a dominant CLO manager in Europe agree that volumes could fall from this year’s spectacular heights, and that the number of active CLO managers in the US will shrink. In Europe, already subject to ‘skin in the game’ retention requirements, the reduction in manager numbers is clear, says Ranero, pointing out that the five largest CLO managers in Europe are now behind more than 50 percent of all deals.

However, Ghose and Ranero also share the view that these criticisms fail to take account of the positive effects of regulation just as they ignore the fluidity and creativity of a prospering market, able to adjust to the new environment.

“I’m sure it will have a dampening effect on volumes but I don’t think the naysayers are correct. Just two years ago they said that the European market would never come back due to risk retention requirements, but the market did brush itself off, adapt and move on,” says Ranero.

European market volumes were predicted to struggle this year. But CLO volumes had reached €12.7 billion by 25 November, well ahead of full year 2013 volumes of €7.4 billion, according to S&P Capital IQ LCD.

The argument that the rules are negative for investors because they limit choice is of limited weight, says Ghose. Yes there are fewer managers, but it is easier for investors to assess performance before committing to a vehicle. In investor meetings now, they have full information on the track record of every manager available.

“Now, investors go into much more detail with their diligence before they choose to invest in your deal. The depth and accuracy of their knowledge is much greater than I remember in the version 1 days,” explains Ghose.

Risk retention rules have aligned the interests of managers and resulted in greater transparency for investors without damaging the size of the market.

The extended regulatory burden has also demonstrated the resilience of the instrument. When the Volker rule was applied to CLOs (restricting banks from investing in CLOs not made up exclusively of loans), the US market recovered and adjusted to the new rules within about a month, says Ranero.

Also, by making it more difficult for US banks to invest, Volcker has resulted in a much diversified investor base, pension funds, insurance companies and asset managers are all evaluating the opportunity.

The European risk retention experience holds some lessons for the US. Some CLO managers have simply tapped their parent for capital, but one of the most innovative potential solutions so far has come from Blackstone/GSO.

Blackstone/GSO Loan Financing Limited is a London-listed vehicle which launched its initial public offering in July this year. The equity capital raised will be used to provide the capital for the firm’s CLOs. Investors in the closed-end listed investment company gain exposure to Blackstone/GSO Corporate Funding Limited, the firm’s CLO origination platform.

So while the critics have bemoaned the plague of regulation, others have simply got on with the business of adjusting, innovating and embracing the positive effects of inevitable market changes. To which we say: kudos.