CLOs: At the crossroads

As if collateralised loan obligation (CLO) managers did not have enough to worry about, the clock is ticking down to the deadline to comply with US risk retention rules. Market headwinds and a 70 percent fall in CLO issuance this year were already causing headaches, but now firms must either find ways to comply with the “skin in the game” regulations or face getting out of the business. 

The new rules, which come into force on 24 December, demand that a CLO sponsor retain a 5 percent interest in the credit risk of securitised assets, either as a vertical or horizontal strip.

As managers search for a solution an alphabet soup of acronyms is becoming common lingo in the CLO community.The MOA (majority-owned affiliate), the CMV (capitalised manager vehicle) and the combined C-MOA appear to be the three main options facing the industry. 

Is there another way? Likely not, managers say. Most firms will choose one of these options, while smaller managers that don't have enough capital will probably either shut down or be forced to sell to a larger sponsor. 

Some M&A activity has already taken place with Regiment Capital selling its remaining CLOs to Bain Capital Credit (formerly Sankaty Advisors) last year and Octagon Credit Investors being sold to Conning. 

And then there are the large firms that issue CLOs both in the US and Europe. Finding a way to comply with risk retention on both sides of the Atlantic is their Holy Grail. Lawyers at Dechert, as well as some of these managers, say the combined C-MOA is a good way to get this done. PDI has spent some time looking at the routes CLO managers may take:

THE CMV ENTHUSIASTS

New York-based Napier Park Global Capital was one of the first to set up a CMV structure last year. The vehicle involves creating a new separate asset management firm to manage the collateral and hold retention interests for future CLO transactions. Some argue that it's too challenging, as it involves setting up a new business, with its own investment advisory registration, documents, financials and staff. 

“The manager has to demonstrate that the CMVs have their own employees and own materiality,” Oliver Wriedt, co-president at CIFC, a CLO specialist manager, tells PDI. 

“The CMV option involves the creation of a newly capitalised and self-managed entity that would both act as the collateral manager and hold retention interests on a go-forward basis for a number of transactions,” adds a comment published by John Timperio and Cynthia Williams of Dechert last July.

“This approach involves significant commitment on the behalf of a manager sponsor to pursue the development of a novel structure bespoke to its existing platform.”

Los Angeles-based Canyon Partners was also said to have set up a CMV last year and printed its first CLO via that structure in March. Apollo Global Management is also raising a $700 million CMV vehicle to issue CLOs in the future. The original firm will cease to issue CLOs after the new entity is raised.

Questions remain over how the employees at the NewCo would be paid considering they are joining a new organisation that has not yet issued deals and has not collected any management fees. “Whether it holds up with a regulatory perspective is still an uncertainty,” says Wriedt. 

THE MOA WAY

Marathon Asset Management raised $200 million last year for an MOA that would see it put up about half of its own capital and raise the other half from outside investors to issue CLOs. The MOA doesn't require an entirely different entity, so it could be an easier way to comply. It can also be used for CLO deals on a one-off basis, which could work well for those who don't do CLO deals often. 

“The MOA is much easier to deal with, though it requires real capital. The CMV can be set up with zero capital,” says Wriedt. 

“The MOA is very straightforward and can be a nice partnership. It essentially buys the risk retention equity of the CLO,” says Matt Natcharian, managing director at Babson Capital Management, who oversees a group that invests in CLOs.

Babson issues CLOs out of a different group and complies with risk retention by having its parent, Mass Mutual Life Insurance, buy a vertical strip in Babson CLOs. Other CLO managers owned by insurers or banks are said to do the same. Credit Suisse Asset Management, which priced a €411.6 million CLO in Europe in April, is one of them. Sources tell PDI Credit Suisse is already issuing deals that are compliant in both the US and Europe. Alcentra is also said to issue compliant deals with help from its Bank of New York parent.

In February, Blackstone said it was planning to ask shareholders in its European CLO risk retention fund for permission to invest in the new US vehicle Blackstone/GSO US Corporate Funding (BGCF). 

The firm said that the structure would enable Blackstone to seek higher returns in US CLO securities. Blackstone also asked shareholders in the Blackstone/GSO Loan Financing (BGLF) vehicle, which raised €260.5 million from investors for its listing in 2014, for permission to invest across the capital structure of CLOs and loan warehouses. The European vehicle previously focused on floating rate senior loans. “The addition of a US risk retention company to the underlying structure will give the company the ability to invest, through BGCF, in US loans or European loans – whichever are more commercially attractive – and finance those loans via risk retention compliant CLOs in the US or Europe, whichever offers more efficient cost of capital,” Blackstone said at the time.

CROSS-BORDER RISK RETENTION

Los Angeles-headquartered Ares Management is also setting up a European risk retention vehicle. According to LP documents, the firm is seeking commitments from limited partners to invest in its European CLO platform to help the firm comply with risk retention rules. The firm is targeting initial equity capital of €280 million, which is expected to make investments in eight to 10 CLOs managed by Ares. The firm plans to invest €30 million in the vehicle.

Ares is also sweetening the deal for investors. No management fees will be charged at the partnership level. “The partnership anticipates to benefit from CLO management fee rebates in CLOs initiated with initial capital,” the documents say. 

Ares will evaluate listing possibilities in three to five years from initial deployment. The firm is publicly traded in the US and also has a listed BDC and real estate fund.

Several other firms are weighing ways to comply with both US and European risk retention rules. Regulations in Europe kicked in some time ago, but with the deadline approaching in the US it's easier for managers to find ways of being compliant with both regulations.

CIFC, one of the largest US managers of CLOs, has been considering a move into Europe and Wriedt tells PDI he is interested in finding a method of compliance that will work in both jurisdictions.

“Right now, there is a benefit to being both US and European compliant. Some of the clever deals being done are compliant in both,” he says.

Dechert has been working with clients on risk retention and lawyers there say that the C-MOA, which combines attractive attributes of both structures, is the way to go. 

“Unlike the MOA, which is a special purpose vehicle, the C-MOA would be capitalised beyond what is necessary to simply hold the retention interest so that it can originate loans itself or through a related party,” its research paper said.

While firms come to grips with these regulations, CLO issuance continues to be low, but not simply because of risk retention rules, notes Wriedt. “The decline in issuance is more of a function of limited deal activity,” he says. 

Leveraged buyouts were down 30 percent last year and stricter leveraged lending guidelines are causing banks to do fewer deals. 

CLO issuance in the US fell to $8.23 billion in the first quarter of this year, compared with $29.79 billion in the same period of 2015. 

“It's so hard to get a deal done right now. But the top-tier managers will be able to do that. There is a strong bias toward larger managers,” says Babson's Natcharian. “I'd expect more consolidation and the larger firms will be able to raise risk retention capital.”