US debt: Can CLOs survive new regulations?

US regulators don’t have a reputation for spreading Christmas cheer, but the 24 December 2016 implementation date for the Dodd Frank risk-retention rules promised a particularly bleak midwinter for the collateralised loan obligation market. The risk-retention rules require firms to hold a five percent interest in the all the collateralised loan obligations issued – so-called “skin in the game” – and is intended to align issuers’ interests with end-investors.

With the total assets under management of outstanding CLO volumes standing north of $450 billion, according to data from LPC Thomson Reuters, that adds up to nearly $25 billion worth of capital needed just to support the existing amount of CLOs in circulation. Unsurprisingly the market was widely expected to be sluggish in 2017, but instead the opposite happened. The flood of issuance at the end of 2016 continued well into the following year and by the end of the first half of 2017 total CLO volumes had hit $52.4 billion – a 100 percent increase on the same period 12 months earlier. For Sean Solis, New York-based partner at law firm Dechert there are two parts to explaining this apparent paradox.

“A lot of folks had predicted lower CLO volumes for 2017 given the onset of the Dodd-Frank risk-retention rules,” he says. “In fact it has been a very busy year and that has been informed by a couple of factors. Firstly there is still a global chase for yield, and CLOs have an interesting profile in that they trade wide of other fixed income products, and the demand from investors has been insatiable.”

The second driver is that CLO managers don’t have to put all of the “skin” in the game themselves. Issuers can use a mechanism, known as a majority owned affiliate, to obtain third party finance for up to 80 percent of their risk-retention capital. A number of high profile CLO managers, such as Neuberger Berman and Carlyle, have successfully raised this type of capital in 2017, amid what Solis says has been firm investor demand.

“Perhaps surprisingly, there has been a decent amount of capital raised for these types of risk-retention vehicles and that has allowed a lot of managers to go and deploy funds into in a market that is booming right now.”

It’s not just the new issuance CLO sector that is booming – according to figures from ratings agency Moody’s, there has also been a glut of both refinanced and reset CLOs in 2017, with almost 200 refinancings completed so far this year, with a value of about $85 billion, plus 57 resets with an as-yet unspecified amount. Critically, Leon Mogunov, manager in ratings agency Moody’s new issue CLO group, says this has been accompanied by a number of new investors entering the market.

“What is interesting about this year is, in addition to this new formation of CLOs, you have a lot of activity in refinancing, and so called resets – which are a subset of refinancing,” says Mogunov. “And we are also seeing an increasing number of new investors in the US CLO market, specifically from Asia and Europe.”

On the face of it, large issuance volumes which are being snapped up by a ready supply of new buyers sounds like great news for the market. But Bram Smith, New York-based executive director of the Loans Syndications and Trading Association – a vocal critic of the rules since they were first announced – says there is no guarantee good times will continue.

“It’s early days, let’s not make sweeping statements or take conclusions on the back of seven months data. Anyway, here’s the punchline – every single market known to mankind is at, or near, all time highs: the Dow Jones is at 22,000 and it’s a similar story across a number of asset classes. I’d argue that this euphoria is a big source of what is going on in the CLO market.”

Smith cautions that while the CLO market may benefit from favourable market forces the sector could suffer more than others in a downturn due to the additional friction of the risk-retention capital. He points to the volatility in issuance numbers over the last five years – 2017’s numbers are still well below the all time record high of 2014, for example – as proof that today’s strong market could still evaporate as a result of the sector’s new capital requirements.

“The long term impact of risk-retention capital on CLO formation is a story yet to be told. With market forces, there will be good times and bad times, and now there is the added burden of risk-retention capital. This capital originates from either the managers or third parties, and who knows how either of those are going to continue providing that capital over the next few years.”

Indeed Dechert’s Solis says that while volumes so far in 2017 have been impressive they would have been even heavier without the requirement for managers to fund risk-retention capital.

“The US CLO market has exceeded expectations, I would say that if the risk-retention rules weren’t in place there would have been even more demand, maybe 30 percent more. This kind of informs the idea that investors are not overly concerned about risk retention – they always assessed the managers on an individual basis.”

BEATING EXPECTATIONS

How many CLOs would have been issued without the risk-retention rules remains a matter of speculation but Deborah Festa, Los Angeles-based partner in the alternative investment group of law firm Millbank, says it is clear the number of collateral managers acting as sponsor in transactions has fallen. According to Festa the imposition of capital requirements has seen CLO issuance concentrated among a smaller number of players.

“The sponsors which always had the ability to acquire equity positions in the transactions they managed are today issuing in a prolific manner – doing upwards of five or six new transactions a year. But there has been a fall-off in the numbers of new managers issuing as they were sometimes unable to secure the financing for the risk-retention piece.”

According to Moody’s this trend had already emerged by the end of 2016, with managers unable to secure financing ahead of the 24 December risk-retention rule deadline, pulling out of the market. In a report published in July 2016 the ratings agency warned of the potential negative effect of this, saying that “smaller managers offer the greatest diversity but are issuing fewer deals and remain merger targets”. Yet by the time the report was published Moody’s was already rating 25 percent fewer managers than the previous year, a situation which means higher obligor overlap for investors holding CLOs, in turn increasing default correlations.

And it’s not just the number of managers that is shrinking, the resurgent CLO refinancing market reduces the amount of collateral for new issuance which, combined with the bullish market, has left issuers struggling to find the underlying assets for new structures. So, is now time for the return of the synthetic CLOs? Festa thinks not – for the moment at least.

“We saw synthetic CLOs right before the crisis when the market was really heated, yet so far we are not seeing that. It will be interesting to see how that structure will play with Dodd-Frank requirements that inhibit managers’ ability to bet against their investors, because in a true synthetic CLO you have a hedge with the potential to work against other investors. But just because there are challenges doesn’t mean synthetic CLOs can’t be structured again.”