Risk retention (RR) has loomed large on the US CLO horizon since 2011, and despite industry lobbyists having advocated hard for the exclusion of CLOs from the 'skin in the game' provisions during the intervening period, the final rules, which were adopted in October 2014 and published on 24 December 2014, made no exception for CLOs. RR comes into effect on 24 December 2016. Those managers that do not already have RR financing in place are now seriously looking at sources of RR capital and at structural solutions that may alleviate or reduce funding shortfalls. Structural solutions already adopted for European RR, and some of the newer structures developed in the last few months of 2014 for US RR, certainly provide some room for optimism, although market participants are still searching for a 'holy grail' RR structure that meets the RR requirements of both EU and US regulators and one which is tax efficient and not overly complicated. The European market has been grappling with RR for several years now, yet 2014 was the most successful year for the European CLO 2.0 market. Some of the solutions and structures that are seen in Europe are transferable to, and have already been utilised by, the US market whose RR rules are substantially similar.
Summary of the Rules
Whilst we defer to the expertise of our onshore legal colleagues in providing a complete and comprehensive analysis of the US and European RR rules, we have, in layman's terms, outlined some of the key rules below for the purposes of this article.
Under the final rules, the 'sponsor' of a CLO is required to hold at least 5% of the credit risk of all of the securities issued in the transaction for the active life of the deal. There are different sunset dates but the general view is that the retained notes will have to be held until, at the earliest, the end of the reinvestment period (typically four years from the closing date of the CLO). A sponsor is the person who organises and initiates the securitisation transaction by selling the assets directly or indirectly (e.g. through an affiliate) to the CLO issuer. As CLOs do not originate the loans that they securitise but purchase them from third party originators in the open market, lobbyists and the industry participants sought to differentiate CLOs and CLO managers from other ABS products/managers on this basis. However, no exemption was granted. The retention requirement can be complied with by the sponsor either: (a) taking a 5% vertical slice of each class of securities issued (based on par value); (b) taking a portion of the equity tranche equal to 5% fair value of all the securities issued (horizontal interest); or (c) a combination of (a) and (b) above (a so-called "L-shaped" interest).
In terms of who and how the retained interest can be held, there are four main options: the CLO manager as sponsor; a majorityowned affiliate of the CLO manager, or retention by the originator or the arranger.
Where a manager cannot take a direct 5% holding, or chooses not to, the majority-owned affiliate (of the manager) is a good alternative as it significantly reduces the capital required to meet the RR requirements, while ensuring retention by the manager of a significant financial interest in the affiliate.
One point of interest is the narrower interpretation of the US rules, compared with the EU, on what constitutes 'originating'. In the US, for example, whilst middle market lenders are considered to originate loans, lenders under US broadly syndicated loans are limited for these purposes to lead arrangers and do not include CLOs that take participations in such loans. In the European market, however, the consensus is that an originator can be any named lender of the original loan, including entities taking participations on to their balance sheet in order to sell them on to a CLO.
Conversely, in Europe there are no majority-owned affiliate or arranger options, only sponsor, originator and "original lender" and only some EU regulated managers may satisfy the definition of sponsor.
One of the current areas of debate, particularly in Europe, is how long an asset must be 'seasoned' or held by an entity before it can be transferred to the CLO issuer to enable such entity to qualify as an "originator" for these purposes. EU regulators have not given any guidance on this issue yet and the concern among industry participants is that the regulators will clamp down on originators that only hold assets for short periods of time, such as 24 to 48 hours, before transferring them. Consensus seems to be building, however, that 15 to 30 days or so is a reasonable time period to 'season' loans before selling them into a CLO.
The regulators in the EU and the US have also taken different approaches in terms of enforcing compliance with the applicable RR rules. In Europe, non-compliance affects 'credit institution' investors whose capital risk weighting requirements increase significantly where they invest in non-compliant deals. In the US, however, the onus falls upon the sponsor of the CLO to ensure compliance with the rules with significant penalties for failure to do so.
Structures We are Seeing
As the Maples group acts on the Cayman Islands legal and fiduciary side on over 60% of the US CLO market, and a significant portion of the European market, and has capabilities in the Cayman Islands, Ireland, Luxembourg, Holland and Delaware, we see the innovative products that are being developed on both sides of the pond to address RR. Whilst a number of US deals in 2014 closed as EU RR compliant with the manager sponsor retaining the 5% stake, below are just some of the other solutions we are seeing implemented to address RR.
GSO pioneered the first originator fund in the summer of 2014. In outline, an originator fund invests in a loan originator entity established by the manager (the "Originator") via the purchase of equity (shares) or profit participating notes, or a combination thereof, issued by the Originator.
The Originator in turn makes direct investments in European and/or US senior secured loans and on a CLO closing, transfers some or all of the loans to the CLO issuer under, for example, either a sale and purchase, a forward sale or a master participation agreement. The Originator will then typically retain a majority portion of the equity in that CLO.
Maples and Calder acted on the first US CLO originator transaction in 2014 structured to meet and comply with EU RR rules as well as strategic preparation for US risk retention. A special purpose Cayman Islands vehicle acted as retention holder and accumulated middle market loans, at the same time as entering into a matching future sale agreement with the CLO issuer.
We have been working with a number of managers who are setting up their own European originator structures and originator funds. These funds tend to be established by asset managers that already run investment or hedge fund businesses and can easily accommodate a CLO originator fund alongside existing investment and credit funds.
We have also established Cayman Islands majority owned affiliate vehicles in which the manager owns a majority interest but which have significant third party investors. The special purpose affiliate then typically acquires a horizontal interest in the CLO by purchasing subordinated notes to satisfy the 5% retained risk requirement. As the horizontal 5% equity investment will have to be calculated based upon 'fair value' we understand that this option may become less attractive going forward because, in order to calculate fair value, accountants will require disclosure in the CLO offering document of any discounts provided to investors across the entire capital stack.
Cross Border Solutions
We have already seen, and expect to see, an increase in structures established to maximise jurisdictional advantages and to combine features across jurisdictions to provide structural solutions for RR. The use of Irish section 110 companies tacked on to Cayman Islands structures and Cayman Islands incorporated Irish tax resident entities are two such examples which provide cross border flexibility.
CLO Manager Consolidation?
While the expected market consolidation at the start of the decade failed to materialise, as the CLO 2.0 bull run reinvigorated the space, with RR and other regulatory concerns, such as Volker, now very much in focus, it would actually appear that the forecasters may have been right with their predictions, albeit a year or two early. Consolidation is now front and centre once again as pundits predict a significant amount of manager consolidation ahead of the RR rules going live at the end of 2016.
We believe that, whilst a modest amount of consolidation is inevitable, a number of factors mitigate the effects of mass consolidation that some market participants foresee. These include the development of structural solutions to address RR, the availability of risk retention investors (including certain arrangers providing such assistance) and the fact that many managers, including smaller managers with whom we have spoken, already have alternate solutions in place through access to other sources of capital. There may be surprises as certain 'smaller' managers not only continue to issue CLOs but also look to increase issuance volumes and move into the 'larger' manager bracket. On the flip side, not all larger managers have RR financing locked down so, whilst the CLO manager landscape will no doubt change, it may change in ways people do not necessarily anticipate.
About the Author
Mark Matthews specialises in structured products and has extensive experience in SIVs, securitisations, repackagings and credit funds including hybrid funds and CLO/CDOs. He has also worked on private equity and hedge fund related matters since 1998. Mark also has experience in general corporate, partnership, banking and regulatory matters.
Mark is head of the Cayman Finance group and co-head of the Sports, Media & Entertainment group.
About the Author
Nicola Bashforth specialises in structured finance transactions, particularly CLOs, securitisations, repackagings, credit funds and other CLO investment structures. Recognised as a leading offshore lawyer in the credit market, she works closely with all arrangers, CLO managers and their counsel, helping to establish and structure their CLOs, warehousings and refinancings, based on a solid understanding and experience of the market pre, during and post credit crisis. Nicola also has experience in general corporate, finance and regulatory matters
About the Author Stephen McLoughlin advises on a wide range of capital markets and structured finance products and related issues, including CLO, RMBS and other securitisation structures, fund-linked structured products, repackagings and debt issuance programmes. He also advises on regulatory issues impacting on structured finance vehicles including those in relation to the Prospectus Directive, Market Abuse Directive, AIFMD, EMIR and risk retention requirements for securitisations under the Capital Requirements Regulation.
Extracted from Maples and Calders' The CLOser, published February 2015
Originally published in Cayman Finance Magazine, 2015-2016, Issue 2
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.