Cayman Islands: Risk Retention And Emerging Structures

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.

US Rules

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.

Originator/Originator Funds

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.

Majority-Owned Affiliates

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Topics
 
Related Articles
 
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions