New risk retention rules went into effect on December 24, 2016 for commercial-mortgage bonds, asset-backed securities and similar products that were designed to prevent lenders from making risky loans, packaging them into bonds and selling them to investors who would incur losses if securities defaulted. It’s important to note that these rules came as a response to the financial crisis. The new regulations required issuers to hold onto five percent of their securitized deals, ensuring exposure if the securities’ deteriorated. Since the rules went into effect, managers with access to capital have set up financing vehicles to comply. A new market was created and first-time investors could conveniently invest in collateralized loan obligations (CLOs).
In response to a litigation with the Loan Syndications and Trading Association (LSTA), on February 9, 2018 the U.S. Court of Appeals for the Washington, D.C. Circuit ruled that the Credit Risk Retention Rule did not apply to managers of open market CLOs. The opportunity for an appeal expired and on April 3, 2018: the Washington, D.C. Circuit issued a “mandate” to the Washington, D.C. District Court. On April 5, 2018 the Washington, D.C. District Court ordered that i) summary judgement is granted in favor of the LSTA regarding the application of risk retention to open-market CLO managers, ii) summary judgement is vacated on the issue of how to calculate the five percent risk retention under the Credit Risk Retention Rule, and iii) the Credit Risk Retention Rule is vacated insofar as it applies to investment managers of open-market collateralized loan obligations. The LSTA has been very active in updating the market on the status of the litigation, and it’s likely that May 10, 2018 will be the end to risk retention for CLOs as that is the last date the agencies can ask the United States Supreme Court to review the Washington, D.C. Circuit’s decision. However, the LSTA thinks that is highly unlikely given the lack of action since February.
It is important to note that the D.C. Circuit Court’s decision only applies to open-market CLOs. This excludes middle market CLOs, which lenders to small and midsize companies use to securitize loans they have underwritten and hold on their own books. Also, those CLOs already structured to comply with both U.S. and European Union risk retention rules may not be considered as open-market CLOs due to EU rules.
Consequences of Exemption
What happens when the regulation does not apply to open-market CLO managers? Here are some scenarios that we have discussed with several market participants:
- More CLO managers will enter an already competitive market
Many large CLO managers with substantial capital quickly established separate vehicles to retain risk and issue CLOs to be compliant with the regulations. But, even for many mid-size managers, compliance was a financial and administrative burden, and a non-compliance to risk retention is welcome. The group most threatened by risk retention was the smaller CLO managers who were not able to easily raise capital and comply with the regulation. With the elimination of this requirement, we are likely to see many more managers who never lined up significant capital for risk retention come into market for the first time. The removal of this barrier to entry will create more competition, which should lead to more options in legal deal terms and types of deal which can only benefit investors.
- Some managers are likely to retain their interests, post ruling
Even though from a regulatory point of view a manager no longer needs to retain five percent, few managers’ CLO interests are likely to be up for sale in the next few months. Consider that a manager’s ability to sell their interests may depend on the wording of the indentures. In addition, some CLO investors may prefer managers whose interests are more aligned with their own and who like the fact that they have “skin in the game.” Also, the costs of setting up financing vehicles and complying with the rules have also fallen since the middle of 2017. With investors showing greater willingness to invest in a manager that continues to retain a portion of their new issues in addition to lower costs to comply, it is likely some managers will continue to retain their interests.
- Risk retention vehicles will survive
Market participants also expect that vehicles or funds raised originally for risk retention will continue to exist. Risk retention vehicles also serve as a convenient way for third-party investors to gain exposure to CLO equity without the challenges associated with a direct investment. Many retention interest purchases are made by funds and third-party investors who all have their own investment mandates.
- Continued increase in refinancings
The ruling removes the associated costs of taking an investment in a refinanced deal. Managers will not have to weigh the benefit of lower debt cost against allocating risk retention capital to existing deals or new issues.
- Continued increase in new issuances
With continued healthy demand for these investments and more entrants in the marketplace, one would expect new issuance to pick up. U.S. CLO issuance was around $118 billion at year-end 2017 (versus approximately 72 billion in 2016), up 65 percent from 2016,.
As the deadline to file for an appeal passed a number of CLO managers in the U.S. have already brought to market new issues and refinancings with no intention to retain the 5 percent previously required under risk retention. As we are already starting to see, it will be easier for even more managers to enter the CLO market, given current demand. This should increase the requirement on lenders to issue corporate loans to fund private equity buyouts and other highly leveraged acquisitions. We would expect that higher volume of CLO issuances and active managers will create more transparency, liquidity and value for our clients.