For sale: Skin in the game

CLO issuance has recovered to pre-financial crisis levels. New risk retention rules in the US, resulting in increased capital requirements, are about to pinch, however. CLO managers and investors are increasingly looking at the originator route to address the rules.

 

In a bid to better align the interest of managers and investors, US CLO managers will be required to hold some skin in the game in the form of 5 percent of any CLO issued, from December 2016. The rules, which have been in place in Europe for some time, have sparked a lively debate in the CLO market. Many feel the rules were not designed with CLO managers in mind, as asset managers are not incentivized in the same way as others parts of the securitization markets, which make or originate loans.

 

The same managers argue that the capital requirements are onerous and an inefficient use of capital with managers of sponsored CLOs typically needing a lot of cash to splash. 

 

Many managers are not happy but the spirit of the regulations – investor protection – has been made clear. The rules are a fact of life and one manager, more resigned to the inevitable, says that they will help to prevent “two guys and a Bloomberg terminal” from setting up their own CLO business, a highly levered investment strategy.

 

In response, a number of managers have structured their CLOs in such a way that the risk retention piece is held in an originator vehicle. And in some cases, a proportion of the risk can be sold to a third party investor. 

 

US managers are still working through the implications on their side. “For Europe, the originator route may enable retention financing to help finance the 5 percent piece. The first few deals that were done in Europe about two years ago went down the sponsor manager route financed partly with third party money and the European Banking Authority deemed that inappropriate,” Jonathan Bowers, partner and senior portfolio manager at CVC Credit Partners, tells pfm.

 

Newer structures are said to meet European regulator rules though, as prescribed in a paper from the European Banking Authority (EBA) in December 2014. Most managers who have used the route have had to undertake a lot of due diligence to get to this point. And market sources observe that more are in the pipeline.

 

Furthermore, global CLO managers now wonder whether this route will meet US regulations, the initial guidelines for which were published in December 2014. CLO equity investors and risk retention financiers, as well as smaller CLO managers, are also assessing the opportunity. 

 

 

CVC Credit Partners was the first manager in Europe to use the originator route to comply with European risk retention rules with its $621 million CVC Cordatus Loan Fund III in April 2014. A few months later, GSO Capital listed Blackstone GSO Loan Financing (BGLF) to raise funds on the public equity markets for its CLO originator vehicle, with total net assets standing at around €329.4 million at time of publication. In August last year, Chenavari Financial Group used the originator route for its first CLO, the €360 million Toro European CLO 1. This May, it was reported to be transferring its CLOs into a permanent capital vehicle.

 

Though the final rules are a moving target, the CLO community is pinning their hopes on the originator route to meet the requirements in both Europe and the US. “The holy grail for the managers at the moment is to be compliant with the US final rules and the European CRR (Capital Requirements Regulation).” 

 

“I guess from that perspective, the originator solution sits in the middle of that Venn diagram,” Steve Berry from Investec Fund Finance tells pfm, confirming that it too is working with a US CLO manager on an originator structure. It has previously invested in originator structures and provided retention financing to them.

 

CLO manager and equity investor Babson Capital is also assessing the opportunities. “There are definitely a lot of US managers that would like to come up with a structure for both markets and I don’t think anyone has cracked that completely yet,” Matt Natcharian, managing director and head of structured finance at Babson, says.

 

Like other managers, Babson is working on an idea for the equity to invest alongside managers and be a third party investor in risk retention structures. “We are interested in how managers of various sizes are aligning themselves with CLO investors,” Natcharian says. 

 

US CLO managers, coming from a bigger and deeper market, are driving the changes but managers in Europe are also looking at the route as a way to grow their CLO business, sources say.

 

Institutional investors that haven’t had the same restrictions post-AIFMD, such as pension funds, have been drawn to investing up and down the capital structure of CLOs. It’s expected more investors will look to gain exposure to risk retention pieces, through equity and vertical slices offering a premium in returns.

 

In these vehicles, the originator holds the required five percent either through just the equity or by taking a vertical strip of the CLO. Returns depend on which slice the manager decides to hold. If it is all equity then you can expect a target of 14 percent return, Bowers says. “If vertical, low single digit returns,” he adds.

 

 

The originator route is also seen as a way that smaller managers in particular could continue to stay in business.

 

Listed vehicles in the US such as Eagle Point Credit and Fair Oaks invest in CLO debt and equity and it’s been posited whether existing pools of capital will tweak mandates to finance third party managers that don’t have the capital for risk retention. Tom Majewski, managing partner at Eagle Point Credit, says: “The expansion of public originator vehicles may allow smaller CLO collateral vehicles to continue issuing.”

 

Blackstone’s publicly listed vehicle has generated a lot of interest in this respect. BlackRock is one of the main investors in the Blackstone GSO vehicle, which yields 8 percent at present. The return is lower than typical CLO equity returns but likely reflects a lower level of leverage. It could be a difficult model to mimic though with sources commenting that Blackstone may have tapped much of the investor demand for this type of product already.

 

It is this lower leverage that is seen as an attractive offering over a sponsored CLO, which will be about 10 times levered. “I haven’t seen that level of leverage within retention facilities,” Berry says, adding that as well as the lower leverage, the cost of debt is typically at a premium to that within a CLO.

 

And for smaller managers who avail of this option, retention financing promises to offer a long-term financing solution rather than a case-by-case deal approach. “We can provide a programmatic support for these managers,” Berry says.

 

In return, managers who avail of the support would pay fees and give up some of their brand and perhaps some decision-making authority. The fees paid would be proportional with how much the managers are in demand, Natcharian says. Babson would likely charge fees that range between five to ten basis points, he says.

 

“A lot of interest has been generated because the CLO equity piece gives pretty good returns but CLO equity plus a share of the managers’ economics is even more attractive. It has gotten a lot of investors interested in the idea. It is a little less liquid than investing in other structures like CLO equity with a CUSIP that can trade in the market. But it has a higher expected return,” Natcharian says.

 

 

Above all though, the main concern for those in this new market is the uncertainty around what the term “substance” means under the new regime. The EBA has been clear that originator vehicles will need to have sufficient substance but it is still working on quantifying that. It is also closely watching what happens in the US, according to a market source.

 

“The regulations are evolving and it’s important to make sure that any originator structure meets the letter and spirit of the rules,” Majewski says.

 

Debt investors too are keenly aware of the changes. Andrew Bellis, managing director and partner at 3i Debt Management, says: “Debt investors will be asking if the originator structure is robust enough, in particular if it is in the spirit of the regulation because if they think it’s not, then arguably they won’t buy it and the debt will price wider.”

 

From a risk retention financing perspective, Berry says: “Lenders in this space are probably closely aligned to the regulator here. From a commercial perspective, we need the counterparty to our loan to stand up to financial scrutiny.”

 

Berry’s view is that substance means over and above that 5 percent retention to ensure that there is no implied credit risk transfer under that structure. “Put simply, the balance sheet of the originator needs to be substantial and robust,” he says.

 

There are also questions about whether vehicles are truly originating loans if they are buying them on the secondary market. “There are various shades of grey when people use an originator structure, between one which isn’t really an originator and doesn’t take any risk and therefore doesn’t meet the spirit of the regulations, to one that does true origination and meets the spirit,” says one market source.

 

Some don’t believe that the European regulator will look at deals on a case-by-case basis though and that ultimately it will be up to national governments to monitor developments.

 

In the US, things are at an even earlier stage. And though managers are looking at different structures which could meet US and European rules, there is a significant difference between the way managers will be treated in the US if they get it wrong. “The key difference is that in the US the risk of non-compliance is much more severe for the manager whereas in Europe the risk of non-compliance rests with the investor,” one market source said.

 

 

While not anticipating a huge rush from US managers to meet structures, simply because of the amount of capital that would be required to do that, Natcharian can certainly see changes in terms of managers setting up originator vehicles that support smaller managers. “It does require a lot of capital though so I don’t think a lot of US managers are going to rush to meet that structure necessarily. But there will be some people that try to create originator structures themselves and hire managers to sub-advise them. I think that will happen.”

 

For Berry it will come down to size: “The challenge is, for such a new market, specifying and agreeing upon what that substance translates to in terms of balance sheet.”

 

Another challenge will be keeping the vehicles simple and easy to understand, to avoid backlash from regulators. For managers in the US, the consequences would be much more punitive than for those in Europe. Janet Yellen, US Federal Reserve chairwoman, recently voiced concerns about an overheating leveraged loan market, and her perspective, as chief regulator, cannot be ignored by US managers.

 

The leveraged loan market is a big one however. At around $900 billion and €400 billion outstanding in the US and Europe, and the CLO market at $47 billion and €7 billion year to date, according to S&P Capital IQ LCD, the opportunity for the CLO market to refinance some of it should not be dismissed. It will all depend on whether each deal can meet the clear spirit but much vaguer letter of the law.