Some CLO Managers Strategizing for U.S. Risk-Retention Rollback

(Bloomberg) -- For some U.S. CLO managers it simply wouldn’t make sense to comply with European risk-retention rules if similar restrictions are rolled back by Congress as part of the Trump administration’s pledge to dismantle Dodd-Frank. Firms could get stuck holding an illiquid retention piece if the U.S. regulation is withdrawn, prompting U.S. managers to back away from dual-compliant deals.

While the Financial Choice Act faces a stiff battle in the Senate, its advancement by House Republicans has given a glimmer of hope to some managers that U.S. risk retention rules will eventually be rolled back. The majority of CLO managers don’t necessarily believe it will ever come to pass -- at least not via a Congressional solution -- yet a handful of larger, well-capitalized managers are imagining their global retention-compliance plans without the regulation.

“With a potential reduction or repeal of the U.S. regulations, a number of U.S. CLO collateral managers are electing not to make their transactions dual-compliant and foregoing marketing their issuances into Europe,” said Thomas Majewski, managing partner and founder of Eagle Point Credit Management.

The benefits of complying with the European rule, including pricing and liquidity, is becoming negligible for some managers.

“They’re thinking, ‘Is it worth being committed to holding on to a risk retention piece over the next eight or twelve years?”’ said Sean Solis, a partner at law firm Dechert LLP who represents several CLO-manager clients. “They’re willing to give up European investors for the potential liquidity they’ll have for the retention piece if U.S. rules go away. Influential managers are adopting this idea.”

No Pricing Advantage

Any pricing benefit for dual-compliant transactions is negligible.

“Right now the rules in the U.S. and EU are mostly very similar, but if one rule becomes divergent or requires more retention capital, you can only justify the extra cost of EU compliance if there’s enough of a pricing pickup. And in many cases, there’s not enough of one to justify the capital outlay," said Dave Preston, a senior analyst at Wells Fargo & Co.

"If there is a change in the U.S. law, managers want their CLOs to easily adjust to reflect the new reality," he added.

Whether Europe’s risk retention rules will change again - with the potential for an increased retention requirement above 5 percent possible - should be apparent in the coming weeks as the trilogue negotiations for the EU’s new securitization regulation wrap up.

Approximately 40 percent to 50 percent of CLO managers currently have dual-compliant programs, according to Wells Fargo. Managers such as GoldenTree and CVC Credit Partners have recently issued dual-compliant CLOs, according to Bloomberg data.

Demand from Asia

The recent deepening of the CLO investor base in Asia has bolstered the case for dropping European investors if U.S. rules are weakened, Dechert’s Solis said. Deals issued by several U.S. CLO managers that aren’t EU-compliant are "pricing just fine," he said.

“Demand from Asia (for CLOs) is unabated,” Oliver Wriedt, co-CEO of CIFC Asset Management, said in a recent interview. “The Japanese market has gotten deeper; we saw a number of new programs there. And Korea is getting deeper than it’s ever been."

Those managers who have raised large global risk retention funds may be less bothered about dropping the European risk retention element, as they have the financing raised already, analysts say.

But that doesn’t reflect the reality of the majority of CLO managers, Majewski said. “We estimate that less than 10 percent of CLO collateral managers have raised enough capital to be a long-term solution for their business," he said.

The possibility of a change or appeal of the regulations has contributed to a gradual slowing-down of fundraising efforts for most retention strategies, according to Eagle Point’s Majewski.

Several Paths to Rollback

Aside from the FCA, which is sponsored by House Financial Services Committee Chairman Jeb Hensarling, there are several other avenues for risk-retention rollback:

  • The Trump administration, and specifically Treasury Secretary Steve Mnuchin, suggests it may separately tackle several regulatory fixes to address post-crisis rules, including risk retention; President Trump also signed an executive order in February directing the federal agencies to consider scaling back regulations
  • In addition to the FCA, bipartisan initiatives, such as those advanced by Senator Mike Crapo (R-Idaho) and Senator Sherrod Brown (D-Ohio), aim to take a more targeted approach at changing aspects of Dodd-Frank, rather than promoting a wholesale repeal
  • The Loan Syndications and Trading Association (LSTA) has worked over the last few years to challenge the decision to include CLOs in risk-retention rules, engaging in ongoing litigation with the government and even writing a letter directly to Mnuchin last month. The legal case, which is currently in process in the DC Circuit Court of Appeals, may not be finished until early 2018, according to the LSTA