On February 9th, a U.S. court of appeals unanimously ruled that risk-retention rules for securitizations should not apply to CLOs (collateralized loan obligations). If the ruling stands, as many expect, it could increase potential opportunities for CLO investors. Perhaps most significant, the higher-yielding equity and subordinate debt tranches that were previously retained by CLO managers could become available in the secondary market. The potential regulatory change also highlights the challenges for CLO funds created solely for risk retention. PIMCO’s CLO team explains below.
Q: What are U.S. risk-retention requirements and how do they impact CLOs?
A: The risk-retention rules were adopted in 2014 as part of the Dodd-Frank Act and require the manager of a securitization to retain a portion of the risk in the securitization ‒ essentially, “skin in the game.”
Originally targeting the mortgage sector, the risk-retention rules also included “open-market” CLOs, investment vehicles typically set up by asset managers to buy corporate loans and securitize them. CLO managers have been required to retain 5% of each CLO, either by investing in approximately half of the equity tranche (a “horizontal slice”) or by investing in 5% of each CLO tranche (a “vertical strip”).
In 2014, the Loan Syndications and Trading Association sued the SEC and the Federal Reserve to exempt open-market CLOs from the rules, since CLO managers do not originate the loans they securitize. After losing its case in federal district court, it has won on appeal.
Q: How did the CLO industry respond to risk retention?
A: CLO managers with ready access to capital (such as insurance-owned platforms) have invested in their CLOs outright. Less well-capitalized managers have had to create and raise capital for special purpose companies designed to comply with the rule and retain some of the equity and/or debt from the CLOs.
Q: What happens now that the U.S. risk-retention rules have been overturned for CLOs?
A: The SEC and the Federal Reserve have a 90-day period in which they can petition the Supreme Court for a rehearing, but given the current anti-regulatory climate in Washington, many expect the court’s judgment will stand.
Q: What does the potential repeal of risk retention in CLOs mean for investors?
A: PIMCO’s CLO team believes repeal would have important implications for the CLO market for the following reasons:
More secondary offerings: Repeal may lead to the sale of existing CLO positions currently held to meet the rule. To date, roughly $11 billion has been raised for risk-retention funds, of which an estimated $8 billion is invested in CLO equity and debt.1 It is likely that some of these instruments will be sold into the secondary market if risk retention is repealed. This could increase CLO market volatility.
Greater CLO issuance: In the absence of risk-retention requirements, we expect to see more primary equity issuance and, in particular, more control equity blocks (i.e., majority ownership positions) available for sale. We also expect the reemergence of small CLO managers that had previously been unable to comply with risk-retention rules. These managers may be more willing to be flexible on fees and structure, opening the door for proactive investors to drive value through negotiation.
Existing risk-retention funds less relevant: Because they were set up specifically to buy new-issue equity of a single CLO manager, most risk-retention funds do not invest in opportunities in the secondary market or look for value across managers. Eliminating the risk-retention requirement will only highlight the opportunity cost of this structural disadvantage. Investors may want to consider “clean slate” approaches, which are not subject to these investment limitations. Over time, it is likely that risk-retention vehicles will become less relevant, particularly since their ongoing costs are higher for managers and investors.
Learn more about CLO structures and investments.
Giang Bui, Harin de Silva and Kristofer Kraus are portfolio managers at PIMCO focusing on CLOs.
1 Source: Citigroup, US CLO 2018 Outlook, February 22, 2018