NEW YORK (LPC) - US investment managers seeking to raise new Collateralised Loan Obligation (CLO) funds are adding a ‘put option’ to help them comply with European risk-retention regulations after a recent court decision let them off the hook in the US.
CLO managers no longer have to hold 5% of their US funds after a February court ruling, but a similar rule still applies in Europe, where US managers still need to comply with costly ‘skin in the game’ requirements.
US managers are selling funds to European investors to take advantage of tighter pricing. The spreads on the most senior tranche of a recent European CLO was about 20bp tighter than the Triple A slice of a recent US deal.
Collateral managers, including CIFC, are therefore including a contingent sale agreement, or ‘put option,’ in deal documents, which allows CLO funds to hold credit risk without ‘transferring’ or selling the loan into the fund, which could now negate the recent US court exemption.
The put option allows US CLOs to buy loans from banks directly, with the manager agreeing to buy the debt if it defaults within a set time period. Previously using the ‘originator’ route, managers would buy a loan and transfer it into the CLO to comply with EU rules.
Risk transfer was at the heart of the court case which was successfully fought by the Loan Syndications and Trading Association (LSTA), the trade group for the US$979bn US loan market. Under Dodd-Frank rules, a sweeping financial reform package signed into law in 2010, Congress said that US risk-retention regulation applies to a ‘securitizer’ that ‘transfers’ or ‘sells’ an asset.
The LSTA sued the Federal Reserve and Securities and Exchange Commission (SEC) in 2014, warning the US regulation could cut off funding for borrowers that depend on the US$518bn US CLO market for financing.
A US Appeals Court agreed that CLO managers do not ‘transfer’ broadly syndicated loans as defined by the legislative statue and ruled therefore that CLO managers are exempt from risk-retention regulation.
In Europe managers still have to hold 5% of the assets in their CLO.
Under the previous originator model, managers bought loans and held the credit risk for a set ‘seasoning’ period, typically 15 days. If the loan did not default, it would settle into the CLO, according to Sean Solis, a partner in New York at law firm Dechert.
The put option structure avoids the appearance of a sale or transfer. The loan will trade directly into the CLO and if the loan defaults during that 15-day period, the manager will buy it back, he said.
“In Europe, we are allowing for synthetic or contingent form of retention, so [the put option] could potentially work,” said Christian Moor, principal policy officer at the European Banking Authority.
CIFC told potential investors in its CIFC Funding 2018-II CLO that it will agree with the CLO to identify certain assets equal to at least 5% of the target fund size for the CLO to purchase to comply with EU rules, according to a preliminary deal document. The manager will buy those assets from the CLO if certain criteria are not met during the 15 days following the purchase.
This allows US managers to hold retention and comply with the EU regulations, while avoiding hefty US retention disclosure requirements. Some firms may, however, decide against selling funds to European investors to avoid retention altogether.
Heading across the Atlantic also helps US CLO managers to cement existing relationships and offer diversity to European investors facing relatively low volume.
Only €6bn (US$7.7bn) of European CLOs were raised in the first three months of 2018 compared to almost US$32bn of US CLOs in the same period, according to Thomson Reuters LPC Collateral data.
About 40% of all US CLOs issued last year were compliant with both regulatory regimes, according to Wells Fargo data.
E-mails to an SEC spokesperson were not returned. Oliver Wriedt, co chief-executive officer at CIFC, declined to comment.
Reporting by Kristen Haunss; Editing by Tessa Walsh and Michelle Sierra