NEW YORK, May 24 (Reuters) - Five months after regulations took effect that require Collateralized Loan Obligation (CLO) managers to hold some of their fund’s risk, several practical issues about the rules’ application and lasting impact have yet to be resolved, according to sources.
Risk-retention rules require managers to hold 5% of their fund under the Dodd-Frank Act. The final regulation was announced in 2014 and went into effect on December 24, 2016.
Despite a long runway from the announcement to effective date, the US$450bn CLO market is still trying to find a consensus on issues that have been raised in the last five months, which have required significant negotiation of documents and terms.
CLOs are the largest buyer of US leveraged loans and provide financing to back acquisitions. The retention rules may reduce the loan buyer base by limiting the number of firms that can issue compliant CLOs.
Despite numerous efforts to eliminate or alter the rule, market participants are resigned to the fact the requirement will not change in the near term.
To comply, managers may buy a vertical strip, which is 5% of every tranche of a CLO, or a horizontal strip, which is 5% of the face amount of all of the fund’s tranches that is held in the equity slice. Firms may also buy a combination of the two.
Managers can buy the retention directly or use financing from a third party. Some firms have set up a capitalized manager vehicle (CMV) – a standalone management company that oversees the CLO to buy the retention stake – or a majority-owned affiliate (MOA) or capitalized majority-owned affiliate (C-MOA).
Since the rule took effect, the market has been working to answer questions on how best to comply, including when mangers need to disclose to investors how much risk they intend to hold and who is responsible for those determinations.
Market consensus suggests that managers will first provide preliminary information about horizontal tranche fair-value determinations two business days prior to the CLO’s pricing date, according to Deborah Festa, head of law firm Milbank, Tweed, Hadley & McCloy’s West Coast securitization and investment management practices.
The CLO’s trustee would then release the final calculation within a month of pricing or potentially sooner if there is a material change, she said. The market has also concluded that these fair-value disclosures are generally the responsibility of the CLO rather than the manager, Festa added.
Several questions remain, including what happens to the retention if the manager changes, Festa said. Under the rules' current language, the original manager would still be responsible for holding the retention even if it is replaced due to a sale.
“The market hasn’t had to face this yet,” she said. “It is a, watch this space type-area to see how the market will react and what people will be comfortable with.”
The Loan Syndications and Trading Association (LSTA) is reaching out to the new Republican administration in the hopes it will be willing to loosen regulations as the market continues to work to resolve the questions raised.
President Donald Trump has repeatedly said that he wants to dismantle the Dodd-Frank Act and signed an executive order on February 3 requiring Treasury Secretary Steven Mnuchin to advise within 120 days on possible regulatory changes.
In a letter to Mnuchin on April 7, the LSTA said risk retention should be eliminated in order to advance the interests of investors. The trade group asked the US Senate to consider an alternative, the QCLO, in a second letter that it sent last month to Senate Banking Chairman Mike Crapo and Ranking Member Sherrod Brown.
A ‘Qualified CLO’ would require a manager to hold 5% of the CLO’s equity slice and meet a number of tests in areas including diversification and structural protections.
A lawsuit that the LSTA brought against the Securities and Exchange Commission and the Federal Reserve in 2014 is also continuing. The trade group appealed its case earlier this year after the Federal District Court for the District of Columbia ruled against the LSTA in December. (Reporting by Kristen Haunss; Editing by Tessa Walsh)