When US risk retention rules were announced late in 2014, the reaction from CLO managers was nearly unanimous. The rules – which require managers to hold on to 5% of the securities in a CLO for the life of the fund – would make CLO issuance prohibitively expensive for most managers, killing the nascent 2.0 market in the crib.
Of course, as with most predictions of regulatory Armageddon – including the Foreign Account Tax Compliance Act and the Volcker rule, both of which were supposed to consign CLOs to the dustbin of history – this didn’t quite happen.
While some smaller, less well-regarded managers fell off the map, most were able, at the very least, to raise enough capital to ensure their short-term survival.
In February 2016, for example, a survey of around 60% of active CLO managers by law firm Maples and Calder found that 70% of respondents viewed risk retention as a challenge, “but said they are either facing bigger issues or believe risk retention is not business critical”.
In November – one month before the rules came into force – a follow-up survey by Maples found that 89% of respondents had risk retention solutions “in place or imminent”.
As a result, the CLO market has beaten expectations in 2017. As of 24 July, approximately $54bn of new CLOs have priced, according to Wells Fargo – more than double the $26bn seen at the same point in 2016.
Late in June, analysts at Deutsche Bank, JP Morgan, Morgan Stanley and Wells Fargo all increased their 2017 CLO issuance projections from $50-70bn, to $80-100bn – putting 2017 on course to be one of the most active years for the new issue market ever.
The current record total – $124bn – was set in 2014. From a short-term to a long-term approach While most managers have some kind of risk retention solution in place, a large proportion of these vehicles are only short-term fixes, and can be quite capital-intensive.
Maples’ November survey found that 49% of managers with a retention structure in place had opted for a “majority-owned affiliate” (MOA) – a thinly-capitalised special purpose vehicle designed to provide risk retention capital for a fixed (small) number of CLOs.
In a typical MOA, a manager earmarks a fixed amount of capital (say, $100m), which can be used to support the issuance of one or more CLOs.
Generally, the manager must contribute at least 50.1% of the equity capital to the MOA – in this case, $50m – for the structure to qualify as “majority-owned” by the manager for regulatory purposes.
The remaining 49.9% may be contributed by external investors. One of the earliest managers to go down this path was Red Bank, New Jersey-based Zais Group.
The firm, which has issued six CLOs since the financial crisis, launched its own MOA for risk retention in August 2015 – over a year before the rules came into effect.
Zais contributed 51% of the equity capital for the new MOA, while a longterm investor took down the other 49%.
Two years on from the launch, Zais Group’s chief operating officer, Mike Szymanski, says that the firm is revisiting its retention strategy to see how it can be improved – particularly given a surge in investor interest in risk retention vehicles.
“A lot of investors have expressed an interest in partnering with managers on a risk retention vehicle,” says Szymanski.
He explains that the driving dynamic behind risk retention has changed over the last year. “When US risk retention rules were initially announced at the end of 2014, we focused mainly on how to comply with the letter and spirit of the rules. Now, we are looking to optimise our strategy so that we can comply with risk retention in a more capital-efficient manner.”
John Fraser, head of Investcorp Credit Management US, echoes this sentiment, pointing out that investors are becoming more open to different retention strategies.
“The number one question that investors asked CLO managers in 2016 was how they would comply with risk retention,” says Fraser.
“Now that it’s clear there are several options available, we are increasingly seeing investors working together on dedicated risk retention funds.”
Investcorp Credit, which is backed by Qatarbased fund-of-funds manager Investcorp, has used internal capital to support its US and European CLOs so far this year, but Fraser says the firm is exploring its options for a risk retention fund.
Acronyms, acronyms, acronyms
Risk retention vehicles can take a number of forms, with each fund looking very different from the last. While one manager may use a thinly- capitalised SPV to support one or two CLOs, another may opt for a dedicated, independent asset management firm with its own staff and balance sheet.
At least one firm, Tetragon Financial Management, has set up a multi-manager platform, somewhat similar to a fund-of-funds.
Having said this, market participants have come to understand risk retention vehicles as falling into one of three broad categories: the MOA, detailed previously; the capitalised majority- owned affiliate (CMOA); and the capitalised management vehicle (CMV).
“Deciding between an MOA, a CMOA and a CMV depends largely on structural complexity and cost, capital requirements, utility of European CLO distribution, and investors’ risk retention preference,” explains Zais’ Szymanski.
As explained previously, 49% of managers have used the MOA route to launch risk retention- compliant deals in the early days of the new regulatory regime.
MOAs are by far the cheapest and quickest vehicles to set up, allowing managers to keep their CLO issuance program ticking over in the absence of a more comprehensive strategy.
Managers often raise an MOA for the purpose of vertical risk retention, and then obtain financing on the senior portion of a retention piece, to get more mileage out of their MOA capital.
However, these structures come with several disadvantages. Typically, an MOA can only support one or two new CLOs, meaning that a manager will have to raise a new vehicle in short order.
While a single MOA is relatively cheap, raising several can be inefficient. Meanwhile, managers who opt to retain vertical strips must contribute more capital to the MOA itself – typically 85-100% – to make sure that their fund is not seen as an avoidance technique.
At the other end of the scale is the CMV: an entirely new asset management company, sufficiently capitalised to support a CLO issuance program in its own right.
Unlike an MOA, which requires a minimum 50.1% investment from the CLO manager, a CMV can be structured as a permanent capital vehicle, with third party investors contributing up to 100% of the equity capital.
CMVs have the added benefit over an MOA of allowing compliance with European risk retention rules, via the “manager-originator” route.
However, since a CMV is a brand new asset management company which requires a separate board, and needs to demonstrate true independence from the original manager, setting one up can be a very costly and time-consuming exercise.
So far, CMVs have been mostly limited to large firms with significant balance sheet capability. For example, Apollo Global Management launched a $700m CMV, Redding Ridge, last year, while GoldenTree Asset Management launched a $600m vehicle of its own – GoldenTree Loan Management (GLM) – in January.
Both vehicles took over a year to set up. This is where the CMOA comes in. These vehicles, which are typically set up as private equity-style funds with an eight-to-10-year life and a three-year drawdown period, allow managers to lock up capital and support their CLO issuance program over the course of several years.
“One of the benefits of a CMOA is its flexibility,” says Hunter Covitz, a portfolio manager at Acis Capital Management in Dallas.
Acis set up its own CMOA last year. “Our vehicle will allow us to issue between six and 12 CLOs over the next few years, depending on market conditions and investor preferences.”
Like the CMV, CMOAs allow compliance with US and European risk retention rules. The CMOA was developed last year by Dechert, as a compromise between the MOA and CMV.
Crucially for managers, the CMOA requires a smaller equity contribution.
“Most, if not all, existing CMOA vehicles have seen the manager retain 15-20% of the total equity, while keeping economic control as defined by US generally accepted accounting principles,” says Dechert partner John Timperio.
The option to contribute less capital while retaining economic control has made the CMOA a particularly attractive option for managers.
For example, $21bn distressed debt specialist King Street Capital Management opted for a CMOA, Rockford Tower Capital Management, when it began its CLO issuance program earlier this year.
And, late in July, Neuberger Berman held the final close on a $450m CMOA of its own, named Neuberger Berman Loan Advisers.
Alignment of interest?
While it is obvious that CLO managers benefit from launching a risk retention vehicle, investors are learning to love these structures as well.
“Initially, a lot of investors took a ‘wait and see’ approach to risk retention – sitting back, and waiting to see how it played out,” says Jeff Herlyn, a principal at Tetragon Financial Management in New York.
“Now, as they’ve become more aware of the different approaches, they are more amenable to investing in a dedicated retention vehicle.” Tetragon, a long term CLO equity investor, made headlines last year when it launched a multi- manager risk retention fund.
Tetragon Credit Income II is unique in that it acts as the CLO manager for risk retention purposes, with external firms managing the portfolio in a sub-advisory role.
TCI II has supported CLOs managed by Columbia Management, NYL Investors and Symphony Asset Management in the last year. Dechert’s Timperio echoes this sentiment.
“We’ve seen a significant increase in investor interest in risk retention capital – particularly CMOAs – in the last six to nine months,” he says. “Managers like the flexibility of the structure, while investors like the ability to lock up capital with a manager in a PE-style fund.”
Meanwhile, in Europe, Napier Park Global Capital launched a similar vehicle to support managers in providing risk retention capital.
Recently, the fund, which counts as an “originator” for risk retention purposes, backed a new European CLO issued by Rothschild affiliate Five Arrows, and supported a reset of Intermediate Capital Group’s St Paul’s CLO V.
Allocating to a risk retention vehicle – rather than directly investing in individual CLOs – typically comes with perks for investors.
“Risk retention vehicles typically benefit from a certain level of exclusivity that gives them preferential access to a manager’s equity (as compared to ad hoc CLO equity investors),” says Christian Parker, a partner at Paul Hastings in London.
For example, GoldenTree’s CMV retains 100% of the equity and sub-investment grade debt in CLOs that it issues, reducing the fees paid to underwriters since these tranches are traditionally difficult to place.
Meanwhile, the firm works with multiple arrangers to sell the senior debt to as wide an investor base as possible. GoldenTree launched its first GLM-managed CLO, GLM US CLO 1, in March, working with Morgan Stanley, Baml and Wells Fargo as arrangers.
The deal achieved a AAA discount margin of 122 basis points over Libor – at the time, the tightest print for several years.
Napier Park’s risk retention vehicle is understood to bene t from fee-sharing arrangements with the managers it supports, providing an additional boost to investors in the fund.
Alternatively, investing in a risk retention fund may be a simple necessity for investors seeking exposure to CLO equity.
“Risk retention has changed the traditional distribution model for CLO equity,” says Tetragon’s Herlyn.
“Now, access to top tier managers’ equity is more limited, so investors are much more keen to form a partnership with a risk retention fund.”
Finally, risk retention vehicles can give investors access to structured credit expertise that may not otherwise be available.
Acis Capital Management’s CMOA, for example, also has the ability to invest opportunistically in CLO debt and equity tranches when market conditions are not conducive to issuing new CLOs.
By taking advantage of this capability during the credit sell-off in 2016, the vehicle returned over 60% to investors that year.
“Investors are beginning to see risk retention vehicles as a product akin to a traditional CLO debt or equity fund,” agrees Zais’ Szymanski.
“Investing in a vehicle – rather than buying CLOs directly – allows them to make use of the manager’s expertise in CLO tranche investing.”
Having said this, not all CLO investors are jumping at the chance to lock up capital in risk retention fund.
Tom Majewski, managing partner at Eagle Point Credit Management in Greenwich, says that investing in a risk retention fund can result in conflicts of interest between the investor and the CLO manager.
“Investors in a risk retention vehicle concede control of the key economic decisions involved in the life of a CLO, such as when to price, and when to call a deal,” he says.
“While investors are primarily concerned with getting the best return on their capital, collateral managers may be reluctant to give up management fees by calling a deal early.”
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