LPC/IFR: Managers choose dual compliance as U.S. risk-retention rules loom

By Kristen Haunss and Mariana Ionova

NEW YORK (Reuters) - With U.S. rules forcing managers to hold onto a portion of their fund’s risk set to go into effect this year, some firms have chosen to make their deals compliant with both U.S and European risk-retention requirements to expand the buyer base and potentially lock in lower interest rates.

CreekSource, the risk-retention manager set up by 40/86 Advisors, a unit of CNO Financial Group, and Credit Suisse Asset Management are among the firms that issued dual-compliant Collateralized Loan Obligations (CLOs) in the first quarter, according to Thomson Reuters LPC data. During the first three months of the year, almost 20% of US CLOs arranged were dual-compliant, according to JP Morgan data.

Issuance of U.S. CLOs, the largest buyer of leveraged loans, is forecast to fall more than 60% in 2016, in part due to risk retention, which takes effect on December 24, decreasing the appetite for the US$880bn leveraged loan market. Spreads on the debt slices of U.S. CLOs are wider than European funds, offering European investors a higher return than other assets, while the additional buyers may allow U.S. manager to price tighter than other deals.

“The payoff has been in the execution and ability to execute,” said Eddy Piedra, manager at CreekSource. “Investors overseas have been very receptive and to a large extent they are eager to put money to work outside of Europe. They just want comfort that it’s the right structure and no one is going to ask them to liquidate their investment or pony up more capital.”

There was US$8.2bn of U.S. CLOs raised in the first quarter, down 72.5% from the US$29.8bn arranged during the same period last year, according to Thomson Reuters LPC Collateral. In Europe during the first three months of the year there was €2.64bn of CLOs issued, down from €3.3bn during the same period in 2015.

Ten US CLOs issued this year have been U.S. risk-retention compliant as of April 26, of which five were dual U.S. and European compliant, according to Morgan Stanley data.

CLOs pool loans of different credit quality and sell slices of the fund of varying seniority from Triple A to B to investors such as insurance companies. Equity investors, holders of the most junior piece of the fund, are paid last with what interest is left.

Under existing rules for the €65bn European CLO market, it is the investor’s job to ensure the deal complies, said Deborah Festa, the head of Milbank, Tweed, Hadley & McCloy’s West Coast securitization and investment management practices. A manager can render a CLO compliant by holding the retention position as a sponsor if it is a Markets in Financial Instruments Directive (MiFID) registered adviser.

A transaction can also be compliant if the originator of a significant portion of the collateral holds the required retention position, she said. If the originator is not the manager, it must originate a higher proportion of the collateral than it otherwise would. To qualify as an originator, it must bear either limited default risk or market risk with respect to the collateral it acquires before transferring to the CLO.

“The idea is to have assets on the books for a sufficient amount of time to give the originator credit risk or market risk exposure to those assets,” Festa said.

In Europe, the finer details of how managers can meet risk-retention requirements have been in a state of flux. Last year the European Commission cleared a revised set of rules after a five-year tug-of-war over how to handle originator-style retention, but the framework has yet to be finalized and implemented.

Credit Suisse Asset Management’s US$504.9m CLO issued in February with JP Morgan was expected to comply with both the U.S. and European rules, according to sources. CreekSource raised a US$302.5m CLO with Goldman Sachs in March that is also compliant with both rules, according to sources.

Spokespeople declined to comment.

U.S. CLOs may offer European investors more generous returns than euro deals. U.S. AAA spreads were 158bp in April, compared to Euro AAA spreads of 150bp this month, according to Morgan Stanley data.

Carlyle Group’s US$499m CLO that priced in April pays a rate of 156bp over Libor on the Triple A slice, according to sources. In Europe, Blackstone Group’s GSO Capital cleared its senior tranche at a discount margin of 150bp in April. Carlyle, which printed a European deal earlier in April, tightened its Triple As to 145bp. Sources noted the European Triple A market may tighten further.

“If you are already making a deal U.S. compliant, there can also be benefits to making it European risk-retention compliant,” said Dave Preston, a CLO analyst at Wells Fargo in Charlotte. “There is a lot of demand from European investors so that can lead to better pricing for the issuer.”

(Reporting by Kristen Haunss and Mariana Ionova; Editing By Michelle Sierra and Jon Methven)

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