March 22, 2018 / 7:02 PM / a year ago

Mid-market CLOs still on the hook for risk retention

NEW YORK, March 22 (LPC) - Managers of Collateralized Loan Obligation (CLO) funds that lend to mid-market US companies must continue to meet ‘skin in the game’ rules despite a court ruling which let most of the investment firms off the hook.

Middle market balance sheet CLOs will not benefit from a recent exemption to Dodd Frank regulation that is helping the rest of the US$511bn US CLO market to thrive, as they often securitize the loans that they originate.

The mid-market funds, which are used by lenders including commercial finance companies and private credit asset managers for funding, will still have to fund the retention, despite a victory for the asset class in a US Court of Appeals last month.

“Risk retention still applies to middle market CLOs. The ruling only applies to participation vehicles, but does not apply to those who do directly originated deals,” a middle market lender said.

Most CLOs - often referred to as broadly syndicated CLOs - are investment vehicles that sell tranches of varying risk to investors backed by a pool of loans made to large US companies, including retailer Party City and Dunkin' Brands, which runs the Dunkin’ Donuts chain.

Balance sheet CLOs, in contrast, serve primarily to offload a portfolio of middle market loans originated by the manager.

“In what the market is referring to as ‘balance sheet CLOs,’ there is typically a sale or transfer of assets from an entity that organizes and initiates the related transaction. It is that sale or transfer that is going to make the entity effectuating such sale or transfer subject to the US risk-retention rules,” said Sean Solis, a partner at law firm Dechert.

Middle market lenders often held the equity in balance sheet CLOs, even before the Dodd-Frank rules were implemented.

Many managers use the transactions as a funding portfolio and historically have held the equity of their deals, according to David Burger, a vice president at Moody’s Investors Service.

“Risk retention didn’t really change much; that’s the nature of their business,” he said. Middle-market managers “held the equity, so not a big deal in the switch to risk retention.”

The sweeping Dodd-Frank rules were signed into law in 2010 in response to the credit crisis and include risk-retention rules that force managers to hold 5% of their funds, a requirement that was hotly contested by CLO managers.

After the final release of the rule in 2014, the Loan Syndications and Trading Association, the trade group representing the US CLO and leveraged loan markets, sued the Federal Reserve and Securities and Exchange Commission arguing risk retention was “arbitrary, capricious" and "an abuse of discretion.”

A US court ruled in the LSTA’s favor in February and agreed that CLOs that invest in broadly syndicated loans are exempt from the rule, because they do not originate the debt they invest in.

Regulators have 45 days from the February 9 ruling to seek a review from the Appeals Court. There is also a separate 90-day window to request a Supreme Court review.

Although the court ruling will not impact most middle market CLOs, there may be gray areas for some funds depending upon how they were set up, according to Matt Zola, head of fixed income at Natixis.

“There are some structures where there is an affiliate that does the origination and another affiliate that is the actual manager, and in those circumstances, that’s where it gets a little less clear whether or not the Circuit Court applies,” he said. “In those circumstances where there is an origination entity and then a separate management entity, there might be some daylight for the Circuit ruling to apply.” (Reporting by Kristen Haunss and Leela Parker Deo Editing by Tessa Walsh and Michelle Sierra)

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