Some markets seemed doomed however hard the financial paramedics try to resuscitate them. Take European collateralised loan obligations (CLOs). Cairn Capital re-opened European CLO dealflow in February, to great acclaim. But the latest regulatory proposals risk putting an end to that kind of deal altogether.
The problem is that the European Banking Authority has tweaked the wording of an article in its draft technical standards, published last week. The result is to explicitly expand the so-called skin-in-the-game requirement whereby an originator, sponsor or lender was to be forced to retain a 5% slice of the deal to include investment firms. And that includes CLO managers.
That presents a new hurdle, since CLO managers didnt fit into the previous categories of originator, sponsor or lender. Deals still needed someone to retain a 5% slice, however, if they were not to attract a punitive capital requirement for investors. And since managers would not typically have balance sheet, they would simply offload that slice to a third party.
Thats exactly what Cairn did, with an M2 equity tranche retained in a structured credit fund backed by US pension funds. Apollo and Blackstone, who brought another two of the four deals to have priced this year, sold subordinated certificates to third parties.
Only one Pramericas Dryden XXVVII Euro CLO does not fall foul of the new rules, reckon ABS analysts at Morgan Stanley. In that deal the manager had enough capital to take the slice itself.
This isnt just an issue for Europe. Interpretation of risk retention is still being thrashed out in the US and in the meantime, deals are powering ahead without it. But the EBA itself reckons that only 13% of CLO managers in the US would have the balance sheet to retain a 5% vertical slice of their deals. And it says that 87% consider retention to be challenging.
Compliant? Not any more
When the first batch of European CLO deals emerged this year, it had been widely assumed that they were all in compliance with the rules. After all, as part of the due diligence process, regulated investors would have required the arranging banks to provide a considered legal opinion that the investment was compliant with retention rules articulated in article 122a the relevant part of Europes Capital Requirements Directive II, and which is being updated for CRD IV, due for implementation next year.
Because the rules had until now been pretty vague as to exactly which party should retain the necessary 5% risk, CLO managers had been able to structure deals in which a third party investor was effectively also the sponsor. And investors must have believed that deals such as Cairns were compliant, otherwise they would not have bought them.
The EBA doesnt seem too perturbed by its move quite the opposite, in fact. It recognises that by forcing CLO managers to retain risk themselves, the market could well be whittled down to a smaller pool of participants. This could potentially translate in the long term into a modification of the currently existing managed CLO model, the EBA says.
That makes it sound like it is aiming for just such a change. It will certainly set back the rebirth of European CLOs. The longer term picture is harder to read.
In the meantime, though, those investors that bought into the European CLO renaissance could stand to suffer. There is going to be a fast receding bid on deals that will consume a lot more capital than they originally thought. Grandfathering would be the obvious answer, but the EBAs paper does not make it clear that this is going to happen.
August 22 is the deadline for market participants to submit comments to the EBA. Time is of the essence.