The primary market in arbitrage CLOs, long hamstrung by regulatory confusion when it seemed that risk retention rules designed for RMBS might apply also to CLOs, could be set for a comeback. New guidelines from the European Banking Authority might now have cleared the way for deals to return — but not until spreads start to line up.
"Theres enough clarity here to structure a deal," said David Quirolo, structured finance partner at Ashurst, a law firm. "Were clear enough about what role the equity investor needs to have, so people can now start having purposeful conversations with investors."
The EBA also backed securitisation more generally, and said it was committed to uniform application of structured finance regulation across Europe. The new guidelines are clarifications of Article 122a of the EUs capital requirements directive. This article aims to align the interests of originators and investors in a securitisation by making the originator retain some of the risk 5% of the transaction.
As CLOs have no originator, figuring out who should be subject to the retention proved difficult. CLO managers, who control what loan collateral goes into the structure, are typically thinly capitalised institutions similar to fund managers. They raise funds for clients, rather than deploying their own capital. Forcing them to deduct 5% of the value of a CLO transaction from their own funds would have rendered the business prohibitively expensive.
But the EBA has clarified that, in certain circumstances, it will be possible for funds providing equity investment to fulfil the risk retention role. "Weve got much more clarity on how an equity investor retention will work," said Quirolo. "They need to be involved in structuring and initial portfolio selection, and approve any material changes to the transaction such as eligibility criteria, but they dont need to approve each investment, which is great for CLO managers."
This is the second pair of eyes solution the equity investor must not be advised by nor linked to the CLO manager, so it can oversee construction of the initial portfolio and selection criteria. This is not strictly alignment of interest in the sense intended by the original design of the rule for RMBS, but it does provide extra oversight for buyers of the liabilities.
Its not all good news, as the EBA guidance includes one unwelcome clarification. If a CLO manager sells loans at a profit and reinvests the money with a resulting increase in the par value of the exposures in the securitisation the retention must also be increased.
Solutions to this problem could include applying trading gains to the senior notes, or pro rata to the debt tranches. Before the global financial crisis, trading gains were typically applied to the equity. If trading gains are no longer available, CLO equity funds may seek higher returns through other means.
Despite the improved regulatory environment, Quirolo says economics are still a problem. "When the arbitrage between loan spreads and CLO liabilities starts to make sense, people will be able to structure deals that work from a risk retention perspective," he said.
In a recent research report, JP Morgan analysts put triple-A high yield CLOs at 250bp over Euribor, with double-A at 675bp, single-A at 1,000bp, triple-B at 1,300bp, and double-B at 1750bp. The same research put generic European leveraged loan spreads at 796bp.
The EBAs guidance note also clarified the treatment of ABCP and correlation trading portfolios. ABCP investors are effectively left to do their own due diligence work getting conduit sponsors off the hook with respect to disclosure. "The EBA is aware that sellers often use ABCP for the purposes of anonymity and that according to the guidelines, confidential arrangements do not need to be disclosed," the EBA said. "It is therefore primarily the decision of investors as to what due diligence requirements and level of granularity of the disclosure they consider as most appropriate for each asset class. It is not the EBAs intention to prescribe these requirements."
This gives the regulator more flexibility, as investors must be able to demonstrate due diligence to its satisfaction.
"The EBA doesnt want to give macro guidance on how every investor should do their due diligence, given the diversity of transactions in the market," said Quirolo. "Each investor needs to be able to look their regulator in the eye and explain what due diligence was done."
Doug Long, executive director at Principia Partners, a provider of investor due diligence software, said this principle extended throughout the EBA guidance. "This is a strong statement of intent, theres no wiggle room around reporting, whether exposures are off-balance sheet, transferred through total return swaps and so on," he said. "Wherever your exposures go, and whatever kind of credit institution you are, you have to do due diligence on it."
"In general, if youre not sure whether there has to be a retention or whether you have to do due diligence, the answer is always yes."
Long added that interpretation was crucial, though. "This guidance gives regulators plenty of flexibility, but it will really matter where they choose to draw the line, how it works in practice," he said.