Securitization: Down, but not out: CLOs seek to overcome Dodd-Frank hoodoo
The US CLO market boomed in 2014, overcoming Volcker ule jitters at the start of the year to break issuance records in the last quarter. But risk retention regulation could force smaller managers out of the market. Will Caiger-Smith reports.
After the doom and gloom at the end of 2013, when the final Volcker Rule, which requires sellers to retain 5% of their deals, put a dampener on CLO issuance prospects for 2014, analysts scrambled to increase their forecasts over the summer, after months of record issuance.
GlobalCapital data put new issuance of broadly syndicated CLOs at just over $97bn as of mid-November, with over $25bn of middle market CLOs to boot.
But just as 2013 ended with a regulatory bombshell, so did 2014 — although this one was better anticipated.
Risk retention regulation, part of Dodd-Frank, the US implementation of Basel III, could lead to a sharp reduction in CLO issuance immediately, not just from when the rules become active. That’s bad news for everyone, says Brian Juliano, vice president and portfolio manager in Prudential Fixed Income’s US bank loan sector team.
“Risk retention will reduce choice between the spectrum of different types of manager styles — conservative versus aggressive, diversified versus concentrated,” he says. “You may end up with only the large institutions as managers of CLOs. That might be what regulators intend but I believe that it is bad for the loan and CLO market, and eventually for companies that need capital. Investors have different style preference and if you reduce the amount of managers, that is problematic.”
Market participants expect issuance to be between $70bn and $80bn in 2015, and to continue to dwindle after that. That will inevitably have a knock-on effect on leveraged loan volumes and eventually on retail investors in the high yield bond market, says Juliano.
“The loan market will shrink and CLOs will be less active in buying loans,” he says. “Issuance will shift to high yield where there are more retail investors than the loan market. That means riskier issuance that would normally hit the loan market gets shifted to high yield, and that may have some material effect on the quality of issuance in the high yield market. They can basically issue whatever they want in high yield, and that issuance could end up on the retail market.”
The rules were already hitting managers before the end of 2014.
Just as investors and analysts had expected, the pricing differential between larger managers, which are expected to be better able to deal with the rules, and smaller, less established names, opened up almost as soon as the regulation was passed. Triple-A tranches from established names like Babson Capital Management were pricing at around 148bp to 150bp over Libor in late October, compared to more like 160bp for names like American Capital.
“Small and medium-sized managers are going to have a hard time getting on board with risk retention unless they can find some workaround,” says Juliano. “But larger managers like Prudential which are part of bigger institutions may be able to co-invest and gain market share.”
Smaller managers — many of them founded by old-time CLO or CDO market experts — flocked to the market in 2013 and 2014.
As of November 2014, some 29 managers had issued just one CLO since the start of 2012, while 30 had issued just two. The number of experienced managers in terms of deals issued is a lot smaller — just eight managers had issued five deals since 2012, while only three had issued 10.
Some of these smaller managers may be bought out by larger managers. Or they may simply be forced to cut headcount so that the trade is still worthwhile for the people left, says John Popp, managing director of Credit Suisse Asset Management’s (CSAM) alternative investments division in New York.
“If you work at a smaller shop, and it’s a partnership and you own it, you’re going to try and make the best run you can over the next couple of years to try and raise CLOs,” he says. “But if the market turns against you and you can no longer participate, your first step is going to be to cut overhead.
Here today, gone tomorrow
After the mass migration of human capital to the CLO market in 2014, it will not be long until many analysts at smaller firms see the writing on the wall, says Juliano.
“If I were a talented analyst at a smaller manager, I might see the writing on the wall and say I am sitting on a melting ice cube of fees, and they’re going to have to lay people off, so I would end up looking elsewhere,” he says.
Investment banks that spent 2013 building up their staff to try and muscle their way into the CLO market — like Mizuho, Mitsubishi, RBC and Nomura — may also find life more difficult, says Popp.
“The firms that are going to be vulnerable here are the new entrants, many of whom are foreign banks,” he says. “Whoever is trying to get into this space, it is going to be harder.
“For new entrants, unless there is something particular that those institutions can bring, it will be very difficult. Most of them can’t bring relevant primary or secondary dealflow in terms of paper, because they don’t have big leveraged finance businesses. They could work really cheaply, but in a contracting market, with the economies of scale, the bigger shops will be aggressive too.”
Most large US CLO arranger houses have maintained small teams since the crisis — Citi, Credit Suisse and Bank of America Merrill Lynch, to name but a few — so are more efficient, he says. But smaller shops would not be in the market unless they truly believed they had something extra to offer, says one New York CLO banker.
“We all know that Japan is a major player at the top of the capital stack,” he says. “If you are one of the Japanese firms, then you have a natural reason to be involved in the business, because those buyers are a very important part of the equation these days.
“In the US, the major [triple-A buyers] like to dictate their terms a lot more, whereas that happens less in Japan.”
Thankfully for managers, lawyers have been busy coming up with ways to mitigate the impact of the rules. Most of these methods are focused on the concept that the holder of the 5% risk retention piece of the CLO only has to be a majority owned affiliate of the manager — effectively cutting the amount of capital required to be invested by the issuing manager in half and allowing the rest to come from elsewhere.
CSAM was bringing a similar deal at the end of 2014, which it hoped would be a blueprint for future transactions. It will likely buy equity and debt in the deal, and will take a conservative view of the rules and stick to 51% of the 5% retention tranche, says Popp.
“At Credit Suisse, we will stay within the definition as well as the spirit of the regulations,” he says. “For example, I heard someone saying a majority owned affiliate could be 25% and perhaps as low as 10%.”
Some firms, like Chicago middle market lender Monroe Capital, are looking for ways to comply with European and US risk retention rules, in order to sell their deals on both sides of the Atlantic.
“Finding a way to structure a CLO that is compliant in both the US and Europe is the optimal solution. We have an active CLO investor base in both the US and Europe and are in a good position to grow our CLO business in both regions. We are exploring options to satisfy the sponsor and arranger options for the US,” Jeremy VanDerMeid, managing director at Monroe Capital.
A more immediate problem is that risk retention takes all the value out of equity investors’ refinancing option, because by the time noncall periods of newly issued CLOs end, risk retention will be in place and the refinancing will count as a new deal and therefore have to comply.
At least there is a glimmer of hope around the Volcker Rule. Banks spent much of the second half of 2014 amending documentation of legacy deals — whether through a refinancing or separately — to remove bond buckets so the deals complied with the Volcker regulation and could therefore be held by banks.
That activity has slowed, as the market is no longer as good an environment for refinancing as it was during the summer. But 2014 gave bank investors an extra bargaining chip in the form of Standard & Poor’s changes to how it presents its loan recovery ratings, as well some hope for potentially revived legislative solutions on Capitol Hill.
The S&P changes could benefit equity investors by enabling the manager to buy higher yielding assets. Those additional changes may have convinced equity holders to agree to the Volckerisation, says Mike Hatley, president and portfolio manager at West Gate Horizons, a Los Angeles CLO manager that incorporated the new changes alongside a Volckerisation in November.
“I’m not sure the equity guys would have been so excited about Volckerisation [without the added benefit of the S&P changes],” he says.
The CLO market is not short of challenges in 2015. A market that surpassed initial expectations in 2014 is now subject to even more onerous regulation, and risks are rising in the leveraged loan market. But the product still has relative value on its side and that alone may be enough to convince some of the more at-risk managers to stick around for the ride.