By Kristen Haunss
(LPC) - Collateralized Loan Obligation (CLO) funds are already being issued that do not comply with Dodd-Frank risk-retention rules, as managers bet that regulators will not appeal a February court decision.
A US Appeals Court ruled on February 9 that CLOs, the largest buyer of leveraged loans, should be exempt from the regulation which requires managers to hold 5% of their fund.
The decision could further boost CLO issuance as managers that lacked the capital to meet the rules may now be able to raise new funds, after an already strong start to the year with US$28.5bn of volume, according to Thomson Reuters LPC Collateral data.
The prospect of a potential appeal is complicating the matter, however. Regulators have until Monday to seek a Court of Appeals review and a separate 90-day window to request a Supreme Court review.
Managers are keen to issue now amid some of the lowest CLO spreads in 10 years and do not want to hold part of their fund if they do not have to.
Bain Capital Credit, BlueMountain Capital Management and Neuberger Berman may have found a solution by arranging new or reworking existing CLOs without complying. They are including an option that could increase the size of the fund to buy retention and become compliant if necessary, according to sources.
“The idea is to be as transparent as possible that if the US risk-retention rules are not applicable to the subject transaction, the related sponsor is not intending to purchase and/or retain the applicable notes,” said Sean Solis, a partner at law firm Dechert.
Funds would otherwise have to avoid issuing until the court ruling is finalized or hold retention that may not be required in the near future.
CLOs 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.
The Loan Syndications and Trading Association, the trade association representing the US CLO and leveraged loan markets, successfully sued the Federal Reserve and Securities and Exchange Commission in 2014, arguing the regulation was “arbitrary, capricious” and “an abuse of discretion.”
Some CLO managers may wait until the appeal period is over before creating new funds, but many are keen to price now to take advantage of pre-crisis lows on debt tranche coupons.
Spreads on the Triple A tranche of recent CLOs, the most senior portion of the funds, have dropped to the low 90 basis point area, according to LPC Collateral data.
Lower debt coupons boost payments to the most junior investors, the equity, who are paid last with the interest left over after all other distributions are made.
Managers may also want to get ahead of a possible burst of activity if the rule is finalized, as firms that were unable to issue or rework deals due to capital constraints return to the market.
Bain told potential investors in its US$611.3m CLO this month that it would not comply with the rule initially, but could increase the size of the deal to buy retention if necessary, according to a preliminary deal document.
Neuberger Berman refinanced its Neuberger Berman CLO XXI last week. It also chose not to hold retention at pricing but the fund allows for an upsizing to become compliant if needed, according to two sources.
BlueMountain told investors in a term sheet for a reset of its BlueMountain CLO 2015-3 that if it determines after pricing that risk retention will apply on the closing date, the deal will be increased to buy retention, according to three more sources.
Spokespeople for Bain, Neuberger Berman and BlueMountain all declined to comment.
There are institutions offering managers short-term financing to bridge the gap in case they need capital to purchase retention.
Some managers have alternative language in their deals and lined up temporary financing to comply with the rule if regulators appeal the Court of Appeals’ decision, according to Neil Weidner, a partner at law firm Cadwalader, Wickersham & Taft.
It is unclear how many CLOs have included this language, but it is an option many investors seem willing to accept for now.
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