Written by: Medita Vucic and Bruce Boyd | Corporate Trust, BNY Mellon
The window for the SEC to appeal February’s court ruling that will exempt Collateralized Loan Obligation (CLO) funds from risk-retention rules that require investment managers to hold some of their deals’ risk has closed and risk retention for most US CLOs is no more. While consensus across the industry says eliminating risk retention rules is likely to add more heat to a hot asset class, we see a few unthought implications from our perspective as a CLO service provider to issuers and investors. More than a month has gone by since the window closed, but the industry is just beginning to experience the scale of these implications.
To touch on the basics, we fundamentally agree that the CLO space will see an increase in issuance volumes and increased draw for investors. In fact, that trend was already well in place even before the DC Circuit Court of Appeals ruled. US$118B was issued in 2017, the highest since the record of US$124B in 2014; US$55B has been issued as of May 31, 2018. There is every reason to believe that 2018 issuance will be greater than the current US$124B record. In research that BNY Mellon completed in November of 2017, we found nearly half (46%) of investors expected allocations to private debt to increase for the coming year, and 35% to CLOs specifically. Investors continue to crave yield as there is enough supply to source the collateral.
The rising tide may float all boats, but the biggest segment unlocked by risk-retention rules will be smaller managers with good track records who are now able to come back into the market for the first time in a while. In turn, new managers may also be able to test the waters. Re-entrants and new entrants will be able to build up their Assets Under Management at lower cost and with lower barriers. Ultimately, it creates more competition in the market while giving investors more opportunities to diversify and greater ability to negotiate deal terms.
Removing risk-retention rules also opens the door for broader structural innovation. The CLO market continues to find innovative ways to create greater efficiency. The Applicable Margin Reset (“AMR”) feature provides a mechanism for repricing a CLO using an auction rate method. With its automatic refinancing feature, investors can bid in the auction without the need to create new securities. The AMR is just the tip of the innovation iceberg however. We also expect the wave of innovation to hit warehouses. Without risk retention constrains, warehouses can create new facilities that can reduce market value exposure and make use of cash flow techniques similar to those in CLOs, such as overcollateralization ratio tests and new structures that better align with capitalization and business structures.
Finally, the convergence of new volume, new managers, and new investors will create the ideal conditions for innovation in the servicing of CLOs. For some it may create new capacity constraints, not a bad problem to have. From our standpoint as a Collateral Administrator and Trustee at BNY Mellon, the market will require more from service providers, as well as more efficient processes and systems to handle the volume. The delivery bar for service providers gets higher; as the need for greater transparency increases, the ability to deliver information on a more real time basis becomes critical. We call it the transparency imperative. Clients need to be able to integrate loan data and exchange compliance information, ratings, custody reporting, and asset and collateral details. Finally, managers that are more sophisticated need to be able to access their loan data in multiple ways, such as the flexibility to bring data and reporting into their own proprietary systems using APIs. In short, what is needed is a service infrastructure that helps managers and investors better understand the asset class and better manage risk within it.
It comes back to the underlying promise of this asset class. Being able to deliver critical alerts, deal milestones, pending trades, and unexpected changes to their portfolio is going to help collateral managers and portfolio managers dynamically manage these portfolios to drive towards the performance and results that the market expects. Ironically, this means the barriers to entry for service providers have gotten higher, even as those for managers and arrangers have gotten lower. With the market benefits of eliminating risk-retention rules comes the market responsibility to handle new capacity and supply, and to do so with a sober, experienced hand.
About the authors
Medita Vucic, Director, US Financial Institutions, Corporate Trust, BNY Mellon, is an influential and sought-after speaker on wide range of topics in alternative assets and debt markets. She works closely with global issuers, managers, intermediaries, and investors, with a particular focus on the U.S. market. Bruce Boyd, Vice President & Senior Transaction Manager, Structured Products - CDO Transaction Management Group, BNY Mellon, has been an innovator in the CLO space since its very inception.