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LPC: CLO risk-retention rules may lead to hefty bill

By Kristen Haunss

NEW YORK, April 19 (Reuters) - Rules requiring Collateralized Loan Obligation (CLO) managers to hold onto a portion of their fund's risk may also force them to pony up millions of dollars before raising a compliant deal.

Firms are grappling with how best to comply with the Dodd-Frank rule, which forces managers to hold 5% of their fund, a requirement some may not have the capital to adhere to.

The cost to comply can run from tens of thousands to millions of dollars, sources said. The most intricate compliance plans include setting up a new, standalone company that requires renting office space, hiring employees, enrolling in benefit plans, and buying everything needed to run a firm from furniture and computers to pens and paper clips.

"There isn't a one-size fits all structure for managers and their investors," said Craig Stein, co-head of the structured finance and derivatives group at law firm Schulte Roth & Zabel in New York. "It requires complex structuring to make these structures work for different clients. I think everyone will have a slightly different variation on the same theme."

Issuance of US CLOs, the largest buyer of leveraged loans, is forecast to fall more than 60% in 2016, in part due to risk retention, which takes effect on December 24, decreasing the appetite for the US$880bn leveraged loan market. There was US$8.2bn of US CLOs raised in the first quarter, down 72.5% from US$29.8bn arranged during the same period in 2015, according to Thomson Reuters LPC Collateral.

CLOs pool loans of different credit quality and sell slices of the fund of varying seniority from Triple A to B to investors such as insurance companies. Equity investors, holders of the most junior piece of the fund, are paid last with what interest is left.

To comply with the rules, a manager can purchase a portion of the vehicle directly or through a majority-owned affiliate (MOA) where the affiliate majority-controls, is majority-controlled by or is under common-majority control with the manager, said Deborah Festa, head of law firm Milbank, Tweed, Hadley & McCloy's West Coast securitization and investment management practices.

Control is measured by ownership of 50% or more of the equity of an entity or ownership of any other controlling financial interest under Generally Accepted Accounting Principles, she said.


Some firms have sought to raise third-party capital to help with retention, either by investing in the manager or buying securities in the new MOA vehicle, Festa said.

Another option is to create a standalone CLO management company, Stein said. The principals or employees of the existing manager, as well as third-party investors, will invest in the new company, which will manage CLOs and purchase the required risk-retention portion.

This option, referred to as a capitalized manager vehicle (CMV), may be capitalized with a "couple of hundred million" dollars or more, and may take a year to set up, said John Timperio, a partner in the structured finance and securitization group at law firm Dechert in Charlotte. It may take four to six months to set up a capitalized majority-owned affiliate (C-MOA).

Forty-seven percent of respondents to a February survey of CLO managers by law firm Maples and Calder said they had risk-retention structures in place. Maples said it surveyed more than 60% of US CLO managers active in 2015. Of those with structures, 40% prefer the C-MOA option while 32% chose the CMV model, according to the survey.

"Given the timing constraints for the year-end deadline and the fact that investors are requiring managers to have risk-retention structures in place imminently, the C-MOA option appears to be more accessible for many managers," said Guy Major, global head of fiduciary at MaplesFS.

To set up a new manager, there is the cost to register with the Securities and Exchange Commission (SEC) as an investment advisor and file ADV forms to register with both the SEC and state securities authorities, Festa said. There is also the cost for compliance officers, lawyers and accountants.

Depending on the structure, the new company may need a new office and furniture. It would need computers, telephone lines and secure IT systems. It may need a website, a new logo and trademark, and new subscriptions to ratings firms and news services. The company will also need dedicated staff requiring healthcare plans and benefit packages.

Everything you look at or touch in an office needs to be purchased, an investor said.


BlackRock and Credit Suisse Asset Management are among firms that issued US risk-retention compliant CLOs this year, according to Thomson Reuters LPC data.

BlackRock issued a US$501.15m CLO in February with Deutsche Bank in which it purchased at least 5% of each security tranche and intends to retain those holdings "in a manner consistent with the US risk-retention rule," according to a source and the deal's pricing memo.

Credit Suisse Asset Management's US$504.9m CLO issued in February with JP Morgan was expected to comply with both the US and European risk-retention rules, according to sources.

Carmel, Indiana-based 40/86 Advisors, a unit of CNO Financial Group, chose the CMV option creating CreekSource, a manager allowing it to comply with both US and European rules, said Eddy Piedra, vice president, leveraged loans.

CreekSource raised a US$302.5m CLO with Goldman Sachs in March, according to LPC Collateral.

The new firm, which took about six months to set up using capital from CNO affiliates, has a board of directors and managers responsible for identifying what assets are purchased, at what price and how much, Piedra said.

"For us, [the cost of setting up the CMV] had to be a break-even of a few transactions to make sense for us," Piedra said. "It's still a large number for us. It wasn't easy to get started. Some managers just can't afford it."

BlackRock and CSAM spokespeople declined to comment. Spokespeople for regulators declined to comment or could not be reached for comment.

The cost to comply may be too much for some managers.

Setting up a CMV "is time consuming and complicated, and not all managers are in a position to deal with such an undertaking," said Mark Matthews, global head of Maples and Calder's finance group.

A smaller firm may be more focused on a C-MOA or MOA model, typically purchasing a vertical strip because it is less capital intensive, Timperio said.

Compliance may be a large investment up front, but many say it is worth it.

It was "more expensive to set up in the beginning, but our view is if we are going to be issuing CLOs and do a lot of business in the CLO market, it behooves us to establish something that is cheaper in the long run," Piedra said.

(Reporting by Kristen Haunss; Editing By Lynn Adler, Jon Methven)