By Kristen Haunss
NEW YORK (Reuters) - Firms that sell their Collateralized Loan Obligations (CLO) may end up in the precarious position of holding millions of dollars of debt in funds they no longer manage.
Intended to ensure managers have skin in the game, risk-retention rules require firms to hold 5% of their fund. But questions about the rules application linger four months after the regulation went into effect, an impediment to the issuance of new funds. As the biggest buyer of leveraged loans, fewer CLOs may mean less capital for companies to refinance or back acquisitions.
The rule, part of the Dodd-Frank Act, states that a sponsor, defined as the entity that organizes and initiates the transaction, must hold the retention. In a CLO, these actions take place before a deal is completed, so the original manager is typically the sponsor, according to Sean Solis, a partner at law firm Dechert LLP who focuses on structured products.
The original manager, then, even if it is replaced due to a sale of the fund, would still be required to hold the retention. With an expectation more managers may sell their funds if they are unable or unwilling to comply with the rules, the CLO market is working to quickly address the succession question.
“There isn’t a certainty in the rules about what happens if a manager resigns or is removed and replaced, about who will be the sponsor of the transaction at that point,” Solis said. “In the absence of guidance, everyone is assuming the manager who was the sponsor, even if removed, continues to be the sponsor and will need to still hold the risk retention.”
Some managers and investors have sought to include language in new CLOs to address succession, Solis said. Proposed language would allow for a new manager to purchase the risk-retention securities at a fair market value.
The provision may not be too helpful, though, unless the Securities and Exchange Commission says a new manager can step in as the sponsor and act as the risk retainer, he said.
It is unclear if the term has been included in a final deal document.
An SEC spokesperson declined to comment.
To comply with risk retention, managers may buy a vertical strip, which is 5% of every tranche of a CLO, or 5% of the face amount of all of the fund’s tranches that is held in the equity slice, which is known as a horizontal strip. Firms may also buy a combination of a vertical and horizontal strip.
EURO CLO PROVISIONS
European CLOs have already addressed the question of replacement managers and have included disclosures in deal documents since shortly after European risk-retention rules took effect in 2011, according to James Warbey, a partner in the London office of Milbank, Tweed, Hadley & McCloy.
The European Union rules state that in most cases the retention must be held by the entity that established and is managing the transaction. In the risk factors section of a euro CLO offering document, a provision highlights the point that replacing the collateral manager may lead the fund to be non-compliant, Warbey said.
To address the issue, in the contractual provision portion of the document, language is included that says a manager is allowed to transfer its risk-retention holding to a replacement manager if it complies with European risk-retention rules.
This provision, however, has yet to be tested, so it is unclear if regulators would approve, he said.
The US CLO market is also unsure if regulators would approve a similar provision and is a reason some participants have been reluctant to include language in deal documents that define a replacement manager retention transfer process.