Fitch: Newer CLO Managers Face Uncertainty Post Regulation

Less experienced, thinly capitalized managers and/or those that have begun operations in the past few years with the primary focus of managing collateral loan obligations (CLOs) will be most affected by new risk-retention rules, according to Fitch Ratings. US regulators voted on Oct. 21 to move forward with CLO risk-retention rules that will have a meaningful impact on the US CLO management landscape.

The rules, stemming from the Dodd-Frank legislation in the US, require CLO managers to retain a 5% interest in all CLOs they sponsor. The rules stipulate that the retained portion may be held horizontally in the first-loss (equity) tranche or vertically through a single security with interests in each of the issued tranches up and down the capital structure. The move by US regulators follows a similar direction as the capital requirements directive in Europe.

Smaller, CLO fee-dependent managers without the financial resources to participate in issuance following the implementation period will likely be forced to seek acquisition by a larger manager, leading to industry consolidation. Implementation in the US will not happen until 2016, giving the market two years to comply. Risk retention has already affected the CLO market in Europe where CLO issuance since the finance crisis has lagged behind the US.

If implementation of the rules was to take effect immediately (instead of the two-year grace period), we estimate that approximately 13% of current US CLO managers would have business viability concerns, assuming those managers are unable to issue subsequent CLOs. Of the roughly 120 managers with active CLOs, 16 are currently standalone, unaffiliated firms with two or fewer deals under management and are heavily reliant on CLO fees for income. Normally, a standalone, CLO-only platform needs three or more deals of average size ($400 million) in a benign environment to be profitable. In a stressed environment, where performance fees are likely affected, we believe four CLOs are needed by smaller managers to remain profitable.

We expect CLO issuance to remain strong in part as standalone platforms currently managing two or fewer seek to issue CLOs over the next two years leading up to rules implementation. If vulnerable managers are unsuccessful in attracting investors or the CLO market shuts down, these firms may need to develop other meaningful streams of revenue and/or cut costs. However, managers drastically changing investment focus to compensate may risk deviating from their original expertise. Furthermore, significant cost-cutting would likely affect the smaller managers' operational capacity in terms of investment staff. Given that CLO management is a credit-intensive, people-driven business, any material reduction in staff costs could have a significant impact on the overall performance of the business.

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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