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CLOs: Risk Retention Legislation 2.0

September 21, 2017 - Last week, Congressman Andy Barr (R-KY) and Congressman David Scott (D-GA) introduced H.R. 3772, the Expanding Proven Financing for American Employers Act. This is the 2017 version of the Qualified CLO bill that the duo sponsored in 2016. As retention aficionados may recall, that bill passed out of the House Financial Services Committee on a bipartisan basis, 42-15, but never made it to the floor of the House. The new bill is almost identical: In effect, if a CLO meets tests in six areas – asset quality, portfolio diversification, CLO capital structure, alignment of interests, regulation of manager, and transparency and disclosure – the manager can purchase and retain the equivalent of 5% of the equity. (Fun fact: In the original bill, the 5% retention was in the form of first loss equity. A Democratic amendment altered the retention structure keep the same amount of retention, but to have 70% of it in the equity and the remaining 30% in a vertical strip. In effect, it now is an “L-shape” retention.) 

Admittedly, CLO formation is strong this year, so why reintroduce a risk retention fix? There are several reasons. First, as was discussed at ABS East, while some managers have put together permanent(ish) risk retention capital – and thus can issue CLOs for several years – we are told that more managers have raised a limited pool of capital, allowing them to issue in 2017 and perhaps into mid-2018. Thus, despite the apparent strength of the market, there are vulnerabilities. Second, a non-trivial amount of risk retention capital has been expended in resets (or refis that do not qualify for Crescent No Action Relief). Thus, this capital isn’t being used for new credit formation for companies, but rather to make existing CLOs work in the today’s spread environment. 

Importantly, the lawmakers understand the importance of making decisions for the long term and not being swayed by day-to-day sentiments. That is why Congressman Barr said, “[w]hile the CLO market is currently doing well, I am concerned that in the event of another economic crisis, due to the currently misaligned regulation on CLOs, this valuable and safe form of financing will dry up at the worst possible time. That is why I’m proud to introduce this bipartisan legislation with Congressman Scott to fight for more affordable, more sustainable credit for businesses which will result in greater competition, more jobs, and a sound return for investors.”

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