July 1, 2016 - July 1, 2016 – In early June, we learned that proposed amendments to the EU’s “Simple, Transparent and Standardised (STS)” securitizations had the potential to increase risk retention to 20% and to effectively prevent US CLO managers from issuing European CLOs and from accessing the European CLO investor base. This week, we learned that Brexit might make UK-based CLO managers suffer the same fate as their American brethren. Below, we explain what STS could do to non-European CLOs – and why Brexit could put UK CLO managers in the same boat.
We tackled these issues by hosting Cadwalader partner David Quirolo in a June 30th webcast that answered the question, “Brexit: What Does It Mean for CLOs?” (The webcast slides and replay are available here; in addition, here is a Cadwalader memo on STS and one on Brexit and CLOs.)
To begin, the STS rules were meant to reduce capital charges on “simple, transparent and standardised” securitizations in order to help revitalize the European securitization market. (And, to be clear, CLOs do not qualify as STS.) However, some members of European parliament saw the STS rules as an opportunity to introduce more restrictions into all securitizations. Specifically, the proposed amendments to STS include i) increasing the risk retention amount for all securitizations from 5% to 20%, ii) limiting the originator, sponsor or original lender to EU regulated entities, iii) limiting investors in European securitizations to EU regulated institutional investors, iv) public disclosure of a securitization’s (anonymized) loan data, and v) disclosure by investors of their investments in securitizations.
It goes without saying that an increase in retention from 5% to 20% would be highly problematic for all securitizations. However, some of the other tenets would be particularly problematic for US CLOs (at least in our parochial view of the world). First, to comply with European risk retention rules today – and access the European investor base – CLO managers can utilize either the “sponsor” or the “originator” approach. However, sponsors must be investment firms authorized under MiFID – in effect, they must be European investment firms. Because most US CLO managers are not MiFID authorized investment firms, they must use the originator structure to issue Euro risk retention compliant CLOs. However, the proposed amendments to STS would close off the originator route to non-European managers – thus preventing European investors from investing in CLOs issued by US managers.
Another constraint is that European investors would be the only ones permitted to invest in European CLOs. This, presumably, would preclude non-European investors from investing in European CLOs.
None of this is good – but perhaps it is not dramatically different from the state of play today. When looking at US CLOs issued thus far in 2016, LCD’s database suggests that 56% of these CLOs may not be risk retention compliant in either the US or Europe, 23% are compliant with US risk retention, 8% are compliant with European risk retention, and 13% are compliant with both regimes. Thus, with just 21% of 2016 US CLOs to date complying with European risk retention rules, it would seem that the US market is not relying on the European investor base.
However, the situation is dramatically different for UK-based CLO managers. There are two scenarios to consider: First, how Brexit alone impacts UK-based CLO managers. Second, what happens if both Brexit occurs and the proposed STS amendments pass.
Brexit alone is not good for UK-based CLO managers, but is not fatal. First, UK CLO managers may no longer qualify as MiFID-authorized investment firms. For this reason, they may be precluded from using the sponsor structure to meet risk retention compliance, but could still utilize the originator method. (Indeed, LCD wrote on Thursday that UK originator CLO structures are moving forward.) In addition, existing CLOs utilizing a sponsor structure likely could be amended to switch to an originator retention structure. So that is not good, but presumably not deadly.
What could be far more problematic for UK CLO managers is a combination of: i) Brexit going through, ii) the UK no longer having access to the financial passporting regime, iii) UK CLO managers no longer being considered MiFID investment firms, and iv) the proposed STS amendments passing. In this scenario, UK CLOs likely would be in the same boat as their American counterparts: Unable to issue a European CLO and also unable to access the European investor base. While this is definitely not ideal for US CLOs, it is highly problematic for UK CLO managers, whose job is to issue European CLOs and sell to European investors.
The good news? The form of Brexit is not clear, and any split is more than two years away (presumably with time to adapt). Meanwhile, the STS amendments are simply proposed amendments at this point. The LSTA is preparing a comment letter on STS and will, of course, continue to follow these developments closely.