July 27, 2016 - July 27, 2016 – The impact of risk retention has been mostly analyzed for two constituencies: Managers (who must raise capital to meet the risk retention rules) and borrowers (who may see a decline in credit availability or an increase in credit costs). This week, Moody’s discussed the impact on a third constituency: Investors, who may face reduced asset diversity and increased portfolio correlation. We discuss the impact below.
Moody’s notes that risk retention is likely to reduce CLO formation, particularly from smaller managers, who may struggle to source sufficient capital to purchase and retain 5% of the notes of new CLOs. And –even though the rule doesn’t go live until Dec. 24, 2016 – we may have already begun to see the impact. In the first half of 2016, Moody’s rated 54 BSL CLOs (down one-third from last year) from 45 managers (down one-quarter from last year). But this actually understates the decline: because CLOs generally have been smaller this year, total issuance volume is down by 50%. To be fair, market conditions and collateral scarcity are major drivers of the decline. However, the drop-off has been sharper for smaller managers – and that is mostly driven by risk retention.
Risk retention paring the ranks of managers clearly is not good for them. However, it is also rather bad for investors as it will likely reduce manager diversity and increase obligor overlap across CLOs. Moody’s ran the numbers to assess the possible impact. While obligor overlap across the entire CLO universe is 33%, CLOs run by one manager have an average obligor overlap of 76%. (So, fewer managers means more overlap.) Moreover, larger managers tend to invest in similar names and have greater overlap with each other. Looking at the 10 largest BSL CLO managers (who manage an average 15 CLOs each), Moody’s found obligor overlap of 52%. In contrast, smaller manager are more likely to have a niche investment focus. In turn, the overlap of the 25 smallest BSL CLO managers (who manage 2-3 CLOs) is 30%.
This loss of diversity could worsen if risk retention forces smaller managers into the arms of larger ones. When big managers take over smaller managers, their obligor overlap increases over time. Moody’s looked at a case study of Apollo’s acquisition of Stone Tower and Gulf Stream in 2011. In December 2011 – shortly after the acquisitions – the obligor overlap of all the CLOs was 43.2%. By December 2013, obligor overlap was 61.4%.
But why does this matter? Because high obligor overlap increases correlation across CLO portfolios, something investors look to avoid. When different CLOs hold mostly the same assets, default correlations across the different portfolios will rise. Moreover, high obligor overlap would increase the risk of simultaneous overcollateralization (OC) or collateral performance breaches across different CLOs. This could mean that, in a stressed environment, more of an investor’s CLOs could defer payments at the same time. At the end of the day, investors that work with different managers to seek diversity and uncorrelated outcomes could find that their investments are performing similarly. And that is not the goal of a diversified portfolio. – nor, presumably, of risk retention.