U
K collateralised loan obligation (CLO) managers have adapted their risk retention structures in response to the EU referendum vote, effectively ‘Brexit-proofing’ their structures in the event of a full Brexit where UK firms do not continue to enjoy financial passporting rights into the EU.
Since 2011, EU-regulated investors have only been permitted to invest in new securitisations where the sponsor or originator agrees to retain at least 5% of the risk of the securitisation.
Prior to the Brexit vote, the vast majority of euro-denominated CLOs had a UK sponsor act as risk retainer. Because only EU-regulated firms qualify as sponsors under the Capital Requirements Regulation, investors and arranging banks have been concerned that securitisations could become non-compliant with the EU risk retention rules if, following Brexit, UK managers cease to be EU-regulated and the UK’s regulatory regime is not otherwise recognised as ‘equivalent’ under MiFID II.
Euro CLOs provide roughly 30% of the funding to non-investment grade borrowers in the EU, making continued access to European markets for UK-based CLO managers an important consideration for both the UK and the EU. While Brexit should not force the sale of existing investments in UK sponsor securitisations, imperfect grandfathering could lead to reduced secondary-market liquidity.
For new transactions, the market’s response has been to shift from sponsor risk retention structures to ‘manager-originator’ structures that do not require the manager-originator to have an EU or EEA regulatory status. Manager-originator structures have been increasingly used by US managers since 2015 to enable them to market US dollar-denominated CLOs to EU-regulated investors. Since 23 June, five of six euro CLOs issued by UK managers have also used manager-originator structures (the sixth used a different type of originator structure also protected from the effects of Brexit).
These proposals, if adopted, could have a significant impact on the UK securitisation market.
In addition to managing the CLO, a manager-originator must contribute some of the loans or bonds to the CLO issuer. Manager-originators must have been exposed to the credit risk, but not the market risk, of the loans or bonds prior to contributing them to the CLO issuer.
The EU rules do not specify a minimum percentage of loans or bonds that must be contributed by the manager-originator, or a minimum holding period. Based on market practice both before and since the Brexit vote, the expectation is that most manager-originators will come to market having contributed around 5% to 10% of the loans or bonds, having been exposed to the credit risk of such loans or bonds for at least 15 business days.
In addition to Brexit, the EU securitisation and CLO markets are due to be regulated under a new Securitisation Regulation, introduced as part of the EU’s Capital Markets Union initiative. A draft version of the regulation proposed by the EU Commission and approved by the Council is currently before the European Parliament.
Under the Commission’s proposal, originators and sponsors will be under a direct requirement to ensure compliance with the risk retention rules. This approach is a departure from the current regime, which applies to EU-regulated investors rather than to sponsors and originators directly, and reflects the approach taken under the new US risk retention rules (which have applied to sponsors of residential mortgage-backed securities (RMBS) since 24 December 2015 and will apply to sponsors of other securitisations, including CLOs, from 24 December 2016).
The Commission’s proposal also includes an additional requirement that would prevent originators established or operated for the ‘sole purpose of securitising exposures’ from acting as risk retainers. Manager-originators should naturally satisfy this requirement by receiving management fees in addition to the returns expected from acting as risk retainers. However, other types of originator structures will need to demonstrate an economic purpose beyond acting as risk retainer.
While the market’s reaction to the Commission’s proposal has been broadly positive, a number of significant amendments have been tabled at the committee stage of the Parliament’s review, including proposals to increase the risk retention requirement from 5% to 20% and to limit eligible risk retainers to EU-regulated entities.
These proposals, if adopted, could have a significant impact on the UK securitisation market. In particular, limiting eligible risk retainers to EU-regulated entities could prevent UK manager-originator structures as well as UK securitisations involving a single originator acting as risk retainer (including most UK RMBS, credit card, auto and corporate securitisations) from complying with the EU risk retention rules following Brexit, which would prevent EU-based investors from investing in UK securitisations.
The Commission has sought to reassure the market by indicating that it does not support the proposed amendments to the Securitisation Regulation. Following the resignation of the UK’s Jonathan Hill as Commissioner, it will now be left to Latvia’s Valdis Dombrovskis to argue the Commission’s position.
Chris McGarry is a finance partner and James Jirtle is an associate in the London office of Ropes & Gray.