Fitch: Risk Retention Rule Will Hurt Small US CLO Managers

NEW YORK--(BUSINESS WIRE)-- Many small CLO managers will likely find complying with the risk retention rule difficult, Fitch Ratings says. Several strategies have reportedly emerged to assist them and more could develop. However, their effectiveness in satisfying the rule remains uncertain. In one, banks that arrange CLO collateral would provide financing by taking "vertical strips," or a small stake in each of the deal's classes. In another, a majority-owned affiliate with third-party capital is structured to invest in CLOs.

These strategies may not be available to independent, smaller employee-owned partnerships. During 2013, the number of CLO issuers in the market grew by 65%, with 47 new managers entering during 2013 and 2014 (through October). Many are smaller than the "frontier" CLO 2.0 issuers of 2010 and 2011. We expect the number of small CLO managers to decline in 2015 as the industry undergoes consolidation ahead of risk retention rules going into effect in 2016.

In addition to risk retention implementation, there are several important considerations for investors in CLOs of smaller managers. Some smaller managers with fewer financial or operational resources may underutilize governance, risk management, investment processes and operational controls. Smaller managers may also be vulnerable to business concentration and smaller asset bases and lack clear distribution networks and the benefit of affiliating with a larger firm.

In our view, new managers with adequate administration capabilities, thorough indenture review procedures, advanced portfolio setup procedures and strong modeling tools can limit these operational risks. We recommend investors monitor managers' compliance with their investment guidelines.

The market responded to this complexity by increasing the number of backup managers being added to newer CLOs with less experienced issuers. Large, frequent CLO issuers have been named as backups in CLO documents and are expected to step in as replacement managers following specific breaches or for "cause," as defined in the collateral management agreement. Going forward, the effectiveness of this technique remains an open question, as regulators have not yet commented on whether the backup manager would need to comply with the risk retention rules.

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.

Applicable Criteria and Related Research:

CLO Market Expands Requiring More Investor Scrutiny (Increase of New Entrants Highlights Investors￢ﾀﾙ Need to Focus on Unique Risks)

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=829410

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Fitch Ratings
Kevin Kendra
Managing Director
U.S. Structured Finance - Structured Credit
+1 212 908-0760
or
Ian Rassmussen
Senior Director
Fund and Asset Managers Rating Group
+1 212 908-0232
or
Rob Rowan
Senior Director
Fitch Wire
+1 212 908-9159
or
Media Relations:
Sandro Scenga, +1-212-908-0278
[email protected]

Source: Fitch Ratings

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