NEW YORK (LPC) - Banks are expecting increased US Collateralized Loan Obligation (CLO) fund issuance after a US court ruled that the funds will shortly be exempt from regulations that require managers to hold some of their deal.
Morgan Stanley increased its 2018 US CLO forecast by US$10bn to US$110bn following the decision and Deutsche Bank raised its forecast to US$120bn from US$110bn, according to reports this month.
The US CLO market, the largest buyer of leveraged loans, cheered a decision by a US Court of Appeals on February 9 that the funds will be exempt from Dodd-Frank risk-retention rules, which require managers to hold 5% of their fund. Removing the retention hurdle should help more firms to raise deals, especially smaller managers that lacked the required capital.
Issuance is off to a strong start this year with US$13.5bn of CLOs printing through February 16, showing an increase of more than 700% in volume from the same period in 2017, according to Thomson Reuters LPC Collateral data.
CLO forecasts for 2018 were already strong, ranging from US$90bn to a record US$140bn, but some banks now expect the court decision to fuel even more funds.
Citigroup kept its record US$140bn forecast in place, but increased its estimate for the number of deals that will be reworked, according to a February 20 report. The bank says US$110bn will be refinanced and US$120bn will be reset, up strongly from a January forecast of US$60bn of refinancings and US$105bn of resets.
JP Morgan also increased its forecast for US CLO refinancings and resets, raising it to US$115bn from US$70bn, according to a February 23 report.
Refinancings keep funds’ maturities in place but change the interest rate on one or more debt tranches, whereas resets extend maturities to allow CLOs to stay outstanding longer. Decreasing spreads paid to senior CLO debtholders increases the payout to investors in the most junior tranche, as equity holders receive the interest left over after all other investors are paid.
With the ruling, managers no longer need to raise long-term capital to refinance and improve the economics of older deals, which may drive more refinancing and reset activity, according to Maggie Wang, head of US CLO and Collateralized Debt Obligation research at Citigroup.
“Doing a reset will allow [managers] to modify terms and boost CLO equity [valuations] at the same time,” she said in an email.
Citigroup estimates US$11bn was raised to help managers comply with risk retention, and about US$3bn is still left to be deployed, according to the report. The retention vehicles will stay in place, but may seek more flexibility in order to invest in the equity of existing funds, the bank said.
Risk-retention vehicles brought new investors into the market that offered CLO managers long-term capital, said Jonathan Insull, managing director at Crescent Capital Group.
“The advantage of a dedicated pool of capital has been proven,” he said.
Earlier this month, the US Court of Appeals for the District of Columbia Circuit ruled in favor of the Loan Syndications and Trading Association (LSTA), the trade association representing the US CLO and leveraged loan markets. The LSTA sued the Federal Reserve and Securities and Exchange Commission in 2014 arguing risk retention was “arbitrary, capricious” and “an abuse of discretion.”
Regulators have 45 days from the ruling to seek an en banc review, a hearing in front of the active US Court of Appeals judges. There is also a separate 90-day window to request a Supreme Court review.
The market remains optimistic while it waits to see if the court’s decision will stand.
The court ruling “will encourage more asset managers, particularly smaller ones, to issue CLOs in the US market,” Wang said.