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News
European CLO market hit hard by change to interpretation of risk retention vehicle wording
by Shant Fabricatorian
The European CLO market was rocked by a double whammy at the beginning of April.
Alongside the volatility from the Trump tariffs, European regulators issued new guidance that sowed confusion and contributed to a chilling effect on primary activity.
The Joint Committee of the European Supervisory Authorities (ESAs) changed the interpretation of the ‘sole purpose’ test for CLO risk retention vehicles. Centred around an innocuous-sounding paragraph in the European Securitisation Regulation, the guidance — published on 31 March and effective immediately — clarified that the word “predominant” in this instance meant “correspond[ing] to no more than 50%” on the exposures to be securitised.
“There is widespread sentiment that this has not been thought through, and concern for what might be coming next,” James Warbey, a partner at Milbank, told Creditflux. “In particular, there’s concern that there seems to be a lack of understanding of how the market works, and a real concern about how blunt an instrument this test is, because it captures a whole bunch of entirely legitimate structures in its purview.”
Managers and investors sought clarification from regulators about the extent and nature of the changes, while the regulators themselves — who considered the updated guidance a relatively minor change, according to sources — appeared surprised at the extent of the backlash.
There’s a lack of understanding of how the market works
James Warbey
Partner
Milbank
At the same time, the lack of clarity around how the guidance impacted deals in the market, and those which had priced but not closed, had a negative impact on further issuance.
CLO managers and lawyers — particularly those with deals that had priced but not closed — faced long nights to rework their compliance arrangements. Combined with the effect of the Trump tariffs, this resulted in European CLO issuance taking a near-month-long hiatus.
While the revised guidance caught market participants by surprise, the extent of the market backlash equally caught the ESAs off-guard, according to lawyers who were working with clients to adapt to the change.
“It does seem fair to say that the view had been taken by the ESAs and the Central Bank of Ireland, that this wasn’t being seen as any kind of a material change,” said John Goldfinch, a partner at Proskauer Rose.
“There was anecdotal feedback that there was surprise on the part of both the ESAs and the Central Bank of Ireland that it generated the market impact it had and continues to have.”
Following consultation with the Central Bank of Ireland, the joint ESAs subsequently clarified that market participants could operate on the basis that the transactions were grandfathered in under the previous interpretation, on which basis the market has since proceeded. But the changes continue to reverberate, particularly amongst small managers and those which were reliant on horizontal structures.
Some managers, particularly those with a manager/originator structure which holds the equity in their deals, are in a favourable position, said Aaron Scott, a partner at Dechert. They are likely to already be compliant, and while they will need to consider the revenue test going forward, it will largely be “business as usual”, he said.
But some other managers — in particular, small managers which have set up third-party-originated vehicles with a small portion of other non-retention assets — remain in a difficult spot.
“These managers may have quite a few legacy deals from this vehicle,” Scott said. “All of those legacy deals are grandfathered, but if the manager is looking to do their next deal, they will have substantial revenue from the risk retention assets from these legacy deals and it’s very hard to then try to offset that with non-retention revenue.”
