In Europe, captive CLO equity funds are a boon to CLO managers and the wider economy

Christian Parker

Partner Paul Hastings

The envy is inevitable. But criticism of these structures is entirely misplaced

Fifteen years on, arguably the best regulatory reaction to the 2007-8 sub-prime global financial crisis has been the implementation of risk retention rules, as encapsulated in the European Securitisation Regulations and in the US as section 941 of the Dodd Frank Act. Applied by the US, EU, Japan and the UK, these rules require that an originator, sponsor or original lender must explicitly disclose that it will retain, on an ongoing basis, a material net economic interest of 5% in the securitisation for the life of the transaction.

As a result, the incentive only to securitise robust financial assets has been strong. Defaults, payment delays and other problems with traditional balance sheet securitisations have much reduced and CLOs remain as robust as ever. This regulatory development could be a key link in the absence of any repeat of a securitisation-induced financial meltdown.

Europe opts to keep skin in the game

One significant area of the securitisation market where the ‘skin in the game’ approach has come under some scrutiny, not least in Creditflux, is in the CLO market.

Unlike in a traditional balance sheet securitisation, where the originator/sponsor is invariably a bank selling loans (typically mortgages, auto loans and credit card receivables) to an SPV, and can easily retain a slice of those loans, the CLO market does not lend itself so obviously to such a practice.

The US (or at least its courts) has accepted that CLOs do not easily fit into the standard arrangement by way of the open market exemption. This explicitly recognises that a CLO is not an arrangement used to dump questionable loans onto unsuspecting institutional investors — even during the late 2000s, a vanishingly small number of CLOs have defaulted or missed a coupon payment. They again proved robust during the darkest days of March 2020 (covid), February and March 2022 (Ukraine) and March and April 2023 (Silicon Valley Bank).

Sadly, there is no immediate prospect of regulators in Europe developing anything approaching the open market exemption. Such an exemption is still just about possible in the UK, but remains highly unlikely — the EU, in this regard (as in many others), serves as the baseline, given its due diligence requirements.

Hence, in Europe, we have seen the evolution of captive CLO equity funds. These funds have prompted scrutiny, criticism and envy as they enable managers to issue CLOs at times when market conditions have often hindered competitors that can’t draw on certain sources of investment in the equity.

The scrutiny is welcomed. The envy is inevitable. But any criticism of these structures is entirely misplaced. Captive CLO equity funds are, in fact, a refreshing example of financial innovation.

Capital finds a way

In the best tradition of capitalism, CLO managers, whose business models do not obviously coincide with the risk retention rules (and specifically the 5% requirement), have found sources of capital to meet this regulatory requirement. Meanwhile, certain sophisticated institutional investors know of the consistent mid-teen track record of CLO equity.

Such investors are increasingly banding together and partnering with CLO managers to provide the required capital. This is done by way of establishing a captive equity fund in a manner that will meet the legal and regulatory criteria imposed by the authorities (in both letter and spirit), and simultaneously give those investors financial enhancements that a CLO manager would be unlikely to cede to ad hoc CLO equity investors.

Most importantly, the fact that these vehicles provide capital even in difficult market conditions will typically be part of the exclusivity negotiations between sophisticated parties. Maybe the institutional investors are cognisant of the fact that long-term CLO equity returns have typically been strongest for transactions established in difficult market conditions.

Overall, the capital that these vehicles provide is proving a boon to CLO managers and investors. More CLOs are issued, ensuring CLO managers receive more fees and institutional investors see strong investment returns. At the same time, the broader economy is boosted too. After, all, CLOs are proportionately the largest corporate lenders in the US, EU and UK, and they increase competition and therefore reduce borrowing costs across the entire economy.

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