In Practice: Consolidation in the CLO Management Industry: Hampered by EU and UK Risk Retention Requirements?

Introduction

Challenging recent market conditions have contributed to an increase in consolidation in the collateralised loan obligation (CLO) management industry, with a number of smaller asset managers putting their CLO management businesses on the market to garner interest from larger and more established market players.

Under the EU and UK securitisation frameworks, an originator, sponsor or original lender to a securitisation transaction must retain a 5% economic interest during the life of the deal. On European CLO transactions, this is typically achieved by the use of a third-party originator or by the CLO manager holding the risk retention interest as either a “sponsor”Subject to the relevant manager obtaining specific European regulatory permissions. or “manager originator”.

New UK risk retention rules expected in 2024 offer limited hope of flexibility for CLO managers considering the acquisition of a set of CLO management mandates from another manager, so managers need to consider whether they should future-proof their business structures.

The Challenge

Typically, the preferable structural approach in these acquisitions is to have the acquirer purchase the CLO management contracts from the seller. This is often more desirable than outright acquiring the CLO management entity, such entity potentially coming with actual or potential liabilities and/or housing unwanted business lines beyond CLO management.

However, once a CLO transaction is closed, both the EU and UK frameworks contain a default rule that the risk retention interest cannot be transferred away from the entity acting as retainer at closing (such as the incumbent CLO manager). This is problematic for a CLO manager who wants solely to acquire a CLO management contract from the incumbent manager. The selling party will want to make a clean break from the relevant CLO and transfer the risk retention along with the management contract. In addition, once the management contract moves, the interests of the original manager and the CLO investors are no longer aligned.

The obvious commercial solution is that the risk retention transfers along with the CLO management contract, but on the face of it the EU and UK frameworks prevent that from happening.

Regulatory Requirements

With the coming into force of the EU risk retention regulatory technical standards (EU Risk Retention RTS)Commission Delegated Regulation (EU) 2023/2175. in November 2023 and new risk retention rules on the way in the UK, some exemptions to the restrictions on the transfer of risk retention may be available, although these are very limited in scope (and the UK rules may be even more limited than the EU rules).

Article 6 of the EU Securitisation RegulationRegulation (EU) 2017/2402. sets out the basic risk retention requirement in the EU, and the EU Risk Retention RTS provide further detail as to how the risk may be retained.

Article 12(1)(b) of the EU Risk Retention RTS states that such retention is only effectively held if the retainer does not sell, transfer or otherwise surrender all or part of the rights, benefits or obligations arising from the retained net economic interest.

The UK Securitisation RegulationRegulation (EU) 2017/2402 as it forms part of UK domestic law by virtue of the European Union (Withdrawal) Act 2018. does not contain substantive differences to the EU Securitisation Regulation that are relevant for the purposes of this article. However, the EU Risk Retention RTS were adopted after the end of the transitional period following the UK’s exit from the EU, which means they do not apply in the UK. In addition, the UK’s securitisation framework is set to diverge further from the EU when the UK Securitisation Regulation is replaced, largely by rules proposed by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) (both currently in draft form), which is expected to take place at some point in spring/ summer 2024.

Exemptions

Article 12(3) of the EU Risk Retention RTS provides exemptions to this restriction on transfers of retention interest:

1. in the event of the insolvency of the retainer;
2. where the retainer, for legal reasons beyond its control and beyond the control of its shareholders, is unable to continue acting as a retainer; and
3. if a mixed financial holding company, parent institution or financial holding company established in the EU retains risk on a consolidated basis and the retainer is no longer included in the scope of supervision on a consolidated basis.

With respect to (b), the European Banking Authority has emphasised that any such change of retainer entity must be a necessary and unavoidable consequence due to reasons beyond the control of the retainer itself and any of its shareholders and not based on a voluntary decision.

While the draft FCA and PRA rules contain wording largely equivalent to Article 12 of the EU Risk Retention RTS, as drafted they will not contain exemption (b) above, i.e. permitting a transfer of retention interest if the retainer is unable to continue in its role due to legal reasons beyond the control of a retainer or its shareholders.

Consequences of Divergence

Despite what may look like additional flexibility at first glance, the EU risk retention regime offers no more practical flexibility in the context of a CLO management acquisition than the proposed UK regime. While the conspicuous absence of the “legal reasons” exemption from the draft UK framework could pose problems for cross-border compliance (if a risk retainer replacement permitted under the EU regime is not recognised under the UK regime) for transactions involving mixed UK and non-UK originators, sponsors or original lenders, the narrow nature of the legal reasons exemption means it can have virtually no practical application in a scenario where a CLO manager is the subject of a voluntary sale/purchase.

Conclusion

CLO managers contemplating an acquisition or merger may be tempted to look for flexibility, as regards the restriction on transfers of retention interest, in the exemptions of Article 12(3) and the corresponding exemptions expected in the new UK framework. However, it is difficult to see how these narrow and inherently ambiguous exemptions can be practically applied with any certainty. As a result, acquisition structures often need to default to full acquisition of the CLO management entity.

CLO managers should pre-emptively consider seeking to future-proof their business structure by either creating a third-party originator risk retainer which could be sold simultaneously with, but independently of, the change in the management role. Another alternative to consider is to ensure the entity signing up to the CLO management contracts as CLO manager is solely dedicated to CLO management, rather than housing other investment management business. The latter approach will often require the entity to have the requisite regulatory authorisation to perform investment management services in the relevant jurisdictions, so does not come without hurdles.