Wall Street Rushes to Aid CLO Market as New Rules Cloud Outlook

  • JPMorgan, Citigroup and BofA explore arranging new financing
  • Funding would allow managers to put up less of their own cash

Wall Street is moving to prop up the $881 billion market for leveraged loans by helping the largest buyers of the debt tackle tougher regulations.

JPMorgan Chase & Co., Citigroup Inc. and Bank of America Corp. are among banks exploring ways to arrange a type of financing for managers of collateralized loan obligations that would help them comply with the rules, according to people with knowledge of the matter. The funding would allow managers to put in less of their own capital to conform with so-called risk retention rules that require them to keep some skin in the game to avoid excessive risk-taking.

The banks have a very good reason to help. CLOs purchased more than 60 percent of leveraged loans last year and if they aren’t able to get off the ground, that could jeopardize buyout deals that have relied on the backing of credit markets. CLO issuance has already plunged to its slowest pace in more than four years and making it easier for managers to comply may help revive the market.

“Risk retention and the financing solution is part of a bigger puzzle for the whole leveraged-finance universe,” said Maggie Wang, Citigroup’s head of U.S. CLO research. “If CLO issuance falls, it will have a major impact on the loan market."

Vertical Strip

CLOs pool high-yield corporate debt that are often sold to finance some of the largest buyouts. The bundled debt is sliced into securities of varying risk with ratings that range from AAA down to B. The new risk-retention rules, a part of the Dodd-Frank reform, require CLO managers to hold 5 percent of their deals. 

A manager can do this either by buying up 5 percent of the deal in the junior-most portion, known as the equity tranche, or by purchasing a little bit of each portion of the CLO structure -- or the so-called vertical strip -- to make up its 5 percent holding.

The banks are offering to raise money from investors to help provide the vertical-strip financing for CLO managers, the people said, asking not to be identified as the information isn’t public. One option the lenders are discussing is arranging financing for the safest portion of the vertical-strip, leaving the CLO manager having to look after the rest, the people said.

Smallest Check

Banks may be willing to provide financing for between five and 12 years, the people said. Longer-term financing that more closely matches the maturity period for the vehicles is better for CLO managers so they can avoid the risk of having to refinance before their fund matures.

Without the financing from the banks, the manager of a $500 million CLO might have to put in $25 million to comply with the rules. That’s five times as much as the $5 million the same manager may have to tip in if it can secure financing for most of the vertical strip, the people said.

“This is the path to the smallest check for a manager to write,” said Oliver Wriedt, co-president of CIFC Asset Management. “The reason this financing solution is a hot topic is because poorly capitalized CLO managers and their underwriters want to find access to market.” 

Representatives for JPMorgan, Citigroup and Bank of America declined to comment.

New CLO sales plunged to $8.2 billion in the first three months of the year, its slowest stretch since 2012. That follows nearly $100 billion of CLO sales in 2015 and a record $124 billion in 2014.

Bank of America cut its CLO issuance forecast for the year to $45 billion, less than half the total in 2015. JPMorgan analysts said it could fall to as low as $35 billion, after loans last year suffered their first downturn since 2008 and as managers grapple with the new rules. 

Strategists were expecting CLO issuance to drop this year partly because of concerns about the new rules, according to David Preston, an analyst at Wells Fargo & Co. They cut their projections further in the first quarter after issuance stagnated amid credit-market strains.

Funding discussions between banks and CLO managers come as firms including Leon Black’s Apollo Global Management LLC raise fresh capital to address the new rules.

“Financing will be a big part of the solution,” Preston said. “It will certainly help CLO managers continue issuing deals."

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