Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

It's been a rough few years for debt-fund managers. Their fees have shrunk and competition has grown.

In response, asset managers have become creative. This is particularly true in one corner of the risky corporate loan market, where managers of collateralized loan obligations have been borrowing money to essentially goose their fees. 

Record Pace
U.S. junk-rated companies are issuing loans at a record pace this year
Source: Bloomberg
CLOs have historically owned about half of the U.S. leveraged loan market

These firms have been under unique pressure. New rules instated after the 2008 financial crisis require them to retain 5 percent of their deal's risk. That often amounts to a significant commitment considering that the average size of these CLOs has been about $400 million, meaning that typical risk-retention allocations would be about $20 million a deal. 

These rules may soon be thrown out as part of President Donald Trump's push to ease financial regulations. But before decrying this as an example of how fewer rules will spur another crisis, it's important to remember that these regulations actually didn't do much about reducing risk. In fact, it arguably increased it.

Here's how managers, particularly smaller ones, found a way around risk-retention requirements. Sometimes firms will borrow money directly from, say, a pension or sovereign-wealth fund, with proceeds going toward buying CLO debt. Other times they'll craft a special purpose vehicle that sells bonds specifically to offset their risk-retention requirements.

For example, Moody's Investors Service just rated a bond offering, with proceeds going toward buying a 5 percent vertical slice of all the CLO tranches issued by HPS Loan Management 2013-2. The purpose is "for the issuer, who is also the collateral manager of the underlying CLO, to comply with the retention requirements of the U.S. risk retention rules," according to an Oct. 23 note from Moody's.

These types of transactions have helped fuel this year's record issuance of CLOs. In many cases, fund managers wouldn't have been able to do nearly as many deals without the help of outside capital.

CLO Surge
The volume of CLO sales has surged this year as demand for riskier assets increases
Source: Bloomberg

At first blush, the economics don't make much sense. Fund managers earn about the same amount from their investments in CLOs as they have to pay for the financing. In other words, these deals don't boost CLO returns for the fund manager. Instead, this is largely a way for money-management firms to increase their assets under management at a time when investors are increasingly gravitating toward securitized leveraged loan funds.

Bigger Returns
Investors have gravitated to CLO debt because of the potential for bigger returns
Source: Palmer Square CLO Debt Index
The Palmer Square CLO Debt Index is designed to reflect the investable universe of U.S CLO mezzanine original rated A,BBB and BB debt

A nice ancillary benefit-- and perhaps even the primary one --  is that their fee revenues go up.

This presents some issues in a downturn. First of all, these derivative deals are complicated and raise some thorny questions. For example, what happens to the fund management if the investment firm overseeing it becomes insolvent? And any time extra layers of complexity are introduced into a deal structure, there's the risk that different creditors argue about who's owed what. 

And it also shows that these risk-retention rules didn't truly offset any risk. Smaller CLO managers have still done a lot of deals without committing much of their own money to them. And arguably they've only made the market more complex and fragile while boosting their fee revenues.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net