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.
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.
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.
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.
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Daniel Niemi at email@example.com