Credit funds insight - issue 7
29 Nov 2016
The impact of Brexit on CLO transactions
The complexity and the operational difficulty inherent in the EU risk retention rules has been compounded by uncertainty as to the future status of UK-based CLO managers due to Brexit.
UK-based CLO managers have for some time been able to comply with the risk retention requirements under Capital Requirements Regulation (CRR) as the “sponsor” of the securitisation. In order to qualify as a sponsor under CRR, managers need to be authorised by their national supervisor to conduct certain specific investment services under the Markets in Financial Instruments Directive (MiFID).
While the UK is still part of the EU, Financial Conduct Authority authorisation will continue to be valid for retention purposes and UK-based CLO managers will continue to be classified as a sponsor if their authorisation includes the relevant activities. However, there is a risk that this authorisation could fall away in a Brexit scenario where the UK does not remain in the EEA and no equivalence regime is agreed. In that case, existing transactions using a UK-authorised sponsor as the retaining party will cease to comply with the CRR retention requirements on the effective date of the UK’s withdrawal from the EU.
It has become clear very quickly that most investors in new CLO issuance are not willing to accept the risks of non-compliance. It seems that investors will only invest in new CLOs if a suitable alternative plan is built into the transaction to deal with the situation.
A first option is to establish a subsidiary as a “sponsor” entity in another EEA jurisdiction which meets the definition in CRR and is the named collateral manager for new CLOs. Managers will need to consider whether the substance of such an arrangement is within the CRR retention rules, and also the taxation, employment and corporate governance implications of moving management of the CLO to an EU subsidiary. Furthermore, it will generally take six to nine months in most jurisdictions to obtain the necessary MiFID authorisation. This means that although many managers see this as the longer term solution, a different arrangement is required in the immediate term for new issue CLOs. Indeed, since the referendum, several UK-based managers have started work on this option and are considering Luxembourg and Ireland as possible jurisdictions.
The delay inherent in the above option could be mitigated by the inclusion of provision in the CLO documentation allowing the UK manager to remain as the sponsor for the short to medium term while the UK remains in the EEA, but move operations after Brexit to another authorised affiliate entity within the EEA. However, it has never been clear from the risk retention rules or from discussions with the EBA whether the transaction would remain compliant in these circumstances. As a result, this option is unlikely to provide investors with any additional comfort.
A third option is to use the originator/manager structure, in which the manager originates a portion of the portfolio and assumes the credit and market risk of the assets for a “seasoning” period. Typically, this is achieved by the manager acquiring assets during the warehouse period and holding them for approximately 15 business days before on-selling the assets to the CLO issuer.
Unlike the sponsor route, the use of an originator/manager does not depend on the manager having a MiFID authorisation and therefore insulates the transaction from a Brexit scenario that does not include EEA membership or equivalence.
This approach has a degree of a track record, in that it has been used by the majority of US-based CLO managers seeking to comply with EU retention rules in order to sell their CLOs to EU investors. It has also been used on several European transactions. These transactions should continue to satisfy the current EU risk retention requirements after the effective date of the UK’s withdrawal from the EU. In addition, UK managers that have used the sponsor structure in the past should be able to use the same entity as an originator for future CLOs without any further regulatory approvals being required.
It appears that post-Brexit this option has attracted early favour from the market. Several of the European CLO transactions that have priced since Brexit have been from UK-based managers that have historically relied on the sponsor route but have now opted for the originator/manager structure. In addition, at least one post-Brexit US CLO transaction that achieved compliance with the European risk retention rules via the sponsor route (by employing a sub-advisor structure) has switched to the originator/manager structure, in line with most other US CLOs.
This publication is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to. Readers should take legal advice before applying the information contained in this publication to specific issues or transactions.