Collateralized loan obligation (CLO) risk retention rules enacted in Europe and proposed in the US could increase balance sheet leverage for those asset managers who need to obtain financing to comply with the rules, according to Fitch Ratings.
For those managers without the financial resources or market access to comply, this could result in their exit from the CLO market, or push them to seek an acquisition by a larger manager. This could drive further industry consolidation as managers seek to achieve greater scale and diversification.
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Asset managers typically operate a balance sheet-light business model, with minimal debt issued to fund the acquisition of another manager, seed new investment strategies, or co-invest in follow-on funds.
While retention of a portion of CLO issuance better aligns CLO manager and CLO investor interests, it also introduces increased balance sheet risk to the asset management business model. Risk retention requirements could also increase leverage and/or net debt for managers without excess cash on the balance sheet, which could adversely affect ratings.
Smaller asset managers without the financial resources or market access to fund CLO risk retention will be challenged to meet these new regulations, which could spur consolidation. This could be one of the motivating factors behind KKR’s announced acquisition of Avoca Capital (Avoca) last week, along with the distribution capabilities it provides Avoca and the geographic expansion it affords KKR in the credit space.
Two factors will influence which managers choose to pursue future acquisitions.
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By GlobalDataFirst, the acquirer would need to have sufficient financial resources to fund CLO risk retention without adversely affecting their own cash position, borrowing capacity, and leverage levels. This would likely limit participation by banks and insurance companies, given their sensitivity to the regulatory capital requirements associated with CLO equity investments.
Second, the acquirer would need to have an undeveloped or underdeveloped CLO platform in terms of scale, staff, or geographic reach. Otherwise, the acquirer’s CLO business can be grown organically rather than through acquisitions.
The European Banking Authority’s Capital Requirements Directive states that, effective Jan. 1, 2014, CLO originators or sponsors will be required to retain a 5% interest in originated or sponsored CLOs. The Dodd-Frank Act proposes a similar framework in the US, although it is not expected to be finalized until fourth-quarter 2015 at the earliest.
