13 Sep 2013
In the first half of 2013 Maples and Calder closed approximately 60% of all US broadly syndicated CLOs. Advising across such a broad spectrum of the CLO market and working with all of the major investment banks, managers and law firms in this space gives Maples and Calder a unique insight into this market and enables us to provide some useful commentary on market developments and trends.
As a leading international provider of legal services, Maples and Calder has been servicing the US CLO market, together with the broader structured products market, for over 15 years. Since the market's rebound, we recognise that it is of paramount importance for us to share any newsworthy industry information and market knowledge, relating to the Cayman Islands, with our clients, given the broad spectrum of deals that we see.
We are also aware that, for the most part, those involved in the CLO market already have access, on a daily basis, to the latest statistics on CLOs from a plethora of excellent websites reporting on data, such as year-to-date volume, issuance levels by arranger and manager, spreads, pricing information, etc. Through our periodical distribution of our newsletter, The CLOser, we aim to provide you with a little more colour and insight on market developments.
Swings and Roundabouts
CLOs are seen largely as a success story in the credit market and the industry view is that they generally held strong and performed well throughout the downturn because of the nature of the underlying assets that they hold. Issuance levels have since generally rebounded to approximate pre-crisis levels, providing good relative value investment opportunities vis-à-vis other credit products. This is borne out by the increase in the number of credit funds formed (many of which are Cayman Islands domiciled) for the purpose of investing in CLOs or acquiring loan assets directly, and augers well for a continued strong demand for this product.
In the first half of 2013, 93 US CLOs priced. Of those, 86 were issued via Cayman Islands registered entities, six were Delaware issuers and one was an Irish issuer of US debt. For further details, please click here to view a CLO deal list.
In 2011, managers were consolidating at a rapid rate and word on the street was that only a handful of large global asset managers would be left in the space by 2014.
Less than two years later, pre-crisis managers continue to re-emerge and new managers are pulling deals together. Whilst a core set of arrangers continue to dominate, new arrangers have entered the fray and others are actively eyeing the space. Increased competition among arrangers also means that the types of warehouse structure, and the warehouse terms offered by arrangers, have proliferated. We have heard that new arranger entrants are gaining traction because of their flexibility in structuring, in particular, at the warehouse stage and because they are also able to provide quicker access to the primary markets than the larger arrangers, whose pipelines are full. Whilst the final form of the US risk retention rules is not yet known, if US regulators adopt similar rules to those implemented in Europe, the market anticipates further consolidation of managers in the US over the next couple of years, with commentators estimating 25-30 managers remaining in the space who have the ability to retain 'skin in the game'. Inevitably, the same is predicted to happen in Europe with the final number of managers estimated to drop to a dozen or so.
Although issuance volumes for 2013 are already ahead of total issuance for 2012, various concerns have affected the CLO market since the start of the year. Notwithstanding record issuance volume in Q1 of 2013, a shortage of assets was reported as a significant commercial concern for the industry. This has been exacerbated by competition for loan assets from loan funds which continue to compete with CLOs for collateral. Onshore market participants have informed us recently, however, that loan prices have since improved and sourcing collateral is now less of a problem. The dearth of AAA buyers is currently the most frequently cited difficulty. Following the FDIC rule changes that came into effect on 1 April 2013, the universe of AAA investors (which was already fairly small) shrunk further with market participants estimating it as low as 10 or so key AAA investors. As a result, Q2 marketing activity saw a number of arrangers and managers heading to Asia to drum up senior investors.
This current paucity of AAA investors should be contrasted with the 2011 market. At that time, the major concern was finding equity investors. As the CLO 2.0 market developed, only large asset managers who could provide first loss support, were able to close deals, with a few exceptions. An increase in the establishment of CLO equity funds, together with an increased willingness of investment funds to buy lower tranche notes and equity, has deepened the equity investor base. We have also seen a marked increase across our deals in third party investors, both at the closing stage of the CLO, and also at the warehouse stage, where they provide first loss funding. Some, but not all, warehouse investors also go on to invest in the subsequent CLO.
Whilst loan refinancing activity over the last 12 months has, according to rating agency reports, reduced the refinancing cliff to around US$340 million and pushed many loan maturities out to 2016/2017, there are still many deals in the market that will need to be refinanced through the end of this year and into next year. We have also heard that many of the early CLO 2.0 transactions, including most of the 2012 vintage, will be refinanced in due course in order to take advantage of lower coupons on new issue debt.
Refinancing is definitely a hot topic right now. We have been, and continue to be, actively engaged in discussions with our manager clients and US counsel, in respect of various structuring options for refinancing from a Cayman Islands legal perspective. There are, of course, the traditional refinance methods, such as a refinancing using the same issuer (which is typically re-pricing of the existing deal which may also involve an upsizing) or the formation of a new issuer to acquire any outstanding underlying assets from the terminating transaction (where investors in the old CLO are usually given the option to invest in the new CLO). This refinancing route involves terminating the old transaction in accordance with the documents for that deal and then liquidating the Cayman Islands issuer company in the Cayman Islands. The process generally takes three to six months to accomplish given that the minimum time period for liquidating a Cayman Islands company is three to four months.
If permissible under the original deal documents upon which onshore counsel will advise, an alternative and, in our view, more attractive option, is for the old CLO to be refinanced through a merger of the old issuer with a newly formed issuer. The advantage of this approach is that the terminating company ceases to exist on the day of merger without the need for the lengthy liquidation process and without the continued operating costs through liquidation. The closing date of the CLO in this type of refinancing will usually coincide with the final payment date of the terminating company's CLO. A portion of the proceeds from the new CLO issuance is used to pay merger consideration to the old issuer for the value of its outstanding assets, and those proceeds are used to settle the terminating CLO's outstanding liabilities and to provide a reserve for any anticipated final costs related to the old transaction. Under the Cayman Islands Companies Law, upon the merger, the assets and liabilities of the terminating company become the assets and liabilities of the surviving company. Not only is the drawn out liquidation process avoided, but there is also no need for the underlying assets to be physically transferred, which can avoid significant assignment fees.
Maples and Calder has completed a significant number of these refinancings and, regardless of whether the terminating CLO is registered with us or another service provider, we have an experienced legal and fiduciary team who can advise on this structure, incorporate the new issuer and deal with the Cayman Islands aspects of the merger.
In August 2013, the Cayman Islands Government ("CIG") announced that it had agreed a Model 1 Intergovernmental Agreement ("IGA") with the United States. The terms of the IGA have not yet been published, but are expected to be broadly similar to those agreed with the United Kingdom and the Republic of Ireland, taking into account the nature of the Cayman Islands’ financial services. Under the IGA, which has not yet been formally signed, a CLO will not be required to enter into a foreign financial institution agreement with the IRS, but instead will be required to comply with Cayman Islands legislation that will be implemented to give effect to the IGA. This announcement closely followed the announcement by the IRS (Notice 2013-43) that certain timelines in relation to the implementation of FATCA have been extended, the most relevant for Cayman Islands CLOs being that the substance of FATCA / IGA should not come into effect until 31 December 2014, given that the Cayman Islands is a Model 1 partner jurisdiction.
At this stage, the exact terms of such legislation are still uncertain and it is not yet clear whether a CLO will be a 'certified deemed compliant' entity with no reporting required or a 'registered deemed compliant' entity, requiring the CLO to report to the Cayman Islands Tax Information Authority, which will exchange such information with the IRS under the terms of the IGA. We anticipate further information on this in due course and should be in a position to provide an update on the final terms of the IGA in the coming weeks.
Maples and Calder provided substantive comments to CIG in advance of their IGA negotiations with the US. We have also been assisting ISDA, the LSTA and SIFMA, in connection with a proposal to the US Treasury and the IRS which they have been working on relating to the treatment of SPVs. The form of this proposal has just been published by ISDA (see ISDA website for a copy). In the event that a Global Intermediary Identification Number ("GIIN") or any other certification will be required, MaplesFS is fully set up to handle registration and, should clients so desire, any FATCA reporting.
AIFMD Update and Cayman Islands CLOs
As many in the CLO industry have been focused on FATCA and US regulatory rules arising out of the Dodd-Frank Act, another potential regulatory issue has arisen from the other side of the Atlantic: the European Union's Alternative Investment Fund Managers Directive (the EU "AIFMD").
Key Points for CLO Managers
(a) Trigger Date: AIFMD only applies where there is an offering of securities on or after 22 July 2013. As such, existing Cayman Islands CLOs, which are no longer issuing securities, are essentially grandfathered.
(b) European Investors: If you are not looking to market Cayman Islands CLOs to any European investors, AIFMD is of no concern to US CLO managers. AIFMD is only applicable where securities are marketed to EU investors.
(c) Is a CLO a Hedge Fund?: While the AIFMD is fairly and squarely aimed at hedge funds and private equity funds, the definition of an alternative investment fund ("AIF") in the AIFMD is somewhat wider than the fund industry norm and, on its face, a CLO could therefore fall within that definition.
(d) SSPE Exemption: Despite the AIFMD providing an exemption for securitisation special purpose entities (an "SSPE"), the definition of an SSPE in Article 4 of the AIFMD includes a component definition of 'securitisation' that requires "…a transaction or scheme whereby an asset or pool of assets is transferred to an entity that is separate from the originator…."; where 'originator' means "…the transferor of the assets, or a pool of assets, and/or the credit risk of the asset or pool of assets, to the securitisation structure...".
Unfortunately a CLO does not clearly fit within the SSPE definition as a CLO does not have an 'originator' in the classic securitisation sense.
(e) Regulator Guidance: This issue has been compounded by a lack of clear guidance from the European Securities Markets Authority ("ESMA"), which is the pan-European regulator. The most helpful guidance has come from the UK's Financial Conduct Authority ("FCA"), which noted that, in general, an issuer of debt securities is not an AIF and, in providing a list of common fund types, did not include CLOs, which seems to suggest that they were not meant to be caught. However, the FCA guidance also, unhelpfully, does not appear to rule out SPVs, and thus CLOs, being an AIF where the "…SPV is set up to invest in financial assets…" and "…all the profits and losses flow through to the investors…". They do note, however, that further guidance from ESMA may be given in due course.
The general consensus is that, pending any further guidance from ESMA, CLOs do fall within the securitisation exemption and so are not AIFs. However, many market participants (including Maples and Calder), have expressed the view that it would be sensible to include appropriate risk factors in the offering document disclosure to highlight the point, especially where arrangers are offering securities of the CLO to EU investors or want the flexibility to do so.
A form of disclosure is now becoming common in CLO offering documents and we would be very happy to discuss the wording we have seen and believe is prudent for the directors of the CLO vehicle to include in an offering document.
This only covers the scenario of a Cayman Islands CLO with a US manager. AIFMD itself is a fairly large and complicated topic and more detailed advice will be required in other cases. We have teams of qualified Irish lawyers in both our Dublin and Cayman Islands offices who can assist in relation to any questions you may have with respect to either Irish CLO issuers and/or EU based managers
Partner Cayman Islands
T: +1 345 814 5530
Partner Cayman Islands
T: +1 345 814 5317
Partner Cayman Islands
T: +1 345 814 5242
T: +44 20 7466 1699
Partner Cayman Islands
T: +1 345 814 5547
Partner Cayman Islands
T: + 1 345 814 5129
Associate Cayman Islands
T: +1 345 814 5185