Governance Perspectives for a Modern Approach to Risk Retention

Evolving structures in the European CLO space using The Taxation of Securitisation Companies Regulations 2006 in the UK, allow CLO managers to efficiently establish investment vehicles that actively originate CLOs and retain the necessary CLO equity investments to meet risk retention requirements. These structures demand a hands-on, sophisticated approach to the governance of the investment vehicle, along with deep knowledge and understanding of the underlying investments.

Sponsors or originators who are established in the European Union or who engage with investors in the region are required to hold at least a 5% interest in their CLOs under the EU Capital Requirements Regulations, the latest iteration of the rules introduced in response to the financial crisis.  While the CLO market in Europe is smaller and less liquid than its US counterpart, it has attracted increased interest from managers on both sides of the Atlantic.  CLO structures proved to be resilient to the tumultuous effect of the pandemic on financial markets during 2020 and, if anything, pricing weakness was seen as an opportunity by CLO managers to ramp up portfolios.

Following record levels of issuance in 2021, there was an active market at the start of 2022, however following the Russian invasion of Ukraine, high global inflation levels and significant movements in interest rates, the market has become more challenging.  That said, a number of warehouses remain open and we anticipate that there will be issuances later in the year as loan and CLO markets adjust to the new conditions albeit with flex around pricing as a result of interest rate movement.

Managing the risk retention requirements remains an important consideration for managers and some of these vehicles also originate or sponsor US domiciled CLOs. Sponsors of US securitisation transactions were required to retain an eligible interest of their transaction equalling not less than 5%.  While US CLOs have been effectively exempt from risk retention rules since 2018, some managers are adding voluntary risk retention features to provide comfort to investors higher in the capital stack. Historically, risk retention vehicles have been set up as traditional fund structures, however this can be expensive for managers in an environment where every basis point counts towards a deal’s success, and also more complex to run. This is particularly the case in the current market where debt is becoming more expensive at all levels of the capital structure and loan assets are becoming more challenging to source.

Recent deal activity that the Maples Group has been involved in has seen a variation on the traditional structuring approaches, via the incorporation of a Jersey domiciled note issuance vehicle with UK tax residency, which is efficient to set up and the listed notes are an attractive and familiar instrument for investors.  While this structure still enables the pooling of capital to invest in CLOs (and their associated warehouses) as an asset class, it also allows the company to qualify under the UK Permanent Regime.  These structures are attractive to CLO managers since they qualify as EU compliant originators and US compliant sponsors of CLOs, and ultimately provide the required risk retention investment.

Sophisticated Governance

The growing trend of domiciling these vehicles in Jersey may be in order to access a politically stable crown dependency of the UK with a robust regulatory framework which is nevertheless outside the EU.  Part of the attraction of Jersey as a jurisdiction for structured finance vehicles, just as with its highly regarded funds sector, is the robust approach that the domicile has taken towards AML / CFT compliance and its consistent application of high standards.  With these vehicles operating in the middle ground between securitisation and fund management, a high level of expertise and an involvement from specialist independent directors is paramount.

Although these structures simplify the process for the manager in terms of deal setup, there is a requirement for more sophisticated board composition and governance, with a necessity for the board to have the requisite knowledge of leveraged loan origination and CLO equity investing, being able to take a hands-on approach to the origination of CLOs, as well as having clear independence from the manager.

The Maples Group’s extensive expertise and knowledge in leveraged loans, CLOs and investment funds, helps ensure that these entities’ boards are guided and governed to the highest possible standards. Our team of Jersey and UK resident directors possess a range of relevant backgrounds, including capital markets, investment management, legal and accounting, with specific experience covering leveraged loan markets, CLOs, structured finance and alternative investment funds.