Risk-retention rules mandated under the Dodd-Frank Act have raised issues for managers seeking to raise collateralized loan obligation (CLO) funds. Credit risk-retention rules have been considered paramount to the Dodd-Frank Act and apply to sponsors of asset-backed securities requiring such sponsors to hold 5 percent of the value of the securities offered by the sponsor. Although CLOs are a type of structured credit that has a perception of being riskier than more traditional types of fixed-income financing sources, CLOs typically have experienced much lower default rates, lower volatility and higher recovery rates than corporate bonds, and the provide a source of financing, through a CLO’s business development company (BDC), to mid-sized companies. According to S&P Global Market Intelligence, approximately $63 billion has been raised with CLOs through July 2017, which is more than twice the amount raised this time last year.
BDCs are closed-end investment funds that are regulated under the Investment Company Act of 1940 and use CLOs as part of their funding strategy. However, the risk-retention rules that are at the heart of Dodd-Frank may be at odds with the original regulations in place for BDCs. As reported in a recent Reuters article:[1]
Managers seeking to raise CLO funds as part of their strategy to lend to smaller, middle-market companies are finding their plans to use a BDC to hold the retention are falling foul of the Investment Company Act of 1940 that governs the specialized closed-end vehicles.
“It’s a material conflict between the two regulatory regimes,” said Sean Solis, a partner at law firm Dechert. “The provision in risk retention that allows for a CLO to use the BDC for risk retention conflicts with limitations on affiliate transactions set forth in the” Investment Company Act of 1940.
Market participants have asked the Securities and Exchange Commission for clarity on the issue.
The risk-retention rules have been a concern for CLO market participants dating back to 2013, when risk-retention rules were initially proposed. Given the focus on deregulation in Washington, these risk-retention rules highlight one area that may affect available financing liquidity to mid-sized U.S. companies.