Absolute Credit Series: Risk Retention Roundup

LT (00:10)
Good afternoon and welcome to another episode of Kirkland & Ellis Absolute Credit. My name is Lindsay Trapp. I’m a partner based in our New York office, and I’m joined today by my partners, Jared Axelrod and Michael Urschel in our debt finance group. Welcome guys.

JA (00:26)
Hey Lindsay, great to be here.

MU (00:29)
Thanks very much, Lindsay. Much appreciated.

LT (00:31)
So today we thought that we would bring back an oldie but a goodie, U.S risk retention, which of course after the LSTA decision and those kinds of things sometimes gets forgotten about in certain aspects of the market, but we thought that it would be helpful to have a good refresher. So with that, let’s get right into it. Michael, we’ve got a lot of things in relation to U.S. risk retention that folks maybe, you don’t know that much about the background and the history of it. So can we discuss the origin of the rule and the problems that we were looking to solve when this came into place?

MU (01:07)
Sure, happy to help. My role today is to play the dumb traditional asset securitizer. We’ve got funds and CLO colleagues who in fairness have made some great advances in just understanding risk retention. But let’s take it all the way back to Dodd-Frank in 2009. Obviously, as everyone knows, the original reason for the risk retention regulations were concerns after the global financial crisis around the originate-to-distribute model, right? So as we all know from like 2005 to 2007, the big problem in the market in structured finance, which caused the global financial crisis in many people’s minds, was the originate-to-distribute model, taking risky mortgages or other risky financial assets, bundling them up, getting them off one balance sheet and then onto other investors’ risk balance sheets. And then, you know, those were rated, those were tranched, et cetera. What came out of Dodd-Frank, of course, was the risk retention rule, which said originators or securitizers had to keep skin in the game. So, if you are securitizing a portfolio of asset-backed securities, which loosely defined, is securities which payments depend primarily on cashflow from self-liquidating financial assets, then you need to comply with the risk retention regulations and you need to hold 5% in either of the three permitted forms of risk retention. We’re all used to that. We’ve all been dealing with that for 17 years or so now, particularly in the types of transactions that our team does in the more cash flow-based asset-based securitizations, most of our transactions comply with risk retention. So any mortgage-related transaction, anything that’s tied to a lease or some other financial asset that has a specific term with which it makes its payments, you that’s pretty much automatically subject to the rule. If you’re issuing securities backed by that, of course, obviously loan-based transactions are outside the rule in the U.S pretty much completely. That’s not the case of the EU obviously, but as things have gone on, obviously more things have been securitized than were securitized in 2009. In 2009, the esoteric securitization market was very small. It was basically wireless towers and a few other things. Nowadays, we have whole-business securitizations at scale. We have wireless towers, we have fiber, we have data centers, we have solar cash flows, we have other things. And there has been, especially in infrastructure, oil and gas, etc., there have been a lot of transactions where we actually take the view that it’s not a self-liquidating financial asset. Really good example, for example, is some of the first deals that we decided were not self-liquidating, or the franchise whole-business securitizations where the franchisor has to maintain its menu. It has to maintain its intellectual property. It’s a royalty stream over time that doesn’t have a defined term to it. So these are not self-liquidating financial assets. These are operating assets. And so across the market, we’ve taken the position that operating assets are not self-liquidating financial assets, therefore aren’t subject to the rule. Bottom line is a lot of these things are whole-company securitizations or other securitizations where as a practical matter, the equityholder of the business is holding way more than 5% anyway. So it’s really not an originate-to-distribute model either. And so even though we take a position that it’s not a self-liquidating financial asset, there really is still a lot of equity skin in the game. But let’s take it back to that though, because one of the big themes today is going to be what does it mean to be self-liquidating and what does it mean to be originating an asset to distribute it. And so really when you’re thinking about risk retention and whether it should apply, you kind of need to come at it from both angles. And we expect over time, continued analysis, continued regulatory developments on this. The tricky part though is there hasn’t been very much enforcement. There hasn’t been a lot of good case law. And so rarely are we seeing legal opinions given. Oftentimes we prepare memorandums, we prepare reasoned analysis of why we think a position is correct. Or we’ll even state in document sometimes, hey, we’re complying with risk retention solely out of caution, but if we ever get legal advice that this transaction doesn’t have to comply anymore, we can stop. So we do have things like that. But again, that’s the sort of transactions that our complex securitization team sees from an esoteric point of view or a traditional asset-securitization point of view. One thing where our colleagues in CLOs and rated funds have started making some real intellectual leaps, again, also helped by a court case, is what does it mean on that origination arm? Like, what does it mean if you’re originating or whether you’re creating a structure that originates its own assets? So with that, I’ll take it over to Jared to talk about the LSTA case and how the CLO market sees that.

JA (05:47)
Thanks, Michael. So CLOs, like most other securitizations, were subject to the risk retention rules coming out of the financial crisis. So the rule came into effect in 2015, 2016. CLOs, both kinds, you have the BSL CLOs, you have the private credit, which at that time were referred to as middle-market CLOs, were subject to the rule. Shortly after implementation, there was a court case filed. This is commonly referred to as the LSTA court case or the district, the DC district court opinion case. And essentially what the LSTA was getting at was that risk retention should not apply to CLOs. The focus of the opinion in the case turned on this idea of transfer. In particular, the risk retention rules identify the sponsor of a CLO as the party who organizes and initiates the transaction by transferring or selling the assets into the securitization issuer. And the argument was that BSL collateral managers, that is collateral managers of broadly syndicated loan CLOs, do not ever transfer the assets into the issuing entity. CLO managers are never the party who take these loans on their balance sheet. They don’t actually possess the loans at any time. They are acting as an agent on behalf of the issuing entity who is actually buying the assets. And that was basically what the court case turned on, was this idea that the managers are inappropriately identified as the per se sponsor because they don’t actually take possession or transfer the loans. That’s the basic gist of the LSTA decision. There was no argument about whether or not loans were self-liquidating. I think, you know, everyone’s in agreement that, you know, a standard BSL loan or even a private credit loan would qualify as a self-liquidating asset, it really turned on this idea that there is no transfer and therefore there is no sponsor for these securitizations. And if you don’t have a sponsor, the rule doesn’t apply.

MU (08:13)
Appreciate that, Jared. And look, again, one thing we want to keep people thinking about today as we turn to the next part of this presentation is, again, why was all this put together? Because if you go back to 2004, 2005, the securitization market was the 144A or the public market where securities were structured under 144A or in a registered format in order to sell those tranches out to the market. Nowadays, 17 years later, and my favorite phrase, the rise of private credit, means there’s a lot of private credit capital out there. There’s a lot of managed capital out there that is sophisticated, that thinks about risk in a different way. But more importantly, there’s a difference between originating something to distribute risk and otherwise understanding and allocating risk on your own balance sheet and getting it to the right pockets of capital within your organization. And so a lot of times when you’re talking about complicated fund managers who have multiple sources of capital they need to deploy, it’s less about originate-to-distribute. And it’s more about allocation of risk to the right, you know, temporal time concern. You know, if you want to have a five-year or a 10-year or a 15-year bond, you maybe have insurance capital that’s got a much longer horizon than shorter, you know, higher-grade capital, lot of different places to put risk. And it’s more about that. So when we think about this stuff, obviously the rules need to evolve over time, but I think right now the sort of prevailing view is, look, if you’re structuring bonds and you’re going to sell bonds out into the market and it’s self-liquidating financial assets, yep, you’re probably subject to the rules. If you are structuring bonds, but it looks more like a corporate and you’re really just securitizing a corporate credit on a whole-business level or some other operating asset, probably not inside the rule. But the fun part, and again I’m just learning this from our new colleagues also, is: What about when you’re looking at this stuff from the lens of a fund? When you are a credit investor who is hungry for credit risk and you want that stuff on your balance sheet and you want to look at that asset and think about how you’re going to evaluate it, rate it, hold it on your own balance sheet, what does that mean for risk retention for you and whether you need to either nominally comply with the rule or not comply with the rule at all?

So for now, I’ll take it over to Jared and Lindsay to talk about how their funds clients and their CLO clients are thinking about these risks and how it looks from their perspective as far as when they’re actually trying to acquire the risk and how does that affect their portfolio.

LT (10:37)
Sure. Thanks, Michael. So I guess, you know, from the structured capital & insurance solutions team side, we certainly do have to think about and think through risk retention a fair amount when we’re doing different types of structures. Rated note feeders obviously are very popular product. That would be a structure that in a lot of ways may look like a securitization, but also oftentimes wouldn’t necessarily be considered a securitization depending on how it is structured. But ultimately the asset that’s going to be held by the issuer is a limited partner interest. So an equity interest. So from that perspective, in general in the market there’s been a lot of consideration around, well, is that really just in that case not a self-liquidating asset even if the underlying assets of the fund might have some self-liquidating properties. The other thing there is that funds as a general rule are always going to have a reinvestment period. So, assets are going to be bought on a blind pool basis or originated on a blind pool basis. And then they’re going to churn for several years. So even if you started, it’s very unlike a CLO where you have a warehouse set of assets, and then those go into a box and then that’s kind of your asset base more or less for the entirety of the transaction. So in a general sense, not to say that there aren’t any specific cases, but in a general sense, it doesn’t tend to be the case that risk retention comes up much in feeders. However, in rated funds that are a standalone issuer, definitely something that we consider quite a bit. There are different features. Does it look more fund-like does it look more securitization-like you know and then what are the underlying assets that we’re talking about? Those are the types of things that start coming up in rated fund land. But certainly Jared you know for CFOs we have similar discussions and you know kind of how those structures operate is a little bit different than a rated fund.

JA (12:47)
Yeah, that’s right, Lindsay. So oftentimes, maybe not oftentimes, there are instances in the market where we hear parties use rated note feeder and CFOs interchangeably. Frankly, in our view, they’re not the same, right? So for a rated note feeder, it’s an entry point into a single fund. Whereas you compare that to a CFO, that is a SPV that holds multiple fund interests that are the collateral for the notes that are being issued. So first and foremost, just wanted to clarify like what the basic differences are between these structures. So for CFOs, right, the underlying assets are going to be fund interests, right? So same as rated note feeder, it’ll be an LP interest in multiple different funds. First and foremost, right, are those self-liquidating assets? I think the market’s pretty clear that limited partnership interests, equity interests are not self-liquidating, in part for many of the reasons that Lindsay already went over. So then there’s a question of, you know, who are the relevant parties and is there a sponsor to this securitization? So with the CFO, you’re gonna have the same sort of cast of characters that you would see in many other securitizations. My background’s in CLOs, so that’s what I, you know, the lens through which I see these structures. And they are very similar in that regard to CLOs. So you’ll oftentimes have an investment manager, a trustee, third-party investors, collateral administrator. If it’s offshore, you’ll have Cayman fiduciary services, legal, etc. And so of those parties that are involved in the transaction, the question comes down to who, if we even need to get to the sponsor analysis, because as Michael indicated earlier, you need self-liquidating assets in order for that to be ABS securities. You need them to be ABS securities in order for the risk retention rules to apply, so assuming we get to the point where we’ve established that there are self-liquidating assets, the question is, is there a sponsor? And again, going back to what we talked about earlier with the LSTA decision, that analysis comes down to whether or not there’s a party who organized and initiated the transaction by transferring or selling the assets into the issuing entity. And more times than not, to the extent we ever even get to the sponsor question, there isn’t actually a party that transferred the assets because the assets have been originated in the first instance out of the fund or in the rated fund structure in the issuing entity.

LT (15:36)
Absolutely. And I think the underlying assets do play a part for sure. We’ve got private equity funds and credit funds and CFOs tend to make a mix a lot of times of having sort of both types, not always, but in a lot of ways they do tend to get there. And now we’re seeing a massive expansion, you know, similar to the way that Michael was saying, where there was a large expansion in the types of ABS that were done, we’re following suit here in fund world and we’re starting to see funds that are investing in more esoteric types of assets. And then we’ve got a lot of open-end and evergreen funds where there just simply is going to be constant churn of those assets over and over and over again. So I think that all of those positions become very relevant to what we’re looking at. And in CFOs, I know Jared, you and I have discussed is there a tipping point? And when you’ve got maybe all credit funds or all PE funds, maybe there’s a brighter line in that discussion. But ultimately, even if you get there, there is a lot, including in the context of a standalone rated fund, that is going to come back to do we actually have a transfer in or a sponsor? And so for standalone rated funds, if you do have some warehousing, and sometimes in rated feeders as well, there’s considerations around if there’s warehousing before the fund starts and there is a transfer in off the balance sheet. We do probably need to dive a little bit deeper and take a look at that. But ultimately, I think one thing that’s quite interesting about U.S risk retention compliance as well, at least from my perspective, comparative to my background in European risk retention compliance, is that there tends to be different people that can participate in the compliance from the sponsor side if there is a sponsor, or if there isn’t one, there just isn’t that retention requirement. So I think that’s quite a big difference with the EU and the U.S. And that can make it easier. But there’s also disclosures that we certainly put in on occasion as well about whether or not something should be compliant or if it’s determined if it should be compliant who that retainer would be. And so I think for CFOs and rated funds for sure, there’s a lot of interesting analysis that goes into those things. And from an investor’s standpoint, certainly something you should consider and look at when you’re looking at these types of deals and kind of make your own assessment or discussions that you should have with your counsel when you’re investing into these types of deals. I guess, you know, what are the motivations, Michael, as we’re driving transactions that end up being, you know, compliant or what were the motivations to even get here in the first place?

MU (18:40)
Thanks, Lindsay. You know, one thing I wanted to bring up today, just by analogy, is a little bit of a lens of practicality. I think this is going to be a good illustrative piece for some folks. I mean, think back to when risk retention started. I mean, look, the basic model of risk retention is that the originator of the securitizer has to hold 5%. But at the very beginning, there was a permissible exception in the form of CMBS B-pieces. CMBS B-pieces are allowed to have a third party hold the risk retention piece as long as they’ve been around at the beginning for the portfolio selection, they’ve done diligence on the underlying assets. So even at the very beginning of the rulemaking, people realized in CMBS it was important and there were people who understood that bottom-piece risk, were excited about being a part of it and that the transactions were structured to allow that. And so I think we always have to think forward-looking like that, and I think you have to think about how you’re structuring a transaction. I mean, if you’re specifically structuring a transaction because you want to offload risk and then go off and originate new assets, and then primarily all of the risk is going to be held by third parties afterwards, you know, it’s a self-liquidating financial asset, etc. That’s something you should think about what the risk potential is. If instead, you’re setting up a vehicle that’s a fund because you crave that risk, and you want to be able to understand that risk, hold that risk, tranche it different ways for different accounts on your own institution, et cetera, then it’s a little bit more on the other side of the spectrum. So I think it’s important that we think about these things in these ways, think about the reason for the rules being set up in the first place. And it’s kind of a smell test as you’re structuring a transaction as to how much risk there really is on whether something has to actually comply with the letter and spirit of risk retention rights. And I think, again, as these products become more hybridized as structured finance and fund finance interact more, we’re going to have to a lot more of these conversations. We’re going to have to think about who are the parties to the transaction, how sophisticated are they, where the different pockets of capital sit, and where the financial assets sit within the structure. When are they originated? How are they originated? Who’s holding them? Obviously, basic questions, but important questions to ask for all these products. And we’ve got to ask, I think, for each new product in an independent way and thinking about how those products are set up.

So eventually I think we’re going to get to the point where there’s certainty in all this stuff. But I think right now we do have to look at every single transaction in its own lens based on, first of all, what’s the nature of the product being created? Is it a security? What’s the underlying asset? How do the parties understand it? How are the parties working together to set up the transaction? And when in the cycle of the transaction are the assets being acquired? You have to look at all of that. And again, on some of the stuff, there is no perfect answer. I have clients in my space who I wrote them a memo that said, you guys shouldn’t have to comply with risk retention. They said hey, we want to do it anyway because we don’t want to take any risk. And that’s the client’s choice. In certain asset classes that we’re pretty sure that people don’t have to comply, there are people out there complying anyway. And that’s always someone’s choice as well. Rarely do we see people taking extraordinarily aggressive positions. I think everything is generally defensible. People on all sides of the transaction often expect reasoned memorandums from law firms saying it’s a position that while it’s not without doubt, it is a reasonable position to take where there’s other people taking the market, that sort of thing. So look, I think things are generally at a pretty good space. But I do think as this sort of hybridization of structured finance and fund finance continues, and I think we all on this call predict that there’s going to be a lot more of that, it will only lead to more opportunities for us to have these questions, have these discussions. And, you know, there’s probably going to be going forward, some people going for more certainty on a regulatory basis. I mean, I could see people going for no-action letters or for other things as we move forward, hopefully. And we’d like to see more color like we got out of the LSTA case.

JA (21:43)
Yeah, so Michael brought up lot of good points there. One of the items that sort of follows logically from what you just touched on is, you know, whether or not it’s appropriate, and we’ve seen this come up a few times in different deals, whether or not it’s appropriate to do what people refer to as a look-through analysis in some of these structures. And what we mean by that is rather than looking and stopping the analysis simply at the LP interest level in the case of a CFO or rated note feeder, whether you should look through the structure and look at the underlying funds and the type of assets they hold. And usually the analysis as to whether or not to move forward with that look through, I think turns largely on whether or not there’s any cute behavior or cute structuring taking place, meaning if the parties are putting these structures in place to evade the application of the risk retention rule, I think in those instances, which frankly, we rarely, if ever, see anything that comes close to that type of behavior. But if that were to exist, I think there’s an argument to be made that one should look through to the actual fund and look past the LP interest. And so you’re not just saying, hey, look, the CFO, the collateral are LP interests, so therefore it’s not self-liquidating, therefore risk retention doesn’t apply. Rather, you would look through and say, okay, you know, the underlying fund, what does that hold? Are they self-liquidating assets? Are they sufficient in the, you know, in the aggregate relative to the other assets that they meet the definition of self-liquidating for purposes of ABS securities? And then is there a sponsor, right? And I think that’s the right way to go through the analysis. And, you know, I think largely, not largely, the vast majority of market participants aren’t trying to evade any of the risk retention rules. They’re really putting these structures in place in good faith in order to, you know, expand their LP or investor universe to, you know, get efficient financing, things like that.

LT (25:32)
Excellent. Well. Jared and Michael, as always, it is wonderful to not only get to work side by side with you, but to have you here on the show. And to all of our wonderful clients and other market participants who watch, we hope this has been helpful and informative. And certainly, as you’re doing these new products, as you are moving forward with new asset types, all of those types of things certainly keep retention in the back of your mind. And we are always here to help.

Thank you for listening to us today and we look forward to seeing you in the next episode.