New risk retention rules for collateralized loan obligations (CLO) could lead to increased consolidation among asset managers, says Fitch Ratings.
In a new report, the rating agency says that new requirements that have been enacted in Europe and proposed in the U.S. could increase balance sheet leverage for asset managers that need financing to comply with the rules. For firms without the financial resources, or market access, to comply with the new requirements, this could result in their exit from the CLO market, or push them to seek an acquisition by a larger manager, it suggests.
“This could drive further industry consolidation as managers seek to achieve greater scale and diversification,” Fitch says, noting that this could be one of the motivating factors behind KKR’s announced acquisition of Avoca Capital last week.
European rules will require CLO originators or sponsors to retain a 5% interest in CLOs, effective Jan. 1, 2014. The U.S. is proposing a similar framework, although it is not expected to be finalized until the fourth quarter of 2015 at the earliest, Fitch says.
It notes that, while requiring the retention of a portion of CLO issuance will better aligns asset manager and investor interests, it also increases balance sheet risk in 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, it warns.
Two factors will influence which managers choose to pursue future acquisitions, it also suggests. The buyer would need to have sufficient financial resources to fund risk retention without adversely affecting their own balance sheet; which would likely limit participation by banks and insurance companies. It would also need to have an underdeveloped CLO platform in terms of scale, staff, or geographic reach; otherwise, the business can be grown organically rather than through acquisition.