Would it really matter if CLO risk retention came back?

Probably not. But also, maybe yes.

Elizabeth Warren loves to pick fights with big finance. Last month she revived an old conflict, and people got mad.

The US Senator’s provocative private-equity reform bill, first published in 2019 and reintroduced to Congress in October, has predictably polarized opinion. Left-wing lobby groups claim it would protect consumers, workers, and savers, while those on the right say it would hurt taxpayers and investors.

Its most ambitious ideas—making sponsors liable for portfolio company debt, restricting dividends and layoffs for two years after an LBO—have prompted some firms to update their risk factors (see KKR’s most recent 10-K). But few appear genuinely worried that these suggestions will actually become law; they seem designed to provoke rather than to pass.

And yet, one tiny part of the bill has got the leveraged loan market (or at least, its paid advocates) hot under the collar: its proposal to reinstate risk retention for CLO managers.

The Loan Syndications and Trading Association is upset. In a statement on its website, the industry group called the proposal a “solution in search of a problem” that would impose “needless costs and friction” on corporate funding markets.

Compared with the rest of the bill, this idea—tucked away in the last of the text’s 116 pages like an obscure footnote—seems fairly reasonable. And that’s exactly what Elliot Ganz, who blasted it in an op-ed earlier this week, is worried about.

“It is very different from the rest of the bill, which is why we have to take it seriously,” Ganz told 9fin. “As part of this bill, we don’t think the prospects of it getting through are high, but it would be easy to take out those one-and-a-half pages and get it done in a different context.”

It’s not hard to see why the LSTA is triggered. Back in 2014, the group sued the SEC and the Fed over this exact issue, ultimately leading the DC court of appeals to repeal risk retention for CLOs in 2018. Now, like low-rise jeans and movie adaptations of Dune, it’s suddenly a thing again.

Not only that, but this is happening after the CLO market withstood a global pandemic. Despite being labelled as the market’s “ground zero” in early 2020, most CLOs emerged from the crisis intact, with losses limited to junior tranches.

Given the market’s resilience—and the Government Accountability Office’s conclusion last year that CLOs are not a threat to financial stability—the continued push to reimpose this rule is “strange”, said Ganz.

“The CLO market performed well through the financial crisis and extremely well through the pandemic,” he said. “The pandemic was a kind of stress test.”

Perhaps this resilience was down to the way CLOs are designed. Maybe that proof of concept is what helped issuance rebound so quickly from the crash, and go on to break records this year.

Then again, the lack of notable CLO implosions might also have had something to do with unprecedented government intervention in credit markets. And this year’s record issuance could also have been driven by inflation fears, or by the boom in LBOs, or the impending demise of Libor.

When you look at the bigger picture, risk retention starts to seem like a pretty marginal issue. The CLO market survived the pandemic; but there’s no way to prove whether the repeal of risk retention played any part in its survival (or its remarkable rebound) and there are plenty of factors that seem a lot more consequential.

Chief among those factors is the simple fact that investors absolutely love CLOs. They are already an extremely popular investment, and that popularity has some strong macro tailwinds. “There are lots of investors who are yet to invest in CLOs but probably will in the future,” a banker told 9fin. “The demand is there, and the secured loan product has few alternatives right now.”

In any case, a growing number of CLO managers were voluntarily retaining slices of their own deals before the pandemic, and plenty continue to do so today. They spent years building that capability, and it helps them comply with regulations in crucial jurisdictions like Europe and Japan as demand becomes increasingly globalized.

Of course, this is easier for bigger managers, many of which are owned by private-equity firms. And this—the adverse impact on the smaller firms that add the spice and variety befitting of a healthy market—is a more legitimate criticism of risk retention than the idea that it would somehow slow down the leveraged loan market.

A common cultural critique of private equity is that it extinguishes character. Fashion brands lose their cool, newsrooms lose their voice; everything becomes depressingly familiar, like a chain restaurant. Ultimately this can harm consumers by reducing diversity of choice and experience, two important features of a competitive marketplace.

The leveraged loan investor base is not especially diverse; CLO managers are under scrutiny precisely because they dominate it. It would be painfully ironic if all Warren’s bill achieved was to reduce diversity within their ranks—especially since that would benefit managers owned by the very firms whose influence it seeks to curtail.

If you have thoughts on this article, drop us an email at team@9fin.com