CLO Risk Retention Rules
Risk retention regulations, implemented post-2008 financial crisis, require CLO managers or arrangers to retain at least 5% of the economic interest in CLOs they issue. This "skin in the game" requirement aligns manager incentives with investor outcomes and prevents "originate-to-distribute" models where managers had no downside risk.
The 5% Retention Requirement
U.S. Rules (2014-Present)
Regulation: Dodd-Frank Act Section 941, implemented via risk retention rules (2014, reinstated 2018 after D.C. Circuit challenge)
Requirement: CLO manager or sponsor must retain at least 5% of "credit risk" in one of several permitted forms
EU Rules (2019-Present)
Regulation: EU Securitization Regulation (Regulation 2017/2402)
Requirement: Similar 5% retention by originator, sponsor, or original lender
Permitted Retention Methods
Managers can satisfy the 5% requirement through multiple structures:
1. Vertical Slice (Most Common)
- Retain 5% of every tranche (AAA through equity) on a pro-rata basis
- Example: In $500M CLO, retain $25M spread across all tranches ($15M AAA, $3M mezzanine, $7M equity)
- Advantage: Diversified risk exposure
2. Equity Retention (Popular Alternative)
- Retain 100% of CLO equity (first-loss position)
- Example: In $500M CLO with $50M equity (10%), retaining 50% of equity = $25M = 5% of total deal
- Advantage: Direct alignment with equity investors; manager experiences losses first
3. Eligible Horizontal Residual Interest
- Retain first-loss tranche representing 5% of deal
- Less common for CLOs (more common in RMBS)
Purpose and Impact
Intended Benefits
- Alignment of interests: Manager loses money if CLO underperforms
- Improved underwriting: Manager has incentive to select high-quality loans
- Reduced moral hazard: Eliminates "originate-to-distribute" where manager has no ongoing exposure
Actual Market Impact
- Most CLO managers were already retaining equity pre-regulation (industry standard)
- Rules formalized existing best practices
- Some managers increased equity retention to 8-12% (above 5% minimum)
- EU CLO market temporarily disrupted 2019-2020 as managers adapted to new rules
Holding Period Requirements
Minimum hold period: Manager must retain the 5% interest for:
- U.S.: Life of deal or until aggregate principal reduced to 33% of original
- EU: Life of deal (no 33% exception)
Hedging restrictions: Manager cannot hedge or transfer the economic risk of retained interest
Key Takeaways
- 5% retention required in U.S. and EU markets
- Most managers retain CLO equity (first-loss position)
- Aligns manager incentives with investor outcomes
- Cannot sell or hedge retained position during CLO life
- Formalized industry best practices post-2008