REGULATORY&STRUCTURALEVOLUTIONOF

COLLATERALIZEDLOANOBLIGATIONS

Thesissubmittedto

HECParis

Inpartialfulfillmentfortheawardofthedegree

of

MasterinManagement

MajorinFinance

by

PahunJAIN

Undertheesteemedguidanceof

Prof.RichardBRUYERE

June2016

1

Declaration

Icertifythat:

i. Theworkcontainedinthisthesisisoriginalandhasbeendonebymeundertheguidanceofmysupervisor.

ii. Theworkhasnotbeensubmittedtoanyotherinstituteforanydegreeordiploma.

iii. IhavefollowedtheguidelinesprovidedbyHECParisinpreparingthethesis.

iv. IhaveconformedtothenormsandguidelinesgivenintheEthicalCodeofConductoftheschool.

v. WheneverIhaveusedmaterials(data,theoreticalanalysisfigures,text)fromothersources,Ihavegivenduecredittothembycitingtheminthetextofthethesisandgivingtheirdetailsinthereferences.

vi. WheneverIhavequotedwrittenmaterialsfromothersources,Ihaveputthemunderquotationmarksandgivenduecredittothesourcesbycitingthemandgivingrequireddetailsinthereferences.

PahunJAIN

2

Acknowledgement

ItakethisopportunitytoexpressmysinceregratitudetoProf.RichardBruyereforhissupport,guidanceandencouragementthroughouttheresearchandthesis-writingprocess.Hiscalmdemeanorandprofoundunderstandingofthesubjecthelpeddefinetheresearchgoalsclearlyrightfromthebeginningandsupportedmeateverystageoftheprocess.

IamalsogratefultoProf.JeanEdouardColliardforhelpingmeunderstandandappreciatethecomplexregulationsassociatedwithvariousfinancialsecuritiesthroughourinteractionsduringthecourse‘FinancialRegulation’atHECParis–MajorFinance.

PahunJAIN

3

Abstract

ThispapertalksabouttheregulatorychangesthathaveaffectedthestructureoftheCollateralizedLoanObligations(CLOs).CLOsareimportantfinancialinstrumentsthathelpdistributetherisksofbanksandotherloanissuinginstitutionstooutsideinvestors.Theseinstrumentsareextremelyusefultoprovideliquiditytotheotherwiseilliquidmarketofleveragedloans.Thefinancialcrisisof2008exposedthestructuraldeficienciesandloopholesinthepre-crisisvintageCLOstructures,popularlycalledasCLO1.0.

Thisledtoaseriesofregulationspassedbyvariousregulatoryauthoritiesaroundtheworld.Thischangingregulationsenvironmentandlackofinvestorinterestduetohugewrite-offsinthethenexistingCLOsledtoadramaticfallintheCLOissuancesafterthecrisisperiod.TheregulationshelpedcreateasaferandmoretransparentstructureforinvestorstherebyboostingtheirconfidenceandtheCLOissuancesatalaterstage.TheseCLOsof2011and2012vintagesaretherebypopularlycalledasCLO2.0.

TheCLO2.0hadabetterperformancerecordovertheCLO1.0transactions.TheymandatedissuerstoretainthecreditriskswhenplacingtheCLONotesandabolishedtheloantodistributestrategywhichhadbecomecommoninthepre-crisisperiod.TheCLOissuancelevelsandtheassetsundermanagementreboundtopre-crisislevelespeciallyintheUnitedStatesbutthentheVolcker’sRulewaspassed.

Volcker’sRulemandatedthatallCLOsof2.0structurearetobeclassifiedascoveredfundsandthatinvestmentsbybankingentitiesintosuchstructuresneededtobesupportedbycorrespondingTier1Capital.ThisclassificationhurttheCLOindustrydramaticallywiththeCLOissuancesfallingsharply.TheCLOmanagersrespondedbyfindingwaystogettheCLOstobeexemptfromthisclassificationandthisledtothedevelopmentofanewVolcker’sRulecompliantCLOstructureorpopularlyknownasCLO3.0.

TheCLOhavehadaturbulenthistorywithseveralregulationsandmacroeventsaffectingitsstructure.Therehasbeenachangeinitsinvestorcompositionaswell.ThepaperfollowssuchchangesandcommentsontheseeventsandtheimpactofitontheCLOindustryanditsvariedparticipants.

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TableofContents

Declaration

Acknowledgements

Abstract

I. IntroductionII. CLOOverview

A. HistoryoftheCLOMarketB. ConceptandimportanceofCLOsC. MarketparticipantsandrolesD. KeytermsofaCLOE. LifecycleofaCLOF. DifferenttypesofCLOs

i. StaticversusManagedCLOsii. BalancesheetversusArbitrageCLOsiii. CashFlowversusMarketValueCLOsiv. CashversusSyntheticCLOs

G. KeyRiskFactorsofaCLOIII. CLO1.0vsCLO2.0

A. OverviewB. MajorDifferences

i. Over-CollateralizationandCreditEnhancementofSeniorTranchesii. CollateralRestrictionsiii. ReinvestmentPeriodsiv. Non-CallPeriodsv. NoteCancellationstoimproveO/Cvi. TranceRefinancingvii. PricingandExcessSpreads

C. RePricingsD. Cov-LiteLoansE. RiskRetentionF. ExampleofapreandpostcrisisCLOTransactionG. PerformanceofCLO2.0ascomparedtoCLO1.0

IV. CLO3.0A. VolckerExemptCLOStructuresB. TheImpactofVolcker’sRule

Conclusions

Bibliography

5

I. Introduction

Financialinstitutions,andbanksinparticular,havetraditionallycollecteddepositsfromthosewhohavemoneyinexcessoftheirconsumptionorinvestmentneedsandredistributeittothosethathaveafinancingneed;theyactasintermediariesbetweenborrowersandlenders.These‘lenders’thuslendtothefinancialinstitutionsasdepositorsofmoney.Thefinancialinstitutionsthentakeuponitselfandmanagestherisksassociatedwithlendingtosuchindividuals,publicbodiesand/orcorporationsthatborrowfundsbytransformingshort-termdepositsintolong-termloans.

Financialinstitutionshavelongstruggledtomanagetheaforementionedrisks.Theinherentrisksinmanagingthedifferenceindurationsoftheseinstitutions’assetsandliabilitiesandthemanagementofthecredit/counterpartyriskshavebecomeamajorconcernforthebanks,moresointhecurrentageofincreasedregulatoryrequirementswhichinturnaffectsprofitabilitybyrequiringadditionalequity.Theseinstitutionshavelongexploreddifferentmechanismstomanagetheserisksonandoffbooks.Thisledtotheuseofanassetsecuritizationstructureknownasa“CollateralizedLoanObligation”,or“CLO”,tomeettheirfinancialobjectives.CLOsenablebankstosellportionsoflargeportfoliosofcommercialloans(orinsomecases,theassociatedcreditrisks)directlyintointernationalfinancialmarkets,andofferbanksameansofachievingavarietyofgoalssuchasbutnotlimitedto–

• Transferofcreditrisktothirdparties• Offbalancesheetaccountingtreatment• Increasedliquidityofbilateraland/orsyndicatedloans• Accesstoefficientfundingsourceforlendingorotheractivities,generallywithalonger

durationthandeposits• Overallreductioninregulatorycapitalrequirementsandincreasedprofitability

ThefirstmajorCLO-$5billionR.O.S.E.FundingNo.1Ltd.TransactionwasplacedsuccessfullyinNovember1996byNationalWestministerBankPlcandthetrendsoonexplodedintheworldfinancialmarkets.MorethansixteenbankCLOtransactions,accountingfor$34.1billionofratedsecurities,wereclosedin1997.Anincreasinginvestorappetitebuoyedbyalucrativereturnonthesefixedincomesecurities,andtheincreaseduseoftheseinstrumentstomanagebanks’risksduetothefavorableaccountingtreatmentpostCLOstructuringledtoanincreasednumberofsuchtransactionsinthemarket.SinceanincreaseddiversityoftheunderlyingincreasedthecreditratingofCLOs,larger,diverseandmorecomplexCLOstructuresstartedappearinginearly2000swhichwerefavorablyratedbytheratingagencies.AsecondlevelandsometimesathirdlevelofstructuringtodevelopsecuritieswithotherCLOsasunderlyingstartedtoappearinthemarketandwereconsideredsaferduetoagreateramountofdiversityoftheunderlyingpoolofassets.

TheincreasedproliferationofCLOswasaccompaniedbyanincreaseinthenumberofCLOmanagersandCLOfunds,whichhadwarehousingfacilitiestobuyloansandthensecuritizedthesaidloansthroughanSPVtootherinvestors.Mostofthetimes,theCLOissuerretainedaneconomicandcreditriskinthetransactionbysubscribingtoapartofthesecuritybutbetween2005and2007,severalsecuritieshadaloan-to-sellstructurewhereintherewasnoriskretentionbythepartymakingtheoriginalloantotheborrower.AnotherimportantpartyinvolvedduringthisperiodofincreasedCLOactivityweretheratingagencies.Theywereresponsibleforassigningratingstosyndicatedloanscomprisingthecollateralof

6

CLOsandalsoratedthedifferenttranchesofthesecuritiespost-structuring.Theinstitutionalinvestors,suchaspensionfunds,whowereprincipalinvestorsinthesefixedincomesecuritiesduetotheirhighpayoutbasedtheirriskassessmentsontheratingagencies’recommendationsanddidlimitedduediligenceofthesameduetoincreaseddifficultiesoriginatingfromthecomplexstructuresofthesesecurities.

Inthefinancialmarketcrashof2007-08,securitiessuchasABSandCLOstookahugehit.ThesystemicfailurecausedduethefinancialcrisisprovedthesupposedlydiverseunderlyingassetsofCLOstobeveryhighlycorrelatedandsawthefailureofanumberofsuchsecurities.TheEuropeanCLOmarket,comparatively,didmuchbetterbutsufferedfromtheincreasedapprehensivenessofinvestorstoinvestinthesesecuritiesresultinginwidenedspreadsowingtoincreasedassumedrisks.TheannualCLOissuancefellfrom$88.9bnin2007to$0.8bnin2009.TheCLOmarkethassincerecoveredbuttheissuanceamountdroppedrecentlyinresponsetonewregulations.

CLOs,andsecuritizationingeneral,havesparkedaheateddebateamongtheinternationalfinancialmarketparticipants.RegulatorybodiesunderstandtheimportanceofsuchsecuritiesandhavebeentryingtocomeupwithnewerandbetterregulatoryandstructuralchangestotheCLOstobuildupinvestorconfidenceinthesesecurities,whichhadplummetedpostcrisis.ThisledtothedevelopmentofanewtypeofpostcrisisCLOstructurepopularlyknownasCLO2.0(pre-crisisCLOstructuresarenowpopularlycalledasCLO1.0).ThenewCLO2.0structuresaredeemedsaferbyregulatorsandinvestorsalikeandfeaturebettercreditprotectionfortheseniortrancheholdersandenforcetheissuerstoretainsomeamountofriskinthesecuritiesbeforesellingthemintothemarket.ThenewCLOsconformingwiththeprescribedCLO2.0structureshaveperformedbetterthantheirCLO1.0counterparts.ThishasenabledtheCLOmarkettobouncebacktoitspre-crisislevels.

In2014,Volcker’sRulewasputintoplaceintheUnitedStateswhichclassifiedthethenpopularCLO2.0structuresascoveredfundsandmakingitdifficultforbankingentitiestoinvestinthesame.Thebanksneededtoposttier1capitaltoholdeventheseniortranchesofthesesecuritiesresultinginlowerreturnsonequityforthem.CLOsseniortrancheshavehadbankingentitiesastheirmostprominentinvestors,therefore,Volcker’sRulewasahugesetbackfortheCLOindustryespeciallyintheUS.MassivelobbyingeffortshavebeenlaunchedbytheparticipantsoftheCLOindustrytopursuetheregulatorstoreevaluatetheclassificationofCLOsintocoveredfunds.Meanwhile,severalCLOmanagershavelaunchedVolcker’sRuleconformingCLOs,popularlyknownasCLO3.0,thatareexemptfrombeingclassifiedascoveredfundsmakingiteasierforbankingentitiestoinvest.Thatsaid,thesenewerstructuresprovidealowerreturnandtheinflexibilityoftheunderlyingportfoliohasmadethemriskiertherebyprovingtheregulationtobecounter-productive.

Therefore,theCLOmarketisever-changingandextremelydependentonnewregulations.TheCLOmanagershavebeenabletokeepupwiththeconstantregulatorychangessincethegreatfinancialcrisisof2008andhavelaunchednewerstructuresintheformofCLO2.0andCLO3.0.ThesenewCLOtypeshavehelpedrevivetheCLOmarketandattractbacktheinvestorstothisveryimportantassetclass.Thatsaid,acloseeyeneedstobekeptontheissuersandtheregulatorsasthenewerstructuresarearesultofthelobbyingtusslebetweenthesetwoprimarymarketparticipants.AbrieftimelineoftheCLOMarketisshowninExhibit1onnextpage.

7

Exhibit1:CLOMarket:Timeline

FirstCDOstructurecreated

backedbyapoolofhighyielding,

speculativegradebonds

(CBOs)

CDOmana-gersstarted

issuingsecuritiesbackedbyapoolofonlyleveragedloanport-folio(CLOs)

CreditDownturn

HighyieldCBOmarketpracticallyended

CLOmarketsflourishandbecometheprimarybuyerofnewissueleveragedloans

CLOmarketstemporarilyshut-offinwakeof

creditcrisis

ResurgenceofCLOmarkets(CLO2.0)

RiskRetentionRegulationsgointo

effectintheUS

CDOmanagersstartedincludingleveragedloaninthecollateralpool

CLOissuancegainsmomentum

Lowrecoveriesinspeculativegradebonds

CLOmarketcontinuedtogainmomentum

NewpeakissuanceintheUSduring2014

On-goingchangesfromUSandEuropeanregulatorybodieswithrespecttorisk-retentionandCLOcomposition

Leveragedloanasacollateralbecamemoreappealingdueto:− Higherrecoveries

− Floatingrateswhichreducedinterestriskandobviatedtheneedforainterestrateswap

Fixedtofloatingasset-liabilitymis-matchincreases

Atonepoint,nearly50-60%ofnewloanissuancesweresecuritized

RiskretentionregulationsgointoeffectinEurope

CBOsbackedbyhighyieldspeculativegradebondsfalloutoffavor

Loanscontinuedtotradecloseto90centsdespitemarketrecession

1998 1990s Early2000 2002 2004-2007 2008-2009 2010-2015 2016

Source:ING,WellsFargo

8

II. CLOOverview

ACollateralizedLoanObligation,orCLO,isaspecialpurposevehicle(SPV)thatacquiresaportfolioofdiversifiedsyndicatedleveragedloansthroughprivateplacementofrateddebtandequitysecurities,providinginvestorswithdifferentiatingriskandrewardprofiles(Collateralizedloanobligations:Accounting,tax,regulatory–Deloitte).Thespecial-purposevehicleisfinancedwithseveraltranchesofdebt(typicallya‘AAA’ratedtranche,a‘AA’tranche,a‘BBB’tranche,andamezzaninetranche)thathaverightstothecollateralandpaymentstream,indescendingorder.Inaddition,thereisanequitytranche,buttheequitytrancheusuallyisnotrated.

Aleveragedloanisacommercialfinancingprovidedbyagroupofcreditors.Suchloansgenerallyconsistofrevolvingcreditand/ortermloanfacilitiesandaretradedintheopenmarket.

CLOstructuresaredesignedtoprovide–

• creditenhancementthroughportfolioovercollateralization• prioritiesofpaymentstoensurehigher-ratedsecuritiesreceiveavailable• fundspriortosubordinatedsecurities• areinvestmentperiodinwhichavailableprincipalproceedsareused• toacquireadditionalportfolioassets• mechanismstoprotectinvestorsfromportfoliodeterioration

Exhibit2:TypicalCLOStructure

PortfolioofSyndicated

Loans

PrivatelyPlacedRatedSecurities

Equity/PreferenceShares

PRIOITYOFPAYMENTS

CLOSPV

Trustee

AssetManager

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A. HistoryoftheCLOMarket

CLOsareatypeofCDOthatuseleveragedloansinthecollateralpool.CDOswerefirstissuedinthelate1980s,andthefirstCLOswereissuedaboutadecadelater.

AlthoughafewbigbankbalancesheetCLOswereissuedinthelate1990s,themarketremainedrelativelysmallforaboutadecade.Intheearly2000s,institutionalinvestorsstartedseekingouthigheryieldingalternativeinvestmentsbecauseoftheincreasedinterestrateriskcausedbythehistoricallylowinterestratesatthetime.Thecorporatedebtdefaultrateswerestartingtodecreaseafterspikingin2002tojustover8%.Thefloatingratenature,seniorityandsecurityinthecapitalstructuremadeexposuretoleveragedloansappealing.CLOsseveredasaneasyandgoodoptionfordomesticandforeigninvestorsaliketogainexposuretotheUSleveragedloanmarketwithouthavingheadministrativeburdenofsettlingleveragedloansdirectly.

Exhibit3:GrowthoftheCLOMarket

Source:“AcaseforCLOs”June2013–ShenkmanInvestorNote,CLOi,Creditflux.com

13.3 14.6 9.1 12.1 16.2 25.5

52.6

97 88.9

13.50.8 4.1 12.3

53.8

89.7

140.1

110.4

17.9

0

50

100

150

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

CLOnewissuancebyyear

4255

3931 35

63 69

11098

173

10

28

69

0

20

40

60

80

100

120

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

NumberofUniqueManagersIssuingCLOs

10

CLOissuancereachedapeakin2006when$97billionofdealswereboughttothemarket.Thestrongtrendcontinuedinto2007,withanother$89billionsubscribedbyinvestors.By2008,however,theweaknessinsub-primecollateralledtoaglobalCreditCrisis,whichdramaticallyaffectedinvestorinterestinallstructuredproducts,includingCLOs.The2008CLOissuancewasonly$13.5billion,c.14%of2006levels.TheCreditCrisisalsocausedthedefaultofleveragedloanstoincrease,andthedefaultratesofsuchloansreachedalmost10%in2009.

Bythelate2010,theeffectsoftheCreditCrisisstartedtodiminishanddefaultratesbegantodeclineagain.Investors,althoughcautiousofre-enteringthestructuredproductmarketasmanyoftheirCDOportfoliossufferedhugelosses,carriedoutincreaseddue-diligenceofsuchproductsandanalyzedtheirhistoricalperformancepreandduringtheCreditCrisis.CLOinvestorsquicklyrealizedthatusingleveragedloansascollateralandthestructureofaCLOofaCLOdifferedsubstantiallyfromothertypesofCDOs.Fearsofdouble-digitdefaultratesandmajor“EventsofDefault”intheCLOstructurewereoverblown.Moreover,vastmajorityofactivelymanagedcashflowarbitrageCLOs,onceperceivedtheriskiestofCLOtypes,remainedintactastheywerebackedbyarealpoolofleveragedloans.

Atyear-end2012,S&Pestimatedover$280billionin670transactionsofCLOswereoutstandingnetoftransactionsthathavebeencalled(S&P’sUSCLOTransactionCount&AssetsundermanagementbyCollateralManagerasofDec2012–RobertJRadziul).AsofMay2013,thereareapproximately$310billionofCLOsundermanagement.Moreover,CLOsrepresentthesinglelargesttypeofinvestorininstitutionalleveragedloanstoday,accountingforoverhalfofallprimaryinstitutionalleveragedloansthatcometomarket(AcaseforCLOsJune2013–ShenkmanInvestorNote).

Exhibit4:CLOPrimaryMarket

Source:“AcaseforCLOs”June2013–ShenkmanInvestorNote

60%

0%10%20%30%40%50%60%70%80%

CLOShareofPrimaryInstitutionalLeveragedLoans

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B. ConceptandImportanceofCLOs

TounderstandtherationalebehindthecreationofCLOs,wehavetodiscusstheimpactoftheseinstrumentsonthreekeypartiesinvolved:

i. Businesses/Corporatestakingoutoriginalloansfrombanksii. Banksgivingoutaforementionedloansandsellingthemtoinvestorsiii. Businesslenders/Investorsbuyingsuchstructuredproducts

i. Business/Corporatestakingoutoriginalloansfrombanks

Corporatesborrowmoneyfrombankstoconducttheirbusinessandtoinvestinprojects.Theseloansaregenerallycollateralizedandaremonitoredbythebanks.Thecostofborrowingthesaidmoneyforthecorporates,theinterestrate,dependsonthecreditworthinessofthebusinessesandthecollateralposted.Anotherimportantaspectofthecostofborrowingistheavailabilityoffundsforborrowing.CLOscreateanincreasedsupplyofinvestormoneyforthecorporatestoborrow.Moreover,theyhelpmakethepreviouslyilliquidcorporateloansmuchmoreliquidastheybecometradableonseveralexchanges.Thisincreasedliquidityandsupplyofinvestormoneyforthecorporatesdirectlyimpactsthecostofborrowingforthem.

ii. Banksgivingoutaforementionedloansandsellingthemtoinvestors

Bankslendtocorporatestocreatelongtermassetsfromtheirshorttermliabilitiesofbankdepositsandotherinstruments.Thedifferenceindurationsoftheseinstitutions’assetsandliabilitiesandthemanagementofthecredit/counterpartyriskshavebecomeamajorconcernforthebanks,moresointhecurrentageofincreasedregulatoryrequirementswhichinturnaffectsprofitabilitybyrequiringadditionalequity.Theseinstitutionshavelongexploreddifferentmechanismstomanagetheserisksonandoffbooks.CLOsenablebankstosellportionsoflargeportfoliosofcommercialloans(orinsomecases,theassociatedcreditrisks)directlyintointernationalfinancialmarkets,andofferbanksameansofachievingavarietyofgoalssuchasbutnotlimitedto–

• Transferofcreditrisktothirdparties• Offbalancesheetaccountingtreatment• Increasedliquidityofbilateraland/orsyndicatedloans• Accesstoefficientfundingsourceforlendingorotheractivities,generallywithalonger

durationthandeposits• Overallreductioninregulatorycapitalrequirementsandincreasedprofitability

BanksuseCLOstoimmediatelysellloanstoexternalinvestors/lenderssoastofacilitatethelendingofmoneytobusinessclientsandearnfeeswithlittletonorisktothemselves.

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iii. Businesslenders/investorsbuyingsuchstructuredproducts

CLOsprovideanexposuretothe,otherwiseinaccessible,leveragedandcorporateloanmarketstoretailinvestors.Theseinstrumentsprotecttheinvestorsfrominterestrateriskswhileprovidingthemanincreasedreturnthanotherformoffixedincomeproducts.Historicallyspeakingtheperformanceoftheunderlyingassetsforthesesecuritieshasbeenexceptionalwithdoubledigitdefaultratesseenonlyoncesincetheirinception–intheCreditCrisisof2008,eventhenthesesecuritiesoutperformedothersbyahugemargin.ThisincreasedperformanceofthesesecuritiesisachievedbycombiningmultipleloansbutnottransmittingtheloanpaymentsequallytotheCLOowners.Instead,theownersaredividedintodifferentclasses,called"tranches",witheachclassentitledtomoreoftheinterestpaymentsthanthenext,butwiththembeingaheadinlineinabsorbinganylossesamongsttheloangroupduetothefailureofthebusinessestorepay.Normallyaleveragedloanwouldhaveafixedinterestrate,butpotentiallyonlyacertainlenderwouldfeelthattheriskoflossisworththeinterestthatischarged.Bypoolingmultipleloansanddividingthemintotranches,ineffectmultipleloansarecreated,withrelativelysafeonesbeingpaidlowerinterestrates(designedtoappealtoconservativeinvestors),andhigherriskonesappealingtohigherriskinvestors(byofferingahigherinterestrate).

Therefore,thewholepointofissuingCLOsistolowerthecostofmoneytobusinessesbyincreasingthesupplyoflenders(attractingbothconservativeandrisktakinglenders).Theyalsoservetominimizetheriskprofilesofbanksandmakingtheirassetsmoreliquidinnature.

CLOswerecreatedbecausethesame"tranching"structurewasinventedandproventoworkforhomemortgagesintheearly1980s.Veryearlyon,poolsofresidentialhomemortgageswereturnedintodifferenttranchesofbondstoappealtovariousformsofinvestors.Corporationswithgoodcreditratingswerealreadyabletoborrowcheaplywithbonds,butthosethatcouldn'thadtoborrowfrombanksathighercosts.TheCLOcreatedameansbywhichcompanieswithweakercreditratingscouldborrowfrominstitutionsotherthanbanks,loweringtheoverallcostofmoneytothem.

Thus,theCLOservedallthreemajorpartiesinvolvedinthetransactionandbyreducingthecostofborrowing,helpedboosttheeconomyaswell.Problemsarosewhentheincreaseddemandofsuchsecuritiesbyinvestorsinmid2000sandtheabilityofbankstotransfercounterpartyriskstothirdpartiesledthemtoconductdecreasedduediligenceonthecreditworthinessoftheborrowers.Moreover,structuralcomplicationsincertainsecuritiesandincreasedleveragingimplodedduringtheCreditCrisis.

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C. MarketParticipantsandRoles

CLOindustryconsistsofavarietyofmarketparticipantscollaboratingtogethertomakeitsuccessful.Someoftheseparticipantsandtheirrespectiverolesaredetailedbelow.

i. ThePlacementAgent

ItisacommercialorinvestmentbankthathasbeenmandatedbytheissuerortheCLOmanagertostructureandplacetheCLO’sunderlyingsecuritiesandotherassets.Theplacementagentactsasaliaisonbetweenotherimportantpartiesandleadsthemarketing,pricingandclosing-dateactivities.Itmayormaynotalsoprovidethewarehousefacilitiesdependingonthecapitalrequirementsofthebankingentity.

ii. TheCollateralManager

ThecollateralmanagerortheassetmanagerisresponsiblefortheacquisitionandmanagementoftheunderlyingassetsoftheCLO.TheassetmanagerhastooperatewithintheconstraintsspecifiedbytheCLO’scollateraleligibilitycriteria,theconcentrationlimitsandovercollateralizationandotherteststhroughoutthelifeoftheCLO.

iii. TheTrustee

TheTrusteeisarepresentativeoftheinvestorsandperformsthenecessaryfiduciarydutiesforthem.He/sheisthecustodianoftheCLO’sassetsandcashflowsandtransferstheavailablefundsintoinvestoraccountsonduedatesinaccordancetothecashwaterfall,ifany.Thetrusteealsomonitorsthecollateralmanagers’managementofthefundassetsandensuresthatalltheeligibilitycriteriaarefulfilledwhentransferofthesaidassetsissanctionedbythecollateralmanager.ThetrusteehascertainvotingrightsduringthelifecycleoftheCLO.

iv. TheCollateralAdministrator

TheCollateralAdministratoractsonbehalfofthetrusteetoperformthebookkeepingoftheunderlyingassetsoftheCLO.Thecollateraladministratorisrequiredtoproducemonthlyandquarterlyreportsfortheinvestorsandthetrusteedetailingtheperformanceoftheunderlyingpoolofassetsanditscompliancetothepre-determinedeligibilitycriteria.

v. TheInvestors

Investors,asthenamesuggests,investsinthedifferenttranchesofaCLO.Eachinvestormighthaveadifferentreasontosubscribetoaparticulartranchebasedontheirriskaversionandthespreadsthey

14

mightseek.Typically,theseniortrancheortheinvestmentgradenotesareheldbybankingentitiesandinstitutionalinvestorssuchascommercialbanks,insurancecompanies,pensionfunds,mutualfundsetc.Investorsinthemezzaninenotesandintheequitytranchearegenerallyspreadseekingrisktakingfundssuchashedgefunds,privateequityfundsetc.

vi. TheCreditRatingAgencies

TheCreditRatingAgencies(StandardandPoor’s,Moody’sandFitch)assignratingstotheunderlyingassetsofaCLO.Theseratingsarebasedonthecreditratingoftheobligorandhisorherabilitytopaybacktheirdebts.ThecreditratingagenciesalsoprovideratingtothedifferenttranchesofaCLOtransaction.Theseratingsarebasedoncertaintestsperformedbytheseagenciesanddifferentagenciesmighthavedifferentprocesstoratethesetransactions.Theratingagenciesalsomonitorthehealthofthesenotesduringthelifeofthetransactionandpublishassociatedupgradingordowngrading,ifany.Theseagenciesmonitorthefund’sabilitytorepayitsinvestorsinatimelymannerandtypicallyanyimpactontheunderlyingassetpoolalsoimpactsthecreditratingoftheCLOtransactions.

vii. TheAttorneys

Aswithallotherfinancialtransactions,attorneysareimportantplayersintheCLOindustry.Duetothelargenumberofmarketparticipantsinvolvedandtheimportanceofthestructureanditscompliance,attorneyshavetheirworkcutoutinatransaction.Differentpartiesemploydifferentcounselstorepresentthemandguardtheirinterestssuchasthecollateralmanagerandthetrustee.TheCLOfundalsoemploysitsowncounseltohelpitdraftthearticlesofincorporation,bylawsandmotions/minutesofaCLOfunds’boardofdirectors’meeting.

viii. TheAccountants

TheaccountantprovidestheaccountingservicesandpassingonsuchinformationtotheassociatedpartiesduringthelifeoftheCLO.

(Collateralizedloanobligations:Accounting,tax,regulatory–Deloitte)

15

Exhibit5:PartiesinvolvedinaTypicalCLOTransaction

SPV Investors

TrusteeRatingAgenciesCollateralPool

(LeveragedLoans)

PortfolioManager

InvestmentBank

(Underwriter)

16

D. KeyTermsofaCLO

i. Warehouse

Theprocessbywhichtheportfoliomanagerbeginstoaccumulateassets(buyloans)foracashCLO.Thisgenerallybeginsoncethecontractbetweenthemanagerandunderwriterissignedandcanlastfromsomeweekstoafewmonths.Thisisaperiodofhighriskfortheportfoliomanagersastheriskisallappropriatedbythem.Duetosubstantialregulatorycapitalrequirementduringthewarehousingperiod,manydealstodayaredonewithoutawarehouse.

ii. Ramp-UpPeriod

Bythetimeofpricingofthetransaction,theportfoliomanagermighthaveonlyacquired50-75%oftheproposedportfolio.Theramp-upoccursafterclosingwhereintheportfoliomanageracquirestherestoftheportfolio.

iii. EffectiveDate

ThedatebywhichthePMmustacquire100%oftheportfolio;CLOcompliancetests&covenantsapply.

iv. DiversityScore

Ascore,originallydevelopedbyMoody’s,whichmeasurestheindustryandissuerdiversificationoftheportfolio.Thescorecapturesindustry-relatedcorrelationbygroupingobligorsinto33industriesandassigninganumericalvaluetoeachindustrythatreflectsthenumberandrelativesizesofobligorswithinthatindustry.ThehighertheDiversityScore,themorediversetheportfolio.

v. WeightedAverageRatingFactor(WARF)

AweightedmeasurementofeveryassetintheportfolioofaCLOwhichservestoprovideauniformmethodofcomparingtheratingsofdifferentportfolios.AhigherWARFscoreisindicativeoflowerqualityofunderlyingassetsandthereforeahigherriskprofile.TheWARFratingscaleispresentedbelow:

Rating Factor Rating Factor Rating FactorAaa 1 Baa1 260 B1 2220Aa1 10 Baa2 360 B2 2720Aa2 20 Baa3 610 B3 3490Aa3 40 Ba1 940 Caa1 4770A1 70 Ba2 1350 Caa2 6500A2 120 Ba3 1766 Caa3 8070A3 180 Ca&lower 10000

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vi. PD,EADandELModelling

PDistheProbabilityofDefault,EADistheExposureatDefaultandEListheExpectedLoss.Thesethreetermsareinter-relatedbytheformulabelow:

EL=PDxEAD

Thesetermsarecalculatedand/ordeterminedfordifferenttranchesofaCLOtransactionthroughvariousstresstestsandfedintoaMonteCarlosimulationtodeterminethecorrespondingratingsofthesame.ThisisapopularratingsapproachusedbyS&PandFitch.Eachhavetheirownmodelsandmethodsofdeterminationofthekeytermsbutmostofthetimestheratingsgivenarequitesimilarinnature.

vii. Over-Collateralization(O/C)Test

Over-Collateralizationistheprocessofpostingmorecollateralthanisneededtoobtainorsecurefinancing.Thus,thetestmeasurestheratioofunderlyingcollateralversustheclass(tranche)inquestion(andallclassesaboveit).TheOver-Collateralization,orparvalue,testrequiresthatthecollateralportfolioexceedtheratedbondsbytheminimumtriggerlevelassetoutintheOfferingMemorandum.

Forinstance, ClassCO/C = TotalParofPerformingCollateral

ParofClassA+ClassB+ClassC

viii. InterestCoverage(I/C)Test

TheInterestCoverageRatioisequivalenttoADSCR,i.e.theratiotodetermineifthecollateralpoolgeneratesenoughcashinteresttoservicetheoutstandingdebtontheparticularclassofthesecurity.InterestCoverageRatioforeachclassiscalculatedsimilartotheO/Ctest,bydividingthetotalinterestgeneratedbythecollateralbytheinterestrequiredtopaytheexpensesandserviceeachclassofdebtaboveit.

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E. LifecycleofaCLO

AlthoughtherearemanytypesofCLOswithvaryingtypesoflifecycles,thetypicallifecycleofanaverageCLOcanbesummarizedinthefollowingfourmainstages:

i. MarketingandAssetAccumulation(0-6months)

Thisisthebeginningphasewhereintheportfoliomanagerandtheunderwriteragreeupontheunderlyingstructuralelementsandassumptionsofthetransaction.Investorappetiteisassessedbytalkingtoafewinitialinvestors.ThePortfolioManageralsobeginstotalktobanksandotherfinancialinstitutionstoidentifyandevenbuypotentialleveragedloansfortheunderlyingportfolio.TheCLOisthenpriced(settingafinalpriceforalltranches)andclosedaboutamonthlater,duringwhichtimethePortfolioManagerpurchasesmajorityoftheunderlyingloanassetsoftheportfolio.

Theearlymonthsofthetransactiongenerallyfollowsthetimelinedescribedbelowduringthisphaseofthetransaction:

• Onemonth: Documentationofthedeal,warehouse(ifused),OfferingMemorandum,andInvestmentManagementAgreement

• One/twomonths: Marketingofthedebtandequitytranches• Pricingdate: Oncefundingforalltrancheshasbeenarranged,apricingdateisestablishedto

determinethespread.Thespreadisdeterminedonthebasisoftheinvestorinterestandoverorundersubscriptionbythesaidinvestors.Typically,50%oftheunderlyingportfoliohasbeenpurchasedbythepricingdate.

• Closingdate: Closinggenerallyoccurs2-3weeksafterthepricingdate.Attheclosingdatetheentiredealfundsandliabilitiesstarttoaccrue.Approximately75%oftheunderlyingportfoliohasbeensuccessfullyacquiredbythePM.

• Effectivedate: ThePMneedstohaveacquired100%oftheportfoliobytheclosingdate.RatingAgenciesalsogivefinalratingstoalltranchesbythisdate.Theeffectivedateisgenerallynotmorethan4monthsaftertheclosingdate.

ii. Non–CallPeriod

EquityinvestorscanchoosetocallandclosetheCLOcompletelyatalaterstage.However,mostCLOhaveapre-determinednon-callperiodwhereintheequityinvestorscannotexercisetheirright.Thisisessentialasitassuresnon-equityinvestorsthattheCLOwillbearoundforatleastafewyears.

iii. ReinvestmentPeriod

Duetorepaymentofprincipalofcertainunderlyingloans,theremightbeacashsurplus.Therearetwoalternativesforthesame.ThePortfolioManagercaneitherpassdownthesefundstothetrancheholdersofthesecurityorreinvestthesameintonewleveragedloansthatmightfulfillpre-determined

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covenantsandchecks.There-investmentperiodisstatedduringthestructuringofthetransactionandthePortfolioManagercannotreinvestfundsoutsideofthisperiod.Recentvintagetransactionshavehadafour-yearreinvestmentperiod.

iv. Wind–Down

Asdiscussedbefore,attheendofrepaymentperiodallprincipalrepaymentsfromtheunderlyingpoolofassetsmustbepassedontotheCLOtrancheholdersstartingfromAAAtrancheholders.However,astheAAAsgetpaiddown,theaveragecostoffinancingthepoolgoesup,therefore,thiswind-downperiodusuallylastsabout18monthsbeforetheentiredealiscalled.

Exhibit6:LifecycleofaCLO(source:FinancialTimesArticle:TheGreatCLODeleveraging,May23,2012)

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F. DifferenttypesofCLOs

i. StaticversusManagedCLOs

Asthewordsuggests,StaticCLOshaveastaticpoolofassetsthatarenotactivelymanagedbytheCLOmanager.OncetheunderlyingassetsintheStaticCLOsarepaidoff,theamountsarepassedontothepaperholdersoftheCLOandthepooloftheunderlyingassetssubsequentlydecreases.

ManagedCLOsontheotherhandhavetheirunderlyingassetsactivelymanagedbytheCLOmanagers.Uponthereimbursementoramortizationofafewunderlyingassetsothersimilarassetsthatadheretopredefinedrulesandconditionsareboughttoreplacethem.ThelevelofmanagementoftheunderlyingmayalsodifferfromoneCLOstructuretoanother.SomeCLOsonlypermitreplacementoftheunderlyingloansonlyiftheexistingassetsarefullyrepaidwhereasothersallowtheCLOmanagertoreplacenon-performingassetsintheunderlyingportfolio.

ThemanagedCLOshavethereforeadynamiccollateralpoolandthemakeupofthepoolmaydifferovertime.ThenewregulationshaverestrictedtheactivemanagementoftheunderlyingassetpoolsbytheCLOmanagertomakethemlessriskyandtoprovideinvestorsaconstantandpre-determinedassociatedriskswiththeportfolio.

ii. BalanceSheetversusArbitrageCLOs

BalanceSheetCLOsarethepurestformofCLOswhichwereinitiallycreatedtoreducethebank’sregulatorycapitalrisksbysecuritizingthecertainassetsandremovingthem,andtheassociatedrisks,fromthebank’sbalancesheet.InnewerCLOstructures,thisishardertoachieveastheissuerisrequiredtoretaincertainriskintheportfolio.Nevertheless,itisapopularwayforbankstomanagetheirregulatoryriskcapitalrequirements.

ArbitrageCLOsaremainlycreatedtotakeadvantageoftheadditionalincomesgeneratedbythepoolofassetsovertheinterestpaidonthedifferentnotesoftheCLO.ThisisquitepopularwhentheinvestorappetiteforCLOsoralternativeinvestmentsishighandthereforethecostoffinancingtheunderlyingpoolofloansisreduced.

iii. CashFlowversusMarketValueCLOs

CashFlowCLOsaresecuritieswheretheunderlyingpoolofassetsisassessedontheparvalue.Sincetheparvalueisnotdependentonmarketmovements,thevalueoftheunderlyingcollateralremainsfairlyconstantunlesstherearesomeredemptions.

MarketValueCLOsontheotherhandaresecuritieswhoseunderlyingpoolofcollaterizedloansareassessedatthemarketvalueofsuchassets.Thetransactionisthussubjectedtomark-to-marketandthepricevolatilitydependsonthemarketvolatility.

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AlthoughtheMarketValueCLOsareabletobetterassessthevalueofthesecuritiesifliquidationiscarriedout,thecorrectassessmentofthemarketvalueoftheunderlyingisoftendifficultasmostofthecollateralpostedisfairlyilliquidinnature.

iv. CashversusSyntheticCLOs

CashCLOsbuyrealassets(actualleveragedloansasunderlyingcollateral).TheaforementionedloansareremovedfromthebalancesheetofthesellerandaretransferredtothebalancesheetoftheSPVorthebuyer.

InaSyntheticCLOstructure,theoriginalowneroftheloansbuysthecreditprotectionfromtheSPVandpaysapredeterminedfeestotheparty.Incaseofdefault,theSPVneedstoreimbursetheowneroftheloansoftheamountowed.Inthistransaction,theloansarestillheldbytheoriginalownerandarenottransferred,onlythecreditriskistransferredtotheinvestorsofthetransaction.Thecounterpartyriskoftheinvestorsdefaultingincaseofdefaultoforiginalloansismitigatedthroughtheestablishmentofareserveorcashholdingaccountbythecustodianorthetrustee.

HistoricallymostCLOswerecashtransactionandnoorveryfewsyntheticCLOshavebeenprintedsincetheCreditCrisis.

v. AmericanversusEuropeanCLOs

LookingbackattheperformanceofCLOsduringthefinancialcrisisperiodof2008,theEuropeanCLOsperformedmuchbetterthantheirAmericancounterparts.Thisbetterperformancehasbeenattributedtotheperformanceoftheunderlyingcollateral.TheAmericanCLOshadagreaterpercentageofnonsecuredandsecondlienloansintheirportfolio.Theyalsohadahigherpercentageofcorporatebondsandothersecurities.EuropeanCLOsgenerallyhavebetterunderlyingcollateralastheiritisprimarilycomposedofseniorsecuredcorporateloanswithamuchhigherdiversityscorethanintheUS.Structurallytherewasn’tmuchdifferencebetweenthetwosecuritiesbutthedifferentperformancewasduetothedifferentialcollateralselectionandperformance.

NearlyalloutstandingCLOsandnewdealscomingtomarketcurrentlyaremanaged,cashflow,arbitragedeals.

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G. RiskFactorsassociatedwithCLOs

CLOshaveavarietyofassociatedriskfactorwhichcanbebroadlycategorizedinto:

i. StructuralRisksii. CollateralRisksiii. MacroeconomicandPoliticalRisks

ItisimportanttonotethateachtrancheofaCLOtransactionmaybesubjectedtodifferentriskfactorsinvaryingdegrees.

i. StructuralRisks

ThestructuralrisksarespecificallyapplicabletostructuredproductssuchasCLOs.Theyincluderisksassociatedtothestructuringofthesecurity,whichincludesleveragetests,non-callperiod,compliancetestsetc.Thereliabilityandeffectivenessofthethirdpartiesinvolvedinsuchatransaction,namelytrustee,custodian,lawyers,accountantsandratingagencies,alsoconstituteanimportantpartoftherisk.

TherelativeilliquidityofaCLOtransactionalsocontributestothisrisk.AsmanyCLOinvestorsconsidertheseinvestmentstobebuy-and-holdtypes,themarketsforthesesecuritiesisrelativelythinnerthanotherfinancialproducts.Inrecenttimes,asmallsecondarymarketforCLOtransactionshasappearedbutthemarketisstillinitsnascentstages.

AlthoughtheseStructuralRisksconstitutethemostimportantandprominentrisksofaCLO,theyarethemostpredictableandaccountableonesaswell.CLOstructuresaregovernedbypredeterminedrulesandthespecificdocumentsrelatedtothemaremadeavailabletotheinvestorspriortothepurchase.Inmanycases,earlyinvestorsareaskedtocontributetowardsdeterminingthestructureofaCLOtransaction.

ii. CollateralRisks

TheyarethecounterpartyrisksassociatedwithinvestingintheCLOtransactions.Thiscategoryofriskarisesfrominvestinginsecuritiesbackedbysub-investmentgradeand/orleveragedloans.Theyaredrivenbycreditspecificeventssuchasdefault,recovery,downgrade,speedofprepaymentsetc.CollateralriskscanalsoarisefromthecreditriskoftheCLOmanagerandhisabilitytoavoidormanagedefaultsandmaintainhighpaymentsfromtheunderlyingpooltosatisfythepaymentstotheinvestorsoftheCLOpaper.

CollateralrisksobviouslyvaryindifferentdegreesfordifferenttranchesoftheCLO.Forinstance,equitytranche,becauseitislocatedatthebottomofthecashwaterfall,isimmediatelyaffectedbyadefaultwhereastheAAAtrancheisbarelyaffected.LikeStructuralRisks,CollateralRiskscanbeanticipatedandareusuallymodelledinwhenpricingoftranchesoccurs.

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iii. MacroeconomicandPoliticalRisks

CLOtransactionsarefinancialinstrumentsandlikeotherfinancialinstrumentsareaffectedbythelargerMacroeconomicandPoliticaleventsthatcanimpactthepricingandliquidityofsuchinstruments.Theserisksgenerallyincludebroadriskssuchasfederalspendingcuts,theperformanceoftheeconomy,andmonetarypolicychanges.TheserisksarefairlyminisculeforCLOtransactionsespeciallyforCLOsmodelledaftercashflowswhereinthecollateralisnotmarkedtomarket.Butstilltheserisksareunpredictableandhardtomodelinthetransaction.

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III. CLO1.0vsCLO2.0

Duringthegreatfinancialcrisisof2008,theCollateralizedDebtObligationsincludingsecuritiessuchasMortgageBackedSecuritiesandCollateralizedLoanObligationsunderperformedandinvestors(mainlyinstitutionalinvestorssuchaspensionfundsandsovereignfundsetc.)whosubscribedtotoptranchesoftheseproductssufferedbiglosses.Thisledtothedevelopmentofanewstructurewhichwasdeemedsaferfortheinvestorsprovidingbetterriskassessmentandimprovedrisk-returnprofiles.Thereby,CLOsstructuredbeforethefinancialcrisishavebeentermedasCLO1.0andtheCLOsstructuredafter2008andcomplyingwiththesenewstructuresarelabelledCLO2.0.

Exhibit6belowshowstheUSCLOliabilitiesoutstandingforCLO1.0,CLO2.0&CLO3.0.ThegraphaptlyindicatestheincreasingproportionofnewCLOstructuredliabilitiesowingtoincreasedissuanceofCLO2.0andCLO3.0.

Exhibit7:USCLOliabilitiesoutstandingfrom2004through2014(source:WellsFargoSecurities)

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A. Overview

TheCLOmarkethadcompletelydriedupforacoupleofyearsafterthefinancialcrisis.Sincetheintroductionofthenewstructuralfeatureswhichgavebettercreditprotectiontotheseniortrancheholdersoftheaforementionedsecurities,therewasaresurgenceintheCLOmarketespeciallyintheUSCLOmarket.Exhibit7belowindicatesthenewCLOissuancesinUSDandEURinthepostcrisisperiod.Exhibit8showsthemostrecentpricedCLOsandtheirsizes.

Exhibit8:CLOnewissuancebyyear(source:CLO-i)

Exhibit9:RecentCLOissuanceasof11May2016(source:CLO-i)

ThisresurgenceoftheCLOmarketismainlyattributedtotheseveralchangesintheCLOstructurespostthefinancialcrisis.Someoftheseimportantstructuralchangesarediscussedinmoredetailbelow.

0 20 40 60 80 100 120 140

2010

2011

2012

2013

2014

2015

2016

EUR(bn) USD(bn)

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B. MajorDifferencesbetweenCLO1.0andCLO2.0

Asdiscussedbefore,theCLO2.0withtheirnewstructuresprovideabetterprotectiontotheinvestorsintheseniortranches.SomeoftheseimportantdistinguishingcharacteristicsinthenewvintageCLO2.0andCLO3.0structuresarelistedbelow.

i. OvercollateralizationandCreditEnhancementofSeniorTranches

Oneofthewaystoachievebetterprotectionforinvestorsisthroughenhancedsubordination,thatistheseniororAAAtranchesizesasapercentageofthecollateralaremuchsmallerthanbefore.ThisimpliesthattheCLOsecuritiescansustaingreaternumberofdefaultsoftheunderlyingcollateralbeforeaffectingtheseniortrancheswhencomparedtoequivalentpre-crisisCLOs.

Exhibit9showsthemediancapitalstructureofCLOsissuedin2006andinthe2012-2014period.TheAAAtrancheoftheCLO2.0sisnearly11%lessthanthatoftheirpre-crisiscounterpartsoralternatively,thepost-crisisCLOstructures’AAAtrancheshavec.11%moresubordinationthantheCLO1.0structures.Therehasbeenaneffectiveonetrancheshiftinthestructure–AATrancheofCLO2.0structurewouldhavebeentheAAAtrancheofCLO1.0structuresandsoon.Thisprovidesagreateramountofprotectiontonotjustthetoptranchesbuttoallsubsequenttranches.TheincreasedequitysliceandwidenedBBtranchecompensatesforthisshift.

Exhibit10:Pre-Crisisvs.Post-CrisisCapitalStructures

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Anotherwaytointerpretationofthistrancheshiftinthenewstructureisobtainedthroughstudyingtheenhancedcreditsupportfortheinvestorsofeachtrancheandbyanalyzingtheirrespectivecreditsupports.Exhibit10indicatesthecreditsupportsforeachtrancheandclearlyshowsthatalowertrancheinthenewpost-crisisstructureenjoysthesamecreditenhancementasahighertranchefromthepre-crisisstructureCLOs.

Exhibit11:AssetCreditSupportSubordination(%ofCreditSupportBasedonCLOAssets)

2006Vintage 2012-2014VintagesAAA 25.0% 36.1%AA 18.6% 24.8%A 12.8% 17.5%BBB 8.1% 12.5%BB 5.6% 8.1%

Source:S&P,Moody’s,Creditflux,Intex,WellsFargoSecurities

ii. RestrictionsonEligibleCollateral

Anothernoteworthychangeinthepost-crisisCLOproductsistheirchoiceofunderlyingcollateral.PostthefinancialcrisisalotofemphasishasbeenlaidonprovidingguidelinestotheCLOmanagerstodefinetheeligiblecollateralforCLOsecurities.Thepercentageofseniorsecuredleveragedloansintheunderlyingcollateralhasincreasedsincethefinancialcrisiswhereasinvestmentsinhighyieldbondsandseniortranchesofothersecuritieshasreducedsubstantially.ThemorerecentVolckerizedCLO3.0structuresdonotpermitanyinclusionofHYBondsorresecuritizationofsecurities.

Anotherimportantrestrictionthathasbeenputintoplacehasbeenregardingthegeography.AnincreasingnumberofCLOsecuritieshaveunderlyingcollateralspecifictotheplaceofissueofthesecurities,forinstance,theUSCLOshavealmostallofitsunderlyingleveragedloansascollateralwrittenintheUS.ThisisabigshiftfromtheCLOcollateralofprecrisisCLO1.0.

Restrictionoftheeligiblecollateralwasputinplacetohelpsafeguardtheinvestors’interestinthesesecuritiesbutonthecontrarythispracticehasledtotheCLOmanagersholdingontosomeriskiersyndicatedloanstoremainfullyinvestedduetotheunavailabilityofcollateralconformingtotheeligibilitycriteriaputinplace.TherehasbeengreaterneednowthanevertomonitortheunderlyingcollateralanditsriskinessonanongoingbasisandhascreatedanagentproblemwhereintheinvestorinterestandtheCLOmanagerinterestisnotaligned.ThisdiscrepancyhasbeenrecognizedandhasbeentriedtobemitigatedwhendiscussingtheCLO3.0structuresbutwithlimitedsuccess.

Exhibit11belowshowcasesthechangeintheunderlyingcollateralforpreandpostcrisisCLOtransactions.Asdiscussed,theshiftinunderlyingcollateralfrombondsandsecuritiestosyndicatedand/orleveragedloanscanbeclearlyseen.In2014and2015,thatisaftertheintroductionofCLO3.0structures,acompletedisappearanceofbondsandtheresecuritizationpracticeisglaringlyclear.

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Exhibit12:AverageCompositionofCLOCollateralbyVintage

iii. ReinvestmentPeriods

AsdiscussedbeforewhendescribingthelifecycleofaCLOtransaction,almostallCLOshaveaninitialramp-upperiodwhereapoolofunderlyingcollateralisdevelopedbyselectingandpurchasingofleveragedloans,bondsandsecuritiesbythecollateralmanager.DuringthesubsequentlifeoftheCLO,thereisamortizationofnotesoccurwhereinproceedsfromthematurityofunderlyingassetsispassedontothenote-holders.InstaticCLOs,ramp-upperiodandamortizationperiodsaretheonlytwoperiods.However,inmorecommonactivelymanagedCLOs,thereisalsoareinvestmentperiodduringwhichtheCLOmanagerisallowedtoselectandbuyothercollateraltoreplacematuredsecuritiesintheunderlyingportfolioofassets.Thisreinvestmentisusuallydefinedbeforehandandeligibilitycriteriaforthenewsecuritiesisputinplace.Howeveroncethenewsecuritiessatisfytheeligibilitycriteria,thereinvestmentsareuptotheCLOmanager’sdiscretion.TheCLOscouldbelightlymanagedwhereonlysomenonperformingassetsarereplacedorcouldbeactivelymanagedwhereCLOmanagerscanreplacecollateralwithmorefrequencytosearchforbetterriskrewardprofiles.

Longerreinvestmentperiodsareusuallyperceivedasriskierfortheinvestorsasitexposesthemtointerestrateriskduetotheunpredictabilityofdurationandweightedaverageinterestrateoftheunderlyingcollateral.InvestorsalsotakeonthepoorinvestmentdecisionriskoftheCLOmanagerforalongerperiod.Thatsaid,reinvestmentperiodshavebeendeemednecessarybytheinvestorsasitgivesanoptiontotheCLOmanagerstoweedoutnonperformingassetsandgivesthemflexibilityinchoosingtheassetsandincreasetheriskrewardprofileofthecollateralpool.

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AsExhibit12indicates,thereinvestmentperiodsinpre-crisisCLO1.0usedtobec.6-7yearsascomparedtoonly3-4yearsforpostcrisisCLO2.0.Therefore,investorsinCLO2.0andCLO3.0areexposedtolesserreinvestmentriskascomparedtoduringthepre-crisisperiod.

iv. Non-CallPeriods

AlmostallCLOshaveabuiltinprovisionthatallowstheequitytrancheinvestorstocallbacktheoutstandingnotesatalaterdatebeforetheactualmaturityoftheCLOnotes.Thisisdonemainlywhenmarketvolatilityandconditionsmakeitnon-worthwhilefortheequitytrancheholderstotakeonthegivenamountofriskfortheprojectedIRRs.Seniortrancheholdersarealsosatisfiedwiththisprovisionastheyareabletoclaimtheirnoteprincipalsatfacevalueorapre-agreedvaluetherebymitigatinganyrisk.TheCLOmanagerisusuallytheunhappiestpersonduetothisprovisionashelosesprecioustimeandresourceshehasspenttobuildupacollateralpooltoonlyseeitbeingusedtopaybacknotesthathavebeencalledearly.

Thenon-callperiodisthetimeperiodaftertheissuanceoftheCLOswhereintheequitytrancheholderscannotcallbackthenotesdistributedtothehighertrancheholdersirrespectiveofhowbadtheconditionsmightbecome.Usuallyalongernon-callperiodisdetrimentaltothenoteandequityholdersasitremovestheoptionalityandexposesthemtogreatermarketrisk.Theseniortrancheholdersmightgetexposedtogreatermarketrisktooasnon-liquidationoftheCLOduetothenon-callperiodmightwipeouttheequitytranchecompletelyandstartaffectingtheirtranchesaswell.

Exhibit12clearlyindicatesthattheCLO1.0hadalongernon-callperiodofc.5yearsatthetimeofissuancewhereastheCLO2.0haveamuchshorter2-3yearsofnon-callperiod.Infact,thenewerVolckerizedCLO3.0haveanoncallperiodofonly1.5years.Therefore,thenewerpostcrisisCLOstructureshaveashorternon-callperiodtherebyprovidingagreateramountofsecuritytothenote-holdersoftheCLOs.

v. RestrictionsonCLONoteCancellationstoImproveO/C

TheO/CtestsorOver-CollateralizationtestsareoneofthemostimportanttriggersindetermininganEventofDefaultoranEoD.Theseniortrancheholders’interestsarethoughttobesafeguardedaslongastheO/Ctestispassedthatistheparvalueofthecollateralpostedasunderlyingdividedbytheparvalueofthenotesoutstandingisaboveapredeterminednumber,often105%.Incaseofsevermarketconditionsand/orwrite-downssuchasthedepreciationofthefacevaluesofloansduringthefinancialcrisis,theO/CtestmayfailandmighttriggertheEoDresultingintheliquidationofunderlyingcollateralbytheTrusteeandpassingonthefundstothenote-holders.

TheO/Ctestwassupposedtohelpprotectthenote-holdersandtohelpmaintainaminimumamountofunderlyingcollateralaboveandbeyondtheoutstandingliabilitiesornotes.Butduringthewakeofthefinancialcrisis,someCLOmanagersboughtbacksomeofthejuniorand/ormezzaninetranchesoftheCLOsathugediscountstoreducetheiroutstandingliabilitiesandtherebypassingtheO/Ctests.Thejuniorandmezzaninetrancheholderswerehappytoselltheirnotesatadiscountbecausetheywerehappytoreceivesomethingasopposedtotheprospectivenothingduetotheadversemarket

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conditions.TheseniortrancheholdersnolongerexperiencetheEventofDefaultastheCLOspasstheO/Ctestsandtherebypreventingthetrusteefromliquidatingtheassetstopaydowntheliabilities.Buttheseniortrancheholdersareinfactinadirersituationafterthisasapartofthecollateralisusedtobuybackthemezzanineandjuniortranchesandtheybearthewholeriskofthedefaultofthecollateralandthereforethenotes.

Inthenewerstructurespostcrisis,thisuseofexistingcollateraltobuybacknotestosatisfytheO/Ctestshasbeenbanned.ThetrusteecansellsomecollateraltopaydowntheseniortrancheholderstosatisfytheO/Ctestsbutcannotpaythejuniorormezzaninenoteholdersbeforepayingtheseniortrancheholders.Effectively,thecashwaterfallismorestringentlyenforcedintheCLO2.0andCLO3.0.ThesamehasbeenindicatedclearlyintheExhibit12.

vi. Trancherefinancing

Duetodecreasedmarketappetiteandlowliquidity,theleveragedloansmarketcompletelydriedupafterthefinancialcrisis.Thisinturnledtoincreaseddifficultytorefinancetheleveragedloansthatwereduetoexpireimmediatelyafterthefinancialcrisisthatisfrom2009to2012.Manyborrowerstriedtorefinancetheirliabilitiesthroughthehighyieldbondmarketwithlittletonosuccess.ThisledtothedevelopmentofAmend&Extendtransaction.Amend&ExtendorA&Etransactionsenabledborrowerstorefinancepartoftheirexistingdebtthroughnegotiatingandgainingtheapprovalofatleast50%ofthelenderstoextendthepayoutdateoftheirliabilities.Theseliabilitiesarerestructuredtoprovideahigherinterestrateandafeetoretaintheexistingcreditarrangementswithalongermaturity.Thesearrangementsareextremelyhelpfultobothborrowersandlendersalikeastheysavebothcounterpartiesconsiderableamountofmoney,effortandtime.

ThesearrangementscreatedhugecomplicationsfortheCLO1.0structures.Theserenegotiatingofliabilitiestogetalongermaturityledtotheweightedaveragedurationoftheunderlyingcollateralpooltobemuchlongerthanitwaspreviouslyanticipated.Thisinturncreatedamismatchinthepaymenttermsofthenote-holdersandthepayoutofthecollateralpool.SincetheA&EtransactionscreatedalotofcontroversyaroundtheirtreatmentbytheCLOmanagers,thenewerCLOstructurespostcrisishaveexplicitrulestoeffectivelytacklethesetypeofextendedloanswhichwaslackinginthepre-crisisCLO1.0.

vii. PricingandExcessSpreads

WehavetalkedabouthowtheCLO2.0andCLO3.0structuredpostthefinancialcrisisissaferandcarrylesserrisks.Thisdoesn’ttranslatetothepricingofthesenotes.TheexcessspreadovertheLIBORforCLO2.0ismuchmorethanthecorrespondingexcessspreadsforCLO1.0.AsExhibit12indicates,theweightedaveragecostoffundsforCLO1.0was120to155basispointsbelowthatoftheCLO2.0.

Thisismainlyduetobuildbackinvestors’appetiteintheCLOsecuritiesandthehighcouponsaregiventonote-holderstopromotetheirtrustintheseinstruments.Therefore,goingforwardthenewerCLOstructureshavebeenmadesaferforinvestorsandareofferingthembetterreturnsthanthepre-crisisCLO1.0.Thatsaid,intherecentyears,particularlyinthelowinterestrateenvironments,theincreased

31

availabilityofcheaperloanstoindividualsandinstitutionsalikehavemadethecollateralpoolofsuchCLOsecuritiesmuchcheaper.ThiscoupledwiththeincreaseddemandofCLOtranchesamonginvestors,mainlyinstitutionalinvestors,haveledtotighterspreadsofnewerCLOtransactions.

ThedemandforhighercouponsintheCLO2.0and3.0structurestoensureinvestorsagainstpossibledefaultsbyreducingthedurationofthesecuritieshasledtoalowerexcessspreadsinthesetransactionsdespiteahigherweightedaveragecostoffunds.ThesameisillustratedintheExhibit12below.

Exhibit13:StructuralFeaturesandInvestorProtectionsinPreandPostCrisisCLOTransactions

CLO1.0 CLO2.0 CLO3.0

a) CreditSupportforSeniorTranche(s) Low High Higher

b) CollateralRestrictionsa. CLOBucketb. HYBondBucket

5-10%5-10%

0%

5-10%

0%0%

c) ReinvestmentPeriod 5-7Years 3-4Years 3-4Years

d) Non-CallPeriod 3-5Years 2Years 1.5Years

e) NoteCancellationstoImproveO/C n/a No No

f) TrancheRefinancing No AfterNon-CallPeriod

AfterNon-CallPeriod

g) PricingandExcessSpreadsa. ExcessSpreadsb. Couponsc. Weightedaveragecostoffunds

HigherLower

50-70bps

LowerHigher

170-225bps

LowerHigher

170-225bpsSource:D.PrestonandJ.McNeilis,“TheInvestor'sGuidetoCLOSeniorNotes,”WellsFargoSecurities(April15,2015)

InadditiontothestructuraltweakslistedaboveintherecentCLOtransactions,whichensuredmorestabilityandsafetyofthesesecuritiesandbuildinginvestors’confidenceandappetiteforsuchsecurities,someotherimportantstructuralelementswereintroducedthatdistinguishedCLO2.0andCLO3.0fromtheirpre-crisiscounterparts.Suchdifferencesareenumeratedinmoredetailinthenextfewpages.

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C. RePricings

AnewfeaturethathasbeenintroducedinmanyrecentCLO2.0structuresistheRe-Pricingclause.AnumberofCLO2.0transactionsareapproachingtheendoftheirnon-callperiodsandinthelowinterestrateenvironmentoftoday,thereisanincreaseddemandbyequityholdersandCLOmanagerstorefinancetheCLOsecuritiesasthespreadsoftheunderlyingloancollateralhastightened.There-pricingtoolisamoreefficientwaytoachievethisrefinancingandismorecostandtimeeffective.

Re-Pricing,asthenameindicates,isthereadjustmentofthespreadsoftheCLOtranchesattheendofthenon-callperiodstocorrectlytranslatethetighterspreadsoftheunderlyingcollateral.There-pricingclauseisoftentriggeredbytheequitytrancheholdersortheCLOmanagersandisofferedasanalternativetotherefinancingoftheCLOsecurities.Inarefinancingdeal,oftennewtermsarediscussedandagreedwithbetweentheCLOManagerandthetrancheholdersortheinvestorsofaparticulartranchegettingrefinanced.Toprotecttheinterestoftheinvestorsoftranchesnotpartoftherefinancingdeal,thenewrefinancingcontracthastoabidebythefollowingfewrulesandconditions:

i. Thespreadontherefinancingdebtcannotexceedthatoftherefinancednotesii. Limitedrecourseandnon-petitionprovisionsshouldbeincludedintherefinancingagreementsiii. Thenewlyagreedpaymentstructureshouldabidebytheexistingwaterfallstructureofthe

transactioniv. Therefinancingholdersshouldn’tgetanypreferentialtreatmentwhendecidingtheirvoting

rights.Infact,thevotingrightsoftherefinancingholdersshouldbethesameasthatoftheexistingholders

v. Anapprovalfromtheratingagenciesisrequiredstatingthatnodowngradingoftheexistingtrancheswilloccurasaresultoftherefinancing

vi. Ataxoptionneedstobeprovidedforexistingandnewdebt

RefinancingonlyresultsinthereadjustmentofthespreadovertheLIBORorequivalentbenchmarkandcansaveconsiderableamountandmoneythatwouldhavebeenotherwisespentinfindingandmarketingthenewofferingtoprospectivenote-holders,gettingtaxcounselandgettingthevarioustranchesratedbytheratingagencies.Ifstructuredproperly,there-pricedtransactionsarenottermedasanewofferingtherebylimitingtherequirementofpreparationanddisseminationofnewofferingmaterials.

UnderrecentCLOstructures,there-pricingclauseistriggeredbythemajorityequityholders.OftentheAAAtrancheisexemptfromanyre-pricingsbutitispossibletore-pricethesetranchesaswellifagreedbeforehand.Anoticeforre-pricingisprovidedatleastamonthortwoinadvancesothatthenote-holderscantakeadecisiononwhethertheywouldprefertheirnotestobere-pricedortobecalledback.Suchnon-consentingnote-holderswouldbepaidbacktheirprincipalinfullalongwithanyaccruedinterestandthenoteswouldbesoldtoconsentingnote-holdersorintothemarketbyare-pricingmarketintermediary.Ratingagenciesdonotneedtoprovideconfirmationsinthesere-pricingscenariosbuttheyarestillnotifiedifandwhensuchaclauseistriggeredbytheequityholdersofthesecurities.

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Re-PricingclauseshaveobviousbenefitstotheequitytrancheholdersandCLOmanagersastheyprovideacheaperandfasterwaytorefinancetheCLOissuers’notes.Thedebt-holdersmightalsopreferthetransactionstore-pricedasitisafasterandcheaperalternativetoredeployingtheircapitalinnewtransactionswithincreasedduediligencerequirements.Moreover,intoday’slowinterestrateenvironmenttheredemptionofthenotesoncethenon-callperiodisoverisinevitable.Thatsaid,somedebtholdersareskepticalofincreasedrisksofre-pricingofsecuritiesupontheearliestsignsofdecreasedcollateralspreads.Therefore,anumberofguidelinesorconditionshavebeensetinplaceaccompanyingthere-pricingclauseinthelatestCLOindentures:

A. ProofneedstobeprovidedbytheCLOManagerthattheunderlyingcollateralspreadshavetightenedbymorethanacertainpredefinedthresholdbeforethetriggeringofthere-pricing

B. Apre-agreedone-timepaymentneedstobegiventonote-holdersofaparticulartrancheofsecurityifthere-pricingofthesaidtrancheoccurs.ThissumcanbecalculatedtobebelowthecostthatmighthavebeenotherwiseincurredbytheCLOManagertocallbackthenotesandrefinancethetransaction

C. Apre-definedminimumpercentageofcurrentnote-holdersneedtoagreetore-pricingbeforetheclausecanbeenforcedbytheequitytrancheholders

CLOmanagersandequityholdersarguethatsincethere-pricingsoccurafterthenon-callperiodhasended,theaboverestrictionsshouldn’tnecessarilyapply.

Anothernoteworthypointisthetaxsavingsthatcanbeincurredbydebt-holdersiftheyagreetore-pricingstherebyreinforcingtheargumenttore-priceinsteadofrefinancingtransactions.

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D. Cov-LiteLoans

Cov-Liteloans,orcovenantlightloans,areloansissuedwithlittleornomaintenancecovenants.Cov-Liteloansaregenerallydeemedtoberiskierthantheircounterparts–leveragedloanswithestablishedandstrongmaintenancecovenants.Thisestablishedfacthas,however,recentlybeendebateduponheavilywithbothpartieslistingargumentsintheirfavor.Peoplewhoagreewiththeestablishedpropositionthatcov-liteloansareindeedriskiersaythatsincethereisalackofmaintenancecovenantsintheissuedloan,thereislittlecontrolofthedebtorontheloanprovidedandheorshestandstolosemoreifnotallhisorherinitialloanamount.Peopleontheothersidecounterthatsincecov-liteloansareprovidedbybankstopeoplewithgoodcreditscoresandhistoryasopposedtoloanswithstrongmaintenancecovenants,theyarelesslikelytodefaultintimesofstress.Moreover,theysay,creditscoresandhistoryoftheborrowershouldbeusedtoassesstheriskofdefaultoftheloanthanthenumberofcovenantsassociatedwithit.Indeed,empiricaldataindicatesthatcov-liteloansinthepasthaveperformedbetterthantheircounterpartsandtheprincipalrecoveryrateofdefaultedloansisatparwiththemaswell.Procov-liteloansgroupalsomaketheargumentthattheincreasedflexibilityprovidedbythelackofcovenantsallowtheborrowertomaneuvererthemselvesintimesofdistresstherebymakingthemselvesabletopaybacktheirborrowingswithgreatereasethaninthecasewhenthemaintenancecovenantsforcetheborrowers’handsandhisorherbusinessstartsgettingdictatedbylender.

Duringthepre-crisisperiod,thepercentageofcov-liteleveragedloansinthetotalleveragedloanspoolwasc.15-20%.Thiswasmainlybecauseoftheincreaseddemandforsuchloansbycorporatesandinstitutionsallowingbankstodictatetheirtermswhenissuingsuchloans.In2010-2011period,therewasasurplusofcashthatcouldbelentoutasopposedtothenumberofborrowers.Theborrowerscould,therefore,startdictatetermswhenborrowingfrombanksandasurgeintheissuanceofcov-liteloansstarted.Todayc.50-60%ofthetotalleveragedloanmarketiscomposedofcov-liteloans.Thecov-liteloanissuancesinthepre-crisisperiodweremadeonlytoaselectfew,oneswithexceptionalcredit-worthinessandstellarcredithistory.Inthelowinterestrateenvironmentoftodayandincreaseofspreadseekingcapital,moreandmorecov-liteissuancesarebeingmadetolesscreditworthyclientele.Therefore,theargumentoftheprocov-liteloangroupasdiscussedinthepreviousparagraphwhereintheysaidthatitismorebeneficialtoissuecov-liteloanstoclientswithhighcreditworthinessthantoissueloanswithlargenumberofrestrictivemaintenancecovenantstoclientswithaweakerandunprovencredithistory,getsdefeated.Thatsaid,thereisstillanincreasedamountofduediligencecarriedoutbybankswhenissuingcov-liteloansthanwhenissuingloanswithrestrictivemaintenancecovenants.

ThismovementintheleveragedloanmarkethasbeenreflectedintheCLOStructuresaswell.Thepre-crisisCLOmanagershadalmostnoorlessthan15%ofcov-liteloansintheirunderlyingcollateralpool.15%wasalsothepercentageofcov-liteloansinthegeneralleveragedloanspool,thereforethisnumberwasagoodproxytobeusedfortheCLOcollateralpoolcompositionaswell.InthepostcrisisCLO2.0period,thedecreasedavailabilityofmaintenancecovenantsrichloanshasdiminishedandCLOmanagershavestartedtoincludemorecov-liteloansintheirunderlyingpoolcompositionwithsomeCLOcollateralpoolscontainingasmuchas70%cov-liteloans.ArecentCLOtransactionwasstructuredwith100%cov-liteloansascollateralpoolmakingitthefirstofitskindtransaction.TheCLOmanagershavestartedtolaymorefocusonthecreditqualityoftheborrowersoftheunderlyingloansthanonthepresenceor

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absenceofmaintenancecovenantsarguingthatsuchapracticeisshort-sightedaspointedoutbythefailureofsuchloansduringthefinancialcrisis.

Therecentincreaseintheissuanceofcov-liteloanshaveledtothetransformationoftheCLO2.0structuresandindentureswhereCLOmanagershaveadaptedtothemarketconditionsandloansavailabilitybymodifyingthedefinitionofcov-liteloans.SomerecentCLOindenturesindicatethattherestrictionsontheloanstobeincludedintheunderlyingcollateralpoolisnolongerbasedonthepresenceorabsenceofmaintenancecovenantsbutonthebasisofthehierarchyofthesaidloansinthedebtstructureofthecorporateortheborrowingentity.Theincludedloanshavetobeparipassuwiththeseniorloansoftheinstitutionandthereshouldbecrossdefaultclausesandtriggeringofmaintenancecovenantsofotherloansintheloanstructureoftheborrowingentityshouldtriggeradefaultoracallforthesaidloanaswell.ThesedefinitionsareusedtodefinethenewereligiblecollateralloansfortheCLO2.0transactionsasopposedtoCLO1.0transactionswherethecov-liteloanswithlittleornomaintenancecovenantswereexcludedfromthecollateralpool.Thestructureshaveincreasedthebasketofcov-liteloansintheCLO2.0andhaveintroducedaclausethatallowstheCLOManagertobuymorecov-liteloansifthemajorityofcontrollingclassofnote-holdersagreetoit.

Oftheratingagencies,onlyS&Phasexpresseditsconcernsovertheinclusionofcov-liteloansintherecentCLOtransactions.S&Pdoesaseverehaircutfortherecoveryrateofcov-liteloansandthereforemakesitunviableforanumberofCLOmanagerstogettheirtransactionsrichincov-liteloanstoberatedbyS&P.Therefore,thepercentageofrecentCLOtransactionstoberatedbyMoody’sorFitchhasincreasedalthoughS&Pstillmaintainsalion’sshareofratingintheCLOmarket.

Theperformanceofthesecov-literichCLOtransactionsisyettobeseenbutitdoesshowtheadaptabilityoftheCLOstructurestotheunderlyingleveragedloanmarket.Sincethissurgeintheissuanceofcov-liteloansisnotsustainableandthiscov-liteloanbubbleisboundtoburstatsomepoint,wemightbeabletoobserveanotherdramaticshiftinthetheCLOstructureswhichwouldresonatewiththischange.Butfornow,CLO2.0haveseeminglyadaptedwelltocoverthelowinterestrateenvironmentinducedcov-liteloansinthestructures.

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E. RiskRetention

AnumberofCLOsstructuredpre-crisiswerebelievedtofollowan‘OriginatetoDistribute’strategy(OtDStrategy)whereintheCLOmanagersorotherissuersissuedorcollectedloanswiththesolepurposeofstructuringtheminvarioustranchesanddistributingthemtoinvestors.Theyhopedtogainfromthedifferenceinthespreadsbetweenthoseoftheunderlyingloansandthatofthedifferentnotes.ThisdefeatedtheoriginalpurposeoftheCLOtransactions,thatis,structuringoftheilliquidloansintomoreliquidCLOSecuritiestoraisecapitalandallowinvestorstoinvesttheirmoneyinlucrativedealswithbetterspreadsthanothersecuritiesinthemarketwithsimilarrisks.Thefinancialcrisisof2008sawthewidespreadfailureofsuchsecuritiesandexposedtheweakloanunderwritingstandardsassociatedwiththewidespreadissuancesofsuchnotes.Amajorreasonfortheexistenceofsuchlooseunderwritingstandardswasidentifiedtobethelackofriskretentionbytheloanissuingorsponsorbody,thatis,theissuerortheoriginallenderretainednorisksassociatedwiththeunderlyingloansanddistributedallthetranchestothirdpartyinvestors.ThehighdemandforsuchsecuritiesmadeitpossiblefortheCLOmanagerstofindinvestorstoinvestintheriskiestequitytrancheorthetrancheofthefirstlossatrelativelytightspreads.PostthecrisisperiodandtheidentificationofthisOtDstrategyregulatorsandinvestorsalikeaskedtheissuersandlenderstokeeptheirown‘skininthegame’implyingthattheissuingorlendingpartiesshouldretainapredeterminedstakeandassociatedrisksinthetransactionforthelifeofthesecurity.Thisisalsoknownasriskretentionrequirements.

ThisisperhapsoneofthemostimportantstructuraldifferencesbetweentheCLO1.0andCLO2.0andforthatmatterCLO3.0.TherewerenosuchriskretentionrequirementsinCLOsofoldervintage(CLO1.0andearlyCLO2.0).Post2011,withfirstintroductionofsuchrules,CLOshavealwayshadariskretentionclauseintheirindenturesbutthepercentageriskretentiondiffersgreatly.TheriskretentionrulesintheUnitedStatesandinEuropehavebeenproposedandre-proposedmultipletimessincethefinancialcrisis.ThisconstantchangeintherulespertainingtoriskretentionresultsinconstantchangesinthestructuresofCLOtransactions.SomeearlyCLO2.0transactionshavebecomenon-compliantwiththeEURiskRetentionRegimesincetheEUreviseditsearlierproposedriskretentionrulesinMay2013forimplementationfromJanuary2014.UnitedStates,ontheotherhand,startedtotakeacloserlookatitsownriskretentionlawsinlate2012andcameupwiththeirownsetofriskretentionguidelinesforqualifyingCLOtransactioninMay2013.TheUS’andtheEU’sriskretentionregimes,unfortunately,donotoverlapwitheachothermakingitverydifficultforCLOmanagerstostructuresecuritiesqualifyingforinvestmentsbyinvestorsfrombothsidesoftheAtlantic.

i. EURiskRetentionRegime

Witnessingthemarketturmoilinthefinancialmarketscausedbythesub-parperformanceoftheAssetBackedSecurities(ABS)duringthefinancialcrisis,thefinancialworldhadtopayacloserlookatthestructuringofsuchdeals.Large,unexpectedlossesaccompaniedbybigwrite-offsintheunderlyingcollateralofsuchsecuritiesledtheindustryparticipantsespeciallytheregulatoryauthoritiestobelieveintheoverlyrelaxedloanunderwritingstandards.TheBaselCommitteeonBankingSupervision(BCBS)wastherebymandatedbytheG20inApril2009tostudytheriskmanagementofsecuritizationsandanalyzetheduediligenceandquantitativeretentionrequirements.TheEuropeanCommission(EC)respondedbyimplementingtheArticle122aintheBankingConsolidationDirective–CRDIILegislative

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Package.Oneofthemaintakeawaysfromthisnewlegislationpiecewasthatasof1January2011,theEuropeanBankscanonlybeexposedtotherisksofinvestinginABSiftheoriginalissuer,lenderorsponsorhasretainedaneteconomicinterestofatleast5percent.Thisminimumretentionispopularlytermedastheriskretentionrequirement.ThelegislationalsoaskedtheCommitteeofEuropeanBankingSupervisors(CEBS)(precursoroftheEBA)toproposeguidelinesfortheconvergenceofthesupervisorypracticesinrelationtothefirstdirective.EuropeiscurrentlyintheprocessofimplementingBaselIIIproposalsintheformofCRDIVLegislativeDirectivesandtheCRR.TheCRRortheCapitalRetentionRequirementActintheCRDIVdirectiverepeatsalmostverbatimtheinitialriskretentionrequirementsestablishedinCRDIIandprovidesasetofguidelinesforitsregulatorybodiestofollowtochecktheimplementationoftheaforementionedlegislations.

TheCRRappliestosecuritiesthatwillbestructuredfromthedateofimplementationoftheaforementionedlegislationandtransactionsthatwerecomplianttothepublishedlegislationatthetimeoftheirstructuringinthepastremaincomplianttotheCRRevenpostitsimplementation.ThisisnoteworthyasthisstarklydiffersfromtheUSRiskRetentionRegimewherethenewlegislationappliestopast,presentandfuturetransactionswithanaddedriskthatanysuchnewlawinfuturewoulddirectlyimpactthetransactionsstructuredtoday.

ii. TheUSRiskRetentionRegime

TheBoardofGovernorsoftheFederalReserveSystem,FederalDepositInsuranceCorporation,DepartmentofHousingandUrbanDevelopment,FederalHousingFinanceAgency,OfficeoftheComptrollerftheCurrency,andSecuritiesandExchangeCommission(collectively,the‘Agencies’)onAugust282013re-proposedrulesforimplementingtherequirementsofSection941oftheDodd-FrankWallStreetReformandConsumerProtectionAct(the‘DoddFrankAct’).ThekeytakeawayofthesemodifiedrulesasentailedintheDodd-FrankActisthattheagenciesarerequiredtoprescriberegulationsthat:

a. Requiresecuritizerstoretainatleast5percentcreditriskofanysecuritizedassets(riskretentionrequirement)

b. Prohibitthesecuritizertohedgeortransferringallorpartofthecreditriskrequiredtoberetained.

Thisretentionrequirementisimplementedtopromoteanactivescrutinyandmonitoringoftheunderlyingassetpoolbythesecuritizertherebyaligningtheinterestofthesecuritizerwiththeinterestoftheinvestorstherebyeliminatingtheagencyproblem.

UnliketheEURiskRetentionrules,theUSRiskRetentionrulesapplytonotonlytransactionstobestructuredfromhereonwithbutalsotopasttransactionsthatwerestructuredwithoutcomplyingtotheseunpublishedrulesthen.ThisentailsabuybackofsomenotesfromtheequitytrancheinvestorstomakethesecuritycompliantwiththechangesproposedbytheDodd-FrankAct.Thatsaid,agraceperiodof2yearshasbeenprovidedtomakethesecuritiescompliantwiththenewriskretentionrulesoftheUS.

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iii. ThemajordifferenceintheUSandEURiskRetentionRules

Asdescribedearlier,thereisverylittleoverlapintheUSandEURiskRetentionRegimes.Althoughbothlegislations–theCapitalRiskRetentionActinCRDIVinEuropeandtheModifiedProposalsoftheSection941oftheDoddFrankActof2010,askforaminimum5percentriskretention,thereisnomentionofhowthisriskretentionwillbecalculatedandthereisalotofconcernoveralikeforlikemeasurementoftheaforementionedrisksinEuropeandintheUnitedStates.ButwewillassumethateveniftheassessmentofthecreditriskissimilarintheEUandintheUS,wearriveatoneofthemostimportantdifferencebetweenthetwolegislations–thedefinitionofthe‘riskretainer’.

BoththeUS’ModifiedRulesandEU’sRiskRetentionDirectiveaskstheissuingbodytoretainafixed,pre-determinedpercentageofriskbeforeaskingthirdpartyinvestorstoinvestinthesecuritytoaligntheinvestorinterestwiththatoftheissuingbody.

Asdiscussedabove,accordingtheEU’sCRRAct,theriskistoberetainedbytheoriginallenderorissuerandnotbytheCLOManagerwhomightonlybebuyingandstructuringtheunderlyingloansandthenmarkettothirdpartyinvestors.Therefore,ifabankhasmandatedaCLOManagertostructureandselltheirexposuretoleveragedloansontheirbalancesheet,thebanksareexpectedtoretainachunkofthecreditriskintheformoftheequitytranche.IncaseofasyntheticCLOtransaction,thebankscannot,forinstance,buytheCDSonthetrancheofthefirstlossintheCLOStructure.Thisismadetoensurethattheoriginallenderstillundertakesthenecessaryduediligencestepsanddoesn’tadoptlooseunderwritingpracticeswhenissuingtheoriginalloans.Thatsaid,itmakesitverydifficulttodecidewhotheissuingpartyortheoriginallenderiswhenloansfrommorethanonelendersaresourcedtobestructuredintoaCLOTransaction.Recently,aSpecialPurposeVehicle(SPV)formedbytheconsortiumoflendersoftheoriginalloanportfolioinvestsandholdstheequitytrancheoftheCLOTransaction.

TheUS’ModifiedProposalsoftheDoddFrankActontheotherhandasksthesecuritizer,orinotherwordstheCLOManager,toretainaminimumamountofcreditriskwhenissuinganABS.ThisisdonetoaligntheinterestsoftheCLOManagerwiththatoftheinvestors.TheriskretentionbytheCLOManagerwouldensureclosemonitoringandchecksbyhimorherontheunderlyingcollateralpoolonanongoingbasis.AnumberofCLOmanagershaveprotestedagainstthispracticeastheysaytheirprimarybusinessistobuy,structureandselltheloansfromaconsortiumoflenders(mainlybankingentities)andtheydonotgenerallyholdcapitaltoinvestintheaforementionedsecurities.ThefunctionoftheCLOManageristokeepacheckontheunderlyingpoolandreportinganydelinquenciesordefaultstotheinvestors.Thisfunctionneedstobefulfilledonanongoingbasisuntiltheendofthelifeofthesecuritiesandthenotes.GoingbythelogicoftheUSRegulators,ifandwhentheequitytranchegetserodedduetothefirstlossesincurredbytheCLOSecurity,theCLOManagerroleshouldbeeffectivelyoverastherewouldbenofurtherincentivetomonitorthecollateralpool.

AnothernoteworthydifferencebetweenthetworiskregimesistheapplicabilityofthelegislationsontheCLOStructures.InEU,thenewlegislationdoesn’trequireCLOtransactionsstructuredpre-financialcrisistobemodifiedandrestructuredtocomplywiththenewguidelineswhereasthisisnotthecaseintheUSwheretheoldertransactionsneedtobecalledbackinpartorasawholeandhavetobemadetocomplywiththenewModifiedProposalsoftheDoddFrankActtobecomeeligibleforinvestmentsfromUSinstitutions.

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Exhibit13belowshowstheslightoverlap,ifany,thatexistsbetweentheModifiedProposalsoftheUSandtheCRRActoftheEUregardingthequalifyingoftheCLOSecuritiesforinvestorsonbothsidesoftheAtlantic.

Exhibit14:OverlapbetweenModifiedProposalsoftheUSandtheCRRofEurope

PotentialRetentionProviders EligibleintheUS? EligibleinEurope?(fromJanuary1,2014)

CLOManagerasSponsor YesOnlysomeEUregulatedCLOmanagersthatmeetthedefinitionof‘Sponsor’

AffiliateofCLOManager Only‘majority-ownedaffiliates’ No

OriginalLenderYes

(LeadArrangerundertheAlternativeOption)

Yes,ifthedefinitionofthe‘originallender’issatisfied

OtherSponsor NoYes,ifthedefinitionof

‘originator’or‘sponsor’issatisfied

Source:D.Festa,N.Robinson&B.Youn,“CLO1.0vsCLO2.0–PartIIIofaseries”Milbank,Tweed,Hadley&McCloyLLP(November22,2013)

iv. MethodsofRiskRetention

UndertheEUCRRActandundertheoriginalproposalsoftheDoddFrankAct,theriskretentionproviderscouldsatisfytheriskretentionrequirementsthroughverticalriskretention,horizontalriskretentionoracombinationofbothinanL-shapedriskretentionstructure.UndertheModifiedProposalsoftheDoddFrankAct,theagenciesconsolidatedtheseoptionsintoacombinedriskretentionoptionthatwouldpermitanyoftheabovedescribedriskretentionfactorssuchthatthecombinedentityshouldbeatleast5percentofthefairvalueofallassetspostedascollateral.Thehorizontal,residualtranchecanalsobesatisfiedbytheestablishmentofareserveaccountintowhichcashequivalenttothe5percentrequirementisposted.

TheModifiedProposalsalsolistoutanimportantdetailthathasbeendefinedquitetroublesomebyseveralCLOmanagersoftoday.TheAgenciesstatethattheholderofthehorizontal,residualtranchesshouldn’tbeabletoreceivethepaymentsonthistranche’sfairvalueatafasterratethantheothernote-holders.Thisisquitedifficultsincethisimpliesthattheequitytrancheholderscannotreceiveanyexcessspreadsuntiltheendofthereinvestmentperiodtherebydeprivingthemoftheupsideofholdingtheriskiesttrancheforaverylongperiod.ThishasresultedintheinabilityoftheCLOManagertosuccessfullyplacetheequitytranchetothethirdpartyinvestorsandthehorizontaltranchehasbecomeoneofthemostcommonmethodsofriskretention.ThereisongoingdebateregardingthesamebetweentheCLOmanagersandtheAgencies.

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F. ExampleofapreandpostcrisisCLOtransaction

InthisexamplewewillseetwoCLOsissuedbythesameCLOManagerKKRFinancialin2005and2013andlookatthedifferentstructuresofthesame.Thestructuraldifferencesdiscussedinthepapersofarareglaringlyobviousinthetransactions.

KKRFinancialCLO2005–2 KKRFinancialCLO2013–2

SecuritiesOffered PrincipalAmount

Moody’sRating

ClassA-1Notes $545,000,000 AaaClassA-2Notes $150,000,000 AaaClassBNotes $57,000,000 Aa2ClassCNotes $64,000,000 A2ClassDNotes $64,000,000 Baa2ClassENotes $30,000,000 Ba2ClassFNotes $10,000,000 B2

SubordinatedNotes $98,500,000 N/A

SecuritiesOffered PrincipalAmount

Moody’sRating

ClassA-1ANotes $100,000,000 AaaClassA-1BNotes $10,000,000 AaaClassA-1CNotes $115,000,000 AaaClassA-2ANotes $38,000,000 Aa2ClassA-2BNotes $10,000,000 Aa2ClassBNotes $18,500,000 A2ClassCNotes $25,750,000 Baa3ClassDNotes $22,000,000 Ba3Subordinated

Notes $29,750,000 N/A

Aaatrancheis68.24%ofthetotalprincipalamount.

Aaatrancheis60%ofthetotalprincipalamount.

UnderlyingCollateralcomposedof:

• SeniorSecuredLoans• SecondLienLeveragedLoans• SeniorSecuredBonds• SeniorTranchesofotherCLOs

UnderlyingCollateralcomposedof:• SeniorSecuredLoans• SecondLienLeveragedLoans

DiversityScore:30WeightedAverageRatingFactor(WARF):2350WeightedAverageSpread(WAS):2.15%WeightedAverageCoupon(WAC):3.65%WeightedAverageRecoveryRate(WARR):44%

DiversityScore:50WeightedAverageRatingFactor(WARF):2850WeightedAverageSpread(WAS):3.70%WeightedAverageCoupon(WAC):6.50%WeightedAverageRecoveryRate(WARR):47%

WeightedAverageLife(WAL):9.0Years WeightedAverageLife(WAL):8.0Years KKRholds5%oftheSubordinatedNotes. KKRholds100%oftheSubordinatedNotes.Source:KKRFinancialCLO2005-2Prospectus,Moody’sRatingReport–KKRFinancialCLO2013-2

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G. PerformanceofCLO2.0ascomparedtoCLO1.0

OwingtotherecentissuancesoftheCLO2.0securities,ithasbeendifficulttoanalyzetheperformanceofthesetransactionsascomparedtothe

TherecentCLOTrackerFilesreleasedbyFitchandotherRatingAgenciesinJanuary2015includesfiveCLO2.0transactionswithacollectiveassetpoolofEUR1.8billion.ThetrackerdatafileshaveindicatedthattheCLO2.0havefaredbetterthanCLO1.0onawhole.

i. TheCLO2.0haveonaveragehad,onaverage,higherweightedaveragerecoveryratesthanseasonedCLO1.0transactions

ii. TheCLO2.0transactionhavelower‘CCC’bucketsthantheirCLO1.0counterparts.The‘CCC’bucketsforCLO2.0areonly2.08%asopposedto8.7%ofthatofCLO1.0

iii. TheborrowerpoolofCLO2.0hasalsobeenobservedtobemoregranularthanthatofCLO1.0.Onaverage,theCLO2.0transactionshave77obligorsascomparedtotheaverage62forCLO1.0transactions.ThisisnotthebestmetricofmeasurementthoughastheCLO1.0transactionsaremucholderandhavebeendeliveringandpayingdowntheirnotesasopposedtoCLO2.070%ofwhicharestillintheirreinvestmentperiods.

iv. Theaverageseniortranchecushionandthecorrespondingjuniortranchecushionhasvastlyimprovedaswell.

v. TheOCtestperformanceoftheseCLOshavealsoseenamarkedimprovementfromtheCLO1.0transaction.

MostoftheabovelistedimprovementsasillustratedintheFitchCLOTrackingDatareportofJanuary2015areadirectresultofthecleanerandsimplerstructureoftheCLO2.0transactions.AlotofemphasishasbeenlaidonmakingthesetransactionseasiertobeunderstoodbytheaverageinvestorandtherebyimprovingtheirstructureandmakingthemeasiertopassvariousreliabilitytestssuchastheOverCollateralizationtests.TherequirementsbytheregulatoryframeworksofCRDIVandDoddFrankActtohaveabiggercushionfortheseniortranchehasmadethe‘AAA’tranchesafertoinvestinalbeitwithlowerreturns.

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IV. CLO3.0–Volcker’sImpactonCLOs

TheOfficeofComptrolleroftheCurrency,theBoardofGovernorsoftheFederalReserveSystem,theFederalDepositInsuranceCorporationandtheSecuritiesandExchangeCommission(collectivelyknownas‘Agencies’),onDecember10,2013,adoptedthefinalsetofVolcker’sRules.TheseruleshavehadaprofoundeffectonUSCollateralizedLoanObligationMarketplace(CLO)byprohibiting‘bankingentities’fromretainingoracquiringan‘ownershipinterest’ina‘coveredfund.’

Eligible‘BankingEntities’includeallbankholdingcompanies,foreignbankswithUSBranchesandagencies,insureddepositoryinstitutions(e.g.MoneyMarketFunds)andaswellastheiraffiliates,franchisesorsubsidiaries.

‘OwnershipInterest’hasbeendefinedverybroadlybythe‘Agencies’.Accordingtothecurrentdefinitioneveninvestorsinthedebttranchecanqualifyashavingan‘ownershipinterest’inthefund.Itisdobecauseinthedefinitionof‘ownershipinterest’inaccordancetoasdefinedbyVolcker’sRule,anyinvestorthatcaninfluenceorhastherighttoparticipateintheselectionorremovalofaninvestmentmanager,investmentadvisororcommoditytradingadvisorofthe‘coveredfund’issaidtohavean‘ownershipinterest’inthefundirrespectiveofwhetherthesaidpersonorinstitutionholdsanyequityinthefundornot.SinceinatypicalCLOtransaction,amajorityofnote-holdersorholdersofthecontrollingclassofthesecuritywhichisusuallythetoptwotranchesofthetransactionhavetherighttoremovetheCLOManagerforcause.Asaresult,holderofeachoftheseseniordebttranchesissaidtohavean‘ownershipinterest’inthetransaction.

‘CoveredFund’areCLOtransactionsbutwithfullrecoursetotheissuingauthority.Therefore,allCLOsthatare‘investmentcompanies’(orSPVsissuingnotes)butfortheexceptionssetoutinSection3(c)(1)or3(c)(7)oftheInvestmentCompanyActof1940,aredefinedas‘coveredfunds’accordingtotheVolcker’sRule.

Section3(c)(1)oftheInvestmentCompanyActof1940statesthatafundnotownedbymorethan100shareholdersisexemptfrombeingcalleda‘coveredfund’andisdefinedasa‘privatefund.’

Section3(c)(7)oftheInvestmentCompanyActof1940statesthatafundwillnotbetermedasa‘coveredfund’ifitiswhollyownedby‘qualifiedpurchasers.’

ThesetwoexceptionsintheInvestmentCompanyActof1940arefrequentlyusedbyHedgeFundstoqualifythemselvesas‘privatefunds’insteadof‘publicfunds’therebyescapinggreaterscrutinyandregulations.

OwingtotheVolcker’sRule,a‘bankingentity’cannotinvestmorethan3percentofitsTier1Capitaltogain‘ownershipinterest’in‘coveredfunds.’Therefore,suchaninstitutionwouldhavetocountitsinvestmentinsuchafundtowardsthat3percentlimitordivestitsinterest.ThisisahugeblowtotheCLOMarketplacewhere,historicallyspeaking,bankinginstitutionshavebeenoneofthebiggestinvestorsintheseniormosttranchesoftheseCLOSecuritiesholdingmorethan75percentofthe‘AAA’CLOtranchesavailableinthemarket.

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A. VolckerExemptCLOStructures

CLOmanagershavetriedandtestedvariousroutestoexempttheirtransactionsfromthe‘coveredfunds’definitionsoftheVolcker’sRuleastheydonotwanttolosetheirbiggestinvestorsintheformofthebankingentities.Thereisrigorouslobbyingtakingplacebytheseinstitutionstoconvincetheregulatorsand‘agencies’toamenditsregulationstomakeitfairerfortheCLOmarketplace.SomeofthemorepopularmethodstoseekexemptionfromtheVolcker’sRulearelistedbelow.TheseCLOstructuresarecollectivelyreferredtoasCLO3.0popularly.

i. UsingSection3(c)(7)exemptionoftheInvestmentCompanyActof1940

ThisiscurrentlythemostfavoredandeasiestoptionavailabletotheCLOmanagers.TheCLOmanagersareplacingthetranchesofthesecuritiesprivatelyandonlyto‘qualifiedpurchasers’andcertainemployeesoftheCLOManager.Sincethe‘qualifiedpurchaser’getsabiggersayandthereforegreaterbargainingpowerintheCLOTransaction,heorsheisabletodrivethespreadsmuchtighterthanwhatitwouldbeifthetransactionhadbeenplacedintothemarket.

ii. LoanSecuritizationexemption

InordertoprovidesomerelieftotheCLOIndustry,the‘Agencies’agreedtoexemptloansecuritizationsfromthedefinitionof‘coveredfund.’Inordertoqualifyasaloansecuritization,theunderlyingassetsoftheABShavetobesolelycomprisedofloans.Thedefinitionofloansgenerallyexcludessecurities.CLOmanagers,beforetheintroductionofVolcker’sRule,investedapartoftheproceedsfromsellingnotesintosecuritiessubjecttocertainconcentrationlimits,includinginseniorsecuredbondsandhigh-yieldbonds.TheseCLOtransactionswouldnolongerqualifyundertheVolcker’sRuleexemptions.

AsimplesolutionisthattheCLOManagerstopsinvestinginsuchhighyieldbondsandothersecuritiesandmakesuphisorherportfolioentirelyofloans.ThisisnoteconomicallybeneficialtotheCLOManagerhowever,sincethehighyieldsecuritiesprovidedamuchhigherexcessspreadtotheequityinvestor(includingtheCLOManagerwhohasbeenrequiredtoretainaportionoftheequitytrancheundertheDoddFrankActof2010).Thishascreatedamismatchinthespreadsbetweenthefixedinterestratesnotesandthevariableinterestratesunderlyingassetsofthesetransactions.Therefore,theCLOmanagersarefacedwithanimpossiblechoiceofeitheralienatingtheirbankingentitiesinvestorsbynotcomplyingwiththeVolcker’sRule’srestrictionsordrivingawaytheirequitytrancheinvestorsbypromisingthemlowerspreadsthanbefore.IthasledCLOmanagerstoseekhigherspreadselsewhere,insecuritiesthatstillqualifyasloansunderthedefinitionprovidedbyVolcker’sRule.Lately,anumberofCLOmanagersareinvestinginsecond-lienloansinpursuitofhigherspreads.Thisiscounterintuitiveasthelessriskyseniorsecuredbondsaregettingreplacedbymuchriskiersecond-lienloansinCLOtransactions.

SomeCLOmanagershaveemployedamixedstrategy.Theyhaveuseda‘springingsecuritiesbasket’intheCLOdocumentationtoallowforalaterinclusionofsecuritiesiftheyadheretotheVolcker’sRule’sexemptioninthefuture.Thesesecuritiesarepureloansecuritizationotherwiseandhaveabiggerbucket

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ofsecondlienloansthanpresentinthepre-Volcker’sRuleCLOtransaction.ThisapproachwhilegivingflexibilitytotheCLOmanagerstotakeadvantageofanyrulechangesthatmighthappenasaresultoftheongoinglobbyingwiththe‘Agencies’regardingthedocumentationofCLOtransactions,doesn’tpromiseahigherreturntotheequityinvestorwhoisinvestinginitsriskiesttranchetoday.

iii. ExemptionunderRule3a-7oftheInvestmentCompanyAct

IftheCLOManagerisabletostructurehisorhertransactionsuchthatitiscompliantwiththeRule3a-7undertheInvestmentCompanyActof1940,thetransactionisexemptfrombeingtermedasa‘coveredfund.’Forthesetransactionstobecompliantwiththesaidrule,theyhavetofulfill,amongothers,thefollowingsalientfeatures:

a. Thesecuritiesissuedbytheissuerhavetoberatedbyatleastoneratingagencyandhavetofallinoneofthetopfourratingclasses

b. Theacquisitionanddisposaloftheunderlyingassetsonanongoingbasisisnotdoneprimarilytotakeadvantageofthemarketvaluefluctuationsofthesaidassets

c. Atrustee,notaffiliatedwiththeissuer,maintainsaseparateaccountwhereinthecash-flowsfromtheissuers’underlyingassetsaredepositedperiodically

Theselistedrules,someCLOmanagersbelieveareeasytofollowandwouldnotimpacttheeconomiesoftheCLOTransactionsinanyway.MostCLOmanagersdonotacquireanddisposeassetstocapturemarketvaluefluctuationsbuttoremovedeterioratingassetsfromtheirportfolioowingtodelinquenciesordefaults.Therefore,portfolioscomprisingofhighqualityassetsthatwouldqualifyinthetopfourratingtranchesandadheringtotheotherlistednormswillnotqualifyasa‘coveredfund’undertheRule3a-7oftheInvestmentCompanyActmakinglifemucheasierforCLOmanagers.Thatsaid,aCLOManagertryingtogaincompliancewiththeRule3a-7needstohavesolidspoliciesandproceduresinplacetoensuresoundtradingpracticesandperformcheckssoastoadherebythestrictguidelinesatalltimesorrisklosinghisorherlicense.

iv. Wholly-OwnedSubsidiaryExemption

IfaCLOisa‘whollyownedsubsidiary’ofabankingentity,itdoesn’tqualifyasa‘coveredfund’undertheVolcker’sRule.Therecanbeanexceptiontotheaboverulewhereinanunaffiliatedthirdpartymayholdupto0.5percentoftheCLO’sequityunderspecialcircumstances.ThisrulelookssimplebutisextremelydifficulttofulfillasthebankingentitywouldhavetheCLOonitsbalancesheetasitisassumingriskofthelowesttrancheandisunabletodiversifythesameduringthelifeoftheCLO.Moreover,itisforbiddentohedgeorbuyinsuranceonthebankingentity’sexposuretothisriskytranche.

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B. TheImpactofVolcker’sRule

Volcker’sRulehascomeasarudesurprisetotheCLOmarketparticipants,whoexpectedtheregulatorsandthe‘agencies’tobemorelenientwiththesetransactionsastheyhadtakenahugebeatingpostthefinancialcrisis.ThenumberofCLOtransactionsintherecentyearshadonlyjuststartedtoclimbuppostthemassiveslumpin2009and2010.TheVolcker’srulesrestrictionscoupledwiththecapitalrestrictionsthathaveburdenedthe‘bankingentities’recentlyhastakenahugetollontheCLOIndustry.ThefactthattheVolcker’sRuleaffectsnotonlythenewtransactionsbutallCLOdealsthathavebeencompletedbeforeandarestillheldbythedefined‘bankingentities’,hasresultedinasharpdeclineinthepricesofthetoptranchesofCLO2.0closedin2012and2013.

Somemarketobservers,though,areconfidentthatthe‘agencies’wouldnoticethenegativeimpactoftheVolcker’sRulesontheCLOIndustryandthestructuresoftheVolcker’scompliantCLO3.0.MostCLO3.0,especiallypureloansecuritizationstructuresareriskierthanthecorrespondingCLO2.0transactions.Thatsaid,anumberofCLOmanagerstodayareissuingCLOsbasedononeoftheexemptionruleslistedabovewithRule3a-7beingthemostpopularamongtheCLOmanagers.Thesenew-ageVolckercompliantCLOsarecollectivelytermedasCLO3.0.

AnimportantimpactoftheVolcker’sRulehasbeenthechangeintheinvestorbasefortheAAAtranche.Bankshavenowtakenabackseatwhileinvestingintheseniormosttrancheandincreasedspreadshavemanagedtoattractotherinstitutionalclientssuchasassetmanagersandinsurancefunds.Exhibit15belowshowsthesameinmoredetail.

Exhibit14:OverlapbetweenModifiedProposalsoftheUSandtheCRRofEurope

Unfortunately,sincetheCLO3.0areextremelynewandalmostallofthemareintheirreinvestmentperiods,itisimpossibletoascertainthestructuralstabilityandperformanceofthesetransactions.

HedgeFunds

AssetManagers

Insurance

Banks

AAAInvestorbase2011-2013

Pension HedgeFunds

AssetManagers

Insurance

Banks

AAAInvestorBase- 2014

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Conclusions

TheCollateralizedLoanObligations(CLOs)areassetbackedsecuritieswithacollateralmainlyformedofloansandothersecuritiesthatissuenotestoinvestorsfrodifferenttranches.Thetranchesaremadeinadecreasingorderofrisksuchthatthetoptranchesdon’tabsorbanylossesofthedefaultsoftheunderlyingtranchesareerodedaway(cashwaterfall).Thesetransactionsaremainlyusedbybankingentitiestodiversifytherisksassociatedwiththeleveragedloansontheirbalancesheetsandbettermanagetheircapital.Sincethesetransactionsarerelativelysafeandprovideahigherspreadthanothersecuritiesinthemarket,differenttranchesofthesesecuritiesareabletoattractdifferentinvestors–bankingentitiesinvestinthetoptranchestogetlessriskyassetsontheirbalancesheets,institutionalfundsinvestinjuniortranchestogetgoodspreadswithlimitedassociatedrisksandhedgefundsmainlyinvestintheequitytranches.CLOsarealsoagreatwaytoprovideliquiditytotheotherwiseilliquidcorporateandindividualloanmarket.Henceitisamarketthatismuchneededandissupportedbythegovernmentsforthedevelopmentandgrowthoftheireconomies.

Firstsetupintheirtruestformin1990s,CLOshavehadaturbulentpast.TheoldvintageCLOsofpre-crisiseragavealotoffreedomtoCLOmanagersthatallowedthemtomodifytheCLOstructurestomakeitmoresuitableforinvestors.Insearchofspreads,unfortunately,someCLOmanagersintroducedcomplicationsthatwhencoupledwithseveremarketconditionsof2008resultedintheunderperformanceofmanysuchCLOtransactions.

ThebankingentitieshavehistoricallybeenoneofthebiggestparticipantsintheCLOIndustryusingthesesecuritiestodiversifyoracquirerisksontheirbalancesheets.Itisbecauseofthisexposureofthebankingentitiestothesesecuritiesanditsimpliedimpactonthepublic,theregulatorsandagencieshavebeenkeepingawatchfuleyeonthestructureofthesesecurities.Theyhavebeencontinuouslyproposingnewrulesandguidelinestomodifythesesecurities.TheCLOsofnewervintagehavedisplayedtheiradaptabilitytoconformwiththeserules.TheCLOmanagershaveissuedseveralCLO2.0conformingtothesenewguidelinesin2011and2012.TheCLOMarkethasthereforeseenaresurgencesinceastheinvestorsareabletoinvestinmoresecureandstableCLO2.0transactionsforwiderspreadsascomparedtotheirCLO1.0counterparts.TheregulationshaveborefruitasisevidentbyRatingAgencies’reportsontheCLO2.0performances.

Muchmorerecently,USAgencieshaveproposedtheVolcker’sRulesthathavedisruptedtheCLOIndustryyetagain,especiallyintheUnitedStates.Volcker’sRuleshavemadeitextremelydifficultforbankingentitiestoinvestinCLO1.0orCLO2.0structuresastheyhavelimitedthebankingcapitalthatcanbeattributedtoinvestmentincoveredfunds–adefinitionthatencompassesalmostallCLO1.0andCLO2.0structures.ThereareseveralwaysthathavebeenexploredbywhichCLOscanbestructuredtopreventqualifyingasacoveredfundtherebybeingexemptfromVolcker’sRule.Althoughsuchstructuringgenerallyincreasestherisksmoreoftenthanreducingitleadingtolobbyingregardingthesamebythemarketparticipants.Butfornow,suchnewage,newvintageCLOsof2015and2016aretermedasCLO3.0.

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