As we are just inking one of the very first pre-risk retention effective date risk retention deals (Potemkin Village anyone?), we are also seeing an increased flow of what are generically referred to as CRE CLOs. It’s time to consider how the Risk Retention Rule (the “Rule”) will apply to this growing market technology.

Typically, the business plan of the sponsor utilizing CRE CLO technology is that of a portfolio lender with the securitization acting as leverage, not a sales device. In CRE CLO land, the sponsor might continue to hold 10% or more at the bottom of the capital stack; think storage companies, not moving companies. In the storage company business plan, having yet another reason to hold the bottom of the capital stack is certainly not an enormous burden. At first blush, our reaction is that the CRE CLO is one of the very few market segments in structured finance that is not negatively impacted by the Rule. True? Sort of.

At this point I’m going to ask all of the employees of the Securities and Exchange Commission, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Company, the Office of the Comptroller of the Currency, and the Secretary of Housing and Urban Development (collectively, the “Agencies”) to stop reading this commentary – it’s not for you. Just put it down and go away. Thank you.

Now for the rest of us, let’s look clear-eyed at what might become a significant challenge in our space.

Will we have to internalize management of CRE CLO sponsors?

The growing CRE alternative lender marketplace is largely composed of permanent finance vehicles such as traded or non-traded REITs and closed-end funds; vehicles which have tended to be externally managed. While the Rule does not specifically address the organization or structure of any party which acts as the risk retention party, and while the Agencies did observe that they thought the existing CMBS business model for the B-piece buyer worked pretty well (79 Fed. Reg. 77,644), the Agencies expressed significant concern throughout the adopting release about entities that were externally managed. For example, “an entity that serves only as a pass-through conduit for assets that are transferred into a securitization vehicle, or that only purchases assets at the direction of an independent asset or investment manager, only preapproves the purchases of assets before selection, or only approves the purchase of assets after such purchase has been made would not qualify as a sponsor… because such activities, in and of themselves, do not rise to the level of ‘organization and initiation.’” (79 Fed. Reg. 77,609).

As a general matter, given this regulatory precatory musing, law firms active in the CLO space have taken the position that “brain dead” funds which rely exclusively on external managers for advisory services cannot serve as a “sponsor”. The CLO business has been diligently beavering away developing structures which meet the government’s views as to what the Rule means, and Dechert has been the vanguard of this effort. We have developed several risk retention models including the CMOA and the CMV. The CMOA structure contemplates a collateral manager which is sufficiently capitalized to hold fifteen to twenty percent of the equity of a downstream majority-owned affiliate (MOA), which becomes the risk retention party. (It is clear than an MOA does not need its own management, as the very nature of the MOA is that it is controlled by the related sponsor.) In the capital manager vehicle (CMV) structure, a new entity is capitalized and the management is internalized with perhaps some management personnel dual-hatted with the original external manager team while some management functions might be vended out to the original manager. Read here for some FAQs regarding CLO compliance, here for our guide to “risk retentionizing” your CLO and here for our take on a recent SEC interpretive letter on the issue. This existing CLO work constitutes a reservoir of ideas and structures to make CRE deals work.

So how will the Agencies look at a CRE CLO? There is some indication that the Agencies perceived the active management inherent in the CLO space as the driving reason behind their insistence on internal management and concomitantly, the reason that the Agencies have been comfortable with the CMBS traditional B-piece buyer as a third party purchaser. While the traditional B-piece buyer was typically externally managed, the transactions were not dynamic and the level of management inherent in the duties of a third party purchaser was relatively slight.

As the CRE CLO market begins to grow once again, it is moving toward a dynamic reinvestment structure. Many CRE CLOs in the past few years have been static. Bankers have been of the view that investors are twitchy about non-static deals and perhaps those deals bring back bad memories of the late unpleasantness of 2005-2007 when the commercial real estate CLOs got off the res, so to speak.[1]

In any event, static deals are, at best, expensive, particularly when compared to bank warehouse lines. While I can make the case that it’s way better to have match term financing through a CRE CLO than live (and die) by warehouse lines, the expense delta is real.

So, to make this business really work, CRE CLOs need a reinvestment feature. Reinvestment allows the sponsor to disperse the relative material costs of a securitization over a larger number of invested dollars and a longer duration. While the investment market place has not been wildly enthusiastic about buying bonds from active managers, we expect this segment of the CRE CLO market place to grow, and to do so dramatically. As the fetor of 2008 continues to wear away, we think investors will look at actively managed whole loan CRE CLOs as a pretty good bet. Investors know how to assess management and know how to assess real estate. How big a leap is it to get comfortable with a high quality manager actively managing a real estate portfolio?

So, REITs and closed end funds which have been externally managed will likely need to adapt. Can management be internalized? Certainly, but once again, we are seeing the regulatory state override the business judgment of commercial parties. By the way, and not to get off the point here, what in the world is wrong with external management? The investors seem to think it’s just fine. Why does external management conflict with the general purposes of the Rule? The manager exercises credit discipline and thereby delivers the alignment of interests between the sponsor and the investors, which is at the heart of the Dodd-Frank enterprise. The managers have skin in the game. Why doesn’t this work? What possible difference does it make whether management is delivered under a contract, or the managers get a W2 from the fund itself? I can’t for the life of me see the policy reasons to treat these differently.

Yet, there’s a fair chance that when the regulatory eye of Sauron turns its attention to the CRE CLO market place, it will find the distinction consequential and will approach this like it has the broader CLO market. The Agencies displayed their jaundiced view of CLOs in the Preamble: “Originators of leveraged loans often retain little or no interest in the assets they originate, and originate and underwrite with the intention of distributing the entire loan. In this regard… loans purchased by CLOs are often originated as a fee-generating, rather than a lending business, and originators do not have the same incentive to underwrite carefully as they would for loans they intend to keep in portfolio.” (79 Fed. Reg. 77,654). Hey, that is not us! The CRE CLO business is a lending business, it is a portfolio business, it is not a trading gig. So one would like to argue that we get a pass but let’s face it, we’re not going to.

There is a fair amount of work involved in resolving business questions and equities in internalizing management and we had best get started. Complaining about silly outcomes flowing from the Rule, negative externalities, unintended consequences and the like and moaning about our inability to get the regulators to engage and help us rationalize the structure of capital formation in a post Dodd-Frank world can sometimes feel good, but it doesn’t get the deal done. We have the Rule and we’re stuck with what we’ve got. It’s ambiguous. Get over it. Time to move on and get this done.

Dammit, we just had an election. Why didn’t I get this commentary done last week. Ok, so now we need to factor in Mr. Trump. We are digesting, as is everyone else, and it has certainly introduced a new element of volatility in how we are all looking at the 2017 world.

Maybe we will get smarter, but at this point I don’t think the election is a Hail Mary to fix Risk Retention, Volcker or pretty much anything else Dodd-Frank-related or otherwise important to capital formation in the commercial real estate space. We just elected a populist, a species of politician not notoriously sensitive to the concerns of the finance industry. Maybe I’m wrong, but I don’t think we should expect much love or help getting us out of the risk retention conundrum. So, once again, time to move on and get this done.


[1] I use that term ironically, remembering that poor Mrs. Clinton had to publicly apologize for her cultural insensitivity. But luckily I’m not running for public office which would be funny and certainly would cause listeners of National Public Radio to shudder.