OREANDA-NEWS. Many small CLO managers will likely find complying with the risk retention rule difficult, Fitch Ratings says. Several strategies have reportedly emerged to assist them and more could develop. However, their effectiveness in satisfying the rule remains uncertain. In one, banks that arrange CLO collateral would provide financing by taking "vertical strips," or a small stake in each of the deal's classes. In another, a majority-owned affiliate with third-party capital is structured to invest in CLOs.

These strategies may not be available to independent, smaller employee-owned partnerships. During 2013, the number of CLO issuers in the market grew by 65%, with 47 new managers entering during 2013 and 2014 (through October). Many are smaller than the "frontier" CLO 2.0 issuers of 2010 and 2011. We expect the number of small CLO managers to decline in 2015 as the industry undergoes consolidation ahead of risk retention rules going into effect in 2016.

In addition to risk retention implementation, there are several important considerations for investors in CLOs of smaller managers. Some smaller managers with fewer financial or operational resources may underutilize governance, risk management, investment processes and operational controls. Smaller managers may also be vulnerable to business concentration and smaller asset bases and lack clear distribution networks and the benefit of affiliating with a larger firm.

In our view, new managers with adequate administration capabilities, thorough indenture review procedures, advanced portfolio setup procedures and strong modeling tools can limit these operational risks. We recommend investors monitor managers' compliance with their investment guidelines.

The market responded to this complexity by increasing the number of backup managers being added to newer CLOs with less experienced issuers. Large, frequent CLO issuers have been named as backups in CLO documents and are expected to step in as replacement managers following specific breaches or for "cause," as defined in the collateral management agreement. Going forward, the effectiveness of this technique remains an open question, as regulators have not yet commented on whether the backup manager would need to comply with the risk retention rules.