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By Bloomberg

Wall Street has another rule it’s trying to get around: regulations seeking to limit risk-taking by managers of collateralized loan obligations.

Leon Black’s Apollo Global Management LLC, Carlyle Group LP and a unit of Credit Suisse Group AG have all taken steps in the past two months to create CLOs now that they may be able to refinance after the rules take effect in December 2016 without having to comply with the new regulations, according to three people with knowledge of the matter. The firms are trying to avoid a requirement to hold a stake in the funds they manage.

The strategy is an attempt to preserve profits in what’s been one of the hottest and most lucrative businesses during the junk-debt boom of the past six years. By making CLO managers retain a portion of their deals, it becomes less attractive to create funds that have been the biggest buyers of leveraged loans. A record $123.6 billion were issued last year.

“What people are trying to do now is to anticipate changes that may be needed post-2016 and effectively deal with them while the going is still good,” said Julian Black, a lawyer and global head of structured finance at Appleby Global Group Services Ltd. CLO managers are issuing extra securities now because after December 2016, “a repricing, a refinancing or an additional issuance of notes” would “suddenly become subject to risk retention.”

Apollo CLO

CLOs pool high-yield corporate loans and slice them into securities of varying risk and return, typically with ratings from AAA down to B. The lowest portion, known as the equity tranche, offers the highest potential returns and the greatest risk because investors are the first to see their payouts reduced when loans backing the CLO default.

Apollo raised a $786 million CLO on Jan. 23 that created two sets of bonds. The first set was sold to investors, while the second hasn’t yet been funded and would be used to refinance or reprice the deal in the future, said one of the people, who asked not to be identified because the information isn’t public. By assigning the shell notes an identification number and dating them now, the New York-based money manager is seeking the option to redo the deal without making it subject to the regulations. Morgan Stanley managed the offering.

‘Uncertain’ Treatment

This type of notes is a new feature in the CLO market and their treatment “under law and regulation is uncertain,” according to Apollo’s deal document.

Fran McGill, a spokesman for Apollo at Rubenstein Associates, and Mary Claire Delaney, a Morgan Stanley spokeswoman, declined to comment.

The risk-retention rule, released on Oct. 21, is intended to make sure managers are on the hook for at least a portion of the risk in their deals. It’s part of the 2010 Dodd-Frank Act enacted in response to the credit crisis that was fueled in part by securitized debt, particularly in the mortgage market.

CLOs must be in compliance as of Dec. 24, 2016, according to the rule.

Citigroup Inc. arranged both the $685.8 million CLO for Credit Suisse Asset Management, a unit of Switzerland’s second- biggest bank, and the $511.95 million fund for Washington-based Carlyle, said the people. The deals also created notes that may be funded at a later date.

Randall Whitestone, a Carlyle spokesman, declined to comment, as did Justin Perras of Credit Suisse Asset Management and Scott Helfman of Citigroup spokesman.

More Deals

Other firms may follow with similar transactions this year, says Danielle Nazarian, a senior vice president at Moody’s Investors Service in New York.

Only 10 of the top 30 CLO managers have sufficient capital to hold 5 percent of their existing deals, the amount required by the regulation, according to a 2013 Loan Syndications & Trading Association-sponsored study by consulting firm Oliver Wyman.

The regulation has prompted Wall Street dealers to project a steep drop in CLO issuance, with JPMorgan Chase & Co. expecting sales of $70 billion to $80 billion this year, according to a Nov. 26 report. Morgan Stanley predicts issuance will fall to $75 billion to $85 billion in 2015, while Wells Fargo & Co. sees a drop to $90 billion.

Issuing CLO notes ahead of the regulation isn’t a guarantee a manager will escape the rule.

Won’t Work

Carlyle’s deal documents say that “recently proposed rules regarding risk retention” may “potentially limit the ability of the issuer to issue additional notes or undertake any refinancing, repricing or partial redemption.”

James Waddington, a lawyer in London at Dechert LLP who focuses on structured finance, doesn’t think the strategy is going to work.

If a fund were to refinance after December 2016 “you would have to be compliant,” he said in a telephone interview. “I don’t think it matters if you issued a separate” identifier, known as a CUSIP.

While no one knows how the rules will be enforced, Wall Street is trying to come up with deals that will either comply with the regulation, or get around it.

Investors “aren’t interested in hearing a manager say, ’I’m going to figure it out,’” said John Fraser, managing partner at the U.S. debt-investment arm of London-based buyout firm 3i Group Plc. “They want to know if there is a plan A or a plan B or a plan C in order to be compliant.”