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September 21, 2018  

Europe Funds Blocked From US Investments

Preparations are under way for a rule change that would curtail the abilities of mutual fund-like vehicles in Europe to invest in securitizations from the U.S.

The measure, part of European Parliament’s ongoing overhaul of its structured-finance regulations, would eliminate a loophole under which so-called UCITS funds currently can buy structured products from issuers that don’t comply with the region’s risk-retention requirements.

Although the update was finalized late last year, it just now is generating a buzz as industry participants get ready for its Jan. 1 implementation date.

UCITS vehicles, or Undertakings for the Collective Investment of Transferable Securities, essentially are hedge funds with tighter risk controls, easier liquidity and more transparency. Managers of the vehicles can market them across the European Union, so long as they are registered in one member country.

Europe’s risk-retention controls, meanwhile, typically bar investors in the region from buying structured products unless the issuers keep 5% stakes in their deals. Operators of UCITS vehicles often have used their exemption to buy large volumes of asset-backed securities, mortgage bonds and collateralized loan obligations from the U.S. that don’t meet that standard.

Now, many of those products will be off limits. “I’m buying 80-90% of my investments in the U.S.,” one manager said. “This is going to have a huge impact on my business.”

For firms that run existing funds, the result could be a major shift in buying strategy. Some also are rethinking plans for future vehicles, with one source indicating that Credit Suisse already has abandoned such an effort.

Neuberger Berman, however, apparently is moving ahead with plans for a similar offering. Managers of existing funds include Fair Oaks Capital and Highland Capital, both with an emphasis on investments in CLOs.

The change comes at a particularly inopportune time for investments in U.S. CLOs. Many issuers in that market had been structuring their deals to comply with Europe’s risk-retention controls, since they already had to keep 5% interests in their offerings under the Dodd-Frank Act anyway. But fewer have been doing so since the deals were ruled exempt from the Dodd-Frank regulation this February.

In 2017, 38% of U.S. CLOs complied with Europe’s risk-retention requirements. That figure has dropped to 21% this year, according to Wells Fargo, and is expected to keep falling.

In the U.S. asset-backed bond market, only 15% of deals completed since 2017 have complied with Europe’s risk-retention rules, according to a Sept. 12 report from Deutsche Bank. That is because the controls differ enough from the Dodd-Frank version that it makes little sense to carry out dual-compliant transactions unless European investors factor heavily into issuers’ distribution strategies. Issuers of jumbo-mortgage securities typically don’t keep skin in the game. “Anecdotally, investor clients have indicated the inclusion of UCITS in this new legislation will prevent them from buying new-issue positions in the same size as today,” Deutsche wrote.

The rule change includes a grandfather clause for existing positions. It also likely would have little impact on the funds’ buying activities in Europe, since virtually all securitizations from the region are risk-retention compliant.

Operators of UCITS vehicles have gravitated to securitizations in the States, in part, because those offerings often carry higher yields than they can find at home and add diversity to their clients’ Europe-focused portfolios. If the loss of demand from those shops is great enough, it’s possible some U.S. issuers will opt to comply with Europe’s rules.

“The growth of the European CLO market has been a real positive, but it still hasn’t made up for the fact that you used to be able to pick and choose among a lot more U.S. deals,” one investor said. “For the UCITS managers, that is magnified. They were used to having their pick of everything.”

UCITS funds had a combined $11.7 trillion under management on Dec. 31, according to the European Fund and Asset Management Association. Among them, dozens exclusively buy structured products and numerous others include such securities in more-diversified portfolios.

The impact also could be felt among U.S. vehicles that invest on behalf of European clients, given an assumption that UCITS rules apply to them.