Sole or Predominant – CLO Risk Retention Update – New Regulatory Guidance

Introduction

On 31 March 2025, a joint committee (the “JC”) of the European Banking Authority (“EBA”), the European Securities and Markets Authority (“ESMA”) and the European Insurance and Occupational Pensions Authority (“EIOPA”) published a report (the “JC Report”) assessing the effectiveness of the European Securitisation Regulation (the “EUSR”) and providing recommendations.

A key takeaway from the JC Report is fresh guidance on the ‘sole purpose’ test under Article 6(1) of the EUSR under which more than 50% of an originator’s revenues must arise from non-risk retention income, as described below. No changes to this test had been anticipated by the market and as a result, the JC Report has caused surprise, concern and even a pause in issuance for market participants relying on certain risk retention patterns.  This sudden JC guidance is certainly unwelcome at a time when European Union and ESMA had indicated a wish to revive and make more competitive the EU’s securitisation market.

Executive Summary

• The new interpretation of the sole purpose test has put a focus on the precise sources of revenue, proportions of revenue and the method of measurement of this revenue for certain vehicles seeking to qualify as originators and hold risk retention interests;
• The changes are most relevant in CLO transactions but have wider application;
• The new guidance has contributed to a pause in European CLO issuance for certain collateral managers and a restructuring of risk retention strategies for affected firms;
• The new revenue test will restrict some entities from qualifying as originators in new securitisations unless the test can be met or a solution can be found;
• Solutions seem to be available including (i) including collateral management fee revenue as non-risk retention income of the relevant entity or otherwise allocating such income to the relevant entity (ii) seeking compliance through a calculation of revenues that includes non-risk retention income from other consolidated group entities (iii) ensuring that non-risk retention income of the entity exceeds 50% of the revenue of the relevant entity;
• Moving forward, the potential expansion of the sponsor definition to allow third country firms may, if implemented, signal a move to sponsor retention models and away from originator models and their ‘sole purpose’ restrictions.

Background

• Risk Retention Requirements

In April 2022, the EBA published the final draft regulatory technical standards (“RTS”) on risk retention in securitisation, specifying detail on the Article 6 EUSR risk retention requirements. The RTS specified the technical requirements under Article 6, including the circumstances where an entity shall not be established nor operate according to the ‘sole purpose test’. Under this test it is prohibited for an entity to qualify as an originator if this entity has been solely established or operates for the sole purpose of securitising exposures.

Any securitisation where an entity seeks to retain the 5% risk retention but is deemed to fail the ‘sole purpose test’ will be considered to be in breach the EUSR due to the effective disqualification of these types of entities from qualifying as eligible risk retainers. As noted below, for new securitisation issuances after the JC Report, certain risk retention structures will no longer be possible.

Article 2(7) of the risk retention RTS stated that an entity will not be held to operate for the sole purpose of securitising exposures if it “…does not rely on the exposures to be securitised, on any interests retained or proposed to be retained in accordance with Article 6 of Regulation (EU) 2017/2402, or on any corresponding income from such exposures and interests, as its sole or predominant source of revenue” (emphasis added).

Up until the JC Report, the “sole or predominant source of revenue” test had remained largely undefined and market participants did not have any particular figures or specific thresholds for calculating what a predominant source of revenue might be. Securitisations including some CLO transactions were entered into with so called third party entities holding risk retention securitisation positions.

• Risk Retention Holder

The retention holder is the essential figure in meeting the retention requirements above and the retention holder will stay the same throughout the life of a CLO and will, for European CLOs, commit contractually through the risk retention letter to fully comply with all risk retention requirements under the EUSR. Despite the changes triggered by the JC Report, it is not anticipated that significant changes will be seen to the language of risk retention letters..

• Traditional CLO Risk Retention

CLOs originally represented a challenge in identifying which party would qualify to hold the 5% risk retention interest in the CLO, and how. Market practice has been for the retention requirements to be met by the collateral manager in one of two main ways, by qualifying either as sponsor; or, now increasingly, as originator.

Where a collateral manager cannot currently qualify as a sponsor (because they are located outside of the European Union or do not otherwise meet the status tests), the originator structure is often used to satisfy the risk retention requirements. Entities seeking to retain the 5% risk retention as originator in a CLO as manager/ originator need to qualify as an originator through either the ‘limb (a)’ or ‘limb (b)’ originator definition routes. Limb (a) originator qualification is achieved by the collateral manager (1) being involved, directly or indirectly, either itself or through a related entity, in primary origination (being primary syndication) of 5% of the underlying debt obligations that are to be collateralised and (2) establishing and managing the CLO. If the collateral manager has not been involved in this way, it will need to fall into the limb (b) definition, i.e. it must be an entity that “purchases a third party’s exposures for its own account and then securitises them”.

Neither route of originator qualification is available though, to an entity which has been established or operates for the sole purpose of securitising exposures and this has been the case since the inception of the EUSR. The JC recognised industry feedback asking for greater clarity, particularly in the context of CLOs, in relation to the term “predominant source of revenue” used in the RTS on risk retention, which stems from the interpretation of the ‘sole purpose’ term.

New Guidance

In order to clarify the RTS position, the JC Report has defined “predominant” as corresponding to a threshold of more than 50% of the revenues of the relevant entity.

This means that in order to qualify as an originator, income from risk retention securitisation positions must be less than 50% of the entity’s income. Income from non-risk retention sources needs to exceed 50% of the entity’s income.

This interpretation represents a significant shift and potentially bars many entities without other substantial business lines from qualifying as risk retention holders particularly as third party originators in CLOs.

The disruption caused by this new guidance is, for certain collateral managers, extreme. Affected collateral managers have been forced to launched new risk retention structures or amend revenue allocation between existing business and risk retention vehicles. Many commentators have observed that the impact of the JC Report goes directly against the current will to modernise and increase competitiveness of securitisation in Europe. It is worth pausing for a moment to consider the most direct comparator to European securitisation and European CLOs: the United States. In the United States, so called open market CLOs are not subject to any risk retention obligation. The JC Report widens the competitive disadvantage in the European CLO market.

There remains a degree of uncertainty surrounding implementation of this new standard. Market commentators agree that revenue/income from non-risk retention sources should be counted as allowable income for the purposes of the test although there is some disagreement as to which income should be counted here. Income from all risk retention sources (risk retention notes) is of course counted towards the restricted risk retention income.

In terms of income that can count towards non-risk retention income, income on senior notes, mezzanine notes and subordinated notes (beyond and expressly excluding any portion of subordinated notes that relate to the 5% risk retention interest) should be included as well as income on other non risk-retention investments (be it in third party CLOs or non-CLO investments). For collateral management fees, most market participants, including Gide, consider that collateral management fees can contribute to non-risk retention income. However, we are aware that certain regulators have expressed a view that collateral management fees should be included in risk retention related income.

Article 2(7) of the RTS remains in force and stipulates that relevant sources of income for an originator seeking to comply with the ‘sole purpose’ test can include: “capital, assets, fees or other sources of income, by virtue of which the entity does not rely on the exposures to be securitised, on any interests retained or proposed to be retained in accordance with Article 6 of Regulation (EU) 2017/2402 or on any corresponding income from such exposures and interests, as its sole or predominant source of revenue”.

Finally, given the RTS language and considering the intention of the sole purpose test, certain participants have expressed support for entities to seek compliance with the new revenue test by including consolidated revenues of regulated asset management group parents. Gide agrees with this. We consider that this is a sensible proposal that can reflect the current reality and wider assessment of the substance of vehicles that are part of larger groups.

The result would seem to be that, under the market’s interpretation of the new guidance, a debt fund or other entity that generates income from the allowable sources indicated above (or calculates income in the ways indicated above) where that income exceeds 50% of the total income of said entity, can continue to qualify as an originator.

The new interpretations contained in the JC Report apply only to transactions issued from 31 March 2025. Existing closed CLOs are grandfathered from the new interpretation and although some uncertainty remains for transactions which were priced but not yet closed on 31 March 2025, these are likely to be treated in the same way and remain unaffected by the JC Report.

A positive recommendation included in the JC Report was to expand the definition of sponsor in the EUSR and notably to remove the requirement that a sponsor is located in the European Union. This has been well received by the market and, if implemented, we may see a return to risk retention structures utilising sponsor retention and a move away from originator retention models and their ‘sole purpose’ restrictions.