THE CDO MANAGER
The crucial agent in an arbitrage CDO is the manager of the portfolio of the CDO. The CDO manager may or may not be one of the equity investors in the CDO. Typically CDO managers are investment advisers and asset managers seeking to expand the amount of assets under their management. Their motivation is to increase their fee income, while having a negligible impact on the costs of their organization.
Qualities of the CDO Manager
Rating agencies look at experience, staffing, and financial and managerial resources of CDO managers when rating a CDO issue. The size of an organization has obviously been an important factor. Below are other important manager attributes that are considered by rating agencies.
Experience
CDO management requires skills that are unique. These skills are relative to the type of assets that the CDO would acquire. For instance, a CDO that would focus on high-yield corporate bonds would need a manager experienced in this asset class, and CDOs that focus on CMBS or REITs would require conversance with that market. However, as compared to generalized asset management, for instance, such as for mutual funds, managing a CDO portfolio has its own pulls and pressures. First, there are stringent rules imposed by rating agencies on portfolio composition. Moreover, there are asset-based triggers applicable. At the same time, in view of its liability structure, a CDO manager has to strike a balance between the needs of the equity investors (high returns) and those of the senior debt (safety). In the context of high-yield corporate CDOs, Moody’s (2001, p. 3) notes:
We recognize further that high-yield experience outside the CDO environment may not translate into skill with CDOs. We have found several cases of seasoned managers who were successful within a mutual fund or separate account context but who failed as CDO managers.
Highlighting the need for relevant experience, Standard and Poor’s (2001) notes:
The ability to analyze performance history in specific asset classes and performance within a structured credit vehicle (as opposed to a total return vehicle) is an important factor in the investment decision. As a result, repeat managers with solid performance records are gaining a strong advantage in the competition for fund management.
Staffing
The rating agencies insist that CDO management teams be adequately staffed. Too many assets per person are frowned upon. If the team is too thin, the rating agencies often insist on a “key man” provision whereby if a key person leaves the organization, it is treated as an event empowering noteholders to replace the key person.
Strong Internal Controls
Strong internal control systems are an essential part of the organization of CDO managers. Too much autonomy granted to any particular individual should be avoided. Periodic reviews by a credit committee, independent of the CDO yet understanding its business, is often considered desirable.
Technological Investments
As investment management gets more and more quantitative, CDO managers would find it advisable to invest in technology products that facilitate identification of investment proposals, compliance with asset and collateral tests, and other requirements and triggers.
Financial Resources
CDO managers need capital to be able to build a sound team and invest in technology.
Balancing between Equity Investors and Debt Investors
The CDO manager has to walk the tightrope of balancing between the needs of the noteholders and the equity holders. The equity holders are interested in value maximization while the noteholders are concerned about the regularity of payments. Their needs are conflicting. From the point of view of rating agencies, noteholder-friendly CDO managers are preferred; but the preference of rating agencies is understandable as they rate only the notes not the equity.
It is difficult to decipher and distinguish between CDO managers who are noteholder friendly or otherwise, but some have acquired a particular reputation over time. Here is Moody’s (2001, p. 4) position:
Moody’s looks for the collateral manager to possess the core competencies that will enable him/her to make sound investment decisions that are consistent with the spirit and letter of the governing documents. In turn, we then analyze the transaction assuming nothing more (or less) than such capable and effective management.
In instances where the CDO manager owns equity in the CDO, the question of conflict becomes all the more glaring. Rating agencies have reviewed both the pros and cons of the CDO manager holding equity in the CDO. Among the advantages are the fact that the CDO manager does not have the pressure of having to account for external equity holders, while having the understanding and support of equity investors if the CDO manager has to strive to maintain the rating of the external notes.
At the same time, the cons are that the equity might have been sold with high-sounding promises and the temptation to give quick rewards to equity owners might conflict with the larger interest of the CDO, and therefore the ability to raise debt in the future. As Moody’s (2001, p. 4) puts it:
Collateral managers who fight the CDO structure to make immediate equity payments (“equity friendly”), while not trying to fix the deteriorating nature of their portfolios, ultimately harm the equity investor, the transaction and themselves. These managers may eventually turn off all payments to the equity investors with no reasonable chance of making any payments in the future. The short-sighted strategy of making immediate equity payments at the expense of a sound portfolio and structural integrity is very visible in the marketplace. Among the many ramifications to this approach is the difficulty, or impossibility, of raising debt at a reasonable cost for future deals. Basically, the CDO market may close for that manager.
The CDO Manager’s Fees
The CDO manager’s fees are among the first priorities in the waterfall. However, quite often the fees are broken into a primary fee and a secondary fee, with only the primary fee being senior to the noteholders and the secondary fee only payable out of the residual left after paying the noteholders.
The adequacy of fees from a marketplace perspective is necessary both as a motivation to the CDO manager to peform well, as well as looking at the possibility of inviting a backup servicer to take the task of servicing in the event of defaults by the primary servicer.
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