Collateralized Debt Obligation managers are complaining about the fee-based roles the Street's underwriters play in bringing CDOs to market. More than just traditional Street versus customer wrangling, their complaints center around the fact that the fees charged for selling the paper--2% is standard--equals several years worth of management fees for the CDO manager.
One veteran CDO manager offers the example of a $300 million high-yield CDO. He argues that most frequently, "The people that make the money in those deals are the [investment] bankers," complaining that bankers pocket a 2% up-front fee for managing the deal, which comes to $6 million without taking down any risk." Assuming a 50 basis point management fee, which brings in $1.5 million annually, he concludes, "It takes a manager four years of work to do what the bank can do in day one."
In respect to crafting a solution between underwriter fees and what CDO managers are willing to pay, one CDO manager says that so far, no CDO managers that he has heard of have successfully negotiated down the now standard fee structure. He ventures that "people who may get a break are the repeat issuers, the TCWs of the market. Those well-known guys can go anywhere they want."
Another experienced CDO manager adds that the biggest challenge for managers remains finding the capital. "First you have to come up with 25% to 50% of the equity tranche with your own bucks," says the manager. "Then you have to put down capital to cover warehousing risk, in case of a default," he adds. "Without at least $10 million to put down up front in the deal, you're not in business." Warehousing risk refers to the period of time during which the deal is pricing (which means the asset management firm has bought most of the collateral), but has not yet closed (wherein no bonds have been issued yet to fund the purchases.)
From both the rating agencies and sell-side perspectives, managers would not get into those deals if they did not expect to be in the money and fast. One CDO trader with Credit Suisse First Boston says that on a $500 million deal, the manager makes $2.5 million a year. "You certainly have enough money to hire as many people as you need to make the deal work," he says. Brian Gordon, CDO analyst with Fitch, draws the line between cost and investment. He says that putting the money down for investment is not what makes a CDO expensive. Rather, the true cost comes from getting the staff and technology to track the transaction, but, "Most people in these deals are already in the high-yield business and they are leveraging their expertise because they already have the system in place," he says.
Brian McManus, head of CDO research with Merrill Lynch, says, "Collateral managers get nice management fees," which he explains are typically 50 basis points or more on an investment-grade CDO and 30 on a high-yield structure. "It can be a very profitable business," he says, especially for repeat managers who get to sell their notes at tighter level, which increases their excess spread. Excess spread is the measurement of the difference between the cost of issuing the notes and the revenues from the receivables in the collateral.
To refute the claims of impoverishment, one CDO analyst offers the example of a $300 million high-yield deal, which generates 300 basis points in excess spread. He hypothesizes that a manager who invests 50% in the required equity will need to put down $15 million. In return, the manager receives $4.5 million a year from the excess spread. "Do the math," says the analyst: "In a little over three years, the manager is in the money."