The performance of an asset manager in a CDO is vital to its success. This importance is magnified in an arbitrage CDO where the underlying collateral is more actively managed than in a balance sheet CDO. In an arbitrage CDO the asset manager performs a variety of duties including:
* selecting and evaluating the collateral for the initial
portfolio and during the re-investment period;
* monitoring the performance and quality of collateral;
* participating in work-outs of distressed collateral; and
* managing the interest and currency risk of the structure
through the use of derivatives.
Any failure or sub-standard performance of these duties would inevitably cause deterioration of the structure leading to credit downgrades and possible defaults.
The tranching of notes in arbitrage CDOs to achieve a positive differential between the coupon on the notes issued and the underlying collateral also places asset managers in conflict situations. Frequently the asset manager will acquire the CDO equity tranche and claim the residual equity cash flows in the deal. Acting as both the asset manager of the deal and as the equity investor creates an inherent conflict of interest that needs to be managed.
There has also been an increase of CDOs in terms of both size and complexity during the past five years and this has been accompanied by an expansion in the types and number of institutions acting as asset managers. The risk here is that the asset manager is not adequately qualified to manage the particular CDO.
There are two types of measures that can be taken to manage asset manager risk. The first category can be loosely termed Structural Controls. These measures relate to building in certain structural safeguards in a CDO transaction so that the financial interests of the senior note holders are not compromised in a situation where there is a conflict with the equity tranche held by the asset manager. The second category of measures which this article will focus on are those directed at the asset manager in its capacity as a service provider and as such are termed Institutional Controls.
Key-Man Provisions
The effectiveness of asset managers depends to a large extent on the calibre of their key personnel. Rating agencies factor in the skill level and experience of individual portfolio managers in rating both the asset manager and the CDOs. This should be contrasted with conventional mortgage-backed or consumer receivables securitisations in which the homogeneity of the assets and the lack of asset trading means that exceptional specialist expertise is not required. The importance of key personnel is heightened in cases where they have specialist knowledge of the collateral involved and also where the asset manager is an institution that is largely people-driven rather than process-focused. For example, managers with significant work-out experience are an important component in a CDO where the collateral comprises sub-investment grade assets and the asset manager is a small boutique partnership. The departure of these key personnel can have an adverse impact on the performance and ability of the asset manager to make timely and accurate investment decisions. The nature of the asset management industry with its high staff turnover further accentuates this risk.
There are several ways to mitigate the consequences of the unplanned departure of key personnel. In some instances, investors or rating agencies require a standby asset manager to be in place at the start of the deal, which increases the cost structure.
Another alternative would be to provide for a detailed consultation process involving the asset manager and the security trustee whereby the security trustee must be advised of the planned departure of key personnel and the identity of their replacements have to be approved by the security trustee well in advance. The inclusion of an elaborate consultative process, usually referred to as key-man provisions, reduces the risk that the transaction would be managed by personnel lacking the relevant skill or ability upon the departure of key personnel.
Constant Surveillance
Constant surveillance of asset managers is also important in managing asset manager risk. Constant surveillance ensures that the asset manager, its personnel, systems and operations are assessed not only at the outset of the transaction but also on a continuous basis during the life of the deal.
The most common way to monitor asset managers involves working through the rating agencies. As a matter of course, the rating agencies conduct annual reviews of CDO asset managers. The purpose of such surveillance is to ensure the integrity of each CDO rating, of which the capability and performance of the asset manager is a key component.
A major component of the annual review is an on-site inspection at the offices of the asset managers. In addition, asset managers are usually required to submit portfolio data and updates to the rating agencies on a periodic basis for their review.
Some rating agencies also rate the asset managers separately and renew the ratings annually. In these cases, the on-going surveillance is absolutely essential in determining the ratings of the asset managers.
From a note holder's perspective, the publication of a negative report on an asset manager should serve as an early warning signal that the CDO should be monitored more closely, or the asset manager should be replaced.
Control Of The Management Fee Structure
Most CDO transactions divide the management fees for asset managers into two components, a senior fee and a subordinated fee. The senior fee is usually a nominal sum and is located higher in the payment waterfall while the bulk of the asset manager's fees come through its subordinated fee which is subordinate to the interest payments on the notes. The purpose of this is to align the interest of note holders and the asset manager, ie the asset manager will only get the bulk of its fees once all interest payments are made. The division of fees into subordinated and senior tranches however does not work well in situations where the underlying collateral deteriorates causing payments of interest on the notes to be withheld or deferred. In those situations, extra skill, effort and vigilance is required to manage the CDO out of the situation but there would be less financial incentive on the asset manager to do so as it would be deprived of substantially all of its fees at that point.
There are at least two solutions to manage this risk. Firstly, some deals have provided for a separate replacement fee which ranks pari passu with the senior management fee and is quantitatively between the senior and subordinated fees. This mechanism allows note holders to attract suitable asset managers to replace poorly performing asset managers and gives the replacement asset managers the opportunity to manage the CDO so that interest payments may be resumed and fees extracted. Another alternative proposed by some rating agencies is to remove the senior and subordinate fees altogether. In their place, a fee component payable to the asset manager is provided for at each level of the payment waterfall where interest is paid to note holders.
Dynamic Funding CDOs
In traditional arbitrage CDOs, there is a time gap between the closing of the deal when the proceeds of the notes are received and the time when the collateral is acquired, ie the ramp-up period. Notwithstanding any guidelines imposed on the asset manager on the selection of collateral, there is a strong risk that the final portfolio will be of a lower quality than that assumed during closing. Having investment guidelines which are too restrictive is not the optimum solution as it could lead to a mandatory prepayment of the senior notes if adequate collateral that falls within the parameters of the investment guidelines cannot be purchased. During the ramp-up period there is also the risk of negative carry as the note proceeds are usually invested in high-quality assets that can be liquidated on short notice to acquire collateral and which have a lower yield than the interest costs of the notes issued.
Some rating agencies believe that the pressure to acquire suitable assets to meet the target par and reduce the impact of negative carry during the ramp-up period causes some asset managers to be hasty in their investment decisions. They could acquire assets that they would not usually purchase simply to meet the target par amount rather than for reasons of price, yield and quality. This subverts the entire credit evaluation process and reduces the quality of the portfolio.
In order to mitigate these asset manager risks, a new form of CDO, the Dynamic Funding CDO, has evolved. Under this structure, the assets and liabilities of the CDOs are matched up as near as possible at closing. Notes are issued only to an amount that would suffice to acquire identified assets at closing. As and when assets are to be acquired, new notes will be issued to fund the purchase of those assets.
Conclusion
The difference in performance of various CDOs in past years can be attributed partly to the varying standards of performance of asset managers. Therefore it has become more important to introduce measures to manage the risks associated with the asset manager in its role both as a service provider and as an equity investor. However perhaps the more important things for investors are to be selective in choosing which CDO they buy into and to understand that no amount of controls, surveillance or credit enhancement will protect a CDO transaction if the asset manager is inherently unsuitable for the deal.
This week's Learning Curve was written by Jason Norman Lee, a senior associate in the banking and finance department at Allens Arthur Robinson in Sydney.
