CDO Managers: The Good, the Bad, and the Valued Few
Book: Structured Finance and Collateralized Debt Obligations | Author: Janet M. Tavakoli | Publisher: John Wiley & Sons (2008) | ISBN: 978-0-470-44344-6
Chapter 11 is short. It is also one of the most useful chapters in the book for anyone who has ever paid a management fee and wondered what they were getting for it.
The answer, for most CDO managers: not much.
What Good CDO Management Actually Looks Like
At their best, CDO managers add value in specific, concrete ways. They monitor collateral. They make sure the trustee understands the cash flow structure and does not accidentally authorize payments that violate deal documents. They catch when reinvestments happen after the reinvestment period has officially ended. They catch payments made between SPEs that were never supposed to happen.
Tavakoli describes this as the ideal version of CDO management. Then she notes that “most collateralized debt obligation managers collected fees for little more than producing reports.”
The conflicts of interest are real. If a manager has a claim on equity cash flows, they have a structural incentive that runs against senior noteholders. If the manager is affiliated with the capital markets group of an investment bank or related hedge funds, there is additional temptation: trade deteriorating assets from the capital markets group into the CDO warehouse, or trade with related hedge funds to create artificial mark-to-market prices for the collateral.
You might think the solution is to use an independent CDO manager. But independence is somewhat of a myth. CDO managers rely on investment banks to award them deals and management fees. The bank has leverage over the manager that an investor cannot easily see.
Best Practices
Tavakoli lays out what the best-practice CDO manager (BPM) actually does. She notes she has never seen all of these characteristics in one manager at the same time. Here is the list:
Portfolio selection and management independence. The BPM takes a lead role in original portfolio selection and often helps source assets. They optimize rating versus spread and have the clout to overrule arrangers. BPMs have their own warehousing capabilities. Managers who rely on the arranger for warehousing are, as Tavakoli puts it, the arranger’s prisoners. BPMs take responsibility for hedging warehoused assets and mark collateral to market until all debt is underwritten.
Surveillance. BPMs monitor every position, including every CDO tranche and its underlying collateral. For mortgage-related deals, that means monitoring prepayment data. BPMs have early warning systems and primary data sources. They have in-house credit analysts and purchase outside credit software.
Structuring. BPMs have extensive hands-on experience with structuring, documentation, asset accumulation, hedging, the warehousing process, the rating agency process, negotiating reduced arranger fees, investor road shows, and deal closing. Not familiarity, experience.
Investor reporting. BPMs have customized investor reporting systems. Web-based information updates, regular communication with investors, and good relationships with rating agencies.
Capital markets experience. BPMs have diverse experience in investment banking or comparable work. This is a necessary condition, not sufficient. Some managers with senior investment banking experience have still been involved in legal disputes with investors. The suggested due diligence question is sharp: “Have you ever been deposed in the past five years? If so, please provide the case number, a copy of the complaint, a copy of your deposition, and the resolution, if available.”
Dedicated resources. The BPM’s sole function is CDO asset management. No managing hedge funds on the side. No structuring other deals. No other portfolio work. Sole focus.
Tailored software. BPMs understand CDO software and can do in-house modeling with backup employees who can perform the same function. Not dependent on one person.
Distribution. Between the arranger and BPM, there is genuine ability to place equity with long-term investors. The BPM usually invests in a meaningful share of equity. Good communication with equity investors throughout the deal life.
The Valued Few
There is a strong correlation between best-practice managers and ongoing high CDO performance. Tavakoli says only a handful of CDO managers meet this standard. The gap between them and everyone else is enormous.
Most CDO managers do not have the expertise or resources to actually do CDO management or surveillance. Many cannot build a CDO model in-house. Some managers have good initial portfolio selection and that makes them look competent for a while, but beyond the initial selection, investors get little value.
Many managers rely entirely on the bank arranger for structuring and for taking the lead with rating agencies. Key personnel have no structuring or monitoring expertise, only portfolio trading knowledge. These managers cannot even negotiate lower structuring fees because they have no leverage. The arranger knows they need the relationship more than the arranger needs them.
Rating agencies rarely do background checks on CDO managers. They check systems on a black-box basis: if the systems produce outputs that fit what rating agencies need, the agencies are satisfied. They do not examine the software. They do monitor some things, like firewalls, capital monitoring, and controls, but their oversight is much lighter than for structured investment vehicles. When managers fail, the rating agency’s standard explanation is that they had the wrong portfolio, even in cases where the manager actively traded down the portfolio’s credit quality.
In legal disputes between managers and investors, rating agencies have claimed journalist-like privileges to avoid turning over notes and analyses from the rating process. Investors need to know this going in.
Trustee Problems
BPMs monitor trustee performance as part of their surveillance. There has been litigation over trustees making payments and allowing asset sales that should not have been authorized, because trustees did not read the deal documents carefully enough to know the agreements were being violated.
Trustees have pushed back on this by saying they do not have the time to read every deal document, they are underpaid, and they cannot always tell if a payment is authorized without extensive review. Most CDO managers take a hands-off approach to trustee monitoring. Tavakoli calls this an unresolved risk in CDO management.
Management Agreement Problems
Management agreements try to keep key people in place, but changing managers in practice is very expensive. The language in these agreements varies widely. Since arrangers usually negotiate this documentation with managers, investors need to become proactive to protect their interests. Investors often do not push back hard enough during documentation because they do not know what good documentation looks like.
BPMs instruct their own lawyers and take responsibility for negotiating deal documents themselves. Many non-BPM managers simply send documents to their legal departments. That is the difference in practice between a manager who understands what they are managing and one who does not.
The Bottom Line
CDO managers are unregulated. Most of them charge the same fees as BPMs. Only a handful deliver value for those fees.
The key areas where BPMs distinguish themselves: portfolio selection, warehouse management, negotiating structuring fees, negotiating documentation, and ongoing surveillance.
If you are paying CDO management fees, Tavakoli’s implicit message is clear. You should be asking for documentation of every item on this list before writing a check. If the manager cannot deliver on all of them, you are paying for reports.
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