CDO manager quality: a critical consideration.

• Author: Gaw, Mark
• Position: Collateralized debt obligations

The goal of any CDO manager analysis is to attempt to anticipate, as well as possible, how well equipped the CDO team is to meet the diverse needs of a variety of constituents. Given the complexity of the analysis and the poor availability of data, it is necessary to take a multifaceted approach. The three major elements that must be assessed are: the team and the organization, the performance of the existing deals, and the operational, systems, and compliance infrastructure. To aid in this assessment, Standard & Poor's is introducing CDO Manager Focus, a new approach for analyzing CDO managers.

1. INTRODUCTION

   CDOs have become a mature investment vehicle and an important liquidity source for the high-yield and leveraged-loan markets. As non-investment-grade markets experience turbulence and many of the early CDO deals season, differentiating between CDOs is becoming more and more important.

   CDO investors face many considerations when picking an appropriate transaction for purchase. CDO structure, projected economic assumptions, and manager quality are the most important drivers for success, regardless of where in the capital structure the investment is taking place.

   Of the three factors influencing CDO performance, manager quality is probably the most important and difficult to predict. As evidenced by Exhibit 1, manager performance within an asset class/vintage can vary dramatically. This variance can be seen when deals of similar asset class/vintage are compared on several dimensions.

   Managers face many challenges in running CDOs, which make them more difficult to address than a typical total-return strategy. In turn, this makes anticipating their performance difficult.

   The conflicting interests of the investors present one challenge in running CDOs. CDO investors are typically composed of senior noteholders, mezzanine noteholders, and equity holders (investors absorbing first loss). These investors have different interests regarding portfolio contents. Senior noteholders typically desire more highly rated assets in the portfolio, while equity holders favor assets that produce higher yield. The mezzanine noteholders want to balance the portfolio's risk and yield to insure their continuing interest payments and the eventual return of their principal. Every investment and divestment decision confronts the manager with this dilemma. These decisions become more difficult when the investors' original expectations (with reference to interest payments, principal return, and expected equity returns) are in jeopardy.

   The restrictions and requirements of CDO structures are also complicating factors. For example, cash flow CDOs measure performance by comparing the par amount of the assets to the outstanding liability amount. A manager may choose to keep these ratios above their thresholds by purchasing discounted or lower rated securities, which improves the total par value of the portfolio while potentially sacrificing overall credit quality. Portfolio studies have shown that as these credits season, their default rates do increase, causing additional collateralization test issues, which in turn may lead to more speculative purchasing. These sorts of issues do not present themselves in a typical total-return strategy.

   Standard & Poor's will address the issues of CDO structure and economic assumptions separately. To this extent, this article will discuss the various factors that investors should take into account when assessing a CDO manager.

2. CDO TEAM FOCUS

   Examining the team, its organizational support, depth, stability, and investment process is a critical component of evaluating a CDO manager. This analysis should be revisited annually, with major personnel/organizational changes, or new deals prompting reexamination.

   1. ORGANIZATIONAL RESOURCES

      In order for a CDO team to be successful, it is vital that the sponsoring entity has the wherewithal and resources to support the manager. This includes having the ability to properly resource the team with personnel, technology, and appropriate capital. It is also helpful if a firm has the ability to help the team in other areas whenever possible. For instance, if a company has a significant convertible bond operation, it may be able to lend additional ideas, support, and redundancy to the convertible bond specialist dedicated to the CDO group.

      In addition, corporate motives must be examined. The CDO business is complex and should only be entered by companies that understand the scope of the commitment needed. It is important that the sponsoring organization recognizes its strategic importance and differentiates it from the total return strategies of its other assets under management.

   2. MANAGER AND TEAM ASSET EXPERTISE

      The first step is ascertaining the asset classification in which the manager is specializing. A typical CDO will have restrictions on the asset types that a collateral manager may purchase. For example, a high-yield CDO may limit all investments to only high-yield bonds. Other CDOs may allow the inclusion of several different asset types, such as bonds, loans, and asset-backed or emerging-market securities. A CDO manager and the supporting team taust have an in-depth understanding of the eligible assets to be purchased by the CDO. Thus, it is important that the asset class categorization is accurate and does not attempt to overstate the experience of the management team by assuming, for instance, that competence in high-yield corporate debt qualifies the team to competently manage an emerging-market or structured finance portfolio. Once the categorization is established, Standard & Poor's seeks to ascertain whether a manager and supporting team have sufficient experience with the relevant asset types.

      A manager should have a several-year track record with the specific asset types that will be included in the CDO. Recommended seasoning varies by asset class and by market cycles experienced. It is generally a risky proposition if the manager is taking opportunistic positions in securities that are not in his/her (or the firm's) core competency.

      In addition to the "core asset classes" for a given strategy, it is also important that a team have expertise in some other disciplines, such as hedging (for currency and interest rate hedging), workouts (particularly if the firm's strategy is to allow troubled issues...