4. How are CLOs Managed

Behind almost every CLO sits a company known as the portfolio manager, the collateral manager or simply the manager. For actively managed CLOs (which is to say, most of them), the manager is the key institution driving the deal.

Managers may be small, standalone firms or they may be large insurance companies, loan managers or hedge fund managers. Most often, the team of people involved in managing the CLO will be small. There is usually a core team of portfolio managers, typically no more than two or three people. They will be supported by a handful of research analysts, compliance specialists and marketing staff. Those resources will usually be shared across other investment products and the small team of portfolio managers will usually manage (or aspire to manage) a suite of several CLOs. The same team will often also manage assets for other related products such as loan mutual funds or separate accounts.

To avoid confusion, we will refer here to the management firm as the manager and to the individual decision-makers as portfolio managers.

Once the deal has closed, the CLO starts to accrue interest on all its notes. However, most deals do not have a full portfolio of assets on closing. This creates a negative carry – a shortfall between the amount of interest coming into the deal and the amount being paid out. Therefore, the manager has an incentive to build the portfolio as quickly as possible in order to eliminate this drag.

However, building the portfolio quickly may be at odds with building a good portfolio (one with diversity and a healthy level of income relative to the credit risk of the loans).

Therefore, between the closing date and effective date, the manager will usually work to optimise the mix of assets in the portfolio. For example, it may start by buying relatively large chunks of loans in the primary loan market, and then trade these for smaller positions in the secondary market, in order to build a more diverse and higher yielding portfolio.

For investors, manager co-investment in a CLO is usually regarded as a good thing. Especially where key people at the firm have their own personal money tied into a deal, it usually ensures that the manager takes decisions in the interests of investors. Of course, not all investors’ interests are the same. In particular, debt and equity investors often have diverging interests. Although it can happen that a manager will invest in the debt tranches of one of its CLOs, usually CLO managers invest only in equity tranches.

Manager co-investment can also help a CLO to be compliant with European risk retention rules (see chapter 12: CLOs and regulation).

Size and style are often closely related. A large manager will need to buy more assets across its various funds and CLOs than a small manager. Therefore it will need to buy larger loans on average to achieve that scale. A smaller manager can choose not to buy these large loans if it feels they are overpriced. On the other hand, the greater buying power of a large manager should mean that it is able to get large allocations to the loans it prefers, and it may be able to buy the loans at more favourable prices.

However, they are not the only factors that determine the performance of a CLO. Perhaps the most important is timing. Some of the most successful CLOs ever have been those that were able to buy assets cheaply when loan prices were depressed, reaping the advantage when those loans went on to perform better than expected. Another factor affecting performance is the rules under which a CLO was set up. A deal prohibited from buying certain types of assets may underperform its more flexible peers. On the other hand, if investors insist that a CLO shun certain assets that turn out to be bad investments, their deal will benefit.

Not surprisingly, asset management firms do not like to include provisions which could see them lose the right to manage a deal. However, the individual portfolio managers concerned will normally welcome the extra bargaining power this provides over their employer.

The senior fee is a fee that the manager will receive regardless of the performance of the deal. It is paid out ahead of most other payment commitments in the CLO’s interest waterfall (see chapter 5: Understanding the cashflows). Typically, the senior fee is around 15 basis points a year (0.15% a year of the CLO’s total assets). The idea of the senior fee is that the manager receives enough money to be able to carry out its management duties, even if the CLO performs poorly.

While the senior fee comes out of the interest waterfall ahead of debt interest payments, the junior fee is paid only if there is enough money for the CLO to pay its coupon on all the CLO notes. Usually, the junior fee is the last item the CLO pays before distributing money to the equity investors. The junior fee is usually bigger than the senior fee – typically between 30-35 basis points a year. It ensures a healthy stream of income for the manager of a CLO that is performing at least well enough to meet all of its commitments.

The third kind of management fee is linked directly to the returns received by equity investors. Usually, once a CLO reaches a certain hurdle rate of return for its equity investors, all equity distributions above that point are split, with the manager typically keeping 20% while equity investors receive 80%. This incentive fee can be by far the largest part of a manager’s income from a CLO, but it is not uncommon for the performance fee to be zero because the CLO fails to achieve the hurdle rate of performance.

Where there are two managers, there is usually a main manager and sub-advisor. Although it might be thought that the sub-advisor plays a subsidiary role, this is often not the case. One of the most important reasons that sub-advisors have been appointed on CLOs in recent years is where the original manager has decided to sell its right to manage a CLO (see mergers and acquisitions, above).

In some cases, the selling manager cannot gain investor approval to transfer its management contract. So, instead, it remains as the legal manager of the CLO, with the acquiring manager taking on the sub-advisory role. In these instances, the sub-advisor becomes, in all practical senses, the manager of the deal and receives the greater part of the CLO management fees.

Manager removal clauses vary considerably from deal to deal. Managers are free to resign from their roles. But the right to choose a successor may be held by equity investors or it may be that all classes of investors need to approve the new manager. Alternatively, the successor manager may need to be approved by only equity investors and the controlling class of investors.

Another important subtlety is that some CLOs allow for the approval of a replacement manager by deemed consent while others require an active vote by investors. Deemed consent means that investors who do not exercise their right to vote are deemed to have approved the proposal. This makes it easier for those proposing the new manager (perhaps the outgoing manager and equity investors) to secure approval for their plans.

Managers can also be sacked against their will. Most CLOs allow some combination of investors to remove a manager either “for cause” or “without cause”.

Typically, the controlling class of investors can vote to remove the manager for cause. But this can usually happen only in a few narrowly defined circumstances, such as:

Alternatively, the manager can also be removed without cause, perhaps because investors are simply unhappy with the way the CLO is being managed. But, this typically requires a high proportion, such as 75% of each class of note holders, to vote in favour of removal.