As the arbitrage for collateral debt obligations comes in waves, placing CDO equity in a flood of deals is continually challenging issuers and their mandates.

Other conditions, such as a few substantial downgrades in the sector - namely a triple-A rated class of Northstar CBO - have made it even more difficult to find equity investors, market sources said.

"Even with the lucrative spreads available on the underlying collateral that goes into CDOs, it's still extremely difficult to place the pivotal first-loss piece, as investors are still uncertain regarding the near-term economic landscape," said David Tesher, a managing director in the CDO group at Standard & Poor's.

Lately issuers have been more inclined to retain the first-loss piece, a two-sided strategy, according to analysts, as it allows the manager to take advantage of an arbitrage on a timely basis, while maintaining exposure to the deal, something investors tend to place stock in.

For example, Canyon Capital Advisors, collateral manager on a $300 million CBO that launched last week, told investors that it is retaining 100% of the equity on the transaction.

CCA is a Los Angeles-based hedge fund founded by three ex-Drexel Burnham bankers.

Market sources said that collateral manager MKP is holding onto 60% of the equity on its $300 million deal, which launched on Jan. 19.

"Sometimes people retain equity in order to develop a track record if they've never done a transaction before," said Dave Howard, a CDO analyst at Fitch. "So they'll demonstrate their track record by keeping all of the equity in their first transaction."

It's also likely that some issuers are retaining equity with the intent to sell it in a better market, said Anthony Thompson, managing director in securitization research at Deutsche Bank Alex. Brown.

"To the extent that it is difficult to place equity at this very moment, to take advantage of the arbitrage, placing the equity at a later date is not necessarily a bad strategy, as the buyer base develops further," Thompson said.

Regardless of the intent of the manager, industry pros are acknowledging that tiering has begun in the CDO sector.

"Equity investors today are clearly in a better place to pick and choose which managers they want to invest in," S&P's Tesher said. "A trend that we're seeing evolve is the ability of repeat issuers to come to market more quickly than first-time issuers."

Tesher went on to say that some managers who have come to market more than once are rotating investment banks in order to broaden their investor base.

Further, according to market talk, banks that do not take equity are clearly at a disadvantage to banks who are willing to use their balance sheets to score mandates.

Adapting to the market

Some players are saying it would be easier to place equity if the collateral manager could get a rating on the first-loss piece.

"Certainly there are a lot of investors who have much more appetite for a security that carries a rating," said Fitch's Howard. "So getting a rating on the equity can greatly expand the universe of potential investors."

Fitch has rated the equity on a few transactions, though Howard said it can't be done for all deals. Since it's not a debt-like security, there are no stated interest payments, for one."So usually it's just a return of principal, which is a different analysis, but it's based on a lot of the same principles that we use in rating a debt transaction," Howard said.

S&P said it would be difficult, under its conventional CDO rating methodology, to rate the equity on a CDO, unless some sort of principal protection mechanism were structured into the deal. One way bankers have achieved this is by diffusing principal risk through Treasury strips.

"Given the degree of leverage and internal rate of return hurdles that managers are trying to achieve, it would be difficult for S&P to rate pure CDO equity that was not principal protected," Tesher said. "Under our various stress scenarios, the equity structured in today's deals would probably not be sized adequately to return a stated coupon and ultimate principal, even at a very low tier non-investment-grade level."

Still, CDO issuers are constantly proving their ability to rapidly adapt to changing market conditions.

For instance, a bearish high yield market was challenging to managers during ramp-up. Many are still choosing, when possible, to have warehouse facilities in place for an extended period of time prior to a deal closing, so that they are not caught in difficult positions, if unable to find choice collateral.

Got high yield?

Going forward, managers peddling high yield CDOs could face a squeeze. As the high yield market rallied over the last few weeks, compressing yields.

"We also see greater firmness in the high yield market and that is being driven by a general feeling that NASDAQ is not going to outperform high yield bonds this year," said Russell Hurst, director, asset-backed research at First Union Securities. "That drives people into high yield mutual funds and that means instead of just the CDO bid on high yield paper, you'll have a mutual fund bid and that will put further pressure on CDO arbitrage."

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