For collateral managers who focus on CDOs, the most recent stream of troubling news in the financial sector has further shaken up an industry already reeling from more than a year's worth of nega-
tive developments, including a scarcity of liquidity, downgrades, declining issuance volume and an overall decrease in investor confidence in structured products. As may be expected during a downturn in any particular market segment, the ensuing chaos has swallowed up the weakest players and provided an opportunity for stronger players to expand their market share by picking up shakier competitors at bargain prices. Although mergers and acquisitions in the collateral management space have been limited to date, the consolidation wave that has swept up the banking industry in recent weeks will likely hit the collateral management world before long, leaving struggling collateral managers forced to either close up shop or seek haven with stronger institutions.
Many of the legal and business issues surrounding collateral manager acquisitions are similar to those encountered in traditional corporate mergers and acquisitions, however, a few in particular are unique to this sector - most notably those relating to the assignment or acquisition of collateral management agreements, which are often viewed as the most valuable assets of a target manager's business.
Acquiring the Management Contracts
The handful of mergers and acquisitions that have been effected thus far have employed one of three basic structures: sub-management, outright assignment and traditional merger/acquisition.
In a sub-management arrangement, the original manager delegates some or all of its rights and duties to the sub-manager while remaining primarily liable to noteholders and other creditors. Because of this retained liability, a sub-management arrangement does not typically require noteholder approval and can usually be accomplished with rating agency confirmation alone, saving time, money and frustration. However, the original manager's continued liability leaves it vulnerable to losses caused by the sub-manager's activities, while the sub-manager is at risk of losing its rights to receive collateral management fees in the event of a removal of the original manager. To address these concerns, the parties to a sub-management arrangement will sometimes negotiate an indemnity from the sub-manager to the original manager to cover liabilities and a liquidated damages provision in favor of the sub-manager compensating for the present value of lost management fees. These protections create an ongoing relationship between manager and sub-manager, which may not be appropriate where the selling party seeks to divest itself completely of its collateral management business.
An outright assignment, on the other hand, minimizes any such lingering relationship, as the new manager succeeds to all of the rights and duties of the outgoing manager. In an assignment, the assigning manager is entirely replaced, and the new manager becomes directly liable to the noteholders. Consequently, assignments typically require approval by at least some noteholders, which may be difficult or, in some cases, even impossible to obtain given the current credit environment.
The third approach, a more traditional merger or acquisition structure, typically involves the purchase of the stock (or, alternatively, all of the assets) of the target company. This approach generally avoids the necessity of obtaining noteholder consent but has the disadvantage of transferring potentially unwanted lines of business and other unrelated liabilities of the acquired manager; thus, an acquirer desiring a more surgical removal of the collateral management contracts would likely prefer an assignment or sub-management structure.
Following the transfer of the collateral management agreement to the successor manager, however accomplished, management fees may sometimes be split by the parties on a going forward basis. An acquired manager may negotiate for this feature to recoup any upfront expenses it may have incurred as the sponsor of its CDOs. An acquiring party already in the collateral management business may be amenable to such an arrangement since even a reduced portion of the management fees to be earned from the target manager's portfolio could outweigh any incremental management costs.
Alternatively, the expected cash to be received from future collateral management fees might be used to finance some or all of the acquisition price over a period of time. In either case, the selling party bears the risk that the new manager will be removed or that the CDOs will default or otherwise amortize prematurely, cutting off the payment of management fees earlier than anticipated. This risk may also be addressed with a liquidated damages clause (as discussed above).
While it is difficult to predict the future of the now fragile CDO space as a whole, if current dynamics in the banking sector are any indication of where the market is headed, we can expect to see a surge in collateral manager M&A volume, at least in the short to medium term.
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