LAGUNA NIGUEL, Calif. - Amid a rash of CDO structural innovations designed to lure equity investors, a familiar debate is again rearing its head - whether CDO managers should invest in the equity of the deals they manage. While some investors say a manager that puts its "own skin in the game," demonstrates confidence and commitment toward its product, others say a manager's equity investment could present a conflict of interest.
"It is definitely a plus to us when we see the manager has invested in a small piece of the equity," said Sandra Johnson-Harris, a director at Invesco, speaking at Opal Financial Group's CDO Summit held here last week.
CDO equity tranches, which are generally unrated, are arguably the riskiest slice of the CDO capital structure. Equity investors are paid the cash flow leftover from a CDO's assets after expenses - such as paying investors holding higher rated notes - are deducted. A CDO manager holding too much or all of a deal's equity could present some conflicts of interest. Horror stories exist within the industry of equity laden CDO asset managers stomping over the interests of debt investors in order to collect as much cash as possible. Now, a recent trend with the CDO sector to eliminate structural features that divert cash flow to higher-rated tranches in the event of poorly performing collateral has some questioning whose best interests are in mind.
Easy on the equity
Invesco's Johnson-Harris, among other investors, was quick to point out that a manager with too much skin in the game could end up favoring its own interests over those of debt investors. "We have certainly seen that happen," said Ronald Mass, a senior portfolio manager at Western Asset Management. Mass painted a scenario of a CDO manager deliberately prolonging triggers from being met in order to infuse the equity tranche with one or two more payments. "We don't think it is appropriate to invest in equity."
Western Asset Management is not alone in its policy against investing in the equity of deals it manages. Trust Company of the West, the largest CDO manager by outstanding liabilities, also follows the same rule. Whether a manager is dinged for opting out of equity investment seems to hinge on the name that manager has made for itself. A lesser known manager suddenly opting out of an equity investment is likely to raise red flags.
"It is the policy of our firm that the manager should have some stake in the equity - unless it is their policy not to," said William O'Brien, vice president, structured finance at IKB Capital Corp. O'Brien said his firm has declined amendments which would have allowed a higher rate of return for the equity his firm, along with the deal's manager, was holding. "We're just not comfortable with the manager stretching like that."
Trigger timing key
In terms of structural features that remove triggers, some would say the jury is still out as to whether they will help or hinder equity investors - but they are popular. "I think we have about as many triggerless deals as plain vanilla mezz ABS CDOs," said Lang Gibson, a senior director in CDO research at Merrill Lynch.
CDOs that lack interest coverage and over-collateralization triggers have been around in the corporate synthetic sector for a while, according to Alex Wei, senior vice president and head of structured credit investments at Delaware Investments. The absence of such triggers is compensated for with another credit deterioration backup plan - excess spread - and issues such as timing of defaults will ultimately dictate the success of a given deal's structure, he said.
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