Equity holders in a fund often seek out replacement managers for ailing collateralized debt obligations (CDOs) based on the strength of the replacement portfolio manager's track record. But rarely, if ever, has a firm established a distinct replacement manager business whereby the firm proactively targets poorly performing CDOs that need replacement managers. That's exactly what Prudential Investment Management (PIM) is doing.
With at least eight deals under its belt so far, the firm, which is a division of The Prudential Insurance Company of America with $310 billion in assets, appears to be carving a new market niche by marketing itself specifically as a replacement manager, in addition to being a traditional CDO manager.
"I am not aware of managers that position themselves specifically as replacement managers," said Adam Glass, a partner at Sidley Austin Brown & Wood LLP, who handles CDO transactions. Glass explained that CDO managers are usually replaced when either a deal is performing poorly, when a "key man" provision has been triggered (when a firm fails to retain certain investment manager or managers that are required to stay on the deal), or when an investment management business is acquired by another company, thus causing a change in control under the Investment Advisers Act that requires the manager to be reapproved by CDO investors to remain in the job.
PIM has taken on CDOs in all three of these scenarios. "We have experience in managing distressed CDOs," said Timothy Aker, a managing director and portfolio manager for loans and high yield at PIM, who spoke at Bear Stearns' 13th annual CDO Conference last week. He added, "We like to provide an alternative for investors.... It allows us to help out existing investors that have a relationship with us, and to create new relationships."
PIM operates its recovery management process through a series of steps so that it can conduct a bottomup review of a distressed fund, Aker said. Beginning with collateral triage, portfolio valuation and document review, the firm will evaluate a distressed fund. Then PIM will consider strategic alternatives, and lastly, hold discussions with the investors and, possibly, the underwriter to determine how the replacement agreement should be settled. Aker said the process can take anywhere from one to six months. Its most recently attained replacement manager role, for Times Square Loan Trust 2000-1 in April, was settled in less than one month, Aker said.
Nonetheless, despite carving this new niche in the market, some market players said replacement managers aren't needed so frequently that droves of firms will rush to set up their own replacement manager businesses. For CLOs, "in many cases, a replacement manager is needed to clean up the loose ends on a maturing deal that a portfolio manager doesn't feel like dealing with," one loan investor said. "But there is probably more opportunity for poorly performing deals in the bond market as opposed to the loan market," he noted. "This service by Prudential certainly isn't common.... Investors probably feel comfortable with the name," he said, explaining that with a distressed fund, a widely known name such as Prudential's managing it might put investors at ease.
Of course, PIM is turning some profit from its new replacement manager business. "In each circumstance, we usually will negotiate an additional fee," Aker said, noting that the firm's right to negotiate fees depends on whether PIM has a limited or more active mandate on the CDO.
The oldest CDO for which PIM is still acting as a replacement manager is ML CBO Series 1998 E&P. In March 2001, Prudential picked up the underperforming CDO from former manager, Elliot & Page.
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