CDO manager quality: a critical consideration.
CDOs have become a mature investment vehicle and an important liquidity source for the high-yield and leveraged-loan markets. As non-investment-grade markets experience turbulence and many of the early CDO deals season, differentiating between CDOs is becoming more and more important.
CDO investors face many considerations when picking an appropriate transaction for purchase. CDO structure, projected economic assumptions, and manager quality are the most important drivers for success, regardless of where in the capital structure the investment is taking place.
Of the three factors influencing CDO performance, manager quality is probably the most important and difficult to predict. As evidenced by Exhibit 1, manager performance within an asset class/vintage can vary dramatically. This variance can be seen when deals of similar asset class/vintage are compared on several dimensions.
Managers face many challenges in running CDOs, which make them more difficult to address than a typical total-return strategy. In turn, this makes anticipating their performance difficult.
The conflicting interests of the investors present one challenge in running CDOs. CDO investors are typically composed of senior noteholders, mezzanine noteholders, and equity holders (investors absorbing first loss). These investors have different interests regarding portfolio contents. Senior noteholders typically desire more highly rated assets in the portfolio, while equity holders favor assets that produce higher yield. The mezzanine noteholders want to balance the portfolio's risk and yield to insure their continuing interest payments and the eventual return of their principal. Every investment and divestment decision confronts the manager with this dilemma. These decisions become more difficult when the investors' original expectations (with reference to interest payments, principal return, and expected equity returns) are in jeopardy.
The restrictions and requirements of CDO structures are also complicating factors. For example, cash flow CDOs measure performance by comparing the par amount of the assets to the outstanding liability amount. A manager may choose to keep these ratios above their thresholds by purchasing discounted or lower rated securities, which improves the total par value of the portfolio while potentially sacrificing overall credit quality. Portfolio studies have shown that as these credits season, their default rates do increase, causing additional collateralization test issues, which in turn may lead to more speculative purchasing. These sorts of issues do not present themselves in a typical total-return strategy.
Standard & Poor's will address the issues of CDO structure and economic assumptions separately. To this extent, this article will discuss the various factors that investors should take into account when assessing a CDO manager.
II. CDO TEAM FOCUS
Examining the team, its organizational support, depth, stability, and investment process is a critical component of evaluating a CDO manager. This analysis should be revisited annually, with major personnel/organizational changes, or new deals prompting reexamination.
A. ORGANIZATIONAL RESOURCES
In order for a CDO team to be successful, it is vital that the sponsoring entity has the wherewithal and resources to support the manager. This includes having the ability to properly resource the team with personnel, technology, and appropriate capital. It is also helpful if a firm has the ability to help the team in other areas whenever possible. For instance, if a company has a significant convertible bond operation, it may be able to lend additional ideas, support, and redundancy to the convertible bond specialist dedicated to the CDO group.
In addition, corporate motives must be examined. The CDO business is complex and should only be entered by companies that understand the scope of the commitment needed. It is important that the sponsoring organization recognizes its strategic importance and differentiates it from the total return strategies of its other assets under management.
B. MANAGER AND TEAM ASSET EXPERTISE
The first step is ascertaining the asset classification in which the manager is specializing. A typical CDO will have restrictions on the asset types that a collateral manager may purchase. For example, a high-yield CDO may limit all investments to only high-yield bonds. Other CDOs may allow the inclusion of several different asset types, such as bonds, loans, and asset-backed or emerging-market securities. A CDO manager and the supporting team taust have an in-depth understanding of the eligible assets to be purchased by the CDO. Thus, it is important that the asset class categorization is accurate and does not attempt to overstate the experience of the management team by assuming, for instance, that competence in high-yield corporate debt qualifies the team to competently manage an emerging-market or structured finance portfolio. Once the categorization is established, Standard & Poor's seeks to ascertain whether a manager and supporting team have sufficient experience with the relevant asset types.
A manager should have a several-year track record with the specific asset types that will be included in the CDO. Recommended seasoning varies by asset class and by market cycles experienced. It is generally a risky proposition if the manager is taking opportunistic positions in securities that are not in his/her (or the firm's) core competency.
In addition to the "core asset classes" for a given strategy, it is also important that a team have expertise in some other disciplines, such as hedging (for currency and interest rate hedging), workouts (particularly if the firm's strategy is to allow troubled issues to default and subsequently try to work them out), trading, and CDO structural compliance.
Besides the breadth of portfolio manager experience, it is also vital to examine the credit analytic team. Four important criteria include coverage levels, asset class, sector specialization, and team experience. If a team of three analysts is expected to cover 100 volatile, emerging market debt issues, it is unlikely that each member will offer sufficient analytical oversight, regardless of their individual level of expertise. These guidelines can vary from asset class to asset class. For example, small-cap leveraged loans may require more time to review (and are consequently more labor-intensive) than some other asset classes. Aside from asset class coverage, sector coverage can also be a mitigating factor to support requirements. For example, if a firm opts for a smaller number of sectors per analyst, it may be able to support more issues per analyst, as the analysts will be able to focus on developments in the industry in question. It is also important that the proper personnel with relevant experience cover the industries they specialize in. Some CDOs have industry diversification requirements-broad company expertise is necessary in these situations. The experience level of the credit analyst is another important consideration. The more experienced an analyst is in a given area, the higher the number of credits he/she can cover. It is also possible that other areas of the asset management organization, such as the equity team, can augment staff efficiency by providing credit-relevant background information on the company and industry.
C. MANAGER AND TEAM STRUCTURAL EXPERTISE
Managers should know the indenture intimately and shouldn't rely on external parties for compliance. To evaluate a manager without CDO expertise, Standard & Poor's will look to his/her prior track record in related asset classes, requiring longer tenure and underweighting this expertise relative to that of a seasoned manager. In situations where a manager lacks specific CDO experience, the organization must compensate by having a compliance officer knowledgeable in CDO structures. This will allow the manager the flexibility to dedicate his/ her time to managing credit within the CDO in a downturn. Given this asset class' unique nature, it is desirable to have the portfolio managers run CDOs exclusively, especially those with the same structure.
D. TEAM STABILITY
Another vital area to evaluate is the depth of the team. It is critical that key skill sets in the major asset classes and major disciplines (such as workouts, trading, etc.) have sufficient levels of redundancy. Given the fluid nature of this market, portfolio manager and analyst turnover is quite high. It is therefore important that the process ultimately be replicable should key talent leave the organization.
Financial incentives can go a long way toward improving team stability and aligning its goals with those of the investors. In some cases, organizations or individual managers take stakes in the lower tranches of a deal, which can prove useful in this regard. Typically, equity ownership can align a manager's interest toward the equity tranche, hut is typically regarded as a positive because the manager is receiving a direct incentive to maximize returns. The most important incentive, however, is that the manager must try to balance the interests of all the investors in order to launch additional transactions.
E. INVESTMENT PROCESS
The investment process is integral to evaluating a CDO manager. This process can be broken down into several components: credit evaluation, buy/sell discipline, and checks and balances.
The primary component of a CDO investment process is its credit evaluation practices. This ultimately underpins most actions related to the portfolio. The credit evaluation process will vary dramatically flora manager to manager. As stated before, some managers will organize by sector, while others will organize by asset class (for example, separate high-yield and investment-grade teams). Some managers rely on equity departments and public information, while others rely on company visits, internally generated cash flow, and residual value calculations.
While the organization of this function and its components are myriad, several practices are considered desirable. Besides having sufficient support and expertise, it is necessary to have periodic reviews, even if no news has emerged about the credit. Company visits or management meetings have varying degrees of usefulness-they are certainly more vital for companies that are smaller or more poorly monitored. Independence is another important element, particularly if the parent company has investment banking or syndication relationships with some of the portfolio obligors. One warning sign of this is a high concentration of assets from a single CDO underwriter. In this case, it is especially vital for the credit team to feel comfortable with each asset on its own merits.
A well thought out, risk-based sell discipline is vital in preserving ongoing interest payments to the investors and helping mitigate defaults. It is important that the stated strategy marketed to the debt and equity investors be consistent with the philosophy of the firm and its strengths. For instance, a firm with a strong workout group may feel that deteriorated assets should be held, possibly even through default, because the recovery terms may be advantageous. An additional benefit of this strategy is that not all deteriorated assets default, which means the CDO will get the advantage of additional interest payments and no par loss, which could result from selling the asset. The exact opposite approach, a high-turnover strategy (if the manager sells before serious credit problems occur), may also be appropriate in that the par erosion of selling these assets will be mitigated and defaults lessened. Whatever a manager's style, this process needs to be evaluated for consistency, results, and conformity with the firm's strengths.
Checks and balances area critical component to ensure process integrity. They can be designed in a variety of ways, but the essential characteristics stipulate that the appropriate senior managers and specialists view and approve the actions of the portfolio managers and credit analysts so the full expertise of the firm is utilized. This helps mitigate over-reliance on key personnel, discourages unauthorized trading, and leverages the strengths of the group's most seasoned resources. The establishment of committees to evaluate credit, make purchase decisions, and formulate asset allocation and other policies is also looked upon favorably.
III. CDO PERFORMANCE FOCUS
In addition to examining the quality of the team and its practices, the analysis of a CDO manager's quality via performance is critical in determining how a manager is implementing investment policies and assessing their effectiveness. This analysis has two components: the first is examining how a manager actually has performed in the past; and the second is the positioning of the current portfolio. These elements need to be examined from an absolute (how close has the manager come to not meeting his obligations) and a relative (positioning relative to peers) perspective. This analysis will be revisited annually, with downgrades, defaults, or new deals prompting a reexamination.
Typically, direct examination of specific CDOs is crucial because, if a comparison is made to a manager's previous or existing performance in a total-return fund, such a comparison could be misleading for the following reasons:
* Simply measuring the bond returns may be more reflective of how floating-rate securities have performed as opposed to the competence of the manager.
* Equity performance is a helpful tool, but does not take into account the degree of risk taken to achieve that performance, and equity pricing information (to compute the returns) is generally not available.
* CDOs are more restrictive than total-return vehicles, and have reinvestment restrictions mad performance triggers that most total return funds do not have.
* To a great extent, cash flow CDOs measure performance by using the par amount of the assets, while total-return funds measure performance by using market value.
* CDOs have different constituents-senior debt holders, mezzanine holders, and equity holders-whose interests are not always aligned.
This is particularly true when the underlying portfolio of a CDO is performing poorly. Experience has shown that, under difficult circumstances, such as in a high-default environment, even the most disciplined manager will usually behave differently while managing a CDO than when managing a total-return fund. For example, a CDO manager may be tempted to sell credit-deteriorated assets and purchase additional deeply discounted ones in order to maintain portfolio par and avoid triggering the various collateralization tests. Thus, it is important to focus on the performance of past CDOs.
However, if a manager has no CDO track record, or has managed only CDOs that are relatively new, it is important to consider the following:
* Long-term team experience with the asset type that will be purchased by the CDO, including various phases of the economic cycle.
* Performance over this period in the relevant asset class is competitive with appropriate indices.
* Consistent investment philosophy has been demonstrated.
Because asset management tends to involve a team (including one or more managers and analysts), and because of the mobility within the market, it is important to ascertain who was really responsible for historical performance. The Standard & Poor's manager evaluation will focus on people as managers, rather than just the institutions.
A. HISTORICAL PERFORMANCE ATTRIBUTION
One critical goal in evaluating current deals is to see the relative efficacy of the management team's policies with respect to its peers and certain absolute standards. A critical component of this analysis is the Standard & Poor's CDO Index. This series of composites, which arc asset-class and launch-year specific, is designed to give peer comparisons across a number of vital attributes that reflect the performance of the CDO portfolio, and is used actively in CDO Manager Focus to establish relative performance.
The most important measure of performance in a cash flow CDO is the default behavior of the portfolio. Ultimately, default behavior is the most accurate predictor of par loss, which can lead to the violation of covenants, de-levering, and other events that can undermine payments to the various constituents. The amount of defaulted securities in the portfolio is examined over a period of time. These statistics are compared to the underlying Standard & Poor's CDO Index in order to determine default behavior in context. Given the seasoning effects and differing behaviors among asset classes, it is not an "apples-to-apples" comparison to simply take a composite of CDOs without taking into account vintage and asset class.
Another important area is covenant violation. Two types of covenants are examined for historical performance purposes: the Overcollateralization Test and the Interest Coverage Test.
Generally, violation of the Overcollateralization Test (portfolio par/face value of a given tranche compared to a threshold ratio) is a result of a higher amount of defaults than were originally assumed by the underwriter. While this indicates significant problems, certain managers may allow a deal to de-lever (by violating the Overcollateralization Test) rather than compromise credit quality by purchasing deeply discounted assets (which would cure the violation, but create a riskier portfolio going forward). Additionally, a manager may feel that he/she has an effective workout group and would prefer to allow the securities to default and achieve favorable recovery rates rather than trade out of the securities at a distressed, pre-default price. The Overcollateralization Test spreads, relative to threshold for the senior and junior-most tranches, are reviewed to see how close the deal is to triggering these tests as well as compared to peers through the Standard & Poor's CDO Index.
The Interest Coverage Test is also crucial, as it examines a portfolio's ability to pay each tranche (interest income from portfolio/interest payments to a given tranche). If the Interest Coverage Test is violated, it is very serious, as the debt can no longer be serviced until the situation is rectified. Violations will typically involve de-levering, paying in kind (issuing debt to cover the defaulted interest payments), or deferring interest. These actions have the most directly negative impact on performance because they directly delay or default specific cash flows.
Weighted average spread and weighted average coupon, while not necessarily covenants, are monitored closely as well. If these measures begin to decrease significantly, it usually signals credit deterioration, because a manager will often trade excess spread to rebuild par.
Another area to examine is par erosion. It is important to examine par erosion across the whole portfolio to see whether the default activity has had a significant, long-term effect on the portfolio, or whether, due to astute trading and workout activity, the par characteristics have been maintained without significantly greater credit risk. In addition, cash holdings are reviewed to ensure that cash is being properly deployed. Standard & Poor's views the breakdown of par erosion in conjunction with portfolio credit quality to ensure that par is not rebuilt at the cost of a riskier, more credit-vulnerable portfolio.
Another area that warrants historical examination is the upgrade/downgrade ratio. This ratio measures the credit trends in the portfolio by comparing the par value of the upgrades to the par value of the downgrades. While many CDOs experience a decline in credit quality, the rate of this decline relative to the trends in the market place is an important indicator of past performance and is a helpful indicator to estimate future default behavior.
B. TRADING AND RECOVERY ACTIVITIES
Trading activity is an invaluable tool for evaluating manager intent, practices, and current positioning of the portfolio. Three primary measures are important in assessing this behavior. The first is selling activity. It is crucial to examine sales prices for all trade types: credit-risk (trades made when credit quality is eroding), credit-improved (trades made to profit flora strengthening credit), and discretionary (trades for repositioning or opportunistic reasons). Additionally, recovery rates and purchasing behavior are important measures.
Examining sales prices will help determine whether the manager is making distressed sales (which means in turn that his &fault rate could be relatively lower) or whether he is pursuing a more aggressive selling policy by selling the securities before significant price erosion. If selling activity occurs at low prices and an accompanying high default rate and poor recovery rate are experienced, it is likely a sign of an unsuccessful strategy. High recovery rates are always viewed positively, but weaker recovery rates are most important if a manager relies on workouts and doesn't sell credit-impaired securities aggressively. Standard & Poor's examines sales prices, recovery, and default rates relative to manager style and its peers via the Standard & Poor's CDO Index. The par loss/gain as a result of the transactions is directly related to sales prices. This is a direct indicator of how successful the trading and workout strategies have been, and is examined relative to peers as well.
Purchase price is also an important indicator of strategy and positioning. High and low purchase prices are not negative or positive per se, but may indicate various practices that Standard & Poor's will examine. High purchase prices typically indicate purchases on the higher end of the credit spectrum. This is generally a positive sign for portfolio default rates, as long as an examination of the Interest Coverage Test reveals that payments will not be diminished enough to cause cash flow problems. On the other hand, a lower relative purchase price could indicate that a manager is trying to rebuild par after a series of defaults or Overcollateralization Test failures. Additionally, a low purchase price at deal ramp-up could indicate a practice that is generally disadvantageous to all but the equity holders. In the ramp-up period, certain managers may purchase securities at steep discounts. Then, once the par amount is within the specifications, they pass out the remaining proceeds to the equity holders. This practice not only leaves the portfolio in a credit-weakened stare, but it could also decrease the overcollateralization amount that may be necessary to absorb future losses due to credit risk sales and defaults. In these situations, portfolio credit quality would be examined for significant declines.
Another possibility is that the portfolio manager is purchasing securities that he expects are undervalued. In this situation, the subsequent performance of the securities should be examined to determine if the manager is an effective active trader.
C. CURRENT POSITIONING
Merely examining what has happened historically in a CDO is tantamount to not examining risk in evaluating return in the total-return space. It is important to examine current portfolio positioning in order to create a balanced evaluation of not only how well the manager has done to date, but how well the portfolio is positioned going forward.
Diversification and ratings breakdown are two important elements in evaluating the contents of a cash flow CDO portfolio.
Diversification has many components, many of which are important to examining CDO portfolios. They include instrument diversification (types of bonds, loans, etc.), geographic diversification (especially important for emerging-market CDOs), sectoral diversification (across industries), and obligor diversification. The degree of diversification in the portfolios is important to understand so that managerial style, risk tolerance, and required support levels can be properly evaluated. Standard & Poor's feels it is important for the investor to understand the various risks implied by various concentrations.
Ratings breakdown is a very important predictor of future portfolio behavior. A large concentration of 'CCC' credits (the cumulative par of all non-defaulted assets below a 'B-' rating) is a definite warning sign that a manager's portfolio credit is eroding rapidly, or that she is aggressively purchasing weaker credits to rebuild the various par measures. In either case, this is a definite negative. Examining rating breakdowns by industry and instrument type can reveal where a manager is taking risks and where a portfolio's vulnerabilities lie. For instance, Standard & Poor's would have a negative view of a manager who had a large 'B' exposure in steel, but did not have any experienced steel analysts. Standard & Poor's would view this negatively because this implies that the manager's practices are oriented toward satisfying some artificial indenture test rather than investing in the manager's area of expertise. This nuance may not have come to light if Standard & Poor's was only looking at the 'B' credits in the aggregate.
IV. SYSTEMS AND OPERATIONS EVALUATION
It is also necessary to examine the systems and operations area. Given the structural complexity of CDOs, it is important that CDO managers have a current perspective on a portfolio's contents and the associated implications for the various covenants and structural issues. Reliance on the trustee for these types of information is not optimal and can lead to operational problems and managerial mistakes. In addition, it is critical that the appropriate controls and documentation be present so that a manager's firm is protected from unauthorized trading, poorly researched credits, and procedural violations. While having adequate operational structure does not guarantee strong CDO management, it is a prerequisite for having an effective organization in this area.
V. WHY STANDARD & POOR'S CDO MANAGER FOCUS?
CDO manager evaluation is a complex, multifaceted process. Standard & Poor's believes that three major elements are needed for a balanced and robust evaluation of the manager--all of which are related. The first component is the team and the organization. Portfolio manager skill is quite important in this product, due to its complexity and the volatility of many of the underlying investments. Portfolio management teams can be evaluated by their experience, depth, organization, and investment process. The second component is assessing the performance of the existing deals. This is also a multifaceted process, involving examining default and return behavior, as well as trading practices and portfolio positioning. Over time, equity return results will be incorporated into the analysis as well. Finally, it is important that an appropriate operational, systems, and compliance infrastructure exist to allow the management team to achieve its objectives.
Standard & Poor's maintains a neutral opinion in terms of evaluating manager style. Looking at past CDO performance tells Standard & Poor's that many different approaches can work, as long as they are properly supported and consistently applied. For instance, some managers are more aggressive traders, selling securities when they become distressed. Others are experts at workouts and allow securities to default to optimize terms upon recovery. Some managers maximally diversify their portfolios, while others focus on a few sectors that are their core areas of expertise. Standard & Poor's main focus in these evaluations is to be able to ensure that the managers are sufficiently resourced to accomplish their goals, that their results compare favorably with those of their peers, and that they conform to their own processes and indenture guideline in a relatively consistent manner. Ideally, all investors should go through a similar line of inquiry when investing in a CDO deal. Alternatively, in building on the large volume of transactions analyzed and access to large amounts of data by Standard & Poor's, CDO Manager Focus can assist investors in effectively evaluating collateral managers.
Standard & Poor's
MARK GAW is an Associate Director in the Structured Finance Division of Standard & Poor's. For the past three years, Mark has rated cash flow and balance sheet CBO/CLO structures, worked on criteria issues, and worked on esoteric structures and new asset types. Currently, Mark is the head of the CDO Manager Focus group. Prior to joining S&P, Mark worked as a tax attorney for the Department of Finance, Tax Policy Division. Mark has an Engineering degree form Polytechnic University, a Law degree from Brooklyn Law School, and a Master's in Taxation from NYU Law School.
Exhibit 1.. Manager Performance Measure Top 10 Bottom 10 Defaulted Securities Held (% of collateral) 0.10% 13.91% Total Sales Net Losses (% of collateral) 0.02% 1.29% Recoveries (% of par, for deals with recoveries) 49.49% 2.55% Source: Standard & Poor's CBO Index Deals, 1999 High-Yield Cohort, six-month average: October 2000-March 2001.
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|Title Annotation:||collateralized debt obligations|
|Publication:||The Securitization Conduit|
|Date:||Mar 22, 2002|
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