CDO managers - Do the ends justify the fees?

With credit conditions likely to deteriorate, more investors are likely to seek active management in synthetic collateralised debt obligations. But do managers make enough difference to warrant their fees? Mark Pengelly reports

In the workplace, those who manage well are supposed to make a difference, and good managers are expected to be compensated accordingly for their skill. Equally, good synthetic collateralised debt obligation (CDO) managers are supposed to have an impact. The good ones should offer investors some comfort during challenging credit markets by using their expertise to limit defaults and losses.

The global CDO market reached an estimated $481 billion in 2006, according to research from Dresdner Kleinwort. Actively managed deals first emerged during the last credit downturn in 2001-02, but since then have come to represent a significant chunk of the global CDO market.

Now that the credit cycle looks poised to take a turn for the worse, the addition of a manager in CDO transactions would appear to be more vital than ever. But just how valuable are managers and do they merit the stiff fees they demand?

For their part, CDO managers are quick to stress that managed deals have helped make the asset class accessible to more cautious investors, such as pension or mutual funds, which may not have the expertise in credit to take a long-term view or do not have mandates to invest without the added protection of a manager.

"There are a number of investors who couldn't invest in structured credit without a manager. We also give them access to someone who's watching structured credit 24 hours a day, seven days a week," says Andrew Jackson, who works in quantitative research and risk management at London-based CDO asset management firm Cairn Capital.

Indeed, many investors believe that managers, by definition, bring security to their investments. In the context of a CDO, a manager can trade out of bad credits before a default or downgrade occurs, protecting the investor against losses. At the same time, those more active managers are able to use their credit knowledge to enhance the quality of the underlying portfolio and create additional value.

Terri Duhon, London-based managing partner at B&B Structured Finance, a consultancy specialising in credit derivatives and structured credit products, likens CDO asset management to "dodging bullets". For her, the benefits of management seem fairly clear: "A period of five years is a long time to take a view on a static portfolio of around 100 corporate credits. As a result, when people ask us for advice, we always say credit needs to be managed."

The benefits of management would appear particularly obvious for equity investors, who could suffer a loss on their investment from the first default onwards. But it can be hard to prove whether managers actually do add value and generate alpha.

"I think it's worth asking the question," says Lebanon-based Oussama Nasr of DNA Training & Consulting, a consultancy specialising in derivatives, risk management and structured finance. "It's really no different a question to that you would ask if you were investing in any other asset class. And it's not convincing that managed deals make sense for everybody, frankly. I strongly feel that in some cases they are not worth the effort."

Do managed deals outperform or not? Finding firm statistics to back up a view on this question is difficult. Derivative Fitch, however, has attempted it. Jeffery Cromartie, a director at the agency in London, has put together research looking at ratings upgrades and downgrades for all Fitch-rated European synthetic CDO tranches from 2002-2006. The survey splits deals into either managed or static categories. Cromartie hastens to point out that this can be a fairly arbitrary distinction for some lightly managed vehicles - where credits are only substituted when a default appears imminent. But he is able to draw a tentative conclusion: "Relative to synthetic CDOs with static portfolios, managed synthetic CDOs in Europe experienced consistently fewer downgrades over the past five years."

In 2006, the proportions of managed and static synthetic CDO tranches downgraded were 2.75% and 8.01%, respectively (see figure 1). While 2006 was admittedly a good year for Fitch-rated CDOs generally, with less than 6% of all tranches downgraded, the data is roughly commensurate with other years. From 2002-2006, the proportion of static synthetic tranches downgraded has been consistently higher than the proportion of managed tranches, by an average of 2.5 times.

In 2006, the average severity of downgrades was also higher for static synthetic tranches, at minus 2.6 notches as opposed to minus two. However, historical results for this measure vary - in both 2003 and 2004, the amount of notches by which managed deals were downgraded on average was in fact higher than static deals by around one notch.

The Derivative Fitch survey investigated upgrades, too - although here the picture is more mixed (see figure 2). In 2006, 12.47% of managed synthetic tranches experienced upgrades versus 12.26% of static synthetic tranches. But in 2005, the number of static synthetic tranches upgraded (33.23%) exceeded that of managed synthetic tranches (8.82%); and in each of the two years prior, the proportion of static synthetic tranches upgraded was higher by a few percentage points.

Equally inconclusive is the data on the magnitude of upgrades by number of notches. In 2006, the average magnitude of managed synthetic tranche upgrades was lower than that of static synthetic tranche upgrades by 0.65 notches. Between 2003 and 2005, this relationship was reversed, with the magnitude of managed synthetic tranche upgrades exceeding that of static synthetic tranches by around 0.4 notches.

Cromartie of Derivative Fitch warns against drawing too much from the upgrade figures. "Upgrades are primarily driven by increases in credit enhancement," he says.

Credit enhancement increases naturally in static synthetic CDOs as a result of the de-leveraging that occurs as deals move closer to maturity. However, credit enhancement does not build up in the same way in managed deals, as credits in the underlying portfolio might be substituted. The result is that managed synthetics are less likely to receive upgrades as a result of a de-leveraging of the structure.

The Derivative Fitch research goes further than any other piece of work yet in demonstrating CDO managers' role in preventing ratings downgrades, and therefore in keeping mark-to-market losses at bay. But it is not perfect: Moody's Investors Service and Standard & Poor's typically receive the lion's share of CDO ratings business, so Derivative Fitch-rated deals represent a smaller slice of the market. Some market participants are also critical of the merits of pooling together CDOs representing diverse underlying assets in a single study.

Cromartie concedes it is a broad-brushstroke picture that does not offer any definitive conclusions. It does not take into account, for instance, actual equity returns, nor does it offer any insight into relative performance between deals that are neither upgraded nor downgraded.

Paul Varotsis, former head of CDOs at Barclays Capital and a London-based partner at Reoch Credit, a consultancy specialising in derivatives, asset-backed securities and life contingencies, thinks the Derivative Fitch study probably justifies the role of the manager. But he believes the real question is whether managers add greater value to the CDO than their overall costs, including the fees they charge investors. Going down this route of inquiry would involve reams of privately held information on management fees and total returns that neither managers nor investors are keen to disclose.

While definitively proving managers add greater value than their costs is difficult, it does not preclude some fervently held beliefs about whether managers can justify their fees. And some market participants, such as Nasr of DNA Training & Consulting, believe many do not: "It's pretty obvious that in some areas of the business, the management fees are way too high relative to the difference a manager can make."

Separating the managers who justify management fees from those who don't is problematic. The lack of comparable, publicly available statistics on manager performance relative to fees has allowed managers with mediocre track records to charge roughly the same as those who have outperformed. However, consultants and investors report an emergent trend toward segmentation of managers on the basis of fees.

CDO asset managers usually hold entitlements to fees at the senior and subordinated levels of the vehicles' capital structures, and can receive additional incentive fees if they outperform above a certain hurdle. B&B Structured Finance's Duhon says she's aware of one manager that had a good track record in structured credit persuading prospective investors to lower the barrier above which incentive fees were to be paid. The outcome was that the final level was several percentage points lower than the market would have otherwise dictated. She believes that this kind of differentiation in CDO managers' fee structures is likely to increase.

Other consultants say tiering is becoming visible in other ways - for instance, the speed at which synthetic CDO deals sell and the pricing of the individual tranches. Nasr of DNA Training & Consulting says this is much more obvious within equity, where those managers deemed to be more experienced and credible achieve tighter pricing.

"It gets more pronounced the further you go down the tranches. What does it matter who's managing the deal if it's an AAA tranche you're buying? The AAA tranche is going to get paid with a 99.98% certainty, even if you've hired a one-eyed chimpanzee to manage the deal. But the BB tranche - that's a very different proposition," he says.

Derivative Fitch is among those attempting to provide some insight into how the varying abilities of CDO managers measure up, via its CDO Asset Manager (CAM) ratings. The ratings work by scoring managers from CAM1 to CAM5 - where CAM1 is highest and CAM5 is lowest. They are based on infrastructure factors such as procedures and controls, technology and CDO administration, as well as company and management experience, staff and portfolio management. However, this does not give investors any information on the relative performance of the CDOs the asset management firms manage.

Making a comparison between managers is made more tricky by the fact that the role of the CDO manager is understood differently by a variety of managers, investors and arrangers. For instance, CDO asset managers such as Axa Investment Managers (Axa IM) stress that they offer more than just the ability to pick credits, and that investors buying into a managed synthetic CDO get a whole package: structuring, credit selection and counterparty management.

Laurent Guenier, Axa IM's Paris-based head of investment-grade CDOs, says the value of the manager also extends to selecting the right arranger to work with, as well as the structuring and day-to-day management of the CDO. "The first responsibility for the manager is to check out what kind of structure he is managing," he says.

London-based hedge fund and CDO asset manager Cheyne Capital is another firm that gets actively involved in structuring deals. According to David Peacock, Cheyne's co-head of credit, preparing and structuring deals is a core part of the managers' work - although this does not extend to all managers. "Some managers are not very structurally focused," he remarks.

Because structures and managers are never exactly alike, it is best to examine both on a case-by-case basis, as opposed to making sweeping judgements about managed versus unmanaged deals. Investor due diligence is vital, particularly as unscrupulous managers do exist and have the ability to torpedo otherwise sound deals (see box).

Even so, most market pundits agree it would be good to see some expansion on the work done by rating agencies such as Derivative Fitch. However, the relative value of managed versus static synthetic CDOs may not become fully apparent until there is a turn in the credit cycle. "I'd think you would find a larger difference - I hope anyway - in a more hostile market," remarks Axa IM's Guenier.

Managed synthetic CDO transactions have yet to be tested in a serious credit downturn. How managers cope with rising default rates and spread widening is more likely to offer key insight into the value they add.

"We've operated in a relatively easy environment," says Reoch Credit's Varotsis. "In my view, every time you come through a credit crunch, some of the managers do not survive. That's when you get to see which ones are worth the money you're paying."

A WEIGHTY ISSUE

There are plenty of horror stories about unscrupulous or inexperienced collateralised debt obligation (CDO) managers. Saul Haydon-Rowe is a partner at Devon Capital in London, a firm that specialises in picking up the pieces where deals have gone wrong.

"We advise on deals that have underperformed and we get consulted by investors on how they can remedy that - whether it's by restructuring, negotiation or, if all other routes have been exhausted, litigation. We've certainly seen some deals where the management has been questionable."

Consultants say it is obvious that a manager's substitutions are not always going to improve the credit quality of an underlying collateral pool. But there are also a number of other ways transactions can be compromised, and some ruses are particularly common.

Not all managers are actively involved in initial portfolio selection, but where they are, so-called barbelling can be an issue. This is a tactic used by some managers to generate the maximum amount of spread from a CDO, but it can be devastating for the portfolio's rating. It involves loading a vehicle with credits whose spreads are trading relatively widely in relation to their ratings. When credits are finally downgraded, it can mean huge mark-to-market losses for the CDO.

"Barbelling has been a major factor in most of the deals that Devon Capital has seen that have gone badly. There's a big temptation on behalf of the manager to barbell but it does increase the risk disproportionately," says Haydon-Rowe.

In the course of day-to-day portfolio management, CDO managers do not always look after the best interests of all investors. In the past, many managers took exposure to the equity tranche, a strategy designed to show that a manager's interests are aligned with that of the investor. However, it is difficult to manage for the benefit of equity, mezzanine and senior investors simultaneously. Some managers now take exposure to different parts of the capital structure to get around this, but one CDO manager who spoke to Risk said some managers are still harming tranches other than equity: "We always try to do the best for the deal, and there are too many people out there who manage completely for the benefit of equity and screw everybody else."