Portfolio Performance Manipulation in Collateralized Loan Obligations

• In Event: Fair Value Issues

Abstract

We examine the discretionary activities that managers of Collateralized Loan Obligations (CLOs) engage in to pass monthly overcollateralization (OC) tests. These tests require the CLO’s loan portfolio value to be greater than its liabilities. We document that CLO managers inflate the fair values of loans and strategically rebalance their portfolios to avoid violating the OC tests. Strategic portfolio rebalancing involves trades that help managers comply with the OC tests by shifting CLO portfolios to riskier loans and selling loans to affiliated CLOs. We show that these discretionary activities enhance OC scores in the current month; however, trading strategically is related to lower future portfolio performance. We further find that discretionary activities to avoid an OC test violation are more pronounced for CLOs with more diverse portfolio structures or administered by managers that receive higher performance-linked compensation, are not closely monitored or are preparing to launch new CLOs. Overall, our evidence suggests that CLO managers use discretion when valuing loans and rebalancing their portfolios to comply with performance requirements, and high monitoring costs as well as managerial incentives exacerbate these discretionary activities.

Authors

• Maria Loumioti, MIT Sloan School of Management

• Florin Vasvari, London Business School