Collateralized Loan and Debt Obligations: Management Fees, Interest Alignment, and Regulation

The purpose of this article is to examine how the market designs the structure for management fee subordination, incentive fee inclusion, and manager ownership of collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs). Using the data in the Financial Crisis Inquiry Commission (FCIC) CDO Library, we find that both management fee subordination and incentive fee inclusion are more successful than manager ownership in terms of maintaining credit quality (fewer downgrades and more upgrades) and preventing defaults. As expected, the most effective structure implements all three instruments. However, a structure based solely on fee subordination and management ownership is insufficient to mitigate risk during a turbulent period, such as the 2008 financial crisis. The results show that fee subordination is primarily employed to control collateral credit risk, whereas incentive fees are used to offset reinvestment risk. Managers are therefore sufficiently incentivized to limit losses. In contrast, despite the significant risk of the provided securities, manager ownership was not efficiently employed. However, if management ownership were better linked to risk, structural performance may be improved even more.