Portfolio Performance Manipulation in Collateralized Loan Obligations

Abstract

We investigate whether managers of Collateralized Loan Obligations (CLOs) engage in discretionary activities to meet regular portfolio performance tests required by their investors. We focus on CLOs’ overcollateralization tests (OC tests) which bind CLOs’ loan portfolio values to be greater than their liabilities. We document that CLO managers inflate loan fair values and strategically rebalance their portfolios to avoid violating the OC tests. Strategic portfolio rebalancing involves selling high quality loans that trade above par, delaying the sale of underperforming loans and selling loans to affiliated CLOs. While these trading choices facilitate the compliance with the OC tests in the current month, they lead to lower subsequent portfolio performance. We also find that discretionary activities to avoid OC test violations are more pronounced for CLOs with more diverse and less liquid portfolio structures and for older CLOs. In addition, CLO managers are more likely to exercise discretion when they receive higher performance-linked compensation, are preparing to launch new CLOs or are not closely monitored. Our study provides unique evidence on how CLO managers use discretion in the valuation and rebalancing of syndicated loan portfolios to meet monthly performance thresholds.