Investors in Carlyle Euro CLO 2025-2 Strip Out Unusual Fee Structure

Carlyle Group has removed an unusual feature from a European new issue CLO because of resistance from investors, according to a source close to the matter.

Last week, Octus, formerly Reorg, reported that Carlyle Euro CLO 2025-2 was initially structured in a way that would have allowed the payment of management fees before conducting a performance test that would force the manager to divert interest money to debtholders.

However, the deal was priced via Morgan Stanley on Monday with the interest diversion test senior to the fees, the structure common across most European and U.S. CLOs. CLOs that allow managers to pay their own fees before testing the health of the deal are unpopular with investors. As a result, changes to the order of tests and fees in the waterfall structure are rare in the CLO market.

In the U.S., the fees-first structures are more common but still far from market standard. Just under 10% of U.S. BSL CLOs that priced from 2021 to 2023 allowed for the subordinated management fees to be paid before the interest diversion test, according to Dealscribe. The share of deals with this language has declined since.

The manager’s motive for paying itself ahead of debtholders is fairly obvious, said a source close to a U.S. CLO manager who has used this feature. “[It was meant to] to ensure that fees were paid regardless of collateral performance.”

The manager in question retained the equity tranche through an internal fund, the source added.

“But in general, [I] don’t really think it’s good for anybody but the manager collecting the fees,” they said. “As equity, you’d rather interest get diverted to buy collateral to shore up the deal than the manager to make fees first.”

Only a handful of European deals have priced with the subordinated manager fees senior to the interest diversion test, including the reset of Carlyle Global Market Strategies Euro CLO 2014-1, which priced in March.

Octus also found the feature in the offering circular of Hayfin Emerald CLO III, issued in 2019. However, the documentation for a reset of the deal in 2021 shows the interest diversion test as senior to the manager fees.

Carlyle Group and Ares Management were the most frequent users of the feature in the U.S., but it has also appeared in deals by Investcorp, Nuveen, Palmer Square, Vibrant Capital Partners and Western Asset Management, according to Dealscribe data.

Managers usually receive fees twice in the interest waterfall – the senior fees and the subordinated fees – as well as an incentive fee tied to an equity internal rate of return threshold. The senior manager fees (normally about 15 bps) sit near the top of the waterfall above triple-A tranche interest. Once it has been paid, the bondholders receive interest. The subordinated management fees (normally about 35 bps) are junior to the single-B tranche but senior to the equity.

Typically, between paying interest to the single-B investors and subordinated fees to the manager, sits the reinvestment overcollateralization test, also known as the interest diversion test.

If it fails – which happens if the overcollateralization drops too close to or below the liabilities – up to half of the available interest is diverted to the principal account. The remaining interest flows down the waterfall, to pay the subordinated fees and certain other subordinated amounts, followed by the equity distribution.

While the overall impact on cash flow should be fairly small, moving the subordinated management fee up in the waterfall could be counterproductive for the equity as well as the debt in some scenarios, a CLO tranche investor said.

Switching the order of fee payment and test also weakens the deal from a ratings perspective because manager fees are considered an almost uncapped payment in S&P Global Ratings’ modeling assumptions.

The CLO will still be rated, but the ratings agency may consider switching off the test, and that may have a negative impact on the results.

A spokesperson for Carlyle Group did not respond to a request for comment.