Manager Discretion Limits
Definition
The set of portfolio restrictions, concentration limits, and trading constraints defined in CLO indentures that restrict manager decision-making. These limits protect debt holders by preventing excessive risk-taking while giving managers enough flexibility to actively manage credit cycles. Typical restrictions include industry concentration limits (not more than 12% in any single industry), single-obligor limits (2-3% max), minimum credit ratings (WARF thresholds), and geographic/currency restrictions.
Why it matters
Manager discretion limits create the fundamental tension in CLO structures: enough flexibility for managers to add value through credit selection and trading, but enough constraint to prevent moral hazard and protect senior tranches. Deals with tighter restrictions trade at lower debt spreads but may underperform in volatile markets when managers can't react. Understanding which restrictions tighten when tests fail is critical—many deals reduce manager flexibility progressively as OC deteriorates.
Technical details
Common portfolio restrictions
Standard CLO limits include: (1) Industry concentration: typically 12-15% max in any single industry. Prevents sector blow-ups. (2) Single obligor: 2-3% max exposure to any single company. (3) CCC bucket: 7.5% max in CCC-rated or defaulted assets. (4) WARF: weighted average rating factor maximum (typically 2800-3000 for broadly syndicated loan CLOs). (5) Weighted average spread: minimum spread requirement. (6) Secured vs unsecured: typically 90%+ secured first lien. (7) Fixed rate assets: maximum 5-10%. (8) Jurisdiction: typically 90%+ North America/Western Europe. These limits are covenant tests measured monthly/quarterly.
Tiered restrictions on test failures
Many deals tighten restrictions if coverage tests fail. Example tiered framework: Normal state (tests passing): all standard restrictions apply, manager has full discretion. First tier failure (OC 123%, threshold 125%): CCC bucket tightens from 7.5% to 5%, industry limits reduce from 12% to 10%, trading restrictions prohibit buying assets rated below B. Second tier failure (OC 120%): No CCC purchases allowed, industry limits reduce to 8%, single obligor reduces to 2%. This progressive tightening forces managers to de-risk as structure deteriorates.