Portfolio Profile Tests
Definition
Portfolio Profile Tests are contractual constraints governing CLO collateral composition, limiting concentration risks across obligors, industries, ratings, maturities, and asset types. Standard tests include: Maximum Single Obligor (2-3% of par), Maximum Industry Concentration (15% per Moody's classification), Minimum Diversity Score (170+ for AAA-rated deals), CCC Bucket Limits (7.5% of par), Maximum Second-Lien/Unsecured (5-10% combined), Weighted Average Life limits (6-7 years), and Minimum First-Lien (80%+ of portfolio). These tests are measured quarterly and violations restrict manager's ability to trade, reinvest proceeds, or distribute cash—forcing remedial action to cure breaches.
Why it matters
Portfolio profile tests create binding constraints on manager behavior, preventing concentration risk that would impair tranche ratings. Without these tests, managers facing fee pressure could concentrate in high-spread CCC credits (boosting coverage tests short-term but increasing default risk), overweight cyclical sectors during booms (creating correlation risk), or extend duration excessively (creating refinancing risk). When tests bind, managers must trade defensively—selling concentrated positions even at losses, buying diversifying assets at tight spreads, or holding cash (dilutive to returns). During 2020, CCC bucket violations forced managers to sell distressed retail/energy exposure at 30-40 cents to maintain compliance, crystallizing permanent losses that could have recovered over 3-5 years.
Common misconceptions
- •Profile tests don't prevent all concentration risk—they limit mechanical measures but can't capture nuanced correlations like sponsor overlap or supply chain dependencies.
- •Test violations don't trigger immediate defaults—they restrict manager actions (trading, reinvestment, distributions) but allow cure periods before causing events of default.
- •Tighter tests don't always benefit investors. Overly restrictive tests force value-destructive trading during stress, preventing managers from holding through temporary dislocations.
Technical details
Obligor and industry concentration limits
Maximum single obligor: Typically 2-3% of total par for any single obligor. Prevents idiosyncratic default from causing material portfolio impairment. Calculated on funded amounts, excluding unfunded revolver commitments. Manager must sell positions exceeding limit or acquire additional assets to dilute concentration.
Maximum industry concentration: 15% per Moody's industry classification, though some deals allow 17% for highly granular industries. 'Energy' sector might be subdivided (Oil & Gas Exploration, Midstream, Oilfield Services) allowing manager to reach 15% in each sub-sector while staying compliant. This classification gaming is common.
Top 10 obligor concentration: Some deals cap largest 10 positions at 25-30% of par. Prevents portfolio from becoming 'top-heavy' where handful of positions dominate. More binding for smaller deals ($300-400M) than large deals ($600M+) where granularity easier to achieve.
Affiliated obligor treatment: Loans to different entities within single corporate family aggregate toward single obligor limit. Prevents circumvention through HoldCo/OpCo structures. Moody's rules determine affiliation based on ownership, guarantees, and operational integration.
Credit quality and rating constraints
CCC bucket limit: Maximum 7.5% of par in Caa1/CCC+ or lower rated assets. Haircut mechanism reduces effective limit—assets rated Caa2/CCC count at 0% of par for OC test purposes while consuming CCC bucket capacity. Forces managers to choose between coverage test optimization (selling CCC) and total return (holding for recovery).
Minimum weighted average rating: WARF maximum of 2800-3200 depending on deal vintage. Prevents manager from migrating entire portfolio to B3/B- for spread pickup. WARF calculated using Moody's rating factor table (Ba3=2260, B2=2720, B3=3490). Actively managed as portfolio ages and ratings migrate.
Fixed-rate asset limits: Maximum 5-10% in fixed-rate loans. CLO liabilities reprice quarterly (floating), while fixed-rate assets create negative convexity during rising rate environments. Limits mismatch risk that would compress coverage tests if base rates rise.
Current pay vs PIK: Maximum 5% in PIK toggle or PIK loans where interest accrues rather than cash-pay. PIK interest doesn't contribute to coverage tests (non-cash income), reducing cushions. Also signals credit stress—borrowers elect PIK when unable to service cash interest.
Maturity and structural restrictions
Weighted average life (WAL): Maximum 6-7 years across portfolio, preventing duration extension that would misalign asset/liability maturities. Calculated as sum of (principal amount × years to maturity) / total principal. Binding during late cycle when 8-9 year term loans become standard.
Minimum floating-rate: 90-95% of portfolio must be floating-rate (SOFR/LIBOR-based). Prevents fixed-rate exposure that creates negative duration gap vs floating liabilities. Small carve-outs allow fixed-rate defensive positions during rate decline expectations.
Second-lien and unsecured limits: Combined maximum 5-10% of par in second-lien, unsecured, or mezzanine debt. Driven by recovery rate assumptions (30-35% for second-lien vs 70% first-lien). WARR constraints effectively bind before explicit limits in most deals.
Revolver exclusion: Unfunded revolver commitments don't count toward par but create contingent exposure. Most deals cap unfunded at 10-15% of par to limit pro forma exposure if revolvers drawn. Particularly binding during stress when borrowers max-draw revolvers.
Test violations and remediation dynamics
Grace periods and cure rights: Profile test violations typically allow 30-60 days to cure before restricting manager actions. CCC bucket violations grant 45 days assuming manager can trade out. Diversity score violations may allow 90 days given complexity of curing through trading.
Trading restrictions during violations: While in violation, manager cannot acquire additional non-curing assets. Can only trade into assets that cure the specific violation—if CCC bucket breached, can only buy B-rated or higher; cannot add more CCC even if attractive. This handcuffs manager during best buying opportunities.
Reinvestment restrictions: Failed profile tests may trigger mandatory principal paydown rather than reinvestment during reinvestment period. Forces deleveraging that reduces fee income and may trigger rating reviews (smaller collateral base supporting same debt).
Market timing problems: Violations often occur during market stress when curing trades are most expensive. Manager must sell concentrated positions at widest spreads (buyers know forced selling) and buy diversifying assets at tightest spreads (limited supply of compliant assets). Creates pro-cyclical forced trading.