Principal Proceeds Allocation
Definition
Principal Proceeds Allocation governs how principal repayments from collateral—scheduled amortization, unscheduled prepayments, loan sales, and default recoveries—flow through the CLO waterfall. During the reinvestment period (typically years 1-5), principal proceeds are recycled into new collateral purchases, maintaining constant portfolio size. After reinvestment period ends, CLO enters amortization period where principal proceeds sequentially pay down debt tranches: first Class A until fully repaid, then Class B, continuing through Class E, with residual proceeds to equity. If coverage tests fail during reinvestment period, principal proceeds divert to senior tranche paydown rather than reinvestment—forcing premature deleveraging. This allocation mechanism determines tranche duration, equity cash flow timing, and manager fee streams.
Why it matters
Principal allocation mechanics create distinct risk profiles for equity versus debt tranches. During reinvestment period, equity benefits from retained principal—manager recycles proceeds into new loans, capturing trading gains and maintaining fee-generating asset base. But after reinvestment period, equity receives no cash until all debt tranches fully repaid—creating 7-10 year lockup until final equity distribution. This sequential paydown also creates reinvestment risk for debt holders: AAA tranches prepaying in year 6-7 receive proceeds during potentially tight-spread environment, forcing reinvestment at lower yields. The 2020-2021 refinancing wave caused principal proceeds to spike—CLOs reinvesting at 100 bps tighter spreads, compressing coverage tests and equity returns. Understanding principal allocation explains why CLO equity has negative duration (benefits from rising rates limiting prepayments) while debt tranches have positive duration risk.
Common misconceptions
- •Principal proceeds don't simply 'pay down debt'—during reinvestment period they're recycled into new collateral. Only after reinvestment period do they amortize liabilities.
- •Equity doesn't receive principal during structure's life—it's residual claimant receiving only what remains after all debt fully repaid. Equity return comes from excess interest spread, not principal return.
- •Trading gains aren't equity proceeds—manager sales of loans above par (trading gains) remain in collateral pool, increasing asset base and improving coverage tests but not distributing to equity until final liquidation.
Technical details
Reinvestment period mechanics
Principal recycling during reinvestment: All principal proceeds—scheduled amortization ($10-15M annually), unscheduled prepayments ($30-50M annually from refinancings), loan sale proceeds—used to purchase replacement collateral. Manager maintains $500M target par throughout reinvestment period despite ongoing principal repayments.
Trading gain treatment: Manager sells loan at $102 (cost basis $100). $2 trading gain stays in structure as 'trading gain account' or increases collateral par to $502M. Trading gains improve OC tests (numerator increases) and can be distributed to equity only after reinvestment period ends. Mechanism prevents equity extraction during reinvestment while preserving manager incentive to trade actively.
Sale proceeds vs prepayments: Voluntary loan sales by manager (portfolio rotation, name reduction, spread capture) generate proceeds available for reinvestment. Borrower-initiated prepayments (refinancings, M&A exits) also generate proceeds but at par—no trading gains. High prepayment periods (2020-2021) forced managers to reinvest $40-50M monthly at compressed spreads.
Defaulted loan proceeds: Recoveries from defaulted loans don't reinvest—they flow through separate 'default waterfall' reducing tranche par values proportionally. Example: $5M loan defaults, ultimate recovery $3M ($2M loss). $2M loss written down starting from equity, $3M recovery doesn't reinvest but reduces debt tranche balances. Protects against managers recycling distressed recoveries into new risk.
Amortization period sequential paydown
Waterfall transition: On reinvestment period end date, principal proceeds waterfall shifts from reinvestment-first to sequential-pay. All principal proceeds (scheduled, unscheduled, sale proceeds) now pay down Class A until fully retired, then Class B, etc. No new collateral purchases permitted except for curing breaches or replacing credit-impaired loans.
Sequential pay mechanics: $500M initial collateral generating $15M scheduled amortization + $30M prepayments annually = $45M available for paydown. Class A ($325M) receives first $45M payment, reducing to $280M. Repeat annually: Class A fully repaid in ~7-8 years, then Class B begins receiving principal. Equity waits 10-12 years for final liquidation proceeds.
Turbo structures: Some European CLOs include 'turbo' clauses where excess interest spread (amounts above required debt service) accelerates principal paydown even during reinvestment period. Creates faster deleveraging and shorter weighted average life. Less common in US CLOs where managers prefer maximizing asset base and fees.
Clean-up call provisions: Most CLOs allow manager to call deal when collateral falls below 10% of original par ($50M). Prevents inefficient management of small portfolios with fixed costs. Manager exercises call by purchasing all remaining tranches at par, liquidating collateral, and distributing proceeds. Creates exit for equity trapped in long tail.
Coverage test failure and forced amortization
OC test failure impact: If OC tests fail during reinvestment period, principal proceeds divert from reinvestment to senior tranche principal paydown—identical to amortization period mechanics. This forced amortization continues until OC tests cure or reinvestment period ends.
Strategic implications: Forced amortization reduces collateral base, shrinking fee income (manager fees = % of collateral par). Also reduces portfolio size supporting debt tranches—potentially triggering rating reviews. Managers strongly incentivized to maintain OC test passage, even if requires selling positions at losses to raise cash for equity cures.
Equity impact: During forced amortization, equity receives no distributions (cash diverted to debt paydown). Equity NAV further impairs as asset base shrinks without corresponding reduction in expenses. Creates downward spiral—coverage test failures lead to amortization, reducing collateral base, making tests harder to pass in future periods.
Recovery scenarios: If tests cure (defaults resolve, prices recover, credit quality improves), normal reinvestment resumes. However, collateral base permanently smaller due to forced amortization. Manager must rebuild portfolio through trading gains or extraordinary collateral management—difficult during stressed environments when tests most likely to fail.
Prepayment dynamics and reinvestment risk
Prepayment drivers: Borrower refinancings when spreads compress (2020-2021: $40-50M monthly prepayments per CLO), M&A exits when strategic buyers acquire portfolio companies (typically 15-25% annual prepayment rate), dividend recapitalizations where borrowers refinance to extract equity. All create reinvestment needs.
Spread compression impact: CLO issued at L+425 average spread sees prepayments of L+450 loans (wide names refinancing to L+350). Manager must reinvest at L+350-375 (current market). This 75-100 bps WAS compression materially impacts coverage tests—potentially requiring manager to reach for risk (buying B3 vs Ba3) to maintain income.
Negative convexity for equity: High prepayments occur when spreads tight (good times)—forcing reinvestment at low yields, compressing future returns. Low prepayments occur when spreads wide (stress times)—preserving high-yielding assets but portfolio faces defaults. Equity can't win: rapid prepayment destroys spread, slow prepayment coincides with defaults.
Debt tranche extension risk: Slow prepayments during stress extend weighted average life of debt tranches. AAA expected to prepay in 6-7 years might extend to 9-10 years if defaults trigger forced amortization or collateral sales halt. Extension creates mark-to-market losses for investors expecting shorter duration—not credit losses but duration losses.