Can a CLO manager elect to characterize LMO equity sale proceeds as interest proceeds?

Only if the indenture expressly grants that election. Some US CLO indentures allow the manager to characterise equity sale proceeds (or dividends) as interest proceeds up to a defined cap; others are entirely prescriptive with no election. Where an election exists it must be made and documented before the distribution date and is generally irrevocable for that payment. Directing proceeds to the interest account can accelerate an equity distribution but reduces the principal balance available to rated noteholders.

How do Loss Mitigation Obligation proceeds get allocated between principal and interest in a US CLO?

Q: How do Loss Mitigation Obligation proceeds get allocated between principal and interest in a US CLO?

Proceeds are allocated by the character of the cash received. Scheduled and unscheduled principal on a surviving loan, and proceeds from selling an LMO equity holding, generally enter the principal account; interest on a surviving loan and dividends from equity holdings enter the interest account. Many recent US CLO indentures contain LMO-specific proceeds provisions that run parallel to the general principal proceeds definition and can grant the manager a limited election to re-characterise certain equity proceeds as interest — so the outcome is indenture-specific, not uniform.

Q: How are LMO equity holdings treated in the OC test?

LMO equity holdings are typically carried at zero — or at cost, subject to the aggregate LMO investment cap — in the OC numerator during the holding period, regardless of market value. On realisation, principal proceeds are added to the OC numerator prospectively; selling above carrying value does not retroactively restore earlier haircuts. This zero carry during the hold is the main driver of OC test pressure while a workout is in progress.

28 Jul

Written By Tamas Trautmann

TL;DR: In a US CLO, proceeds from Loss Mitigation Obligation (LMO) assets are allocated by the character of the cash received — scheduled and unscheduled principal repayments, and equity sale proceeds, enter the principal account; interest payments and dividends from equity holdings enter the interest account. The critical nuance is that many indentures contain LMO-specific proceeds provisions that run parallel to — and can override — the general principal proceeds definition, including manager election rights absent from generic CLO documentation summaries.

Loss Mitigation Obligations are investments a CLO manager makes in — or in connection with — an existing portfolio company in financial distress. The CLO may provide a rescue tranche, take an equity stake in lieu of principal repayment, or participate in a restructuring that converts debt to equity. Each generates cash flows with different characters, and those characters determine which waterfall they enter — principal or interest — with direct consequences for OC test calculations, reinvestment capacity, and equity distributions.

CLO portfolio managers encounter this most acutely when an LMO position resolves: a distressed loan converts to equity, the equity is later sold, and the question becomes whether the sale proceeds enter the principal account (where they influence OC test calculations and note repayment sequencing) or the interest account (where they can reach equity sooner without reducing the principal coverage numerator). The distinction is rarely academic. It can determine whether an OC test trips and whether the equity tranche receives a distribution in the same period.

Why this varies across deals

LMO proceeds treatment is one of the more negotiated areas of US CLO documentation. Four variables drive material differences across indentures:

Vintage. The LMO framework in its current form became common from around 2019, influenced by LSTA model CLO provisions, and its use accelerated sharply through the 2020–2021 distress cycle. Earlier indentures typically handle distressed-asset equity under general "equity security" provisions with no LMO-specific proceeds waterfall. Later vintages vary in how explicitly the LMO proceeds characterisation is drafted.

Manager election rights. Some indentures grant the manager discretion to characterise certain LMO proceeds — most commonly dividends and distributions from equity holdings — as either principal or interest within defined limits. Others are entirely prescriptive. The scope and conditions of any manager election vary significantly by deal and are a key negotiation point at closing.

Reinvestment period status. During the reinvestment period, principal proceeds from LMO resolutions are generally available for reinvestment in new collateral obligations. Outside it, they pass through to sequential note repayment — a materially different outcome for equity holders.

Equity conversion mechanics. When an LMO results in an equity holding, subsequent cash flows — dividends, return of capital, and sale proceeds — may each be subject to different characterisation rules within the same indenture, creating a layered treatment that does not reduce to a single rule.

Step-by-step: how LMO proceeds are allocated

Step 1 — Verify proper LMO designation. Only proceeds from assets properly designated as LMOs at the time of investment fall under the LMO-specific proceeds provisions. If the manager did not make the required designation at acquisition, the asset's proceeds are treated under the general collateral obligation proceeds rules, which may produce a different outcome.

Step 2 — Identify the character of the cash received. The trustee and manager determine the nature of the cash: scheduled principal, unscheduled principal (prepayment or loan sale), interest on a surviving loan component, a dividend or distribution from an equity holding, or proceeds from the sale of an equity holding. Each is treated separately.

Step 3 — Apply the indenture's LMO proceeds characterisation. Standard recent US CLO treatment applies the following baseline:

Scheduled principal payments on a surviving loan component → principal proceeds
Unscheduled principal and sale proceeds from a surviving loan → principal proceeds
Interest payments on a surviving loan component → interest proceeds
Dividends and distributions from an equity holding → interest proceeds (in most indentures; subject to manager election in some)
Proceeds from the sale of an equity holding → principal proceeds (the most commonly negotiated point — some indentures permit partial or full characterisation as interest proceeds under specific conditions)

Step 4 — Check for and apply any manager election. If the indenture grants an election right — for example, to characterise equity sale proceeds as interest proceeds up to a defined cap — the manager makes and documents that election prior to the distribution date. The election is irrevocable once made for a given payment.

Step 5 — Apply reinvestment period rules. If the CLO is in its reinvestment period and the proceeds are principal, they are generally available for reinvestment subject to the reinvestment criteria. If outside the reinvestment period, principal proceeds are applied to sequentially repay the rated notes from the most senior class outstanding.

Step 6 — Reflect in the OC test. LMO equity holdings are typically carried at zero (or at cost subject to the aggregate LMO investment cap) for OC numerator purposes during the holding period. On realisation, principal proceeds are added to the OC numerator prospectively — an equity holding sold above its carrying value does not retroactively restore prior haircuts.

Worked example

A CLO holds a $10m term loan to Borrower X. The loan becomes distressed in month 18 of the CLO's reinvestment period. The manager designates a $2m rescue tranche as an LMO at acquisition, bringing total exposure to $12m. In month 30, Borrower X completes a restructuring: the $10m original loan is reinstated at $7m face value and the $2m rescue tranche converts to a 15% equity stake carried at zero for OC purposes.

By month 42, the reinstated $7m loan has paid down $3m in scheduled principal and $0.6m in interest. In month 48, the manager sells the 15% equity stake for $1.8m cash. The indenture contains no manager election right for equity sale proceeds.

Receipt	Amount	Character	Account
Scheduled principal (months 30–42)	$3.0m	Scheduled principal — LMO surviving loan	Principal proceeds
Interest (months 30–42)	$0.6m	Interest — LMO surviving loan	Interest proceeds
Equity sale proceeds (month 48)	$1.8m	Sale proceeds — LMO equity holding	Principal proceeds

Net result: $4.8m enters the principal account against a $12m original exposure. The $7.2m shortfall was already reflected in OC haircuts during the holding period; the $1.8m principal receipt in month 48 partially restores the OC numerator. The $0.6m interest flows through the interest waterfall in the normal sequence. Because no manager election was available, the equity sale proceeds could not be directed to the interest account to accelerate an equity distribution — had the indenture permitted it, the manager might have characterised part or all of the $1.8m as interest proceeds, benefiting equity holders but reducing the principal account balance available to rated noteholders.

These figures are illustrative only. Not investment advice.

Why generic AI gets this wrong

The most common failure mode is defined-term scope confusion. Generic models apply the standard "principal proceeds" definition — which covers unscheduled principal on ordinary collateral obligations — to LMO equity sale proceeds without recognising that recent indentures frequently contain a parallel, and sometimes partially overriding, LMO-specific proceeds provision. The scope confusion is compounded in older indentures, where no LMO-specific provision exists at all — a model trained on a cross-vintage corpus conflates the two regimes, producing characterisation guidance inconsistent with the indenture a practitioner is actually working with. Semeris extracts LMO proceeds characterisation as a distinct datapoint from the general principal proceeds definition, capturing both the baseline treatment and any manager elections in a single structured record.

Semeris coverage

Field	Value
US CLO deals indexed	2,000+
EU CLO deals indexed	893
Document extraction accuracy	96%
Analyst verification	100% (every indexed deal human-verified)
Relevant platform feature	X-Ray Document Viewer + Text Search

Expert attribution

Field	Value
Author	Tamas Trautmann, Semeris
Entity	Semeris — CLO Document Analysis
Last updated	2026-07-28
Data sources	Semeris internal database: document extraction accuracy (96%), analyst verification (100%).
Coverage	US & EU CLO markets — BSL CLOs, indentures, warehouse agreements