Can LMO trades be funded from principal proceeds outside the reinvestment period?

Often not. Many US CLO indentures permit principal-proceeds funding during the reinvestment period, subject to a sub-cap, but close that route once the reinvestment period ends — leaving interest-proceeds funding as the only permitted source, frequently alongside tighter coverage-test conditions. The precise treatment is indenture-specific, so the source-of-funds provisions must be read for each deal.

Who bears the cost of a principal-funded versus interest-funded LMO?

A principal-funded LMO consumes Principal Proceeds, so senior noteholders (through reduced paydown) and reinvestment capacity effectively bear the cost. An interest-funded LMO consumes Interest Proceeds below senior and mezzanine interest but above the equity distribution, so equity and subordinated fee holders bear it. The same rescue investment can be structured either way where the indenture permits both routes.

What is the difference between a principal-funded LMO and an interest-funded LMO in a US CLO?

Q: What is the difference between a principal-funded LMO and an interest-funded LMO in a US CLO?

The difference is the source of funds used to purchase the LMO, not the asset itself. A principal-funded LMO draws on Principal Proceeds, reducing cash available for reinvestment or note repayment and usually subject to a dedicated 'LMO Principal Proceeds' sub-cap. An interest-funded LMO draws on Interest Proceeds at a subordinated step of the interest waterfall, reducing cash that would otherwise reach the equity distribution. The funding source therefore decides whether senior noteholders/reinvestment or equity effectively bear the cost.

18 Aug

Written By Tamas Trautmann

TL;DR: The difference is the source of funds, not the asset. A principal-funded Loss Mitigation Obligation is purchased using Principal Proceeds; an interest-funded LMO is purchased using Interest Proceeds via a subordinated waterfall step. The distinction governs which account is depleted, which sub-caps and gates apply, and — outside the reinvestment period — whether the purchase is permitted at all. Principal funding erodes note-paydown/reinvestment capacity; interest funding erodes amounts otherwise reaching equity.

Both a principal-funded and an interest-funded LMO can involve the identical rescue investment in the identical distressed obligor. What differs is which waterfall account the CLO draws on to pay for it — and that single choice cascades through the deal's economics. Because Principal Proceeds and Interest Proceeds sit in different accounts, subject to different tests and serving different constituencies (senior noteholders and reinvestment on the principal side; equity and subordinated management fees on the interest side), the funding source determines who effectively bears the cost of the rescue.

For a senior analyst modelling a workout, the question is rarely "can we fund this LMO?" but "from which account, and what does that cost us?" A principal-funded LMO consumes cash that would otherwise repay notes or be reinvested in performing collateral. An interest-funded LMO consumes cash that would otherwise flow down the interest waterfall toward the equity distribution. The indenture's source-of-funds provisions decide which routes are open and how much can flow through each.

Why this varies across deals

Source-of-funds permissions. Some indentures permit only Interest Proceeds funding (via a designated "Permitted Use" or LMO step in the subordinated interest waterfall); others also allow Principal Proceeds funding subject to an explicit "LMO Principal Proceeds" sub-cap; a third group leaves the choice to manager discretion within limits.

Sub-cap calibration. Where principal funding is allowed, it is usually capped separately from the headline LMO investment cap — often a tighter percentage of the Collateral Principal Amount, and sometimes tested per period rather than in aggregate.

Reinvestment period status. Inside the reinvestment period, both routes are more likely to be open. Once the reinvestment period ends, many indentures close the Principal Proceeds route entirely, leaving Interest Proceeds as the only permitted source.

Principal-funded vs interest-funded: how they compare

Dimension	Principal-funded LMO	Interest-funded LMO
Source account	Principal Proceeds	Interest Proceeds (subordinated waterfall step)
Who bears the cost	Senior noteholders / reinvestment capacity	Equity and subordinated fee holders
Typical gate	"LMO Principal Proceeds" sub-cap, tighter than headline LMO cap	Permitted-Use step, sometimes capped per period
Reinvestment-period sensitivity	Frequently prohibited after the reinvestment period ends	Generally remains available post-reinvestment
Effect on note paydown	Reduces principal available to sequentially repay notes	No direct effect on principal paydown
Effect on equity distribution	Indirect	Direct — reduces cash reaching the equity distribution

Worked example

A CLO needs $3m to fund a rescue tranche for a distressed obligor during its reinvestment period. The indenture permits both funding routes, with a principal sub-cap of 2% of the Collateral Principal Amount and an interest Permitted-Use step capped at $5m per period.

Principal-funded: the $3m comes out of Principal Proceeds. That is $3m not reinvested in performing collateral this period; if the deal were amortising, it would be $3m not applied to senior note paydown. The senior OC numerator is unaffected by the source itself, but reinvestment capacity shrinks.
Interest-funded: the $3m is drawn at the LMO step of the interest waterfall, below senior note interest but above the equity distribution. Senior and mezzanine interest are unaffected; the equity distribution for the period falls by $3m.

Same rescue, same asset — but in the first case senior noteholders/reinvestment absorb the cost, and in the second, equity does.

These figures are illustrative only. Not investment advice.

Why generic AI gets this wrong

The most common failure mode is defined-term scope confusion — treating "LMO" as a monolithic category and ignoring that the funding source is a separately gated variable. Generic models describe how an LMO is purchased without distinguishing Principal-Proceeds from Interest-Proceeds funding, and therefore miss both the sub-caps that limit each route and the post-reinvestment-period closure of the principal route. The result reads plausibly but omits the single most consequential structuring choice in the trade. Semeris extracts the LMO source-of-funds provisions — permitted accounts, sub-caps, and per-period limits — as datapoints distinct from the headline LMO cap, so the funding constraints can be read per indenture.

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	Text Search + Checklists — locate and compare LMO source-of-funds provisions across deals

Expert attribution

Field	Value
Author	Tamas Trautmann, Semeris
Entity	Semeris — CLO Document Analysis
Last updated	2026-08-18
Data sources	Semeris internal database: document extraction accuracy (96%), analyst verification (100%).
Coverage	US & EU CLO markets — BSL CLOs, indentures, offering documents

Tamas Trautmann