Tickle Me LMO: A Deeper Dive into Loss Mitigation Obligations (Part 3)
In CLOs, Workout or Loss Mitigation Obligations are not footnotes - they're the hidden factor that can keep the music running - and by taking a bit of risk, skillful managers can increase the satisfaction rate of both debt and equity holders.
While analyzing CLOs, most investors focus on obvious metrics, missing the game within the game. However, seasoned players know that the real action occurs in those dense LMO provisions that most people overlook. These aren't just legal boilerplate - they're the actual power-sharing agreements that determine whether value flows to debt stability or equity upside when defaults hit.
Two contemporaneous deal structures can look similar on the surface, yet behave very differently when defaults appear. That is the point: LMOs are where stakeholders negotiate the future, not merely document the past.
The Three Levers That Matter
Understanding the effect of LMOs on deal power dynamics comes down to three critical mechanisms: purchase buckets, entry conditions, and proceeds allocation triggers. Think of these as the three dials that control how aggressive or conservative a deal can be, with regard to these nonstandard assets.
Purchase Buckets
Limitation thresholds, or "buckets", calibrate how much LMO risk a deal can take on at a time (current limits) and over its life (cumulative). Tight caps act as a governor: managers must prioritize only the highest-conviction workouts, protecting overcollateralization cures and note coupons. Looser or undefined caps enable more shots on goal, potentially compounding equity's optionality but also exposing the debt stack to prolonged par volatility if recoveries lag.
Purchase Conditions
Next, purchase conditions. These are the "gates" that turn LMO ideas into LMO assets. Requirements such as APB> ReinvTPB, Coverage/OC test satisfaction, and no upcoming deferrals align LMO activity with the deal's core health metrics. Maturity guards, or CQT overlays, push managers to justify not only the act of purchasing, but the prudence of doing so now. The more rigorous the gates, the more defensive the structure; the more permissive, the more room for equity-gain maximizing strategy.
Proceeds Allocation
Also known as LMO-to-interest triggers or recovery target equation. This is the payout switch. Structures that allow related-obligation recoveries to count toward the target can accelerate the path to Interest for certain LMO types or funding sources. If recovery target conditions require the full par of the defaulted asset plus the LMO price or OC carry value, these can set an intentionally high bar that preserves debt economics.
Reading Between the Lines
Smart investors don't just analyze whether managers use LMOs effectively; they reverse-engineer what the deal documents reveal about negotiating dynamics and structural philosophy.
When you see restrictive LMO frameworks, you're looking at deals where debt investors had leverage and used it. These structures reflect skepticism about workout value and prioritize downside protection over upside capture.
When you encounter permissive LMO structures, equity interests clearly drove the negotiation. These deals bet on managerial expertise and market timing, accepting higher volatility for potentially superior returns.
The irony? Sometimes the most restrictive structures produce better outcomes precisely because they force discipline. At other times, flexible frameworks enable opportunistic value creation that rigid structures would otherwise prevent.
The Competitive Reality
In today's market, LMO analysis separates sophisticated investors from shallow readers. While others focus on obvious metrics, experienced players are decoding the power dynamics that will govern deal performance during stress periods.
This isn't an academic exercise - it's competitive intelligence. Understanding how LMO provisions align with or constrain stated managerial strategies provides a genuine edge in manager selection and deal evaluation.
For debt allocators, the priorities are clear: insist on meaningful caps with sensible pacing, purchase gates tied to fundamental deal health, and proceeds allocation that requires substantial recovery before equity participates.
For equity investors, flexibility has value—but be cautious of deals with wide lanes but slow-moving cars. Generous buckets with poorly designed gates or targets can still disappoint if allocation triggers delay equity participation or if recovery targets prove unreachable.
The Bottom Line
LMO design is the quiet negotiation that determines who wins when markets get loud. In a world where default cycles are irregular but inevitable, these provisions deserve serious attention from serious investors.
The players who master this analysis don't just understand CLO mechanics - they understand the politics that shape them. In relationship-driven markets, that insight translates directly into competitive advantage.
While the crowd focuses on manager track records and obvious structural features, sophisticated investors are reading the details that reveal how deals really work when it matters most. That's not just better analysis-it's better investing.
Small provisions. Big outcomes. The difference between reading the contract and understanding the deal.
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