PresPrint Template

1
Managing CDO Equity
ASF Conference in Vienna, 4th May 2005
CDO Invest team, Structured Finance
Division Alexandre Martin-Min, head Olivier
Dieudonné, senior portfolio manager
2
Table of contents

• Section 1 Executive Summary
• Section 2 Leveraged Credit Assets The CDO
  Equity Strategy
• Section 3 CDO Invest Case Study of a Specialist
  CDO Investment Team
• Section 4 Prelude Credit Alpha Case Study of a
  CDO Equity Fund

3
SECTION 1
Executive Summary
4
CDO Equity Value Proposition

• Portfolio of fixed-income credit assets- with a
  corporate credit focus or a real estate/consumer
  credit focus- diversified across obligors,
  industries, regions, etc.
• Expert asset manager in charge of managing the
  portfolio within certain limitations agreed upon
  with the rating agencies upfront- generate
  stable, predictable cash flows- minimise
  realised credit losses
• Efficient capital structure using- term,
  limited-recourse leverage with fixed economics-
  par-based (not market-value-based) cash-flow
  diversion triggers
• Portfolio assets held in a bankruptcy-remote
  SPV- initial and ongoing third-party oversight
  by rating agencies and a professional trustee-
  full transparency on portfolio and collateral
  managers activity
• CDO Equity represents a unique credit-based
  alternative investment strategies- mid-teen
  absolute target returns with high current income
  (duration 3-5 years)- low correlation with
  major bond and stock market indices-
  complementary of traditional A.I., such as hedge
  funds and private equity

Diversified credit portfolio
Expert asset manager
Efficient leverage
Security/ Transparency
Great value Investment !
5
CDO Equity Key Considerations

• Primary driver of CDO Equity returns is the
  performance of the underlying credit markets in
  terms of default/recovery rates over the life of
  the CDO (5-10 years)- CDOs are not an asset
  class, it is simply a credit strategy using term
  leverage - the CDO Equity strategy is, by
  nature, primarily short volatility- access to
  reliable, diverse credit expertise is therefore
  paramount in order to assess key
  characteristics/dynamics of the different credit
  markets over the whole credit cycle
• Secondary driver of CDO Equity returns is the
  performance of the collateral manager- the more
  volatile an asset class, the more differentiation
  in performance across managers- the CDO equity
  strategy is inherently short event risk-
  thorough on-site due diligence of managers is
  therefore a must
• Third driver of CDO Equity returns is its capital
  structure and the resulting constraints-
  trade-off between leverage and manager
  flexibility- an ill-defined structure can lead
  to adverse selection by the collateral manager-
  an in-depth understanding of all structural
  aspects and resulting implications is critical
• Whilst CDOs are one of the fastest growing areas
  within the credit markets, CDO Equity remains and
  will likely remain a capacity-constrained
  market- Equity of CDOs managed by top-tier
  managers is at least 2-4 times oversubscribed...-
  if not pre-sold to a few strategic investors
  hand-picked by the manager/placement agent!

Credit market insights
Manager selection
Structural savvy
Limited capacity
6
CDO Equity Key Considerations (continued)

• While secondary market liquidity has dramatically
  improved in the CDO debt market over the past few
  years driven by the involvement of an increasing
  number of market participants of very different
  nature, liquidity should not be relied upon for
  CDO equity- relatively small number of
  long-term market participants- current liquidity
  is probably driven primarily by the overall high
  liquidity market conditions- CDO Equity should
  therefore be analysed through a buy-and-hold
  approach
• CDO Equity returns are highly levered returns
  that can thus exhibit significant volatility-
  leverage ranges from 5 to 75 times (typically 8
  to 25), depending on underlying asset classes-
  realised credit losses and/or credit quality
  deterioration in the portfolio may result in
  partial or total, temporary or permanent
  diversion of cash-flows from the Equity to
  amortise the Debt
• Surveillance of CDO Equity investments is thus
  critical to mitigate aforementioned risks-
  monthly trustee reports and investor letters
  provide great transparency to all CDO investors-
  better, a regular dialogue with managers and
  market participants provides an edge which, if
  combined with market clout, enables some level of
  activism and an opportunity to sell early
• Best of breed CDO Equity investors typically
  exhibit- large investment and support dedicated
  teams, using developed proprietary systems-
  unlimited and timely access to in-house and
  external credit expertise - long-term
  relationships/partnerships with top tier CDO
  managers and arranging banks- purchasing power
  of at least 150-200mn of CDO Equity per annum

Buy and hold approach to underwriting
Volatile performance
Pro-active monitoring
What it takes to succeed
7
We invite you to take a closer look at CDO Equity
funds

• Since early 2004, launch of several closed-end
  CDO Equity fund initiatives, with- different
  target asset mixes, i.e. relative proportions of
  CLO, ABS CDO, IG CDO equities, etc.- different
  reach, i.e. worldwide marketing vs separate
  account, institutional vs. HNW, etc.- and
  varying degrees of success!
• The rationale for an investment in such a CDO
  Equity fund is quite obvious- outsource
  selection and management of CDO equities to a
  specialist asset manager- benefit from
  purchasing power and diversity of the whole fund
  vs individual investments- in certain instances,
  learn from and partner with that specialist asset
  manager
• However, there is a certain number of key issues
  to watch for- different target asset mixes can
  lead to very different risk/return/correlation
  profiles- length, consistency and breadth of the
  asset managers track record investing in CDO
  Equity - independence of the asset manager
  vis-à-vis the structuring/placement agent of the
  fund
• CDO Equity funds have proved attractive to a wide
  range of institutional and ultra high-net worth
  investors, be they newer and more established CDO
  Equity investors- well-suited solution for
  those newer investors who want a hassle-free
  CDO Equity exposure- perfect first step for
  those newer investors who would like to tip a toe
  before jumping in, i.e. hire a team, build
  proprietary systems, etc.- great way to get
  access to or sometimes partner up with a
  specialist and resourceful team for those
  investors who already have an outstanding CDO
  Equity investment program, which they would
  like to grow but lack the resources to do so

A growing market
Investment rationale
Certain issues to watch for
Appealing to a large and diverse investor base
8
SECTION 2
Leveraged Credit Assets The CDO Equity Strategy

9
Under-representation of credit markets in
alternative investment universe
Sizes of credit market vs equity market

• Alternative investment fund under-investment in
• credit markets
• Traditional alternative investment funds have
  tended to focus on the equity marketsover 6,000
  hedge funds invest in the US10.5 trillion US
  equity market
• Few alternative investment funds are believed to
  exist that target assets across the US13.4
  trillion credit markets
• Asset classes include
• Leveraged Loans
• Residential MortgageBacked Securities
• Commercial MortgageBacked Securities
• AssetBacked Securities
• Investment Grade Bonds
• High-Yield Bonds
• Emerging Market Bonds
• REIT debt

Equity
Credit
Source 1 The Bond Market Association 2 Thomson
Financial
Source UBS
10
Credit market access The growing CDO market

• The CDO market has grown substantially since the
  mid 1990s
• Available-for-sale CDO equities only represents a
  fraction of that issuance (less than 5)

Overall CDO market issuance (debt and equity) in
billions US dollars
Source UBS
11
CDO Equity
Enhanced leverage
Lower Potential Return
Senior

• A CDO is a specially-created entity which issues
  debt and equity to finance the purchase of a
  portfolio of credit assets
• The equity class is the most subordinated
  position in the capital structure of a CDO (CDO
  Equity)
• Income on assets less cost of debt, fees and
  expenses flows to CDO Equity holders(see
  diagram)
• Purchasing CDO Equity is thereforesimilar to
  assembling a credit portfoliousing leverage
• Most CDOs employ a manager to monitor investments
  over their life
• For a more detailed overview on CDOs, please see
  Appendix A

CDO
Credit Assets
Mezzanine
Equity
Collateral Portfolio
Higher Potential Return
Collateral Manager
Surveillance
ManagementFee
12
More on Collateralized Debt Obligations (CDOs)
Key parties/basic definitions

• CDO Special Purpose Vehicle (SPV or Issuer)a
  trust, partnership, limited liability company, or
  offshore entity established to purchase and hold
  the CDO Asset Portfolio
• CDO Trusteean independent third party hired to
  serve as custodian for the CDO Asset Portfolio as
  well as prepare/perform (with the CDO Manager)
  the following (i) periodic investor reporting,
  (ii) CDO Asset information management, (iii) CDO
  covenant monitoring, (iv) collections/cash
  management and (v) periodic accounting/tax
  reporting
• CDO Managera professional investment manager
  selected by Noteholders and the SPV to run the
  CDO Asset Portfolio
• CDO Asset Portfolioportfolio of securities/loans
  purchased by the SPV to collateralize the Notes.
  Can include HY and IG Bonds, Bank Loans, ABS,
  REITs and other assets
• CDO Hedgesagreements with approved
  counterparties to exchange cash flows to cover
  asset/liability mismatches in basis,
  fixed/floating rate or foreign exchange risk
• CDO Additional Credit Supportreserve funds,
  insurance policies or letter/lines of credit used
  to enhance the credit support for the Notes
• CDO Senior, Mezzanine, Subordinated Notes and
  Equitythe liabilities issued by the SPV. Senior
  Notes generally have the first claim on cash
  flows, Mezzanine Notes second, Subordinated Notes
  third, and Equity has the residual claim on the
  flows

CDO Manager
CDO Trustee
CDO Senior Notes
CDO Special Purpose Vehicle
CDO Asset Portfolio
CDO Mezzanine / Subordinated Notes
CDO Hedge(s)
CDO Additional Credit Support
CDO Equity
13
CDO Equity
Value proposition
Advantages
Disadvantages

• Can deliver high and stable current cash flow
• Does not rely on general fixed-incomemarket
  direction
• Diversified portfolios
• Experienced management focused assetclass
  selection
• Low correlation with other alternative
  investments
• Senior and mezzanine debt is predominantlyterm-
  financed and not subject to margin call risk
• Nonrecourse (cannot lose more thaninitial
  investment)
• Financing rate is often locked in for the
  duration of the CDO vehicle

• Highly leveraged to credit performance
• Illiquid
• Complex high surveillance cost due to diversity
  of portfolios
• CDO Equity performance can be hampered if CDO
  does not meet rating or par-based constraints
• CDO Equitys cash flows are structurally
  subordinated to CDO Debts cash flows
• Market capacity constraint

14
CDO Equity
Value proposition (continued)

• Cash flow return profile of CDO Equityat base
  case default scenario
• Original investment in CDO Equity can be returned
  through cash distributions within 67 years of
  issuance
• Credit risk profile may improve over time as the
  underlying collateral seasons

CDO Equity return (cumulative cash-on-cash)
250.0
Original investment paid back
200.0
150.0
100.0
50.0
0.0
1
2
3
4
5
6
7
8
9
10
11
Year
Source UBS. The returns presented are
illustrative, presented for discussion purposes
only and based on hypothetical assumptions.
There can be no assurance that similar returns
will be achieved and the returns presented should
not be considered a prediction of future results
15
CDO Equity
Alternative investment portfolio diversification

• CDO Equity complements hedge funds private
  equity funds

16
SECTION 3
CDO Invest Case study of a Specialist CDO
Investment Team
17
AXA Groupa world leader in financial protection
andwealth management
Key Figures 1
AuM
Global Presence
Corp Ratings
Client Base
Market Cap
Revenues
Shares

• 120,000 employees worldwide,
• operating in more than 50 countries

72 billion in gross revenues 2.9 billion in
adj. earnings in 2004
Shares quoted on Paris and New York stock
exchanges (CS FPFrance and AXAUS)
Aa3 (Moodys), A A (Fitch) AA- (SP)3
50 million clients worldwide
Over 35 billion
869 billion 1
Management Structure
AXA Group
Property Casualty
International Insurance
Other Financial Services
Asset Management
Life Savings
Alliance Capital Management
AXA Investment Managers (AXA IM)
Note 1 Source AXA Group, AXA IM, figures as of
31/12//04
18
AXA IM - A multi-specialist investment firm

• Empowered to deliver performancemulti-specialist
  business units consisting of dedicated investment
  teams backed by substantial resources

Management Structure
AXA IM Nicolas Moreau, CEO
AXA Real Estate Investment Management
AXA Private Equity
AXA Multi-Manager
AXA Rosenburg
Securities Investment Management (SIM)Robert
Kyprianou, Head
Finance/Operations/IT
Audit/Risk Management/ Legal/Compliance
Balanced Structured Solutions
Insurance Main Funds Investment
Active Specialist Equity
Hedge Funds
Structured Finance Division P.E. Juillard
Fixed Income
Human Resources/Internal
Sales and Marketing

• Strategic focuson specific investment areas
  where we can add real value for our clients

Focus and Growth Strategy
1
2
3
Establishtrack record,make productsavailable
to thirdparty investors
1
Identifyasset classes whereit can offer
acompetitive edge
Allocate resources neededto exploit
theseopportunities
19
with extensive global reach

• Approximately 2,140 employees across 13
  countriesproximity to clients and key financial
  markets

Global Presence
20
AXA IM - A large and growing asset base

• An innovative and fast growing third party asset
  managerbacked by the AXA Group ensuring
  financial strength and stability
• 150 growth in AUMin 7 years and 18 growth
  since 2003 reaching 345.3bn

Assets Under Management 1
Assets by Client Type
345.0
350
Equities
292.0
98.9 Billion
300
277.0
268.0
255.5
Fixed Income
237.9
250
186 Billion
198.5
Of which 22 billionin StructuredFinance,
73 bn inTraditional Credit
200
138.5
150

100
Alternative
50
61.3 Billion
0
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Note 1 AXA IM, as of 31/12//04
21
Structured Finance DivisionThe benefits of
leadership

• A one-stop source Structured Finance solutionsa
  world leader in the structuring and management of
  CDOs, ABS, Leveraged Loans, Private Loans, as
  well as CDO investing renowned for breadth of
  expertise (rare in buy-side investment firms)
• Commitment and ownership44 professionals
  committed to delivering superior risk-reward
  solutions, with clients at the heart of our model
• At the forefront of the marketSFD has set the
  standard in transforming formerly niche products
  into widely accepted asset classes core to
  optimal asset allocation
• Rapid yet manageable asset growthOver 22
  billion in assets under management

An unrivalled organisation leveraging vast
resources
Head of Structured Finance P.E. Juillard
Globally Shared Resources
SF Communications Manager
SF Chief Operating Officer
ABSGroup
Leveraged Loans
Investment GradeCDO
Private Loans
CDOInvest
Structured Finance Engineering
Fixed Income Investment Research
Macro Research
Legal Compliance
8 people
8 people
9 people
3 people
7 people
6 people
Managing 22 bn
Risk Control and Workout Group
AXA IM, as of 31/12/04
22
CDO Invest - Extensive experience in CDO investing

• Experience CDO Invest as an asset manager is
  the worlds largest investor in CDO equities,
  across multiple asset classes
• Reach CDO Invest benefits from access to AXA
  IMs credit expertise and SFDs structured
  finance savvy

AXA IM CDO Investments by Tranche
AXA IM CDO Investments by Asset Category
420m
600m
600m

• Methodology that worksOur three pillar approach
  to ascertaining a good CDO has been the
  cornerstone of our success

Three-pillar approach

• Assetsexposure/positioning consistent with
  ensuringstable, predictable cash flows

Structure
Asset Class Exposure

• Structurehelps extract alpha within asset
  class,manager needs to sufficient flexibility to
  manoeuvre the CDO and to avoid fighting the
  structure
• structure should be able to mitigate asset class
  volatility to withstand difficult cycles

ManagementStyle

• Stylefocus on mitigating losses and rating
  downgrades in orderto leverage efficiency
• avoid losers rather than chasing for homeruns
• deliver consistent returns across the capital
  structure

23
CDO Invest A comprehensive but selective,
upstream approach
Some key figures regarding CDO Equity investing

• CDO Invests performance lies in its capacity to
  source assets in the market while remaining
  selective

• CDO Invest is given the opportunity to look
  early at over 75 of the CDOs that are relevant
  to it
• CDO Invest gets- full allocation AND
  preferential terms on over 50...- full
  allocation OR preferential terms on over 90...
  of all its CDO equity purchases, thanks to its
  long-standing relationships with managers and
  banks alike and to its early, sizeable and
  reliable commitments

3 months prior to 31/03/2004

• CDO Invest- met with 90...- carried out on
  site due diligence visits on 50... of all
  managers who issued CLOs over the 2003-2004Q1
  period
• CDO Invest- met with 50...- carried out on
  site due diligence visits on 25... of all
  managers who issued ABS CDOs over the 2003-2004Q1
  period

37
37 primary issues
23
Selection of our universe 23 issues
Transaction filtration process
19
Effectively reviewed 19 issues
12
Eventually invested 12 issues(48 refusal rate)
24
CDO Invest Five Phase Investment Process
Phase I Portfolio Construction
Phase II CDO Sourcing
Phase III CDO Selection/Analysis
Phase IV CDO Investment
Phase V Ongoing Surveillance

• Macroeconomic Outlook
• Asset Class View
• Investment Guidelines

• Macroeconomic Outlook
• Asset Class View
• Investment Guidelines

• Qualitative Analysis
• Quantitative Analysis

• Credit Memo Committee Presentation
• Purchase (If Approved)

• Investment Monitoring
• Asset Surveillance

25
SECTION 4
Prelude Credit Alpha (Prelude) Case Study of a
CDO Equity Fund
26
Prelude - Overview of the structure
CDO Invest
CDO1
Collateral
Managers
Equity 1
Management of CDO1
USInvestors
Manages assets in accordance with the Investment
Guidelines
Collateral
Managers
Caymans Feeder
144A Notes (certificated)
Management of CDO2
CDO3
Collateral
Managers
Equity 3
Management of CDO3

Prelude Jersey Master
CDO4
Collateral
Managers
Non-USInvestors
Equity 4
Management of CDO4
Irish Feeder
Reg S Notes (Euroclear) listed on ISE
Collateral management of CDOn
Managers
27
Prelude - Highlights
Master Vehicle Prelude Credit Alpha (Jersey)
Limited Feeder for US investors Bought 144A
fully certificated Notes issued in USD by a
Cayman SPV Feeder for non-US investors Bought
Reg S Notes, listed on the Irish Stock Exchange
and settled through Euroclear, issued in USD by
an Irish SPV Portfolio Manager to Master
Fund CDO Invest team, AXA Investment Managers
Paris Legal Final Maturity 13 years (10th Nov
2017) Investment Horizon 7 years (10th February
2012) Initial Closing 19th November 2004 -
140mn of investor commitments Second and Final
Closing 24th March 2005 - 46mn of additional
investor commitments Distribution Dates 10th
Feb, 10th May, 10th Aug, 10th Nov of each
year Management Fee 1 distributed quarterly
in arrears Incentive Distribution Hurdle 8
realised IRR Incentive Distribution
Amount 20 of all cashflows above incentive
distribution hurdle Trustee JPMorgan
Chase Investor breakdown 85 20 institutional
investors (Europe, US, Middle East, Asia)15 25
ultra high-net-worth US private
investorsInstitutional investor commitments
range from 2mn to 30mn (twice), with an average
commitment size of 7.5mn
28
Prelude Selected investment guidelines