Incentives of Fund Managers and Precautionary Fire Sales

Abstract

This paper investigates how precautionary trading behavior of fund managers induced by a higher junior fee component in their compensation structure affects prices of downgraded loans in the leveraged loans market. Using detailed portfolio data from Collateralized Loan Obligation (CLO) funds, we find that fund managers with a higher ratio of subordinate fee to total fees are more likely to sell downgraded loans. Fund managers exhibit such precautionary trading behavior even when currently unconstrained, in anticipation of future binding collateral constraints. Loans subject to a high probability of precautionary selling exhibit large price declines and subsequent reversals. Our results provide new insights into the role of incentives on managerial risk taking and consequent amplification of fire sale externalities in the corporate debt market.

Keywords: Managerial Incentives, Fire Sales, Collateralized Loan Obligations, Leveraged Loans

JEL Classification: G11, G21, G23, G32, G34