A CLO's mezzanine overcollateralisation test fails after defaults. Does it fail, by how much, and how much interest is diverted away from the equity to cure it?

The test fails, at 110.3% against 112%, and Rs 51.8 crore of interest is diverted to repay senior notes, leaving the equity Rs 33.2 crore instead of Rs 110 crore. After defaults the pool is Rs 3,750 crore and earns Rs 375 crore; the notes take Rs 290 crore. To restore 112%, the notes must fall to Rs 3,348.2 crore, which takes Rs 51.8 crore of the Rs 85 crore left.

Think of a group of friends who lend money to a shared venture, with one friend agreeing to be paid last in exchange for keeping any profit left over. If the venture starts losing money, the others want a rule: until there is enough cushion again, the last friend's share goes to paying them down. An overcollateralisation testA check that the par value of the loan pool is at least a set multiple of the notes above a given level. If it falls short, cash is redirected to repay the senior notes. is that rule: when losses eat into the cushion, the waterfall turns cash away from the bottom of the stack and uses it to shrink the top. It protects the notes; the equity pays for it.

Before defaults the pool of Rs 4,000 crore against Rs 3,400 crore of notes gives 117.6%, a pass. After Rs 250 crore is written off, the pool is Rs 3,750 crore and the ratio is 110.3%. The test fails, because the cushion above 112% was only Rs 192 crore, under 5% of the pool. That is the number interviewers like: a CLO's equity can be cut off by losses far smaller than the equity itself.

Cure the ratio by shrinking the denominator. The pool stays at Rs 3,750 crore, so the notes must fall to 3,750 divided by 1.12, Rs 3,348.2 crore. They are Rs 3,400 crore, so Rs 51.8 crore of senior notes must be repaid. The cash comes from interest that would otherwise have gone to the equity. The pool earns Rs 375 crore on Rs 3,750 crore; senior interest takes Rs 224 crore and mezzanine interest Rs 66 crore, leaving Rs 85 crore, of which Rs 51.8 crore is diverted.

The equity is hit twice. It loses Rs 25 crore of interest on the defaulted loans and then Rs 51.8 crore to the cure, so its cash falls from Rs 110 crore, a 18.3% yield on Rs 600 crore, to Rs 33.2 crore, 5.5%. The senior notes gain: they are repaid early at par and their own cover rises. The mezzanine notes are paid in full this period and their coverage is restored, which is the test doing its job.

Close with what you would read next, which is where the question about the indenture comes from. The priority of payments section sets the order, the tests and their triggers; the definitions section decides how defaulted and low-rated loans count in the pool, often at a haircut rather than at par. That second point matters: in practice the test can fail before any loan defaults, if too many are downgraded. The senior test, here 133.9% on Rs 2,800 crore, is the next one to watch.