Investing in CLO Equity Funds: What You Need to Know

The collateralized loan obligation (CLO) market has grown significantly over the past 35 years, evolving into a $1.1 trillion pillar of corporate financing, with US BSL CLOs accounting for about 68% of demand for US corporate loans.

CLO equity captures the difference between loan interest earned and debt owed to CLO debtholders, offering a unique investment opportunity with potential double-digit returns. This asset CLO equity performance class blends private equity upside with the predictable cash-flow profile of bonds.

Essential Insights

• CLO equity represents a high-risk, high-reward tranche within the $1.1 trillion CLO market.
• Investors can benefit from double-digit returns with quarterly distributed cash flows.
• Understanding CLO equity is crucial for evaluating its place in a diversified portfolio.
• CLO equity behaves differently from traditional fixed income or equity investments.
• It’s essential for investors to assess the risks and benefits before investing.

Understanding CLO Equity: The Basics

To grasp the concept of CLO equity, it’s essential to understand the underlying structure of Collateralized Loan Obligations (CLOs). A CLO is a financial vehicle that operates like a company, purchasing leveraged loans as its assets. It raises funds to buy a diverse pool of 150 to 350 leveraged loans, which serve as collateral.

What Are Collateralized Loan Obligations (CLOs)?

A CLO is a securitization that aggregates a broad mix of leveraged loans into an investment vehicle segmented into tranches spanning different risk and yield levels. This financial structure allows CLOs to offer different investment options to investors.

Equity Tranches Explained

Sitting at the base of the capital stack, the equity slice is vital to a CLO’s design. Being most junior, it takes initial losses yet enjoys first claim on surplus cash after debt obligations are met. This positioning means that equity investors take on significant risk but also have the potential for substantial returns.

How CLO Equity Generates Returns

CLO equity generates returns through the spread between the interest received from the underlying loan portfolio and the interest paid to CLO debt holders. That spread provides leveraged credit exposure, appealing to yield-hungry investors. Recognizing that both assets and liabilities reset periodically is key to forecasting CLO equity outcomes under shifting rate regimes.

CLO Equity Fund Architecture

To diversify effectively, investors must know how CLO equity funds are built. Such funds pool capital to buy exposure to the equity slices of multiple CLOs.

CLO Funding Stack and Waterfall Payments

CLOs use a tiered waterfall to allocate cash precisely. It dictates the order of expense coverage, debt servicing, and equity distributions. After the CLO pays expenses and the interest owed on the CLO debt, the remaining net spread is paid as a distribution to the equity investors. The cash flow from a CLO runs through a quarterly payment waterfall, ensuring that equity investors receive distributions only after all senior obligations have been satisfied.

• Equity sits beneath debt in the stack, often leveraging at 10 times, boosting both upside and downside.
• This structure creates inherent risk mitigation for debt tranches through overcollateralization and interest coverage tests.

Equity Tranche Position and Risk Profile

Because equity investors sit below all debt tranches in terms of seniority, they are the first to absorb losses if any of the underlying loans default. However, CLO equity is also the best positioned tranche within a CLO structure to capture upside value under favorable conditions. CLO equity funds typically hold positions in multiple CLO equity tranches, providing diversification across different CLO managers, vintages, and underlying loan portfolios to mitigate concentration risk.

Understanding the structural protections and constraints within CLOs is essential for equity investors, as these features influence both the timing and magnitude of distributions throughout the investment lifecycle.

Why Invest in CLO Equity Funds?

CLO equity investments have gained popularity due to their potential for generating substantial returns through quarterly distributions. The blend of early cash flow, yield potential, and low correlation makes it an enticing portfolio diversifier.

Yield Prospects

CLO equity funds offer investors the potential for double-digit annual returns, delivered through quarterly distributions. That pattern often outpaces the return trajectories of many alts. Historically, the CLO equity segment has delivered robust results for yield-seeking investors.

Front-Loaded Cash Flows

The front-loaded cash flow pattern of CLO equity investments contrasts sharply with the typical J-curve effect seen in private equity. This provides investors with earlier access to returns and reduces the weighted average life of the investment, making it a more attractive option for those seeking liquidity.

Diversification Advantages

Investing in CLO equity also offers portfolio diversification benefits. The asset class has historically exhibited low correlation with traditional asset classes, with correlation coefficients below 50% even with adjacent fixed income sectors like high-yield bonds. Hence, CLO equity can be a powerful diversifier in a mixed-asset allocation.

Understanding the Risks

Understanding the risks associated with CLO equity is crucial for investors looking to diversify their portfolios. CLO equity investments, while potentially lucrative, come with a unique set of challenges that require careful consideration.

Credit and Default Risks

CLO equity holders face pronounced credit risk. Loan defaults hit equity returns first, given its subordinate position. As the first-loss position, effective credit oversight is nonnegotiable.

• Defaults directly impact equity returns.
• Losses funnel first to the equity layer.
• Robust credit risk controls are vital to limit downside.

Market Volatility Impact

Price swings can sharply move CLO equity valuations. The financing terms can avert fire sales, but M2M swings still pose valuation risk.

Liquidity Risks

CLO equity liquidity merits careful review. The secondary market for these instruments can become constrained during periods of market stress, potentially limiting exit opportunities. Understanding these liquidity risks is vital for investors.

• Trading desks may thin out under stress.
• Limited exit opportunities can affect investor liquidity.
• Sound risk frameworks account for liquidity crunches.

Ultimately, the allure of high returns comes with material credit, volatility, and liquidity hazards. Investors must carefully evaluate these risks and consider strategies for mitigation.

How Active Management Creates Value in CLO Equity

Effective active management is a key driver of value creation in CLO equity. By continually monitoring and adjusting the portfolio, skilled managers can significantly enhance returns for equity investors.

Reinvestment Phase Benefits

In the 4–5 year reinvestment window, managers can trade up holdings to capture fresh value. Such proactive recalibrations are vital to amplify CLO equity upside.

Discount-to-Par Tactics

Par building involves purchasing loans at discounts to par value, which can create substantial value for equity investors due to the leveraged nature of the CLO structure. A discount of 2% can translate to a 20% benefit for equity investors, highlighting the importance of strategic trading decisions during the reinvestment period.

Refinancing and Reset Options

Refinancing and reset options provide CLO equity investors with additional tools to enhance returns. By reducing debt costs or extending the reinvestment period, investors can take advantage of favorable market conditions, further optimizing their investment strategy.

Active management represents a critical value driver for CLO equity investments. Through savvy trades, discount capture, and debt reengineering, managers can unlock material investor value.

Comparing CLO Equity to Other Alts

The distinct profile of CLO equity sets it apart from traditional alternative investments. As investors consider their options, understanding the comparative advantages and disadvantages of CLO equity is essential.

CLO Equity vs. Private Equity

CLO equity offers a unique investment profile compared to traditional private equity. While private equity investments typically follow a J-curve effect, CLO equity provides front-loaded quarterly distributions beginning within 5-6 months of issuance. That yields a typical 3–5 year life, versus 7–10 years for PE commitments. And while it may underperform in booming markets, its stable cash profile and liquidity can be major pluses.

During reinvestment phases, annualized equity cash-on-cash returns have often hit the mid- to high-teens. This characteristic, combined with its shorter duration, makes CLO equity an attractive option for investors seeking relatively quicker returns.

CLO Equity vs. Fixed Income

Relative to traditional fixed income and credit investments, CLO equity provides significantly higher return potential, albeit with higher risk and less liquidity. Its variable-rate structure often cushions equity when rates climb, relative to fixed-rate debt. Investors must weigh these factors when determining the appropriate allocation to CLO equity within their diversified portfolio of alternative investments.

CLO Equity Through the Cycles

Investors often overlook the ongoing potential of CLO equity, assuming its heyday is over. Yet, it has shown strong resilience and counterintuitive returns in various cycles.

Economic Downturns and CLO Equity

During economic downturns, CLO equity can experience mark-to-market volatility. But the financing terms avert fire-sales, giving managers a chance to buy loans on the cheap and boost longer-run yields. Indeed, vintages launched before stress events—like pre-2007—often captured deep discounts in their reinvestment windows.

Rising vs. Falling Rate Environments

In rising rate environments, CLO equity benefits from the floating-rate nature of both its assets and liabilities. Its net sensitivity hinges on how much more assets reset than debt. Understanding these dynamics helps investors develop effective vintage diversification strategies when allocating to CLO equity.

CLO equity’s ability to perform well in different environments makes it a valuable component of a diversified investment portfolio. Performance drivers include manager prowess and the built-in leverage and credit protections of the structure.

Accessing CLO Equity Fund Investing Opportunities

Various routes exist for gaining CLO equity exposure, each with pros and cons.

Direct CLO Equity Deals

Direct deal-by-deal investments in CLO equity offer sophisticated investors maximum control and customization. You can select managers and deal structures tailored to your goals. However, it requires significant expertise and resources to analyze and manage a portfolio of CLO equity positions effectively.

Captive Fund Structures

Captive funds pool capital to buy broad CLO equity baskets. By pooling resources, investors can access a portfolio of CLO equity positions managed by a single experienced manager. It lowers the entry barrier and dampens single-vintage swings via built-in diversification.

Multi-Asset or Opportunistic Credit Funds

Multi-asset or opportunistic credit funds offer a simplified way to gain exposure to CLO equity as part of a broader credit investment portfolio. Although you lose some pure-play benefits, you gain multi-credit diversification under a single strategy. Investors should carefully evaluate the fund’s strategy and fees to ensure alignment with their investment goals.

Which route you pick hinges on your capital, expertise, and desired customization. Larger institutional investors often prefer direct investments, while smaller investors may benefit from fund structures that offer diversification and professional management.

Choosing the Right Manager

Your CLO equity outcome largely rests on manager caliber. A manager’s portfolio design, research depth, and trade execution shape final equity yields.

Track Record and Experience

Past performance and tenure speak volumes about a manager’s market navigation skills. Investors typically seek managers who have demonstrated consistent performance across multiple CLO vintages.

Philosophy & Risk Controls

Managers differ in how they balance distribution yield versus capital preservation. Some managers focus on maximizing current distributions, while others prioritize principal preservation and long-term value creation. Assess their credit research depth and workout strategies for stressed loans.

When selecting a manager, it’s essential to consider their risk management strategy and how it aligns with your investment goals. A well-aligned investment strategy can lead to better performance outcomes.

Conclusion: Is CLO Equity Right for Your Investment Portfolio?

For seasoned investors, CLO equity’s blend of yield and diversification can be highly compelling. With its attractive, double-digit return potential and front-loaded cash flows, CLO equity can enhance risk-adjusted returns in a diversified investment portfolio.

For investors with the appropriate risk tolerance and investment horizon, CLO equity can serve as a valuable portfolio diversifier due to its low correlation with traditional asset classes. Review your risk profile, liquidity needs, and current allocations to decide if CLO equity fits.