Investing in CLO Equity Funds: What You Need to Know

Over the last thirty-five years, the CLO market has expanded dramatically to become a $1.1 trillion cornerstone of corporate finance, with US BSL CLOs making up roughly 68% of US corporate loan demand.

The equity tranche of a CLO represents the spread between interest income on the loans and payments to debt investors, creating a distinctive investment chance for possible double-digit returns. This asset CLO primer class blends private equity upside with the predictable cash-flow profile of bonds.

Main Points

• 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.
• Grasping how CLO equity works is key to assessing its role in a diversified portfolio.
• The performance drivers of CLO equity contrast sharply with those of standard fixed-income or equity assets.
• It’s essential for investors to assess the risks and benefits before investing.

CLO Equity Fundamentals

Understanding CLO equity starts with knowing how Collateralized Loan Obligations (CLOs) are structured. A CLO is a financial vehicle that operates like a company, purchasing leveraged loans as its assets. Typically, it invests in between 150 and 350 leveraged loans that act as security for the CLO.

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. Such a layered structure provides a menu of risk/return slices for various investor appetites.

Equity Tranches Explained

Sitting at the base of the capital stack, the equity slice is vital to a CLO’s design. It sits at the bottom, making it the first to absorb losses but also the first to benefit from excess returns generated by the underlying loan portfolio. This positioning means that equity investors take on significant risk but also have the potential for substantial returns.

Return Drivers of CLO Equity

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. Understanding the floating-rate nature of both the underlying loans and the CLO debt is crucial to appreciating how CLO equity performs across different interest rate environments.

The Structure of CLO Equity Funds

To diversify effectively, investors must know how CLO equity funds are built. CLO equity funds are investment vehicles that allow individuals to invest in the equity tranche of Collateralized Loan Obligations (CLOs).

Waterfall Mechanics in CLOs

The CLO structure features a hierarchical “waterfall” payment system. This system determines how cash flows are distributed among the various tranches. 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.

• The CLO funding stack places equity at the bottom of the capital structure, creating a 10:1 leverage ratio that amplifies both potential returns and risks for equity investors.
• Debt tranches gain protection via overcollateralization buffers and coverage tests.

Risk Characteristics of Equity Tranches

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. Yet in strong credit markets, equityholders enjoy the lion’s share of excess returns. 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.

Benefits of CLO Equity Fund Investing

Quarterly payouts and high yields have driven interest in CLO equity. The blend of early cash flow, yield potential, and low correlation makes it an enticing portfolio diversifier.

Attractive Return Potential

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. Early distributions shorten the weighted average life, enhancing liquidity for investors.

Portfolio Diversification Benefits

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. This makes CLO equity an excellent addition to a diversified investment portfolio.

Understanding the Risks

Recognizing CLO equity’s risk profile is vital for prudent portfolio diversification. They carry distinctive hazards that must be weighed alongside their upside potential.

Credit and Default Risks

Credit risk represents a primary concern for CLO equity investors. 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.
• The equity tranche is the first to absorb losses.
• Credit risk management is essential for mitigating potential negative outcomes.

Market Volatility Impact

Market volatility can significantly impact the mark-to-market value of CLO equity positions. Although the term financing structure of CLOs prevents forced selling during market dislocations, potentially limiting permanent capital impairment, investors must still contend with valuation fluctuations.

Liquidity Considerations

Liquidity considerations are also important for CLO equity investors. The secondary market for these instruments can become constrained during periods of market stress, potentially limiting exit opportunities. Investors must factor in these liquidity dynamics when sizing positions.

• The secondary market can become constrained during market stress.
• Exits may be delayed or costly when liquidity dries up.
• Proper risk management includes considering liquidity risks.

Ultimately, the allure of high returns comes with material credit, volatility, and liquidity hazards. Prudent investors will adopt tailored mitigation tactics before committing capital.

The Power of Active Management

Active portfolio steering is crucial to unlocking CLO equity value. Ongoing surveillance and tactical adjustments by adept managers can boost equity returns markedly.

The Reinvestment Period Advantage

In the 4–5 year reinvestment window, managers can trade up holdings to capture fresh value. Active management during this period is crucial for maximizing the benefits of CLO equity investments.

Par Building Strategies

Buying loans below par can translate a small discount into outsized equity gains via leverage. A discount of 2% can translate to a 20% benefit for equity investors, highlighting the importance of strategic trading decisions during the reinvestment period.

Debt Optimization Techniques

Refinancing and reset options provide CLO equity investors with additional tools to enhance returns. Lowering borrowing costs or prolonging the reinvestment window lets equityholders capture more value when markets permit.

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

CLO equity’s unique blend of yield, liquidity, and risk differentiates it among alts. As investors consider their options, understanding the comparative advantages and disadvantages of CLO equity is essential.

Comparison with Private Equity

Unlike private equity’s long hold and J-curve, CLO equity delivers early, regular cash. CLO equity starts paying out within roughly half a year, shunning the typical PE J-curve. 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. The floating-rate nature of CLO assets and liabilities creates a different interest rate sensitivity profile, potentially making CLO equity more resilient during rising rate environments. Such nuances should guide how much capital to allocate to CLO equity in a balanced alt portfolio.

CLO Equity Through the Cycles

Investors often overlook the ongoing potential of CLO equity, assuming its heyday is over. However, CLO equity has demonstrated resilience across different market cycles, with performance patterns that often defy conventional expectations.

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. Notably, some of the strongest-performing CLO equity vintages were issued just before periods of market stress, such as in 2007, enabling them to acquire loans at significant discounts during their reinvestment periods.

Rising vs. Falling Rate Environments

In rising rate environments, CLO equity benefits from the floating-rate nature of both its assets and liabilities. The impact, however, depends on the relative size of rate increases on assets versus liabilities. Knowing this guides savvy investors on how to stagger vintages for smoother performance.

CLO equity’s ability to perform well in different environments makes it a valuable component of a diversified investment portfolio. Its performance is influenced by a combination of factors, including the manager’s skill in navigating market cycles and the inherent characteristics of CLO structures.

How to Invest in CLO Equity Funds

Investors seeking to tap into CLO equity funds have multiple avenues to consider, each with its unique advantages and considerations.

Direct Deal-by-Deal Investments

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 Equity Funds

Captive equity funds provide a diversified, commingled approach to investing in CLO equity. By pooling resources, investors can access a portfolio of CLO equity positions managed by a single experienced manager. This approach reduces vintage risk and offers lower minimum investment requirements, making it more accessible to a broader range of investors.

Credit Fund Alternatives

Opportunistic credit vehicles often tuck CLO equity into their broader credit mix. 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. Institutions tend to choose direct deals; smaller players often opt for commingled funds.

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. Consistency across vintage cycles is a key due-diligence metric.

Philosophy & Risk Controls

The investment philosophy and risk management approach of a CLO manager can significantly vary. Some chase high current payouts; others emphasize downside protection and long-term gains. 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?

CLO equity offers a distinct combination of return potential and diversification benefits, making it a valuable consideration for sophisticated investors. Its double-digit yield prospects and early payouts help improve overall portfolio returns.

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. Investors should consider their risk tolerance, liquidity needs, and existing portfolio allocations before investing in CLO equity.