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.

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 equity performance class combines the benefits of private equity with bond-like cash flows.

Essential Insights

• The equity slice of a CLO sits at the top of both risk and return in the $1.1 trillion CLO universe.
• 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.
• Investors must weigh both the upsides and dangers prior to deployment.

Understanding CLO Equity: The Basics

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

The Role of Equity Tranches in CLO Structures

The equity tranche is a critical component of a CLO’s capital structure. 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. Thus, equity investors bear the lion’s share of credit risk but can reap outsized rewards.

How CLO Equity Generates Returns

Returns on the equity tranche stem from the net interest spread after servicing debt tranches. 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.

The Structure of CLO Equity Funds

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

The CLO structure features a hierarchical “waterfall” payment system. 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.

• 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.

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. This investment vehicle offers a unique combination of attractive returns, front-loaded cash flows, and diversification benefits, making it an appealing option for investors seeking to enhance their portfolios.

Yield Prospects

Investors can aim for double-digit annual yields via quarterly cash distributions. This creates an attractive time-weighted return profile compared to other alternative investments. Historically, the CLO equity segment has delivered robust results for yield-seeking investors.

Early Cash-Out Advantage

Unlike private equity’s J-curve, CLO equity delivers cash early on. Early distributions shorten the weighted average life, enhancing liquidity for investors.

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. They carry distinctive hazards that must be weighed alongside their upside potential.

Credit Risk and Default Concerns

CLO equity holders face pronounced credit risk. Defaults in the underlying loan portfolio directly impact equity returns before affecting any other tranche in the CLO structure. 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.

Volatility Considerations

Price swings can sharply move CLO equity valuations. 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 Risks

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.
• Limited exit opportunities can affect investor liquidity.
• Proper risk management includes considering liquidity risks.

In conclusion, while CLO equity investments offer attractive returns, they are accompanied by significant risks, including credit risk, market volatility, and liquidity concerns. Investors must carefully evaluate these risks and consider strategies for mitigation.

How Active Management Creates Value in CLO Equity

Active portfolio steering is crucial to unlocking CLO equity value. By continually monitoring and adjusting the portfolio, skilled managers can significantly enhance returns for equity investors.

The Reinvestment Period Advantage

During the reinvestment period, typically lasting four to five years, CLO managers have the flexibility to sell existing holdings and purchase new loans, potentially upgrading the portfolio and enhancing returns for equity investors. 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.

Debt Optimization Techniques

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.

CLO Equity vs. Other Alternative Investments

The distinct profile of CLO equity sets it apart from traditional alternative investments. Investors weighing alts should map how CLO equity stacks up on return, duration, and liquidity.

CLO Equity vs. 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. Additionally, CLO equity offers more predictable cash flows and greater liquidity, although it may yield lower total returns in strong market environments.

During reinvestment phases, annualized equity cash-on-cash returns have often hit the mid- to high-teens. That, along with a briefer time horizon, positions it well for investors wanting speedier payback.

CLO Equity vs. Fixed Income

Versus plain-vanilla credit, CLO equity can hand out much greater yields—but with amplified risk and liquidity trade-offs. 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. However, CLO equity has demonstrated resilience across different market cycles, with performance patterns that often defy conventional expectations.

Economic Downturns and CLO Equity

Equity prices may wobble in recessions. 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

When rates climb, the variable-rate buffer often favors equity over fixed-rate debt. The impact, however, depends on the relative size of rate increases on assets versus liabilities. 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 Deal-by-Deal Investments

Direct deal-by-deal investments in CLO equity offer sophisticated investors maximum control and customization. This approach allows investors to handpick CLO managers and structures that align with their investment objectives. But it demands deep credit analysis capabilities and operational bandwidth.

Captive Equity Funds

Captive equity funds provide a diversified, commingled approach to investing in CLO equity. A seasoned manager then navigates vintages and credit selection on behalf of the fund. This approach reduces vintage risk and offers lower minimum investment requirements, making it more accessible to a broader range of investors.

Multi-Asset or Opportunistic Credit Funds

Opportunistic credit vehicles often tuck CLO equity into their broader credit mix. While this approach dilutes the specific benefits of CLO equity, it provides a diversified credit portfolio managed by professionals. 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.

Manager Selection: Critical Factors for Success

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

Proven Performance

A manager’s track record and experience are crucial in determining their ability to navigate various market cycles. Investors typically seek managers who have demonstrated consistent performance across multiple CLO vintages.

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. Evaluating a manager’s credit research capabilities and approach to managing deteriorating credits is essential.

When selecting a manager, it’s essential to consider their risk management strategy and how it aligns with your investment goals. Strategic alignment often translates into superior risk-adjusted results.

Final Thoughts on CLO Equity

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.

If you can stomach the risk and time horizon, CLO equity’s low correlation makes it an excellent diversifier. Review your risk profile, liquidity needs, and current allocations to decide if CLO equity fits.