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

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.
• Grasping how CLO equity works is key to assessing its role 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 functions like a corporate entity, raising capital to acquire a diversified pool of leveraged loans. Typically, it invests in between 150 and 350 leveraged loans that act as security for the CLO.

Defining Collateralized Loan Obligations

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. 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.

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. This creates a leveraged exposure to corporate credit, making CLO equity an attractive option for investors seeking higher yields. 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

Understanding the structure of CLO equity funds is crucial for investors looking to diversify their portfolios. 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. Only once fees and senior debt are paid does the leftover spread flow to equity holders. Each quarter, the waterfall ensures seniors are paid first, then equity gets the residual.

• 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.
• 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. Yet in strong credit markets, equityholders enjoy the lion’s share of excess returns. By spreading investments across various managers, vintages, and loan pools, such funds reduce single‐CLO concentration risk.

Equity investors must grasp these built-in guards and tilt factors, since they shape when and how much cash flows to them.

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

Investors can aim for double-digit annual yields via quarterly cash 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

Unlike private equity’s J-curve, CLO equity delivers cash early on. 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.

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. Hence, CLO equity can be a powerful diversifier in a mixed-asset allocation.

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

CLO equity holders face pronounced credit risk. Loan defaults hit equity returns first, given its subordinate position. The equity tranche, being the most junior, absorbs the initial losses, making credit risk management critical.

• Defaults directly impact equity returns.
• The equity tranche is the first to absorb losses.
• Robust credit risk controls are vital to limit downside.

Market Volatility Impact

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. Understanding these liquidity risks is vital for investors.

• The secondary market can become constrained during market stress.
• Limited exit opportunities can affect investor liquidity.
• 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.

How Active Management Creates Value in CLO Equity

Effective active management is a key driver of value creation in CLO equity. Ongoing surveillance and tactical adjustments by adept managers can boost equity returns markedly.

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. Active management during this period is crucial for maximizing the benefits of CLO equity investments.

Par Building Strategies

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. For example, a 2% discount may yield roughly 20% equity upside, underscoring tactical trading’s impact.

Debt Optimization Techniques

Managers can also refinance or reset debt to tweak the capital structure in favor of equity. 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. Skilled managers can enhance returns through strategic trading decisions, par building strategies, and refinancing options, ultimately creating significant value for equity investors.

Comparing CLO Equity to Other Alts

CLO equity’s unique blend of yield, liquidity, and risk differentiates it among alts. 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. This results in a shorter investment duration, typically ranging from 3-5 years, compared to the 7-10 years associated with private equity. Additionally, CLO equity offers more predictable cash flows and greater liquidity, although it may yield lower total returns in strong market environments.

CLO equity has historically delivered strong quarterly distributions, often offering annualized cash-on-cash returns in the mid-to-high teens during reinvestment periods. That, along with a briefer time horizon, positions it well for investors wanting speedier payback.

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

When rates climb, the variable-rate buffer often favors equity over fixed-rate debt. 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.

Its adaptability across regimes cements its role as a compelling diversifier. 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. This approach allows investors to handpick CLO managers and structures that align with their investment objectives. 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.

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. Review objectives and cost structures closely before committing.

The choice among these options depends on an investor’s size, sophistication, resources, and investment objectives. Institutions tend to choose direct deals; smaller players often opt for commingled funds.

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.

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.

Investment Philosophy and Risk Management Approach

The investment philosophy and risk management approach of a CLO manager can significantly vary. Some managers focus on maximizing current distributions, while others prioritize principal preservation and long-term value creation. Evaluating a manager’s credit research capabilities and approach to managing deteriorating credits is essential.

Align their risk framework with your own return and volatility targets. 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.