A Guide to Investing in CLO Equity Funds: Essential Insights

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.

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 funds investing class blends private equity upside with the predictable cash-flow profile of bonds.

Essential Insights

• The equity slice of a CLO sits at the top of both risk and return in the $1.1 trillion CLO universe.
• Quarterly distributions can deliver double-digit returns to investors.
• Understanding CLO equity is crucial for evaluating its place 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. It raises funds to buy a diverse pool of 150 to 350 leveraged loans, which serve as collateral.

Defining Collateralized Loan Obligations

Collateralized Loan Obligations (CLOs) are structured credit instruments that pool together a diverse collection of leveraged loans, creating a securitized investment vehicle with multiple tranches of varying risk and return profiles. This financial structure allows CLOs to offer different investment options to investors.

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. This positioning means that equity investors take on significant risk but also have the potential for substantial returns.

Return Drivers of CLO Equity

Returns on the equity tranche stem from the net interest spread after servicing debt tranches. This creates a leveraged exposure to corporate credit, making CLO equity an attractive option for investors seeking higher yields. 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. 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. 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.
• 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.

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

Benefits of CLO Equity Fund Investing

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.

Early Cash-Out Advantage

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

CLO equity adds diversification value to a broader portfolio. 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.

Key Risks Associated with CLO Equity Investments

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 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.

• Equity returns feel the immediate impact of defaults.
• Losses funnel first to the equity layer.
• Credit risk management is essential for mitigating potential negative outcomes.

Volatility Considerations

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

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.
• 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.

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

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

Managers can also refinance or reset debt to tweak the capital structure in favor of equity. 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. 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.

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. This results in a shorter investment duration, typically ranging from 3-5 years, compared to the 7-10 years associated with private equity. And while it may underperform in booming markets, its stable cash profile and liquidity can be major pluses.

CLO equity has historically delivered strong quarterly distributions, often offering annualized cash-on-cash returns in the mid-to-high teens during reinvestment periods. 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. Such nuances should guide how much capital to allocate to CLO equity in a balanced alt portfolio.

CLO Equity Performance Across Market 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.

Downturn Performance

During economic downturns, CLO equity can experience mark-to-market volatility. Yet, the term financing structure prevents forced selling, allowing skilled managers to capitalize on opportunities to purchase discounted loans, thereby enhancing long-term returns. 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.

Rate Regime Impacts

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. Knowing this guides savvy investors on how to stagger vintages for smoother performance.

Its adaptability across regimes cements its role as a compelling diversifier. 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 CLO Equity Deals

Picking individual CLO equity tranches deal by deal grants the most control. You can select managers and deal structures tailored to your goals. But it demands deep credit analysis capabilities and operational bandwidth.

Captive Fund Structures

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. It lowers the entry barrier and dampens single-vintage swings via built-in diversification.

Credit Fund Alternatives

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.

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.

Choosing the Right Manager

Effective CLO equity investing hinges on selecting a skilled manager. The manager’s expertise in portfolio construction, credit selection, and active trading directly impacts equity returns.

Proven Performance

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