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

Main Points

• CLO equity represents a high-risk, high-reward tranche within the $1.1 trillion CLO market.
• 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.
• Investors must weigh both the upsides and dangers prior to deployment.

CLO Equity Fundamentals

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. Typically, it invests in between 150 and 350 leveraged loans that act as security for the CLO.

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.

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.

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. 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.

Waterfall Mechanics in CLOs

CLOs use a tiered waterfall to allocate cash precisely. 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. Each quarter, the waterfall ensures seniors are paid first, then equity gets the residual.

• 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. 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.

Why Invest in CLO Equity Funds?

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.

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.

Early Cash-Out Advantage

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

CLO equity adds diversification value to a broader portfolio. Its historic correlations often remain below 50% versus fixed income peers like high-yield. This makes CLO equity an excellent addition to a diversified investment portfolio.

Key Risks Associated with CLO Equity Investments

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 Risk and Default Concerns

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.

• 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

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

CLO equity liquidity merits careful review. 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.

• 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

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.

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. 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. 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.

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.

Comparison with Fixed Income and Credit Investments

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. 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.

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. 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

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.

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

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

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 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.

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. While this approach dilutes the specific benefits of CLO equity, it provides a diversified credit portfolio managed by professionals. Review objectives and cost structures closely before committing.

The choice among these options depends on an investor’s size, sophistication, resources, and investment objectives. 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.

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. Assess their credit research depth and workout strategies for stressed loans.

Align their risk framework with your own return and volatility targets. 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. Investors should consider their risk tolerance, liquidity needs, and existing portfolio allocations before investing in CLO equity.