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.

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 investing in CLO funds 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.
• 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.

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

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. This financial structure allows CLOs to offer different investment options to investors.

Equity Tranches Explained

The equity tranche is a critical component of a CLO’s capital structure. 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. 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.

CLO Equity Fund Architecture

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. 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.
• This structure creates inherent risk mitigation for debt tranches through overcollateralization and interest coverage tests.

Equity Tranche Position and Risk Profile

As the most junior, equityholders absorb loan defaults before any debt tranche is affected. 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.

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.

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.

Portfolio Diversification Benefits

CLO equity adds diversification value to a broader portfolio. Its historic correlations often remain below 50% versus fixed income peers like high-yield. Hence, CLO equity can be a powerful diversifier in a mixed-asset allocation.

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

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.

• 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.

Market Volatility Impact

Price swings can sharply move CLO equity valuations. The financing terms can avert fire sales, but M2M swings still pose valuation risk.

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.

• 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.

The Power of Active Management

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.

Reinvestment Phase Benefits

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. 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

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.

In sum, skilled navigation and structural tweaks are central to realizing CLO equity’s potential. 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

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.

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. 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. This characteristic, combined with its shorter duration, makes CLO equity an attractive option for investors seeking relatively quicker returns.

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. 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

In rising rate environments, CLO equity benefits from the floating-rate nature of both its assets and liabilities. 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. 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 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

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. 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. 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. 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 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?

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. Review your risk profile, liquidity needs, and current allocations to decide if CLO equity fits.