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 CLO equity ETF class blends private equity upside with the predictable cash-flow profile of bonds.

Main Points

• 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.
• 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

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. 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.

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. 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.

Waterfall Mechanics in CLOs

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

• Equity sits beneath debt in the stack, often leveraging at 10 times, boosting both upside and downside.
• 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. 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.

Benefits of CLO Equity Fund Investing

Quarterly payouts and high yields have driven interest in CLO equity. 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.

Attractive Return Potential

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. The CLO equity asset class has historically provided strong returns, making it an attractive option for investors seeking yield.

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.

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

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. 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.

• Equity returns feel the immediate impact of defaults.
• Losses funnel first to the equity layer.
• Robust credit risk controls are vital to limit downside.

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 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. 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.
• Sound risk frameworks account for liquidity crunches.

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. 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.

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

Refinancing and reset options provide CLO equity investors with additional tools to enhance returns. 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.

CLO Equity vs. Other Alternative Investments

The distinct profile of CLO equity sets it apart from traditional alternative investments. As investors consider their options, understanding the comparative advantages and disadvantages of CLO equity is essential.

CLO Equity vs. Private Equity

CLO equity offers a unique investment profile compared to traditional private equity. 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.

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.

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. The floating-rate nature of CLO assets and liabilities creates a different interest rate sensitivity profile, potentially making CLO equity more resilient during rising rate environments. Investors must weigh these factors when determining the appropriate allocation to CLO equity within their diversified portfolio of alternative investments.

CLO Equity Performance Across Market 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.

Downturn Performance

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.

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

Direct deal-by-deal investments in CLO equity offer sophisticated investors maximum control and customization. You can select managers and deal structures tailored to your goals. However, it requires significant expertise and resources to analyze and manage a portfolio of CLO equity positions effectively.

Captive Equity Funds

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. This approach reduces vintage risk and offers lower minimum investment requirements, making it more accessible to a broader range of investors.

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. 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. Institutions tend to choose direct deals; smaller players often opt for commingled funds.

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.

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 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.

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.

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.

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.