A Guide to Investing in CLO Equity Funds: Essential Insights

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 performance 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.
• 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 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. 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.

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. 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. CLO equity funds are investment vehicles that allow individuals to invest in the equity tranche of Collateralized Loan Obligations (CLOs).

CLO Funding Stack and Waterfall Payments

The CLO structure features a hierarchical “waterfall” payment system. This system determines how cash flows are distributed among the various tranches. 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

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

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

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

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

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. This makes CLO equity an excellent addition to a diversified investment portfolio.

Understanding the Risks

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 and Default Risks

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.

• Defaults directly impact equity returns.
• 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. The financing terms can avert fire sales, but M2M swings still pose valuation risk.

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.

• 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. Investors must carefully evaluate these risks and consider strategies for mitigation.

The Power of Active Management

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

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.

Discount-to-Par Tactics

Buying loans below par can translate a small discount into outsized equity gains via leverage. 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.

CLO Equity vs. Other Alternative Investments

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.

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.

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

Some investors mistakenly believe CLO equity’s best days are behind it. Yet, it has shown strong resilience and counterintuitive returns in various cycles.

Downturn Performance

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. Indeed, vintages launched before stress events—like pre-2007—often captured deep discounts in their reinvestment windows.

Rising vs. Falling Rate Environments

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

Opportunistic credit vehicles often tuck CLO equity into their broader credit mix. While this approach dilutes the specific benefits of CLO equity, it provides a diversified credit portfolio managed by professionals. Investors should carefully evaluate the fund’s strategy and fees to ensure alignment with their investment goals.

Which route you pick hinges on your capital, expertise, and desired customization. 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. A manager’s portfolio design, research depth, and trade execution shape final equity yields.

Proven Performance

A manager’s track record and experience are crucial in determining their ability to navigate various market cycles. Investors typically seek managers who have demonstrated consistent performance across multiple CLO vintages.

Philosophy & Risk Controls

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.

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. Its double-digit yield prospects and early payouts help improve overall portfolio returns.

If you can stomach the risk and time horizon, CLO equity’s low correlation makes it an excellent diversifier. Investors should consider their risk tolerance, liquidity needs, and existing portfolio allocations before investing in CLO equity.