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.

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

Essential Insights

• 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.
• 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.
• Investors must weigh both the upsides and dangers prior to deployment.

Understanding CLO Equity: The Basics

Understanding CLO equity starts with knowing how Collateralized Loan Obligations (CLOs) are structured. A CLO functions like a corporate entity, raising capital to acquire a diversified pool of leveraged loans. 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. Thus, equity investors bear the lion’s share of credit risk but can reap outsized rewards.

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.

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

Risk Characteristics of Equity Tranches

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. 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

CLO equity funds offer investors the potential for double-digit annual returns, delivered through quarterly 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.

Front-Loaded Cash Flows

The front-loaded cash flow pattern of CLO equity investments contrasts sharply with the typical J-curve effect seen in private equity. Early distributions shorten the weighted average life, enhancing liquidity for investors.

Diversification Advantages

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. Hence, CLO equity can be a powerful diversifier in a mixed-asset allocation.

Understanding the Risks

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. The equity tranche, being the most junior, absorbs the initial losses, making credit risk management critical.

• Defaults directly impact equity returns.
• The equity tranche is the first to absorb losses.
• 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. Understanding these liquidity risks is vital for investors.

• The secondary market can become constrained during market stress.
• Exits may be delayed or costly when liquidity dries up.
• 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. Prudent investors will adopt tailored mitigation tactics before committing capital.

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.

The Reinvestment Period Advantage

In the 4–5 year reinvestment window, managers can trade up holdings to capture fresh value. 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. 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. Lowering borrowing costs or prolonging the reinvestment window lets equityholders capture more value when markets permit.

In sum, skilled navigation and structural tweaks are central to realizing CLO equity’s potential. Through savvy trades, discount capture, and debt reengineering, managers can unlock material investor value.

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. 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. 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

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

Economic Downturns and CLO Equity

During economic downturns, CLO equity can experience mark-to-market volatility. 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.

Rate Regime Impacts

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. 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.

Accessing CLO Equity Fund Investing Opportunities

Investors seeking to tap into CLO equity funds have multiple avenues to consider, each with its unique advantages and considerations.

Direct Deal-by-Deal Investments

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 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.

Multi-Asset or Opportunistic Credit Funds

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. 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. Consistency across vintage cycles is a key due-diligence metric.

Investment Philosophy and Risk Management Approach

Managers differ in how they balance distribution yield versus capital preservation. 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

CLO equity offers a distinct combination of return potential and diversification benefits, making it a valuable consideration for sophisticated investors. 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. Review your risk profile, liquidity needs, and current allocations to decide if CLO equity fits.