Investing in CLO Equity Funds: What You Need to Know

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 securities 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.
• 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.

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.

What Are Collateralized Loan Obligations (CLOs)?

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. Such a layered structure provides a menu of risk/return slices for various investor appetites.

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. Thus, equity investors bear the lion’s share of credit risk but can reap outsized rewards.

Return Drivers of CLO Equity

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

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.

CLO Funding Stack and Waterfall Payments

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. 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.

Risk Characteristics of Equity Tranches

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.

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.

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. Historically, the CLO equity segment has delivered robust results for yield-seeking investors.

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.

Portfolio Diversification Benefits

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.

Key Risks Associated with CLO Equity Investments

Recognizing CLO equity’s risk profile is vital for prudent portfolio diversification. CLO equity investments, while potentially lucrative, come with a unique set of challenges that require careful consideration.

Credit and Default Risks

Credit risk represents a primary concern for CLO equity investors. Defaults in the underlying loan portfolio directly impact equity returns before affecting any other tranche in the CLO structure. 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.
• Robust credit risk controls are vital to limit downside.

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.

• 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.

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. Active management during this period is crucial for maximizing the benefits of CLO equity investments.

Discount-to-Par Tactics

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

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.

CLO Equity vs. Other Alternative Investments

CLO equity’s unique blend of yield, liquidity, and risk differentiates it among alts. As investors consider their options, understanding the comparative advantages and disadvantages of CLO equity is essential.

CLO Equity vs. Private Equity

Unlike private equity’s long hold and J-curve, CLO equity delivers early, regular cash. While private equity investments typically follow a J-curve effect, CLO equity provides front-loaded quarterly distributions beginning within 5-6 months of issuance. 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.

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.

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. 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. Such nuances should guide how much capital to allocate to CLO equity in a balanced alt portfolio.

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

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. 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.

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.

Accessing CLO Equity Fund Investing Opportunities

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

Direct Deal-by-Deal Investments

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. 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. 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.

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.

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.

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

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.

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?

CLO equity offers a distinct combination of return potential and diversification benefits, making it a valuable consideration for sophisticated investors. With its attractive, double-digit return potential and front-loaded cash flows, CLO equity can enhance risk-adjusted returns in a diversified investment portfolio.

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.