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 mutual fund 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.

CLO Equity Fundamentals

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. It raises funds to buy a diverse pool of 150 to 350 leveraged loans, which serve as collateral.

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

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.

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. 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.

CLO Funding Stack and Waterfall Payments

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

• 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. The blend of early cash flow, yield potential, and low correlation makes it an enticing portfolio diversifier.

Attractive Return Potential

CLO equity funds offer investors the potential for double-digit annual returns, delivered through quarterly distributions. That pattern often outpaces the return trajectories of many alts. 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.

Portfolio Diversification Benefits

Investing in CLO equity also offers portfolio diversification benefits. 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.

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

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.
• 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

Liquidity considerations are also important for CLO equity investors. 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

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

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. 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.

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.

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. That, along with a briefer time horizon, positions it well for investors wanting speedier payback.

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 Through the Cycles

Investors often overlook the ongoing potential of CLO equity, assuming its heyday is over. Yet, it has shown strong resilience and counterintuitive returns in various cycles.

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. 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

When rates climb, the variable-rate buffer often favors equity over fixed-rate debt. 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.

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

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. 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. Investors should carefully evaluate the fund’s strategy and fees to ensure alignment with their investment goals.

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

Effective CLO equity investing hinges on selecting a skilled manager. 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. 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 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.

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?

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.

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.