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 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.
• 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)?

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. 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. 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.

CLO Equity Fund Architecture

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.

• 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.
• Debt tranches gain protection via overcollateralization buffers and 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. However, CLO equity is also the best positioned tranche within a CLO structure to capture upside value under favorable conditions. 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.

Understanding the structural protections and constraints within CLOs is essential for equity investors, as these features influence both the timing and magnitude of distributions throughout the investment lifecycle.

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.

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.

Front-Loaded Cash Flows

Unlike private equity’s J-curve, CLO equity delivers cash early on. Early distributions shorten the weighted average life, enhancing liquidity for investors.

Portfolio Diversification Benefits

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. 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 Risk and Default Concerns

CLO equity holders face pronounced credit risk. 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.

• Defaults directly impact equity returns.
• The equity tranche is the first to absorb losses.
• Credit risk management is essential for mitigating potential negative outcomes.

Market Volatility Impact

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

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. Investors must factor in these liquidity dynamics when sizing positions.

• 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. 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.

Reinvestment Phase Benefits

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. 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.

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.

CLO Equity vs. Private Equity

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

Relative to traditional fixed income and credit investments, CLO equity provides significantly higher return potential, albeit with higher risk and less liquidity. Its variable-rate structure often cushions equity when rates climb, relative to fixed-rate debt. Such nuances should guide how much capital to allocate to CLO equity in a balanced alt portfolio.

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.

Economic Downturns and CLO Equity

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.

Rising vs. Falling Rate Environments

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.

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.

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

Picking individual CLO equity tranches deal by deal grants the most control. 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 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. 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. Although you lose some pure-play benefits, you gain multi-credit diversification under a single strategy. 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

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.

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.

Align their risk framework with your own return and volatility targets. Strategic alignment often translates into superior risk-adjusted results.

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. Review your risk profile, liquidity needs, and current allocations to decide if CLO equity fits.