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

Main Points

• 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

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. 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.

The Role of Equity Tranches in CLO Structures

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.

How CLO Equity Generates Returns

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

Waterfall Mechanics in CLOs

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

• 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.

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. 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.

Benefits of CLO Equity Fund Investing

CLO equity investments have gained popularity due to their potential for generating substantial returns through quarterly distributions. 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.

Attractive Return Potential

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.

Front-Loaded Cash Flows

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. 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. 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. 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.

Market Volatility Impact

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

• Trading desks may thin out under stress.
• Limited exit opportunities can affect investor liquidity.
• Sound risk frameworks account for liquidity crunches.

In conclusion, while CLO equity investments offer attractive returns, they are accompanied by significant risks, including credit risk, market volatility, and liquidity concerns. 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.

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. 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. 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. 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.

Comparison with Private Equity

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

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

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 Through the Cycles

Some investors mistakenly believe CLO equity’s best days are behind it. 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. Yet, the term financing structure prevents forced selling, allowing skilled managers to capitalize on opportunities to purchase discounted loans, thereby enhancing long-term returns. 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. 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 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. 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. 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

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. 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

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.

Philosophy & Risk Controls

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. 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. 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.