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 mutual funds 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.
• 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.

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 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.

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.

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. This positioning means that equity investors take on significant risk but also have the potential for substantial returns.

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. 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

Understanding the structure of CLO equity funds is crucial for investors looking to diversify their portfolios. 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. 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.

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. 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.

Why Invest in CLO Equity Funds?

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.

Early Cash-Out Advantage

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

CLO equity adds diversification value to a broader portfolio. Its historic correlations often remain below 50% versus fixed income peers like high-yield. This makes CLO equity an excellent addition to a diversified investment portfolio.

Key Risks Associated with CLO Equity Investments

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. 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.

• Equity returns feel the immediate impact of defaults.
• Losses funnel first to the equity layer.
• Robust credit risk controls are vital to limit downside.

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 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.

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

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

Effective active management is a key driver of value creation in CLO equity. By continually monitoring and adjusting the portfolio, skilled managers can significantly enhance returns for equity investors.

The Reinvestment Period Advantage

In the 4–5 year reinvestment window, managers can trade up holdings to capture fresh value. 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

Refinancing and reset options provide CLO equity investors with additional tools to enhance returns. 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.

Comparison with 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. This results in a shorter investment duration, typically ranging from 3-5 years, compared to the 7-10 years associated with private equity. 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

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

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.

Downturn Performance

During economic downturns, CLO equity can experience mark-to-market volatility. Yet, the term financing structure prevents forced selling, allowing skilled managers to capitalize on opportunities to purchase discounted loans, thereby enhancing long-term returns. Indeed, vintages launched before stress events—like pre-2007—often captured deep discounts in their reinvestment windows.

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. 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 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. But it demands deep credit analysis capabilities and operational bandwidth.

Captive Fund Structures

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. 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.

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.

Proven Performance

A manager’s track record and experience are crucial in determining their ability to navigate various market cycles. 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. 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. 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.