CLO equity: Not your average asset class

Why CLO equity?

Investing in collateralized loan obligation (CLO) equity can be a compelling option for portfolio diversification. Not only does the asset class have the potential to generate attractive absolute and risk-adjusted returns, its quarterly dividends have been consistently high. CLO equity distributions start from relatively early in the investment’s lifecycle creating a front-ended return profile that can act as a natural complement to private equity investments. Further, there are potential benefits of the structure itself, including the demonstration of skill by active management and that the financing is both long-term and locked-in in nature.

Historically higher income potential: The source of CLO equity returns 

Investors are taking notice of this unique asset class, having grown to $160 billion in global CLO equity assets outstanding, around 12% of the $1.3 trillion CLO market.¹ Figure 2 draws the essential structure of the CLO special purpose vehicle (SPV) and illustrates the SPV issuing debt and equity to fund the acquisition of a diversified pool of bank loans. Investors take exposure to the underlying pool by investing in the debt or equity financing of the CLO. Each CLO debt tranche (note) has its own risk and return profile with the lowest risk-carrying (AAA-rated) tranche being the largest source of funding — an important point later for optionality considerations. Overseeing the structure sits an active manager who handles the assets and ensures they remain within specified tolerance bands.

There are several features that can contribute to the overall return for a CLO equity investor:

1) Asset spreads. Figure 3 illustrates how the excess spread from the interest payments is generated and transformed by the built-in leverage of the CLO structure once the structure has been priced. The CLO collects the floating rate interest payments from the underlying pool of loans, pays the necessary fees (admin, trustee), and then pays its financing liabilities (CLO notes), distributing the requisite interest payments down the capital stack, first to the senior notes followed by the mezzanine debt tranches and then the equity holders.

Note that expectations of credit losses are a prudent concept (included in Figure 3), but with skilled active management, realized credit losses could be lower – another feature to potentially enhance the equity return profile. For a more accurate representation of the potential returns, the reference rate (typically, SOFR in the US or Euribor in the case of Euro CLOs) is added to reflect the economic cost of funding conditions. This gives a truer view of the expected return for the asset class and could, in total, add up to the mid-teens for an expected return, as shown in Figure 3.

2) Any potential fee-sharing arrangement. Often, a captive CLO equity portfolio will have an arrangement with the asset manager to share in some of the underlying CLO portfolio management fees.

3) The majority equity holder typically benefits from sources of optionality: Refinancing the debt, resetting the debt, and redeeming the structure in its entirety.

The chart on the left of Figure 4 substantiates the impact of active management. Agnostic of the interest rate cycle, the variation in quartile performance highlights the value of manager skill in generating outperformance. The clearest example of this is in 2014, when the bottom quartile of managers delivered a negative IRR, as the top quartile returned close to 10%. The fact that the median observation lies closer to the top quartile indicates the performance of the product universe incorporates left tail observations as some strategies have notably underperformed.

The chart on the right in Figure 4 compares the median cash equity payments of US vintages to those of their European counterparts. This chart verifies the clear advantages of investing in CLO equity tranches, irrespective of jurisdiction, as both evidence similar performance outcomes. Investing in a US or European structure, long-term quarterly distributions have ranged between 3-4%.² Estimates for 2024 annual equity distributions are at 15.7% for the median US strategy and 18.7% for a median European strategy – both definitively offering the potential for strong risk-adjusted returns.*

Front-ended return profile

An equity tranche investor receives two streams of cash flows: From interest payments and from the principal investment. In some cases, the equity tranche investor provides financing to the warehouse facility, and, from this, can start to accumulate returns even ahead of the debt tranches accumulating their returns. The warehouse facility is a temporary holding facility where the loan portfolio is built prior to the final CLO structure being created and marketed to investors. This can start the equity tranches’ “front-ended” return profile with significant early payments directly followed by the more traditional excess spread/interest income.

As the CLO structure closes the investments are transferred to the SPV from the warehouse facility, and the CLO fund manager continues to purchase assets. The portfolio then enters its re-investment period when there is a relatively steady stream of positive cash flows. Quarter-to-quarter fluctuations occur due to changes in prepayment rates and default rates as the fund manager looks to “build par”, a term for increasing the value of the underlying investment pool by reinvesting the principal, ideally by buying loans at a discount to redeem at face value or be sold at a profit.

Note that the first 12-24 months of the reinvestment phase are assigned the “non-call” period. Once the non-call period has expired, the debt tranches within the structure can be refinanced, reset, or redeemed in their entirety, depending on the prevailing economic conditions. This is discussed in more detail in the following section.

As the end of the life cycle approaches, the CLO will begin deleveraging by paying down its debt tranches, beginning with its largest and lowest-cost source of financing. With this, the majority equity investor will be evaluating an optimal time to redeem the structure as it comes to its final maturity. At this time, the assets will be sold to pay down the outstanding debt tranches, and the remainder of the principal proceeds flow to the equity tranche.

The early distributions (from six months after the structure prices and then quarterly) can provide an excellent complement to the cash flows of private equity (PE) strategies. This is because PE strategies typically exhibit a J-curve since they draw down capital in the early stages of the vintage, using committed capital in the form of dry powder to source equity investments, only becoming cash flow positive years later after exiting their multi-year investments in portfolio companies. PE strategies can, therefore, be thought of as “back-ended.” The comparison is shown in Figure 5.

The relatively high liquidity of the underlying assets means the CLO has a deeper opportunity set to source investments for the structure and provides more opportunities to exit underlying exposures, an additional contrast to the uncertain cash flows and illiquid investments within most PE strategies.

Structural advantages

The standout feature of the CLO is how it is financed. More than just the combination of debt and equity, it is that the financing is locked in for the longer term that allows the fund manager to focus on sourcing the most appealing investments without being concerned of needing to meet exit requests of investors and put downward pressure on the underlying assets.

This permits the manager to focus on improving the value of the structure without sacrificing performance to meet liquidity issues. The manager actively seeks to improve returns for the equity holder through distinct channels including:

• Investment screening. Selecting loans to include in the principal pool is an unambiguous way to potentially generate outperformance.
• Trading to build par and mitigate losses. Constant monitoring navigates the risk of the underlying investments as well as potentially adding strategic opportunities to the pool.
• Active refinancing. There is skill in choosing when to use the call options of the strategy, specifically as there are optimal circumstances to enact these types of restructurings.
• Unique relationships with sponsors and arrangers. This allows for favorable allocations, which are markedly important in the warehousing phase.

Although US and European structures do have some specific differences (see Appendix), overall, the structures operate in much the same way. This is demonstrated by Figure 6, which shows the stable excess spreads delivered by both structures side-by-side. This structure seeks to isolate credit risk for equity investors by arbitraging the interest rate received on the underlying investments and the interest paid out on the liability funding cost.

Both US and European structures have enhanced returns through the call optionality of the generic structure. This refers to three discrete actions: Refinancing, resetting, or redeeming the structure entirely. The majority equity holder can elect to take these actions once the non-call period has expired – typically two years into the lifecycle of the CLO. 

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Structured finance securities such as CLOs entail a variety of unique risks. The performance of a CLO is affected by a variety of factors, including its priority in the capital structure of the issuer thereof, the availability of any credit enhancement, the level and timing of payments and recoveries on and the characteristics of the underlying receivables, loans or other assets that are being securitized, remoteness of those assets from the originator or transferor, the adequacy of and ability to realize upon any related collateral and the capability of the servicer of the securitized assets. Highly rated tranches of CLO Debt Securities may be downgraded, and in stressed market environments, even highly rated tranches of CLO Debt Securities may experience losses due to defaults in the underlying loan collateral, the disappearance of the subordinated/equity tranches, market anticipation of defaults, as well as negative market sentiment with respect to CLO securities as an asset class.

Many senior loans are illiquid, meaning that the investors may not be able to sell them quickly at a fair price and/or that the redemptions may be delayed due to illiquidity of the senior loans. The market for illiquid securities is more volatile than the market for liquid securities. The market for senior loans could be disrupted in the event of an economic downturn or a substantial increase or decrease in interest rates. Senior loans, like most other debt obligations, are subject to the risk of default. The market for senior loans remains less developed in Europe than in the US Accordingly, and despite the development of this market in Europe, the European Senior Loans secondary market is usually not considered as liquid as in the US The value of investments, and any income from them, will fluctuate. This may partly be the result of changes in exchange rates. Investors may not get back the full amount invested.

Alternative investment products, including private equity, may involve a higher degree of risk, may engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, may not be required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual portfolios, often charge higher fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. There is often no secondary market for private equity interests, and none is expected to develop. There may be restrictions on transferring interests in such investments.

The Flat Rock CLO Equity Returns Index seeks to measure the unlevered, gross of fee performance of US CLO equity tranches as represented by the market-weighted performance of the underlying assets of funds that publicly disclose their holdings and fair market values to the U.S. Securities and Exchange commission. The reporting funds satisfy certain eligibility criteria. The index inception date is September 30, 2014. The index is calculated quarterly on a 75-day lag. There were 490 CLO’s reporting as of Sept. 30, 2024.