Note: This is an updated version of an article previously published in November 2024.

Key Takeaways:

• The CLO structure provides several key features that have helped to maintain or improve CLO equity’s historically consistent, front-loaded cash flow experience.
• CLO equity offers higher potential risk-adjusted returns, along with a differentiated and attractive cash flow profile.
• A CLO’s underlying debt collateral is actively managed, which allows a skilled manager the flexibility to buy and sell loans to potentially mitigate credit risk and enhance return in multiple investment environments.

Over the last 18 months, the formation of CLOs has skyrocketed, and for good reason. The structure and characteristics of CLOs may offer something for investors of all risk tolerances, from the most loss-averse to the most return-seeking. From a regulatory standpoint, CLOs have supported the growth of the bank loan market, as banks have reduced lending in response to balance sheet regulations following the global financial crisis (GFC). As a result of this demand from a wide range of investors, new issuance is at an all-time high. In fact, the CLO market is now approximately 70% of the size of the roughly $1.5 trillion bank loan market, up from around 40% a decade ago, according to J.P. Morgan research in July 2024.

While CLO debt enjoys a vast and varied constituency of investor types, from insurers and banks to pension funds and asset managers, CLO equity tends to have a narrower pool of investors. Part of this has to do with the relative opportunity size of CLO equity versus CLO debt. However, we believe a lack of appreciation by investors of what CLO equity offers is a bigger driver. In our view, CLO equity offers a set of return and cash flow characteristics that can appeal to a wide range of return-seeking investors.

Explaining the CLO Capital Structure

CLOs are special purpose vehicles (SPVs) that invest in a diversified pool of leveraged bank loans. These loans are packaged together, and the funding for these structures is raised through investors in different tranches (primarily debt, with some residual equity), each representing varying levels of risk and return. The cash flows from the underlying loans are distributed to investors based on the seniority of the tranche they hold (see Figure 1). The highest-rated (AAA) tranches receive payments first and have lower risk of loss, while the equity tranche represents the “first-loss” capital but offers higher potential upside. The CLO vehicle is actively managed by asset managers with resources and experience in leveraged credit. There are various phases of the CLO lifespan, namely warehousing, the ramp, the reinvestment period, and finally the amortization period. During all of these phases, some combination of equity investor capital and debt capital is required. To learn more about potential opportunities in CLO debt, visit Investment Brief: Addressing Key Questions on CLOs.

Equity holders occupy the bottom piece of the CLO waterfall structure familiar to many securitized investors and are entitled to the residual coupon interest generated by the entire collateral pool after all of the CLO debt holders have been paid. Positioned as the first-loss portion of the investor pool, equity owners stand to benefit from the spread between yield on the CLO collateral and CLO liabilities. This spread, commonly referred to as “arb” (short for arbitrage), historically has been the primary driver of CLO equity returns and can be thought of in a similar light as the net-interest margins that banks profit from. Like banks, CLO managers strive to maximize this spread, with more in income being generated by the collateral pool (similar to the loans that a bank makes) than is needed to pay the CLO debt tranches (similar to the deposits that a bank pays out). Anything that negatively impacts the arb reduces returns to equity holders, and anything that improves the arb helps the equity holders’ return. It is also important to note that, as the bottom 10% of the capital structure, both positive and negative developments for the arb are amplified via the leverage inherent in the structure. For example, a 0.10% increase in the arb roughly translates to a 1% increase in return to equity holders, all else equal.

A Better Match Between Assets and Liabilities

There are several structural features of the CLO vehicle that can work to the equity holder’s advantage. For one, both CLO collateral and debt are floating rate, keyed to the Secured Overnight Financing Rate (SOFR), which helps to eliminate one source of basis risk. Second, CLO debt’s spread to SOFR is locked in for the entirety of the CLO’s term, typically 10 years, which can isolate from unwelcome asset/liability mismatch issues. In general, mark-to-market (MTM) adjustments or “haircuts” as well as “depositor flight” are not major CLO risks. Third, but certainly not last, is the section of the CLO lifecycle known as the reinvestment period.

An Opportunity for Active Management—The Reinvestment Period

Unlike other securitized products, CLOs are different in that the underlying collateral is actively managed. After a CLO is issued, the manager can, for a period of time, buy and sell loans within the collateral pool. This reinvestment period generally runs around five years and affords managers the ability to actively buy and sell loans in an attempt to mitigate credit risk and generate additional return. An opportunity for a manager to sell a loan at par and swap into a loan with an identical spread to SOFR at $97 may not seem particularly exciting for an equity investment at first blush, but the leveraged nature of CLO equity can turn that three-point pull to par into a potential 30% return impact on equity. This ability to build par is a core goal for the collateral manager. Likewise, managers seek to avoid par burn, which occurs when losses are realized either through trading or loan impairments.

What Are the Potential Investment Benefits for CLO Equity Investors?

From an investment viewpoint, we believe there are several potential benefits for CLO equity holders, including:

• Portfolio diversification.
• A differentiated cash flow experience.
• The potential for attractive returns in multiple investment environments.

Portfolio Diversification

CLO equity offers diversification from several perspectives. First, the underlying loan pool is typically highly diversified, comprised of 200-300 loans to well-established corporate issuers. Second, CLO equity offers portfolio diversification in the form of low correlation of returns to other risk assets (see Figure 2). This stems in part from the ability of collateral managers to help take advantage of periods of volatility that may negatively impact other asset classes. Since CLO capital is effectively “locked in,” managers can take advantage of opportunities to buy discounted collateral when others are forced to sell due to liquidity needs.

CLO equity offers a cash flow profile that is very different from other investments offering double-digit return profiles, notably private equity. More specifically, CLO equity provides quarterly, front-loaded cash flows, reflecting the character of its underlying fixed-income collateral, while still offering a potentially higher return. That stands in contrast to asset classes, such as private equity and venture capital, that can offer a similar level of historical return but deliver those returns on a back-end basis following an extended “J curve”—an initial investment that experiences negative returns followed by improving and positive returns in later periods.

What’s more, for investors allocating to CLO equity through an actively managed fund, equity commitments are drawn down over time as opposed to all at once. This means that the investor’s fully out-of-pocket capital commitment is relatively short lived; not too long after the final amount of committed capital is called down, cash begins flowing back to investors in the form of income distributions. Additionally, the front-loaded nature of the cash flows delivers what can be thought of as “temporal seniority,” progressively reducing investor’s out-of-pocket, at-risk exposure through potential early return of capital. And while the utility offered through the periodic, front-loaded cash flows is not captured in any return metric, the optionality for investors to direct cash-in-pocket to new investments or spending needs has value, in our view.

Under typical conditions, CLOs do not mark loans to market, thereby protecting investors across the entire structure from short-term volatility. As a consequence, CLO managers can potentially take advantage of periods of volatility by acquiring discounted assets, locking in cheaper valuations, which can build par and improve the equity’s return profile. Take, for example, an environment like 2007/2008 or 2020 (see Figure 4). As bank loan spreads widened and prices fell, skilled managers still in their ramping/reinvestment periods were able to buy discounted collateral in a forced sellers’ market, which led to above-average returns for vintages of CLO equity that were originated in those years. On the other hand, in an environment where CLO spreads are tightening (2023-2024), once outside of the non-call period, equity owners can refinance at a lower spread level, decreasing the cost of debt service. All else equal, this can increase the arb and accrue to equity in the form of higher returns. Finally, in a stable spread environment, the consistent quarterly cash flows from a CLO equity investment can provide attractive current income even if the market is directionally unchanged. 

For investors in both CLO debt and equity, manager selection can be critical to the investment experience. Equity’s stake in the success of the collateral manager is straightforward, as the levered portion of a structure holding risk assets, credit selection, valuation acumen and risk mitigation are key skillsets for a manager to possess. We believe that managers who have experience investing in bank loans across multiple cycles, deep knowledge of the CLO structure, and extensive relationships in the leveraged credit markets are best positioned to succeed in this space.

CLO Equity Portfolio Applications:

1. Complement existing “J curve” alternative allocations (i.e., venture capital or private equity) with a front-ended, consistent cash flow experiences.
2. Complement existing credit allocations with a low correlation asset class that has exhibited strong risk-adjusted returns even in difficult market environments.