CLO Equity: A Compelling Opportunity?

Article by Raman Rajagopal, Senior Client Portfolio Manager – Private Credit at Invesco, as published in Insight/Out magazine #35.

Sitting at the crossroads of equity and debt, CLO equity investments present an attractive investment opportunity by combining structured finance with active management to generate potentially attractive levels of return and historically high levels of portfolio diversification. These investments benefit from a front-ended return profile and structural advantages inherent in a CLO vehicle that can enhance performance while focusing on risk management.

What is a CLO?

A CLO, collateralized loan obligation, is a special purpose vehicle (SPV) securitized by a pool of assets, primarily senior secured leveraged loans. The CLO collects interest and principal distributions from the pool of assets – typically hundreds of unique borrowers – and governs the distribution of these collections based on a waterfall outlined within the CLO indenture. Before issuance, the CLO vehicle is capitalized via the sale of debt tranches and equity. Investors take exposure to the underlying pool by investing in the tranches, with each CLO debt tranche (note) having 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 over a typical four-to-five year investment (reinvestment) period (after two years, CLO debt tranches are typically callable).

Within the CLO structure, coupon and principal payments collected on the underlying assets (loans) are used to make coupon and principal payments on the CLO’s liabilities (CLO notes). Payments first flow to the highest debt tranche of the CLO structure and continue to the lowest debt tranche. Thereafter, the residual cash flows are distributed to the equity. This is referred to as the “cash flow waterfall”. CLOs are structured to capture the spread, or arbitrage, between income from its underlying assets and payments to its noteholders, which benefits its equity holders

Why CLO Equity?

Investing in collateralized loan obligation (CLO) equity can be a compelling option for portfolio diversification[1]. Not only does the asset class have the potential to generate  attractive absolute and risk-adjusted returns, its quarterly dividends have been consistently high[2]. CLO equity distributions start relatively early in the investment’s lifecycle, thus 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

While individual quarters can see fluctuations, long term global CLO Equity cash distributions have historically averaged between 3-4%², with several factors contributing to these distributions.

1. Credit Arbitrage: 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. Equity holders, earning the residual cashflows, benefit from the built-in leverage of the CLO structure and have the potential to receive outsized levels of returns as a result, albeit at the cost of sitting in the first loss position and with the expectation of certain inherent credit loss occurring throughout the CLOs life. With skilled active management, realized credit loss risk could be reduced.
2. 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

Front-ended return profile

An equity tranche investor receives two streams of cash flows, interest payments and principal investment. In some cases, the equity 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 portfolio enters its re-investment period when there is a relatively steady stream of positive cash flows, although quarter-to-quarter fluctuations can occur based on a number of factors.

As the end of the life cycle approaches, a 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 with the remainder of the principal proceeds flow to the equity tranche.

The early distributions (from six months after the structure has closed 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.[3]”

CLO Structural advantages and how they benefit equity investors

The standout feature of the CLO is how it is financed. More than just the combination of debt and equity, 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: Once a CLO’s non-call period has expired (typically within the first 12-24 months of the reinvestment period) the debt tranches within the structure can be refinanced, reset, or redeemed in their entirety, depending on the prevailing economic conditions. These options allow CLO managers to potentially lower their overall cost of capital and better position their CLOs for years to come. 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.

Conclusion

Investing in CLO equity can present a compelling opportunity for portfolio diversification and potentially attractive returns. With their front-ended return profile and ability to leverage active management, CLOs can offer significant advantages. The potential for high returns, driven by the excess spread from interest payments and the strategic use of leverage, makes CLO equity a valuable addition to an investment portfolio. Moreover, the optionality inherent in CLO structures, such as refinancing, resetting, and redeeming, provides additional avenues for enhancing returns. The resilience of CLOs during periods of market stress, as evidenced by their performance during the global financial crisis and the pandemic, further underscores their robustness compared to other structured finance products. In conclusion, CLO equity stands out as a strategic investment choice, offering a blend of high return potential, diversification benefits, and structural advantages that can complement traditional and alternative assets within a portfolio.

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[1] Citi Research as of January 2013 – September 2024, and based on Citi internal racking/reporting, rather than specific indices. Past performance does not predict future returns. Used with permission. Diversification does not guarantee a profit or eliminate the risk of loss.

[2] Deutsche Bank & Intex, as of Nov. 8, 2024. Includes 1,686 US CLOs and 523 Euro CLOs. Excludes US CLOs with less than 2 cash flows to equity and Euro CLOs with less than 3. Distributions are computed assuming equity issued at par. Deal universe includes reinvesting and amortizing deals. 2024 payments are annualized based on reported deals

as of 8 November 2024. Median annual distribution based on US 2011-2024, median quarterly distribution based on 2017-2024

[3] PitchBook and Invesco, as at 30 November 2024. Using average net buyout cash flows 1997-2013 and a hypothetical example of a CLO equity payment schedule using a 2% CDR (constant default rate) priced at 99 with a 60% recovery rate and a 340 bps spread. For illustrative purposes only.EMEA 4771669