The case for CLO equity
Collateralised loan obligation equity tranches sit within the credit universe, but their cash flow and return characteristics make them unique
Collateralised loan obligation (CLO) equity has outperformed most other asset classes including private equity, equities and high yield over the past ten years.
The CLO market has evolved substantially over the past decade, while maintaining a set of core characteristics that underpin its investment case. The same holds true for the equity tranches of CLOs.
CLO equity tranches sit within the credit universe but have characteristics – including cash flows and return drivers – that makes the opportunities and risks they present and the ways they behave in a rising spread or in a crisis environment different to other credit investments.
CLO equity tranches have distinctive characteristics
The equity tranche of a CLO bears the first loss that could occur at the underlying loan pool level. In return, CLO equity tranche investors are given significant control over the length of the life of the overall CLO structure and are entitled to receive the excess cash flows after payments to the CLO debt tranches. These potential cash flows typically display a unique, front-loaded high level pattern which generally makes equity tranches moderate duration instruments in the credit universe.
Robust performance and potential diversification benefits in a rising spread environment
As with any credit investment, CLO Equity tranches were impacted during the 2008 global financial crisis. However, despite a peak in the loan defaults and temporary shutoff of equity distributions, overall returns for most vintages were remarkably resilient through this crisis. The performance of the CLO equity tranche benefits from locking in low funding costs at inception and high loan spreads during the very first years but also greatly depends on the future path of underlying loan spreads.
In the very short term, the valuation of CLO equity tranches tends to react to spread movements similarly to any credit instrument but can also benefit over the medium term from a rising spread environment. This feature makes CLO equity tranches unique instruments in the credit universe and enables them to offer some diversification to a credit portfolio.
Impact of potential losses in the underlying loan collateral
Losses and defaults on the underlying loan collateral do occur, and have the effect of reducing the total interest payment to equity tranches. However, their impact should remain relatively limited when only a few loans default. While possible, a scenario where a CLO structure has been unwound with no cash flows left to allocate to the equity tranche holders has never occurred in the more than 20-year history of CLO issuance – even in the worst years of 2008-2009.
Investing in CLO equity tranches entails several risks such as the subordination of cash flows to CLO debt tranches, leveraged exposure, low liquidity, performance risks and undefined maturity.
Not all CLO managers are created equal
CLO managers actively manage and trade the loan collateral to help assure full payment of debt tranches and to enhance equity returns. Performance-linked fees and the risk-retention rules requiring CLO managers to keep ‘skin in the game’ combine to help encourage CLO managers to maximise the return on equity tranches. However CLO managers can perform very differently in similar market conditions.
Ready to dip a toe in the water?
CLO equity instruments demonstrate a set of characteristics and behaviours unique in the credit universe. High front-loaded cash flows, moderate duration, performance resilience in the face of cash-flow interruptions, and a positive mid-term response to a rising credit spread environment, all serve as potential attractions of investing in the asset class. The wide range of returns across CLO equity tranches of a similar vintage suggests that investors need to carefully select CLO managers and to engage experienced specialists with the insights and governance infrastructure required to achieve the full potential benefits of the asset class.
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