Clo Managers: Investing In Their Own Success?

Collateralized Loan Obligations (CLOs) are actively managed investment products that consist of a diverse pool of leveraged loans that generate cash flow as they are repaid. CLOs are often corporate loans with low credit ratings, and the investor assumes most of the risk if borrowers default. CLOs are divided into tranches, or slices, of risk, with each tranche having a different level of risk and repayment structure. The equity tranche, while potentially the highest returning, is the riskiest portion of the CLO. So, do CLO managers invest in their CLOs? The answer is yes, CLO managers do invest in their CLOs, and they have a variety of tools to gear their returns towards broad changes in the market and economic environment.

CLO Equity Returns

CLO equity has emerged as a source of potentially robust and front-loaded returns for sophisticated investors. While the high-interest rate environment has dampened some enthusiasm for the asset class, CLOs offer investors the opportunity to capture the upside when a transaction outperforms.

Equity investors in CLOs are the first to absorb losses if any of the underlying loans default. However, they also have a claim on profits, which means they can benefit from the difference between what a CLO earns in loan interest and what it owes the CLO debtholders. This makes CLO equity an attractive option for investors seeking prospective double-digit returns with a quarterly distributed front-loaded cash flow.

The performance of CLO equity depends on various factors, including the lifespan of the investment, market and economic conditions, and the ability of CLO managers to generate returns through trading decisions within the portfolio. Recent vintages have shown that CLO managers can generate attractive returns for their equity investors, even in unfavourable market conditions.

Looking ahead, CLO equity could become even more appealing due to the variability in the economic environment and the optionality embedded in CLO structures. Falling interest rates, for example, could lead to wider spreads and more opportunities for equity investors to benefit from par build. Additionally, a "soft landing" scenario, where the economy slows down but remains stable, could provide an ideal environment for CLO equity performance.

When investing in CLO equity, it is crucial to consider the manager's experience, performance, and investment style. A portfolio approach that diversifies exposure across different vintages and managers can help maximize returns and manage risk.

CLO Management Styles

Debt Tranches

Debt tranches, also known as mezzanine tranches, are considered to have lower risk and lower potential returns compared to equity tranches. They are treated like bonds and have credit ratings and coupon payments. Within the debt tranches, there is a pecking order, with the senior debt tranches being the safest and offering the lowest yields. The mezzanine debt tranches offer higher yields but have a higher risk of loss as they are paid after the senior tranches. Debt tranches are typically rated as investment-grade by ratings agencies and are the first to be repaid in the event of a default.

Equity Tranches

Equity tranches, on the other hand, have higher risk but also offer the potential for higher returns. They do not have credit ratings and are paid out after all the debt tranches. Equity tranche investors usually face higher risks, such as assuming most of the risk of borrower defaults, but they are compensated with higher returns. These investors have a degree of control over the CLO that is not available to debt investors, such as the option to refinance underlying CLO loans or reset the reinvestment period. Equity tranches rarely pay out cash flow but offer ownership in the CLO itself in the event of a sale.

Identifying consistent CLO management styles over time is crucial for developing a portfolio of CLO equity exposures that are diversified across vintages, helping to manage risk while delivering attractive risk-adjusted returns.

CLO Equity Works

CLO equity has emerged as a source of potentially robust returns for sophisticated investors. Collateralized loan obligations (CLOs) are a type of security that allows investors to purchase an interest in a diversified portfolio of company loans. CLOs are actively managed investment products that provide investors with access to the leveraged loan asset class in an efficient and structured way.

A CLO is a bundle of loans that are ranked below investment grade. They are usually first-lien bank loans to businesses that are initially sold to a CLO manager and consolidated into bundles of 150 to 250 loans. The CLO manager then sells stakes in the CLO to outside investors in a structure called tranches. Each tranche is a piece of the CLO, with a different level of risk and return. The order of the tranches dictates who will be paid out first when the underlying loan payments are made, with investors in the senior debt tranche being the first to receive cash flows and having the lowest risk of principal loss.

The equity tranche is the riskiest portion of the CLO but also has the potential for the highest returns. Equity tranche investors are the last to receive cash flows but are structured so that if all the loans continue to pay their principal and interest, this tranche will have the highest returns. However, if any of the underlying loans default, the equity tranche will take losses first.

Equity tranche investors also have a degree of control over the CLO that is not available to debt investors. They have options to refinance the underlying CLO loans or reset the reinvestment period. Additionally, they can direct or accede to the manager's decision to "call" the liabilities and refinance the CLO's debt, locking in lower liability costs and higher profits for the remaining life of the fund.

Overall, CLO equity offers a unique set of benefits and risks for investors. It provides access to the leveraged loan market, potential for high returns, and active management to limit downside risk and capture upside opportunities. However, it is important for investors to conduct proper due diligence due to the complexity and riskiness of CLOs.

CLO Structure

A Collateralized Loan Obligation (CLO) is a single security backed by a pool of debt. CLOs are often corporate loans with low credit ratings or loans taken out by private equity firms to conduct leveraged buyouts.

A CLO is a bundle of loans that are ranked below investment grade. They are usually first-lien bank loans to businesses that are initially sold to a CLO manager and consolidated into bundles of 150 to 250 loans. To fund the purchase of new debt, the CLO manager sells stakes in the CLO to outside investors in a structure called tranches.

There are two types of tranches: debt tranches and equity tranches. Debt tranches, also called mezzanine tranches, are treated just like bonds and have credit ratings and coupon payments. These debt tranches come first in terms of repayment, and there is also a pecking order within the debt tranches.

Equity tranches do not have credit ratings and are paid out after all debt tranches. They rarely pay a cash flow but do offer ownership in the CLO itself in the event of a sale. Because equity tranche investors usually face higher risks, they often receive higher returns than debt tranche investors.

A typical CLO structure combines five or more classes, from the senior-most tranche rated AAA down to the most junior and highest-yielding debt tranche rated BB-. The tranches are floating-rate like the assets and are due a coupon on a quarterly basis.

After paying off expenses and liabilities, a residual unrated "CLO Equity" tranche captures the excess spread (returns) that the assets generate. As the equity tranche is leveraged exposure to the underlying leveraged loans, it is the riskiest piece of the CLO structure; however, it can also be the most lucrative.

CLO Benefits

Collateralized Loan Obligations (CLOs) are a type of security that allows investors to purchase an interest in a diversified portfolio of company loans. CLOs offer a range of benefits to investors, including:

Portfolio Diversification

CLOs provide investors with exposure to a diversified pool of loans made to non-investment-grade borrowers. This diversification helps to reduce the risk of default associated with any individual loan or borrower, as the risk is spread across multiple loans and industries.

Higher Yields

CLOs typically offer higher yields than other fixed-income investments such as government bonds or investment-grade corporate bonds. This is because the loans underlying CLOs are made to non-investment-grade borrowers, which are considered riskier and therefore offer higher potential returns. The floating interest rate payments of CLOs also provide higher income in rising interest rate environments compared to fixed-rate instruments.

Credit Enhancement

The structure of CLOs, with their tranches of different levels of credit risk, provides additional protection to investors in the senior tranches against losses due to defaults in the underlying loans. This credit enhancement feature ensures that even if some loans default, the senior tranche investors are still protected.

Stronger Liquidity

CLO securities are typically more liquid than the underlying loans as they can be bought and sold in the secondary market. This liquidity makes it easier for investors to manage their portfolios and exit their positions when needed.

Professionally Managed

CLOs are actively managed by collateral managers who are responsible for managing the loan pool that backs the CLO securities. This professional management provides investors with access to expertise in the credit markets, helping to optimize returns and minimize losses.

Low Correlation with Other Risk Assets

The cash flows from CLO equity investments exhibit low correlation with other risk assets, such as high-yield bonds. This means that CLO equity returns are not strongly influenced by the performance of other risk assets, providing investors with a diversification benefit in their portfolios.

Direct Benefits from Active Management of Credit Risk

The ability of CLO managers to actively manage credit risk is a key benefit. Experienced managers can react to and leverage various factors, such as movements in loan and CLO debt credit spreads, credit losses, net trading activities, and changes in interest rates, to optimize returns and minimize losses.

Frequently asked questions