CLO Equity Investing: The High-Risk, High-Return Tranche

CLO equity represents the first-loss position in the capital structure—the riskiest tranche that absorbs all defaults before any debt investor is impaired. In exchange for this risk, equity investors target 12-18% gross IRRs, capturing the spread arbitrage between loan yields and debt costs.

CLO equity is the domain of sophisticated institutional investors: hedge funds, private equity firms, asset managers, family offices, and insurance companies with dedicated structured credit teams. It requires deep understanding of credit analysis, structural mechanics, and manager evaluation.

What is CLO Equity?

CLO equity (also called "subordinated notes" or "income notes") sits at the bottom of the capital structure:

• No fixed coupon: Receives residual cash flows after all debt tranches, fees, and expenses are paid.
• First-loss position: Absorbs 100% of losses until the equity is wiped out, before any debt tranche suffers impairment.
• Unrated: Rating agencies do not assign ratings to equity (too risky/volatile).
• Typical size: 8-12% of total CLO capital structure ($40-75M in a $500M CLO).
• Duration: 10-12 years to final maturity, though distributions occur throughout the life.

The CLO Arbitrage: How Equity Makes Money

CLO equity profits from the spread arbitrage: the difference between what the loan portfolio earns and what the CLO pays its debt investors.

Simplified Arbitrage Example

Assets (Income Side):

• $500M loan portfolio yielding SOFR + 450 bps (all-in: 9.50% assuming SOFR = 5.00%)
• Annual interest income: $47.5M

Liabilities (Expense Side):

• $300M AAA debt @ SOFR + 135 bps = $19.05M
• $40M AA debt @ SOFR + 180 bps = $2.72M
• $30M A debt @ SOFR + 215 bps = $2.15M
• $30M BBB debt @ SOFR + 300 bps = $2.70M
• $25M BB debt @ SOFR + 525 bps = $2.56M
• Management fees & expenses: $2.0M
• Total debt + expenses: $31.18M

Equity Cash Flow:

• Residual to equity (before defaults): $47.5M - $31.18M = $16.32M annually
• On $75M equity investment = 21.8% gross cash-on-cash return

But wait—defaults happen:

• Assume 2.5% annual default rate, 25% loss severity = 0.625% expected annual loss
• Annual losses: $500M × 0.625% = $3.125M
• Net to equity: $16.32M - $3.125M = $13.2M
• Net equity return: 17.6% annually (before taxes)

Over 10 years, this produces a gross IRR of 15-18% depending on timing of cash flows, refinancings, and actual vs. expected defaults.

Equity Return Drivers

CLO equity returns depend on five key variables:

1. Loan Spread (Asset Yield)

The weighted average spread (WAS) of the loan portfolio is the primary income driver. Higher-spread portfolios generate more excess cash flow.

• Base case: SOFR + 425-475 bps
• Impact: A 25 bps increase in WAS adds ~$1.25M annual income on $500M portfolio = ~150 bps to equity IRR

2. Debt Cost (Liability Pricing)

The weighted average cost of debt determines how much of loan income is consumed by interest expense.

• Base case: SOFR + 160-190 bps (weighted average across all tranches)
• Impact: Refinancing AAA from 150 to 130 bps saves $600K/year = 80-100 bps to equity IRR
• Manager tier effect: Tier 1 managers achieve 20-40 bps tighter debt pricing than Tier 3 managers

3. Default Rates and Recoveries

Equity absorbs 100% of net losses (defaults minus recoveries).

• Base case: 2-3% annual defaults, 70-80% recoveries = 0.4-0.9% net loss rate
• Sensitivity:
  • 1% increase in default rate (e.g., 2.5% → 3.5%) = 200-300 bps IRR reduction
  • 10% decline in recoveries (e.g., 75% → 65%) = 150-250 bps IRR reduction

4. Reinvestment Period Management

During the 4-5 year reinvestment period, manager skill in trading and reinvesting prepayments significantly impacts returns.

• Spread capture: Replacing prepaid loans (par) with new loans at wider spreads
• Avoiding blow-ups: Selling deteriorating credits before they default (selling at 85-90 vs. defaulting at 25)
• Opportunistic buying: Purchasing distressed loans that recover (buy at 70, recover to 95)

5. Refinancing and Resets

Equity investors can significantly boost IRRs by refinancing debt or resetting the reinvestment period.

• Typical timing: 2-3 years post-closing when debt spreads have tightened
• IRR boost: Successful refi/reset can add 100-200 bps to equity IRR
• Requirement: Portfolio must be healthy (passing coverage tests, low CCC exposure)

Learn more about CLO refinancing →

Return Expectations by Vintage and Cycle

Note: Returns are gross of taxes and management fees. Actual investor returns vary significantly by manager, deal structure, and timing.

Risk Profile: What Can Go Wrong

Risk 1: High Default Rates

Scenario: Recession drives leveraged loan defaults to 8-10% (vs. 2-3% base case).

• Impact: Equity cash flows decline or cease entirely as losses absorb excess spread
• Historical example: 2008-2009 equity tranches in many CLOs received zero distributions for 12-24 months
• Permanent impairment: If cumulative losses exceed 12-15% of portfolio, equity may be completely wiped out

Risk 2: Coverage Test Failures

Scenario: Portfolio deteriorates (downgrades to CCC, defaults), causing OC/IC test failures.

• Impact: Cash flows diverted from equity to pay down senior debt (deleveraging)
• Duration: Can last months or years until tests are cured
• Opportunity cost: Equity receives $0 while debt is paid down

Understand coverage test mechanics →

Risk 3: Manager Underperformance

Scenario: Manager makes poor credit decisions, fails to sell deteriorating loans, or misses refi opportunities.

• Impact: Can reduce IRRs by 200-400 bps vs. skilled managers
• Red flags: High CCC exposure, concentration in distressed sectors, missed trading opportunities

Learn about manager evaluation →

Risk 4: Illiquidity

Challenge: CLO equity trades infrequently in secondary markets.

• Bid-ask spreads: 3-10 points (e.g., bid at 90, offer at 95)
• Holding period: Typically must hold to maturity (10-12 years) to achieve target returns
• Mark-to-market risk: Forced sellers during stress can realize 30-50% discounts to NAV

Risk 5: Structural Subordination

Reality: Equity has zero claim until all debt is satisfied.

• $300M AAA tranche must be fully repaid before equity receives final principal distributions
• If portfolio amortizes slowly or experiences late-stage defaults, equity may receive < 100% of original investment

Who Invests in CLO Equity?

Primary vs. Secondary Market

Primary Market (New Issue)

• Pricing: Par (100 cents on the dollar)
• Access: Roadshow process; commitments during warehousing/pricing
• Due diligence: Full access to manager, portfolio, structural terms
• Advantage: No liquidity discount; select preferred managers
• Disadvantage: Must commit before final portfolio is assembled

Secondary Market (Existing CLOs)

• Pricing: Typically 85-105 cents, depending on vintage and performance
• Access: Bilateral negotiations with selling investors; limited inventory
• Due diligence: Review historical trustee reports, current portfolio quality
• Advantage: Can buy at discount to NAV; see actual track record
• Disadvantage: Wide bid-ask spreads; limited selection

Equity Due Diligence Checklist

Before committing to CLO equity, institutional investors analyze:

Manager Evaluation

• Historical equity IRRs across vintages (compare to peers)
• Loan default rates (portfolio-level vs. market)
• Trading activity and portfolio turnover
• Coverage test track record (frequency of failures)
• Team stability and depth

Structural Analysis

• Debt pricing relative to market (did manager achieve tight pricing?)
• Covenant package (OC/IC triggers, CCC limits, diversity requirements)
• Call optionality and refi/reset provisions
• Management fee structure (senior vs. subordinated fees)

Portfolio Quality

• Weighted average rating factor (WARF)
• CCC exposure (should be < 7.5%)
• Industry concentration (no single sector > 15%)
• Covenant-lite percentage (higher = more risk)
• Weighted average spread (WAS) vs. market

Vintage Timing

• Where are we in the credit cycle? (Early/mid/late)
• Current default rate vs. long-term average
• Loan spread environment (wide = favorable for equity)
• Expected forward curve for defaults

Tax Considerations for Equity Investors

CLO equity has complex and unfavorable tax treatment:

• Ordinary income: Most distributions are taxed as ordinary income (not capital gains or qualified dividends)
• UBTI for tax-exempt investors: CLOs may generate Unrelated Business Taxable Income (UBTI) for pension funds and endowments, creating tax complications
• Blocker structures: Many funds use offshore blockers to shield U.S. tax-exempt investors from UBTI
• Complex K-1s: Equity investors often receive K-1 tax forms with multiple income categories
• Non-U.S. investors: Subject to 30% withholding tax unless treaty provisions apply

Alternatives to Direct Equity Investment

For investors seeking CLO equity exposure without $10M+ minimums:

1. CLO Equity Funds

• Pooled vehicles managed by specialists (e.g., Elmwood, CBAM, Sound Point)
• Minimum investments: $250K-$1M
• Diversification: 15-40 underlying equity tranches
• Management fee: 1-1.5% + 10-20% performance fee

2. BDC CLO Equity Sleeves

• Some Business Development Companies (BDCs) allocate to CLO equity
• Publicly traded (NYSE/NASDAQ)
• Lower minimums (cost of shares)
• Drawback: CLO equity is often < 20% of portfolio

3. Interval Funds

• Registered investment companies with quarterly redemption windows
• Blend CLO equity with other credit strategies
• Minimum: $25K-$100K
• Fees: 2-3% total (higher than direct)

Key Takeaways

Further Reading

• CLO Structure – Understand the capital stack and waterfall
• Coverage Tests – How OC/IC failures impact equity
• Manager Rankings – Evaluating CLO manager quality
• Historical Returns – Equity performance by vintage
• CLO Lifecycle – Reinvestment, amortization, and refis