CLO Equity: How Investors Can Benefit From and Access a Compelling Asset Class

• Collateralized loan obligation (CLO) equity has performed well during varying market conditions, with arbitrage benefiting from reduced liability costs during bullish periods and more favorable asset prices during periods of volatility.

• Four key attributes of CLO equity make the asset class worth consideration for a dedicated allocation: front-loaded, historically strong cash flows; the ability for CLOs to adjust to changing market conditions; CLOs’ diversification benefits, due to low correlations with other asset classes; and strong downside protection historically.

• CLO equity also offers investors flexibility in how they incorporate the asset class within a diversified portfolio. It can be a source of liquidity for private equity capital calls, offer protection against mark-to-market volatility, similar to illiquid credit, and provide a source of income generation for those looking for more traditional fixed-income-like returns.

• How can investors best access CLO equity? The most suitable approach depends on each investor’s specific goals, resources, and risk tolerance, with options including captive equity funds; investing directly (deal-by-deal); or multi-asset or opportunistic credit funds.

CLO equity offers a distinctive combination of attractive, double-digit return potential with front-loaded cash flows. The asset class also provides critical diversification benefits, adaptability across market cycles, and historically strong performance – making CLO equity a potent addition to a diversified institutional portfolio.

Here we answer key questions about why we believe CLO equity is an attractive allocation for institutional investors, and how they can best access this asset class.

Why should institutional investors allocate to CLO equity in their portfolios?

We believe a number of attributes of CLO equity may complement a diversified portfolio’s return and cash flow potential across different market environments. Four of these characteristics may be especially beneficial, as we explain below.

1. CLO equity offers front-loaded, historically strong cash flows.

CLO equity cash flows are both front-loaded and substantial relative to other high-return asset classes, such as private equity (PE). CLO equity has historically delivered strong quarterly distributions, often offering annualized cash-on-cash returns in the mid-to-high teens during reinvestment periods.1

Investors often receive quarterly distributions beginning five to six months after issuance, with payouts continuing for the life of the CLO. These features lead to a shorter duration relative to other alternative investments – often three to five years – which reduces uncertainty and accelerates capital recovery.

In contrast, private equity investments often experience the “J-curve effect,” where negative early returns are realized before eventual gains. The upfront distributions from CLO equity mitigate this risk and can complement the cash flow profile of an investor’s private equity allocation.

CLO Equity and Private Equity May Offer Complementary Return Profiles

Illustrative CLO equity return profile

Illustrative private equity return profile

For illustrative purposes only. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.

2. CLOs have the ability to adjust to different market environments.

CLO equity returns are influenced by a variety of factors, including loan and CLO debt spreads, interest rates, inflation, credit losses, and issuance volumes. CLO managers have a robust toolkit for gearing their portfolios in response to broad changes in the market and economic environment through both the inherent structural features of CLOs and the potential for trading decisions within the portfolio.

Experienced CLO managers can use the following three mechanisms to keep CLO equity returns flexible and responsive, which may benefit investors during both growth periods and downturns:

• Active management. CLO managers actively adjust the portfolio during the reinvestment period, reallocating assets to optimize returns and mitigate risks. During this reinvestment period, the most effective CLO managers continually monitor their holdings and the markets for opportunities to upgrade. Active managers can help mitigate credit losses by trading out of distressed credits early or purchasing loans at a discount, which improves arbitrage and thus CLO equity returns.

• Structural protections. Features such as overcollateralization (OC) tests redirect cash flows to protect senior tranches during periods of stress. This redirection of cash flows delays distributions to CLO equity in the short term but preserves the long-term equity value. Strong managers may be able to maintain adequate CLO test levels during periods of stress – and therefore continue to make consistent equity distributions. However, the structural protections are always in place to serve as portfolio guardrails during periods of extreme stress.

• Refinancing and reset optionality. CLO managers can refinance or reset the structure when spreads tighten on CLO debt, improving prospective CLO equity returns. However, only CLO managers with healthy portfolios, characterized by strong market value and other metrics, will be able to realize the benefits available from refinancing and reset opportunities.

3. CLO equity can provide diversification benefits due to low correlations with other asset classes.

The same features that allow CLO equity to adjust to different market conditions and address new risks also lead to low correlations with other asset classes.

Historical correlations across asset classes over time indicate that CLO equity returns and cash flows can provide additional stability to a portfolio.

CLO Equity Exhibits Low Correlation Relative to Other Asset Classes

Source: Citigroup Global Markets Inc., “Cross asset total return correlation” as of 31 December 2024. Asset correlations are calculated for the period January 2013 to December 2024.

Because quarterly distributions are driven by the arbitrage between floating interest rate payments on the underlying leveraged loans and floating-rate CLO debt, CLO equity returns and cash flows exhibit low volatility relative to many other asset classes, which can help stabilize portfolio cash flows in various scenarios. Not surprisingly, CLO equity exhibits the highest correlations with leveraged loans and CLO debt tranches, but even these levels of correlation are no higher than 67% over longer time periods (see chart above).

4. CLO equity boasts strong downside protection based on historical experience.

While CLO net asset values may appear volatile during market disruptions, we believe a more appropriate way to value CLO equity is on a discounted cash flow basis, using an appropriate rate derived from historical data.

Term financing ensures that CLOs do not become forced sellers during periods of market disruption, which prevents CLOs from being redeemed and realizing significant principal losses at a time of abnormally low loan prices. Moreover, term financing and other structural safeguards, such as OC tests, help to ensure that even the worst-performing CLO will return almost all initial capital back to equity investors.

Management style can also influence the probability of downside scenarios. For example, managers focused on principal protection over high current equity distributions could provide better principal downside protection to CLO equity investors.

How should institutional investors think about the categorization of CLO equity within their portfolios, and what are the benefits of the respective alternatives?

When considering broader asset class designations for institutional investors, CLO equity and its characteristics do not fit neatly into a specific category. Depending on how institutional investors look at the opportunity set in conjunction with their investment objectives, CLO equity may be classified broadly under alternatives, illiquid credit, and/or fixed income.

Moreover, a broad range of manager styles may appeal to CLO equity investors, from more aggressive strategies that seek to maximize current interest and par build, to those that place greater emphasis on balancing such aims with limiting credit losses, tail risk, and maintaining strong principal values over time. So, selecting wisely can also help fine-tune outcomes to an investor’s desired risk-return profile.

Here we’ll look at key characteristics of CLO equity and the benefits of inclusion in each bucket.

Alternatives

Why it fits: CLO equity possesses key features typically found in alternative assets, including:

• Double-digit return potential

• Low correlations with traditional asset classes

• Higher complexity

• Limited liquidity

Potential benefits: Consistent quarterly distributions, which can serve as an ongoing source of liquidity to fund capital calls or meet other cash commitments for institutional investors.

Illiquid credit

Why it fits: CLO equity offers leveraged exposure to corporate credit. While there is a secondary market, CLO equity still has lower levels of liquidity when compared with traditional credit, and the leveraged nature of the CLO’s structure can lead to potential mark-to-market volatility.

Potential benefits:

• Better diversification and returns versus first-lien private credit:

  • CLO equity has historically generated returns exceeding those for first-lien private credit

  • With exposure to the $1.4 trillion US broadly syndicated loan (BSL) market, a BSL CLO portfolio is more diversified by industry, issuer concentration, and company size

• Term financing provides protection against the mark-to-market volatility that occurs during periods of abnormally low loan prices.

Fixed income

Why it fits: The underlying driver of long-term returns stems from the financial performance of the corporate loan issuers held within CLO portfolios.

Potential benefits:

• CLO equity historically has generated higher yields than most public fixed income asset classes

• Quarterly distributions can enhance income-oriented strategies

Regardless of how CLO equity is categorized, these potential benefits make an allocation to CLO equity worth considering within an institutional investor’s broader portfolio.

What are the best ways for institutional investors to access CLO equity?

Investors can gain exposure to CLO equity in their portfolios in a number of ways, including through captive equity funds, by investing directly (deal-by-deal), or through a multi-asset or opportunistic credit fund. Each approach offers distinct advantages, and the best choice for an investor depends on their specific goals, resources, and risk tolerance.

Captive equity funds provide a diversified, commingled approach to investing in a portfolio of CLO equity positions from a single manager.

Advantages:

• Diversification and reduction of timing risk. Investors can diversify CLO equity exposure across several vintages of a specific manager, reducing timing risk and gaining exposure to multiple potentially strong vintages.

• Capital efficiency. Investors with a limited allocation to CLO equity can utilize the fund structure to achieve diversified exposure across multiple deals and vintages while still meeting stated minimum fund commitment requirements.

• Lower administrative burden. Captive equity funds provide efficient capital deployment, limiting the administrative burden and removing the need to obtain internal approval for each CLO issued during the fund’s investment period. Fund terms are underwritten and agreed upon upfront, with capital deployed over multiple years.

Considerations:

• Understanding the fees. While different fee structures may appropriately align interests between investors and the manager, a more simplified fee structure can make it easier to assess the value proposition in different performance scenarios.

• Manager selection. The manager generally makes key decisions within captive equity funds, which is helpful to many investors, but highlights the importance of careful manager selection. Investors must conduct thorough due diligence to ensure they are comfortable with the manager, its ability to execute, and the pace of capital deployment over the life of the fund.

Direct deal-by-deal exposure can be an attractive option for sophisticated investors with the capacity to analyze and manage a portfolio of CLO equity positions themselves. Engaging with managers directly requires a certain level of resources and expertise but can offer the investor greater control.

Advantages:

• Customization. Direct CLO equity investments allow investors to tailor their portfolios based on their preferences regarding the CLO manager, structure, liquidity, and market timing. We think the high degree of customization is most valuable to investors with long-term investment horizons.

• Control. An investor who secures the majority of the equity in a particular CLO gains significant decision-making authority over the transaction, including when to refinance, reset, or ultimately redeem the vehicle. This optionality allows the investor to align the CLO with the overall goals of their portfolio.

• Favorable terms. Direct CLO equity investors may be able to secure economic terms that reflect the strength of the long-term relationship between the investor and manager.

Considerations:

• Structuring and management expertise. Direct investments into CLOs require a certain level of expertise in CLO structuring and ongoing management of the transaction. For this reason, many institutions that invest directly in CLO equity rely on the expertise of the manager.

• Illiquidity and concentration risk. Direct investments inherently involve higher illiquidity and concentration risk, especially for those investors with less capital to deploy into CLO equity.

Multi-asset or opportunistic credit funds may provide exposure to CLO equity as part of a broader portfolio of credit investments.

Advantages:

• Asset class diversification. Multi-asset credit funds typically allocate to a mix of asset classes, which can help mitigate risk. These can include below-investment-grade credit, private credit, distressed debt, and CLO tranches (both debt and equity).

• Turnkey solution. These funds provide a turnkey solution for investors that seek broad credit exposure, including CLO equity, but prefer to outsource relative value decisions to a trusted manager.

Considerations:

• Lower returns. While diversified credit funds may reduce risk, returns will likely be lower than those of a dedicated CLO equity allocation.

• Less-attractive terms. These funds also may be allocated to a third-party CLO manager, which could result in less attractive economic terms relative to direct CLO equity investments. This may mute the benefits of a meaningful allocation to CLO equity within a portfolio.

Investors must consider a number of factors when determining how best to access CLO equity, and their specific goals and portfolio needs will guide this decision.

While the method for accessing CLO equity is important, vintage diversification and manager selection are even more critical. Investors should consider the manager’s investment philosophy, the length of its track record, and its historical performance through different market environments and relative to peers when considering an investment.

CLO Equity IRR: Redeemed Deals by Vintage and Percentile

Source: BofA Research CLO Equity Data published 27 January 2025. Note: The majority of deals issued in the 2016 and earlier vintages have been redeemed, whereas the majority of 2017 and later vintages deals remain outstanding. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Past performance is not indicative of future results.

What are the key risks associated with CLO equity investments?

Because the equity tranche’s success depends on the success of the senior CLO tranches – it’s last in line to receive cash flows and first to realize losses – its owners take the most risk of any CLO investors. This underscores the importance of choosing a skilled and experienced manager with a solid long-term track record.

Some areas of risk in CLO structures that investors should consider include:

• Credit strength. While CLOs enjoy strong credit quality due to the senior secured status of leveraged loans, leveraged loans carry inherent credit risk: They’re issued to below-investment-grade companies whose revenue streams are sensitive to fluctuations in the economic cycle.

• Collateral deterioration. CLO cash flows are allocated to tranches in order of seniority. Depending on the severity, if a CLO’s investments experience losses, the junior CLO tranches could lose principal value and cash flows to the equity tranche could be cut off. Since the success of CLO equity is dependent on the success of the underlying loans, it’s important to look for active credit managers with a proven track record of lower default rates and higher recovery rates relative to the overall loan market.

• Non-recourse and not guaranteed. Leveraged loans are senior obligations and, as such, have full recourse to the borrower and its assets in the event of default. A CLO, however, has recourse only to the principal and interest payments of the loans in the portfolio. Investors can seek CLO managers with strong principal preservation, as measured by portfolio market value relative to target par, and a track record of consistent equity distributions to mitigate these risks.

• Loan prepayments. Leveraged loan borrowers may choose to prepay their loans in part or in full. While experienced CLO managers may anticipate prepayments, they’re nonetheless unpredictable. The size, timing, and frequency of prepayments could potentially disrupt cash flows and challenge managers’ ability to maximize portfolio value.

• Trading liquidity. Although CLO equity does trade, it can be illiquid during certain market conditions.

Identifying CLO management styles that are consistent over time allows for the development of a portfolio of CLO equity exposures diversified across vintages, which can help to manage these risks.

All told, we believe CLO equity’s combination of double-digit return potential, front-loaded cash flows, and diversification benefits makes it an attractive option for institutional investors.

For more information, please see our CLO equity primer or visit our CLO capabilities page.