How CLO Equity and Private Equity Can Work Together in a Diversified Portfolio

Collateralized loan obligation (CLO) equity and private equity can offer investors complementary advantages in different market environments – and while allocations to private equity may be more prevalent, both may provide core benefits to an institutional portfolio.

Balancing forces

Recent experience provides an example of the give-and-take between the two asset classes. Private equity (PE) investments have experienced delays in portfolio exits over the past few years, driven in part by rising interest rates and, later on, by expectations that rates would decline – which made it more attractive to postpone portfolio exits, including initial public offerings.

Yet some of the same factors that delayed portfolio exits from PE sponsors – such as general market volatility and higher interest rates – have supported CLO equity distributions, as loan market spreads were generally stable during 2022 and 2023. Unlike private equity investments, CLOs are not dependent on exit transactions to realize positive returns. And critically, active management of CLOs can lead to better outcomes during periods of economic volatility.

CLO Equity Returns Have Remained Positive Across Economic Cycles

CLO quarterly equity distributions: US CLOs in reinvestment period

Source: BofA Global Research, Intex, LCD, Bloomberg, BofA Global Research “CLO Factbook,” as of 7 February 2025.

The market entered a new phase during 2024 that is still largely in place today: Interest rates have started to decline as the Federal Reserve embarked on a rate-cutting cycle, and strong technicals in the leveraged loan and CLO debt markets have led to a significant tightening in credit spreads. As the chart below illustrates, CLO equity arbitrage has remained attractive during different rate environments.

CLO Creation Is Attractive Across Most Rate Regimes

Sources: Morningstar LSTA Leveraged Loan Index, Bloomberg, as of 31 January 2025. Morgan Stanley Research, PitchBook | LCD, The Yield Book, as of 31 December 2024. WACC: Weighted average cost of capital. *Data excludes defaults.

While lower interest rates and tighter credit spreads are each supportive of LBO formation, we have yet to see a significant uptick in the number of transactions. However, as LBO and IPO volumes eventually increase, realized cash flows for investors in private equity funds will likewise accelerate.

At the same time, tighter credit spreads resulted in a massive loan repricing wave in 2024, which reduced the interest generated from loans in CLO portfolios. All else equal, lower loan spreads put downward pressure on CLO equity distributions. Of course, lower credit spreads also present opportunities for CLO resets and refinancings, highlighting the benefits of the optionality present within CLO structures when paired with skilled management.

This means that while near-term equity cash flows may come under pressure as loan spreads tighten, the CLO structure affords the equity investor opportunities to lower the CLO’s cost of capital in line with current market levels – setting the portfolio up to take advantage of future market volatility and potential spread widening.

A winning combination

What’s the result? An investor with both private equity and CLO equity in their portfolio could see an increase in cash flows from PE investments at the same time that CLO equity distributions come under some pressure. However, in this environment, CLOs also have the ability to strengthen their structure to take advantage of future opportunities in the market. Moreover, an increase in loan issuance volumes driven by greater LBO and M&A activity will create additional collateral to support CLO formation.

Given these asset classes’ complementary nature, we believe allocations to CLO equity and private equity can be a winning combination for investors.

How CLO Equity and PE Have Responded to Recent Market Drivers: A Snapshot