CLO Equity Return and Manager Selection

Abstract

In this article, the authors investigate the drivers of CLO equity return and how to identify a good CLO manager. Pre-crisis collateralized loan obligation (CLO) structures proved to be very robust in the end. Today’s CLOs are structured more conservatively with generally more CLO debt subordination, cleaner asset pools, and less reinvestment flexibility. Looking at historical CLO equity performance, CLO 1.0 equity benefited from having cheap funding costs and opportunities to buy discounted loans during the financial crisis, ultimately achieving over 20% IRR. CLO 2.0 equity’s returns have been running lower so far in a benign credit market. The authors note that top-quartile US CLO equity always delivered low-to-mid-teens’ returns, regardless of market timing. It is also worth noting that CLO equity’s deal-level and manager-level performance dispersion is evident across different vintages and even more pronounced today than before the Global Financial Crisis as the number of US CLO managers grew from 100 managers pre-crisis to more than 130 today, with the outstanding US CLO market having more than doubled in size.

TOPICS: CLOs, CDOs, and other structured credit; project finance; legal and regulatory issues for structured finance; financial crises and financial market history; manager selection

Key Findings

• • Any style could lead to good or bad CLO performance. Active trading and portfolio management are the key to outperform and differentiate from peers for CLO managers.

• • It is hard to balance principal and interest returns of CLO equity, because minimizing portfolio losses often hurts running excess spreads. We can tell if CLO manager is more “equity-friendly” or “debt-friendly” by comparing various performance metrics.

• • Manager tiering will continue to be a common theme in the CLO market during the next downturn and the subsequent recovery period.