8. CLO equity

CLO equity is an investment unlike any other. Legally, it can take the form of subordinated notes, preference shares, income notes or membership interests in a fund. Despite its name, it never takes the legal form of equity, that is, the ownership interest in a company.

But in other respects, CLO equity is quite unlike corporate equity. The most obvious difference is that a CLO is a dumb entity with no staff of its own. A CLO operates by pre-set rules carefully agreed in advanced by all participants, and cannot change strategy like a real company can. Nor can it borrow to pay dividends as a real company can: it can only distribute the income that comes in.

In order to assess the prospects of a company, investors need to look at its business plan and the credibility of its managers. In order to assess a CLO equity position, investors need to weigh up the default probability and recovery prospects of the loans which are in the portfolio, and those that may be added to the portfolio in future.

Almost all the structural features in a CLO are designed to protect debt investors. But equity investors enjoy some rights too. For example, they usually have the power to sack the manager if they are unhappy with its performance.

But the most important power enjoyed by equity investors is the right to call time on the deal. They can vote to call the deal – that is, redeem its debt and pay themselves any money left over – at any time after an initial non-call period. Since the financial crisis the period in which the CLO cannot be called most often lasts two years from the closing date.

The timing of the call is hugely important to all participants in a CLO. For the equity, calling the deal at the right time can boost returns hugely. If a CLO does not have a call option, or its equity investors are unable to exercise the call, equity distributions will dwindle rapidly as the CLO pays down its senior debt.

Some older CLOs have found themselves in this position of being uncallable because their equity is widely dispersed, making it impossible for anyone to organise a vote to redeem the deal. (The manager of a deal that has substantially delevered will usually prefer the deal to be called and will often try to trace investors and encourage them to vote for redemption.) The problem has been exacerbated in the wake of the financial crisis by CLO equity holdings changing hands through corporate reorganisation and secondary trading.

The danger of non-callability has led to a change in the way CLO equity is sold in post-crisis CLOs. Most deals issued since 2009 have a majority of the equity tranche owned by a single institution (or a group of related funds or companies). The presence of this majority investor provides assurance to all parties that the CLO will be called at a time that makes economic sense.

In some cases, the manager will be the majority equity investor. One lasting effect of the old US risk retention rules was the development by managers of their own permanent capital vehicles to purchase the equity in their CLOs. The new vehicles help managers control the timing of their deals as discussed later in this chapter. In many other CLOs, a specialist fund such as a listed permanent capital vehicle or a structured credit hedge fund will buy the majority position.

Some equity investors specialise in buying this control equity stake, reasoning that it puts them in the driving seat and allows them to dictate better terms than they would otherwise receive. Other equity buyers prefer the remaining non-control equity positions, either because they are not large enough to buy majority stakes or because they see more value in having small stakes in a large number of CLOs.

The majority equity investor will, in many cases, provide capital for the CLO before it is launched during the warehouse phase. In other cases, the manager or a third-party investor provides the warehouse capital and then steps out of the deal once the CLO is launched.

At least equally important is timing. In the CLO 1.0 era deals launched when returns on loans were high relative to the funding costs of CLO debt (in other words, when the arbitrage was favourable), were expected to do better than those launched in less favourable times. In recent years the performance differences between vintages have decreased as the development of the refinancing and repricing markets make it easier for a manager to improve the arbitrage of a deal throughout its lifetime.

These rolling equity return figures do not tell us the whole story about equity performance. Equity returns come from two sources: the distributions paid during the life of the deal and also the final payment once the deal has been called and its assets sold. Equity returns are often calculated as an internal rate of return (IRR), (see chapter 9: How are CLOs priced?).

Even when a CLO has been called, the final IRR may not be known for a number of years. This is because CLOs usually end up owning a few assets that are illiquid and hard to sell, such as equity which the CLO has received following a debt restructuring. In many cases, the CLO continues to exist as a small fund for some years after its debt is paid down.

The table opposite highlights the CLOs which have delivered the highest equity returns to investors.