In the shadows of the growing private equity market, Collateralized Loan Obligations (CLOs) are gaining traction. Although CLOs indirectly invest in the senior debt of similar companies, they offer a potentially distinct risk-return profile from private equity. Nonetheless, the practical implementation of this asset class presents significant challenges.
By now, it is no secret that the historical outperformance of private equity is largely driven by debt financing, or leverage. Depending on the time period, leverage has accounted for approximately 60 percent (before 2000) to 40 percent (since 2008) of the total return of the asset class. A less examined phenomenon is which parties are willing to provide this debt.
Nowadays, large private equity transactions are largely financed by leveraged loans, which are syndicated among multiple investors. The loans have a senior position in the capital structure, a floating interest rate, a relatively low credit rating, and are tradable in the secondary market. In the US, the size of the leveraged loan market is $1.4 trillion, of which private equity transactions account for about 65%. By comparison, the net asset value of all buyout funds in the US was about $1.8 trillion at the end of last year.
The question that remains is who the ultimate investors in leveraged loans are. The primary investors are CLOs, which buy up to 70% of loans. CLOs are actively managed entities set up to create broadly diversified portfolios of loans. The CLO, in turn, is funded by issuing equity (around 10%) and multiple tranches of debt (around 90%). These equity and debt tranches generate payments according to priority within the capital structure. Thus, a CLO redistributes risk among its financiers according to their risk appetite.
Investments in CLO equity bear the initial credit losses but also offer attractive return potential, averaging around 12 percent p.a. since 2003. Yet CLO equity is a relatively limited part of illiquid investment portfolios, compared to more salient asset classes such as private equity.
Common reasons for investors not allocating to CLOs include their higher complexity and the ‘confusion’ with the (infamous) Collateralized Debt Obligations (CDOs) from the 2008 financial crisis. Despite the similar abbreviation, CLOs bear no resemblance to CDOs in terms of financial exposure. In addition, some investors believe that CLOs provide ‘double exposure’ to companies owned by private equity managers. They are, after all, ‘financing the same companies’. However, where the underlying companies have some overlap, CLO equity’s risk- return profile is complementary to private equity and a valuable addition to the portfolio. These diversification benefits are driven by several components:
- Senior capital position. Leveraged loans hold the ‘first lien’ in the event of bankruptcy. This means that final credit losses are limited (with a historical recovery rate of over 70%). In contrast, private equity investors typically lose their contributions in case of bankruptcy.
- Contractual cash flows. Coupon payments from leveraged loans provide income in most market conditions. To illustrate, in 2022, when both listed equities and bonds fell (-13.3% and -10.5% respectively), CLO equity delivered an average yield of +11.8%.
- Active management. CLO managers are typically allowed to reinvest (early) repaid principal amounts into new loans. This flexibility enables them to purchase discounted loans during periods of market volatility (e.g. during the financial crisis and the COVID-pandemic). Conversely, private equity experiences headwinds in these years.
- Impact of interest rate market. Since both leveraged loans and CLO debt tranches have floating interest rates, CLO equity returns are relatively robust to interest rate increases. However, for private equity investors, returns are constrained by higher interest costs experienced by their companies.
The above factors imply that private equity and CLO equity investments can be complementary to each other in terms of risk/return profile. On a vintage basis, there is a clear diversification benefit of including both asset classes to stabilise returns of an illiquid portfolio (see figure below). In addition, CLOs offer early and stable distributions that can be used to fund other cash flow needs (such as private equity capital calls).
All in all, CLOs are an important but lesser-known financier of private equity transactions. The capital structure of the CLO offers the possibility of enhanced returns for investors with a higher risk tolerance and a long-term investment horizon. Thus, more risky CLO equity investments are potentially complementary to private equity in terms of return and cash flow profile.
Bluemetric Insight | CLOs are a potentially useful investment category to add to a illiquid portfolio. However, gaining exposure to this asset class requires effort. A wide range of fund structures is available on the market, managed by different managers with different risk profiles, investment styles, economic incentives and cost structures. Finally, investors need to determine adequate allocation policies to implement the desired level of their exposure.
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