CLO Equity

Collateralized loan obligation (CLO) equity is the most subordinated tranche in a CLO's capital structure, representing roughly 8 to 10 percent of a typical deal. Elliot Hill, CFA®, a principal at Ares Credit Group, explains why that subordination comes with a return profile many advisors haven't priced in: 10-year average annual cash distributions in the mid-teens, well above the mid-to-high single-digit yields of leveraged loan, high-yield, and investment-grade ETFs over the same period. The return comes from structural arbitrage, the spread between what the underlying loan portfolio earns and what the CLO's debt tranches cost, rather than a fixed coupon. Hill positions CLO equity as a middle ground between private credit and private equity, with front-loaded cash flows and more diversification than either.

Key Takeaways

1. CLO equity has delivered 10-year average annual cash distributions in the mid-teens, compared with mid-to-high single-digit yields for loan, high-yield, and investment-grade ETFs over the same period.
2. Returns come from structural arbitrage: the spread between the yield on the underlying loan portfolio and the cost of the CLO's debt tranches, which has averaged 145 basis points historically.
3. Trailing 12-month default rates are running at 1.6 percent in the U.S. and 2.6 percent in Europe, both near or above their 10-year averages of 1.1 percent and 1.9 percent, respectively.
4. Hill frames CLO equity as a middle ground between private credit and private equity, more diversified than direct lending, with front-loaded cash flows private equity doesn't offer.