Welcome to this edition of CLO Market Musings, where we are revisiting the limitations of using CLO equity cash distributions to determine the tiering of deals or managers.
The term “CLO performance” or “resilience” in the CLO market can have varying meanings. Typically, these terms refer to a CLO deal’s metric performance or the resilience of the CLO debt tranche ratings, rather than the CLO’s investment performance. However, it’s important to note that a CLO’s equity tranche may underperform even if its deal metrics are resilient. After all, CLO managers are paid to deliver investment returns rather than simply exhibiting excellent deal metrics.
While annualized CLO equity payments are useful on a standalone basis, they are less helpful for comparing different CLO deals due to various structural differences such as leverage ratios, par flush, interest reserve amount variation, class X issuance, the release of capital upon reset, transfer to a collateral enhancement account (more common in EU CLOs), transfer of trading gains to interest account (for risk retention compliance), amortization of the lower mezz tranche using interest proceeds, stub payment, reinvestment of equity payments, different management fee structures, and different incentive fee structures.
Additionally, the first payment distribution can increase if there’s a ‘par flush,’ if the interest reserve account is larger, or if there’s a ‘stub payment’ paid for by a higher primary CLO equity price. Conversely, equity cash flows are artificially reduced during the class X amortization period since the class X tranche is paid out of the interest account.
Most importantly, if one only focuses on CLO equity payments, they may miss the health of the MV collateral pool. The MV collateral performance is critical as a CLO deal is typically redeemed before all the underlying assets are paid off, meaning any unrealized losses (or gains) must eventually be recognized.
Therefore, an above-average annualized CLO equity distribution doesn’t always mean that a deal’s arbitrage is good, and a lower-yielding CLO equity doesn’t always mean that its arbitrage is poor. However, if a CLO’s equity cash distributions are lackluster, the deal may face additional pressure to deliver on its final equity NAV.
It’s important to remember that equity payments (cash-on-cash returns) aren’t the same as CLO equity investment returns. On average, 2.0 CLOs rely on final equity NAVs to deliver strong overall returns, and the vintage effect can also play a role, as certain vintages may be more challenging than others.
Related (premium) article:
Final Post-2012 US CLO Equity IRRs: NAV vs Annual Distributions
Related older article:
Redeemed EU CLO Equity IRRs and Annual Default Rates
Disclaimers
The information, research, data, research-related opinions, observations, and estimates contained in this document have been compiled or arrived at by CLO Research Group, based upon sources believed to be reliable and accurate, and in good faith, but in each case without further investigation. None of CLO Research Group or its service providers; authorised personnel, or their directors make any expressed or implied presentation or warranty, nor do any of such persons accept any responsibility or liability as to the accuracy, timeliness, completeness, or correctness of such sources and the information, research, data, research related opinions, observations and estimates contained in this document. All information, research, data, research-related opinions, observations, and estimates in this document are in draft form as of the date of this document and remain subject to change and amendment without notice. Neither CLO Research Group nor any of their third-party providers shall be subject to any damages or liability for any errors, omissions, incompleteness, or incorrectness of this document. This article is not and should not be construed as an offer, or a solicitation of an offer, to buy or sell securities and shall not be relied upon as a promise or representation regarding the historical or current position or performance of any of the deals or issues mentioned in it.
