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.
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