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Opinion CLOs
Long-term CLO investments require strong distributions, healthy equity NAVs, and an extended life
by Poh-Heng Tan
Poh-Heng Tan
clopremium.co.uk
Active trading does not necessarily equal positive selection
At first glance, CLO equity may seem like a high-beta play on credit, but consistent outperformance demands far more than just riding the wave of loan market rallies. A successful long-term CLO equity investment rests on three pillars: strong annual distributions, healthy equity NAVs, and a longer-than-average deal life. While these may sound simple, the path to achieving them is anything but.
Anatomy of high annual distributions
Regular cash distributions are a core driver of CLO equity returns, underpinned by structural leverage and a strong net interest margin (NIM). The timing of these cashflows matters — front-loaded distributions carry greater present value, often boosting internal rate of returns (IRRs) meaningfully. Par flushes at the first payment date or post-reset can significantly enhance outcomes. A case in point: Blackstone’s Avondale Park CLO delivered a 27% annual distribution, largely driven by a substantial post-reset payout of 65.3% made possible by purchasing assets at an average price of 90 cents on the euro. The deal has already hit its IRR incentive fee hurdle, despite being outstanding for less than five years.
Building strong equity NAV and long life
Minimising credit losses is paramount — both from outright defaults and, crucially, from trading activity. While default risk receives most of the attention, distressed trading losses often cause just as much, if not more, damage to equity NAVs. Active trading does not necessarily equal positive selection.
From our proprietary research at CLO Research, a compelling pattern emerges: EU CLO equity NAVs have consistently outpaced their US BSL CLO counterparts across the older vintages. In particular, European deals from the 2013-14 and 2018 vintages stand out with meaningfully stronger NAV metrics, despite US CLOs typically holding more diversified portfolios.
Why does this matter? A resilient equity NAV, supported by strong par preservation, helps establish a price floor for the tranche and facilitates value-accretive resets without requiring fresh equity — thereby avoiding dilution risk and other execution-related challenges.
Resets not only extend a deal’s life but also help preserve arbitrage over time. According to CLO Research’s IRR analysis of redeemed EU deals, reset deals from the 2014-16 vintages outperformed their non-reset counterparts by approximately 300bps. Notably, nine reset EU CLOs from the 2013-16 vintages that are still outstanding have already surpassed their 12% incentive fee IRR hurdles — collectively distributing nearly EUR 22m in incentive fees to date.
Low prepayment rates post-reinvestment are equally important. CLO Research’s deal-level analysis shows that 18 EU CLOs recorded single-digit annualised prepay rates in years 1-3 post-RP — helping preserve structural leverage and funding efficiency, while giving equity investors greater flexibility in timing optional redemptions. This has been particularly beneficial for the less frequently reset 2018 vintage.
What can go wrong?
CLO equity can falter when realised or unrealised credit losses erode NAV, or prepayment rates run high post-reinvestment. Recent loan spread tightening — around 33bps in the US and 17bps in the EU since March 2024 — has further compressed NIMs, straining arbitrage. Meanwhile, the mismatch between short loan non-call periods and longer CLO liabilities poses a structural challenge.
A more objective way to evaluate a manager’s capability is by examining the inception-to-date gross annualised collateral return of their deals, measured relative to the relevant loan indices and assessed on an unlevered basis. This provides a clearer measure of true alpha generation.
According to CLO Research’s alpha analysis, both US and European CLO managers have, on average, broadly tracked their respective loan indices. That said, several managers have deviated from this trend. In 2024, the monthly average of inception-to-date alpha showed Oak Hill Advisors delivering over 50bps — driven primarily by stronger market value performance, which offset slightly below-average interest return alpha. In the European market, Sound Point recorded approximately 30bps of inception-to-date alpha over the same period.
In summary, while past performance is not indicative of future results, selecting a group of consistently high-performing managers — demonstrating strong asset-side execution — combined with appropriate structural features, competitive liability pricing, and well-timed execution, significantly enhances the likelihood of success across the three core pillars.
