For Professional Investors only.

M&G CLO Primer

An Introduction to CLO Equity

The Case for CLO Equity What is a CLO?

● CLOs underpin $1.2trn of the $1.8trn Broadly A CLO (Collateralised Loan Obligation) can best
Syndicated Leveraged Loan market globally.¹ be thought of as a company in its own right.
Legally structured as a special purpose vehicle, it is in
● CLO equity outstanding is approximately $120bn
the business of purchasing loans, funded by issuance
and its appeal is growing thanks to reduced
of long-term, liability notes and equity.
realisations from Private Equity and the historical
delivery of 16.5% cash-on-cash returns.²
● CLO ‘equity’ is a hybrid – in form, a subordinated Typical CLO structure

note but with the control features and upside

Portfolio Manager
participation normally associated with equity.
● At a high level, both Private Equity (PE) and CLO
investment involves the application of leverage to
the ‘beta’ of private companies’ performance – PE AAA ~62%
value-creation comes from sponsors’ operational Acquries
Cash Proceeds

portfolio...
turnaround and/or top-line growth while CLO
Capital Losses

returns are derived from manager selection and Loan CLO

avoiding default loss of senior secured loans. Assets SPV AA ~10%

A ~5%
● CLO equity is not for everyone but, for those ...funded by
issuance of
willing to bear the risk and partner with a manager BBB ~7%
debt and
equity
skilled in credit selection and optimisation of BB ~5%

the structural optionality available, we believe B ~3%

attractive returns prospect are available. Equity ~8-10%

¹ Citi Velocity, PitchbookCS LLI, CS WELLI, February 2024 Source: M&G illustrative example
² Bank of America, Intex, M&G, August 2024
Typically, each European CLO has c.€400m in assets. In simple terms (more detailed explanation later in this
These are largely (c.90%) senior secured, floating rate paper), the equity return is driven by the excess spread
loans, made to a diverse pool of c.150-200 individual (or ‘arbitrage’) between asset spreads of c.E+400bps
corporate borrowers (‘obligors’) and denominated in and liability costs of c.E+200bps and then enhanced
Euro. Loans are sourced in the primary and secondary by the leverage in the structure (usually a 10 to 1 ratio).
market, typically carrying coupons of Euribor + 375- As per the above chart (purple line), the equity arbitrage
450bps per annum.³ is typically driven by the running difference in asset
and liability costs, which is known as the ‘Interest Only’
The loan portfolio is financed by c.10% in ‘equity’
arbitrage. However, there are times such as 2020 and
issuance (a subordinated debt note, legally-speaking)
2022, when liability costs are high and the coupon
and c.90% via tranched, rated, floating-rate notes.
arbitrage is compressed. The ‘self-healing’ nature of
Notes are rated from AAA to B by two of the three
the arbitrage can however make these good moments
major rating agencies, Moody’s, S&P and/or Fitch.
to invest as they are often times when assets can be
The blended financing costs of these notes is c. Euribor
acquired at a discount to face value and so when a
+200-250 bps per annum.³
pull-to-par is achieved the all-in equity arbitrage (dark
The structure dictates that interest and principal green line) is restored, or sometimes even substantially
payments on the notes are distributed in a ‘waterfall’ enhanced. This is known as a ‘Principal Only’ arbitrage,
– from the top of the structure and sequentially which has historically delivered some of the highest
downwards in order – starting with the AAA tranche. equity IRR’s seen in the market, but requires impeccable
With the same required respect for seniority ranking timing in rare market conditions.
among noteholders, any default losses within the asset
Debt-holders receive their potential returns via quarterly
pool are absorbed by note investors from the bottom-
interest payments and final repayments of their notes,
up, starting with the equity.
whilst the equity investor receives the (variable) excess
cashflow each quarter. This broadly equates to the
CLO ‘Arbitrage’ income earned from the portfolio of assets – liability
CLO WACC CLO Full Arbitrage CLO Coupon Arbitrage note funding costs – fees and expenses. Equity IRR’s
have historically averaged mid-teens levels and are
(bps)
generally delivered by front-loaded cashflows, as
500
opposed to the back-ended returns typical of Private
Equity investments.
400
In terms of governance and transparency, the CLO
market has very well established processes and
300
customs, for providing investors with comprehensive
and independently produced monthly Trustee reports.
200
These reports include line-by-line asset detail, through
to aggregated portfolio stats and the results and
100 headroom to the many tests CLO Managers have to
adhere to when managing the portfolios. Leaders in ESG
0 and sustainability are also increasingly disclosing more
Jan-21 Jan-22 Jan-23 Jan-24
sustainability related data in monthly Trustee reports
Source: Bloomberg, September 2024. and supplementary Manager reports, which can include,
All figures reflect rolling 3-month averages.
ESG scores, emissions data, board diversity and the
extent of corporate climate ambitions – amongst other
data points and examples of engagement activity.

³ M&G Investments, January 2024

Actively-managed CLOs are the predominant structure, repayments are immediately applied to sequentially
which enable the CLO Manager to actively trade the amortise the liability notes (AAA through to B), which
portfolio and reinvest repayment proceeds for a pre- typically results in a shorter-duration vehicle, even if
defined period (usually 4.5 years). In this case the liability the legal final of the liabilities is still listed as ~13 years
notes generally have an 18 month non-call period and (typically with a one year non-call period). Static CLOs
legal final maturity of ~13 years. are usually slightly more levered and with cheaper senior
financing costs and lower management fees than their
‘Static’ CLOs are also offered by some platforms, which
reinvesting peers, although equity returns are sensitive
involve a one-off purchase of a portfolio of assets, which
to default loss (which cannot be repaired through
cannot then be traded by the manager (beyond credit
active management) and the speed at which liabilities
sales). Cash proceeds from any credit related sales or
are amortised.

CLO Lifecycle
Amount outstanding (€mm)
Deal non-call period ends End of re-investment Deal
Closing
priced ~18 months after pricing period called
400
Re-investment period ~4.5 years
Warehouse period ~3-6 months

Amortisation period ~5-6 years

300
Price-to-close ~4-6 weeks

200

100

Source: M&G Investments, September, 2024

As per the graphic above, CLOs are incorporated with portfolio throughout their investment period (typically
a portfolio Manager then being appointed together 4.5 years), before the amortisation phase is reached
with various other roles being assigned. An Arranger when the liabilities are naturally repaid as assets in the
provides a warehouse facility to finance the purchase portfolio repay, from the AAA tranche and downwards,
of up to €200m of assets (senior secured, floating rate according to the waterfall. At a point in this natural wind-
corporate loans), whilst the deal is being marketed to down, the deal is ‘called’ by the equity tranche (whereby
liability investors (a joint effort between the Manager the assets are sold, liabilities repaid and the structure
and Arranger). In this way, the vehicle is certain of collapsed). It is very rare for CLOs to reach their 13-year
having revenue-generating investments at the point legal maturity, not least because the cost of capital
of launching and pricing its liability notes. Depending increases as the cheaper notes are amortised first.
on market conditions, the warehouse phase varies
After a non-call period (12-18 months), the notes become
in length from a matter of weeks through to 24-36
callable at 100. At this point, the structure may be reset
months (average of ~six months). Upon Pricing of the
or amended (at the election of the majority equity
transaction’s note issues, investors are committed to the
holder) before the end of the reinvestment period is
deal. At that point, the manager sources the remaining
reached. This could be via refinancing all or some of the
€200m of assets to complete the pool. Four to six
notes at lower spreads, or alternatively the deal could
weeks later, the transaction Closes and funds, with all
be ‘reset’ (ie the non-call and reinvestment periods start
equity and note investors fully committing their cash
from day one again).
to the structure. The Manager will invest and trade the
Who invests in CLOs? Access to all tranches, including equity, can be gained
via the primary or secondary markets. However, large
The embedded protections and tranching of risk, result
and strategic allocations are typically sourced in
in a broad array of risk and reward opportunities that
primary. This is especially true for equity investments,
appeal to different investors. CLOs are a very efficient
for which controlling majority stakes are rarely offered
tool through which capital providers can be aligned
for sale and where investors reasonably expect to
with corporates needing to borrow, within a scalable,
do full due diligence of a manager’s philosophy, style
overseen and well-established framework. For this
and resources.
reason, the two-decade-old market has grown to
become a $1.2trn market with associated primary and For European CLOs, it is especially important to ensure
secondary trading infrastructure. the Manager has structured the deal to comply with EU
Risk Retention rules (simplistically requiring the Manager
As per the graphic below, at the lowest-risk, AAA notes
to invest 5% of capital in the structure). Without this
typically sit with major bank investors (including US,
(often burdensome and complex) structure in place,
European and Japanese institutions) pension scheme
liability investors based in Europe will typically be
and insurance companies or specialist funds (including
unable to purchase the notes, which will likely lead to
UCITs); whilst hedge funds, endowments, family offices
an elevated cost of capital.
and asset managers dominate investments in the higher-
yielding sub-IG notes and equity. Equity investments are generally accessed via three
main channels and are typically, but not always, buy
Bank Insurance Asset Pension Hedge and hold investments;
company Manager fund fund
1. Minority equity stakes (typically €2-10m) can be
AAA
accessed on a deal-by-deal basis, typically via
AA
Arranging Banks or secondary trading desks.
A
2. Majority equity in individual CLOs (>€20m)
BBB
are usually individually negotiated,
BB directly with the CLO Manager.
B
3. Investors looking to strategically allocate to
Equity CLO equity across a particular CLO Manager’s
vintages can also invest in Captive Equity
Funds, which are generally closed-ended
vehicles, raised directly by the CLO Manager.
These vehicles not only diversify exposure
across multiple vintages of CLOs, but usually
also come with added commercial advantages,
preferential allocations and professional GP
oversight to further enhance returns.

It is important to note that during the warehouse phase

Arranging Banks typically offer very attractive financing
costs and so the ‘arbitrage’ earned during this phase
can result in IRRs of c.20-40%. Early participation in
the warehouse phase, and its returns, usually comes via
participation as a majority equity buyer or in a Manager’s
captive equity fund.
Underlying collateral market
EUR CLO outstanding US CLO outstanding

Amount Outstanding (mm)

1200

European (€) & US (USD)

1000 CLO’s outstanding
• EUR CLO’s outstanding account
for €256bn of a c.€400bn
800 BSL market (c.65%)
• US CLO’s outstanding account
for $960bn of a c.$1.4trn
600
BSL market (c.65%)

400

200

0
Jan-12 Jan-14 Jan-16 Jan-18 Jan-20 Jan-22 Jan-24

Source: Citi Velocity, PitchbookCS LLI, CS WELLI, February 2024.

Past performance is not a guide to future performance.

Similar to the market for CLO notes, the market for the
underlying loans in which a CLO invests (‘collateral’)
is deep, long-standing and has an active secondary
market. The Global Broadly Syndicated Loan market
consists of more than $1.8trn in outstanding debt, of
which the European portion is c.€400bn. Therefore, bids
for approximately two-thirds of the loan market is driven
indirectly by the CLO buying-base. The predominantly
floating-rate, senior secured, corporate loans in
a CLO are issued by large, sub-investment-grade
companies, typically to help fund Private Equity The importance of a
buyouts. The leveraged nature of buyouts means that skilled manager
the loans carry sub-investment grade ratings (most
Given a secondary market exists for the underlying
commonly single-B). They are usually senior secured in a
collateral, the manager can regularly refresh the quality
company’s capital structure, ranking ahead of any bonds
of its loan portfolio and actively respond to macro or
in issue and equity. Furthermore, loans trade on an
credit-specific events. Manager skill in navigating the
active secondary market (albeit not via an exchange).
portfolio through an economic cycle, primarily to avoid
default loss, whilst remaining true to their philosophy
and style, is an important determinant of long-term
equity investor returns. A conservatively-selected
portfolio, into which additional buffer (or ‘par’) has
been built through profitable trading activity, will create
additional over-collateralisation and debt investor
protection (especially important to mezzanine and
junior investors) and contribute to the maintenance of
liability note credit ratings (important to senior investors).
Excess par ultimately also accrues – and can be
distributed to – equity investors.
The distribution of such gains usually occurs during Equity risk and returns
the first two payment dates and at subsequent ‘event’
moments, such as the final calling of the deal or an 16.5% average annualised cash-on-cash return
interim refinancing/reset of the structure, thereby Annualised cash-on-cash return (%)
further enhancing the front-ended nature of the 35
cashflows to equity.
30
It is important to note that, as distinct from pre-
25
Global Financial Crisis 1.0 structures, the 2.0 era
CLOs are deliberately designed with higher inherent 20

buffers, meaning that through-cycle assumptions for 15

default loss that encompass the most testing period
10
known to markets have been factored into rating
agency tolerances and accommodated within their 5
structural assumptions.
0
Jan-14 Jan-16 Jan-18 Jan-20 Jan-22 Jan-24
As part of these assumptions and to maintain the
Source: Bank of America, Intex, M&G, August 2024.
agency credit ratings of the notes, a number of strict,
Past performance is not a guide to future performance.
Eligibility Criteria (eg minimum size of obligor total
indebtedness, the presence of a minimum agency rating,
Historically delivering 16.5% average, annualised
etc) and Portfolio Profile Tests and minimum levels of
cash-on-cash returns, as per the above chart, a CLOs
structural enhancement, must be adhered to by CLO
equity return is principally a function of 1) the ‘arbitrage’;
Managers. These include:
2) default-loss avoidance; 3) the purchase price of the
● Credit quality tests assets and the prevailing prepayment or exit price and;
● Diversification tests 4) how well the special rights available to controlling
equity investors are exercised.
● Minimum spread tests
1. The running arbitrage (asset income – liability
● Maximum single issuer exposure limits funding costs and fees and expenses), can best
● Maximum CCC exposure limits be thought of as the bank-like principle of lending
money at a higher rate than that at which it is
● Over-collateralization (‘OC’) tests
it borrowed and garnering that excess spread.
● Interest coverage (‘IC’) tests And, prudently, assets and liability borrowing
terms are matched and locked in, meaning it is
● Interest diversion tests (‘IDTs’)
not possible to cause a ‘run’ on a CLO. Typically,
The results of these tests, along with detailed line-by- the excess spread of a CLO equates to around
line asset reporting, are disclosed to investors (via the 200bps, which is levered through the structure by
independent Trustee), each month. Failure to meet 10-12x, to form the main driver of equity returns.
certain test parameters will result in cash-flows being Distributing this excess spread to equity creates
diverted in accordance with a pre-defined waterfall a front-loaded cashflow profile (particularly
(cashflows from equity up are diverted to repay compared to other investments, such as Private
senior debt down), until the structure is brought back Equity). This cashflow can be further enhanced
into compliance. by ‘flushing’ any par gains (simplistically, trading
profits) to equity investors too. Minimising liability
costs is important in determining the size of the
arbitrage, which itself depends on investing with
a well-regarded Manager and having the deal
syndicated by a respected Arranging Bank.
2. Default loss avoidance is another key determinant 3. In most ‘normal’ market circumstances,
of long-term returns. Whilst the underlying assets performing loans typically trade close to par
are sub-Investment Grade (modest historical, and, given their floating rate and freely pre-
annual, market default rates being 2.8% ), their payable characteristics, it is rare for substantial
priority ranking as senior secured has resulted in sell-offs to be long-lived. The purchase price
historical recovery rates averaging 70-80%. Given of the underlying collateral is therefore usually
the first loss and levered nature of CLO equity not much more than a modest supplement to
investment, it is important to invest with a manager returns. However, in occasional periods of market
with a proven investment capability and low default- dislocation, buying significantly discounted loans
loss track record over the long-term. Managers can result in significant IRR enhancement. Such
with an ability dynamically to trade the portfolio are a scenario is known as a ‘Principal Only’ (PO)
also capable of repairing losses with trading gains return, and contrasts with the more common
excess spread driven ‘Interest Only’ (IO) IRR
profile. The running excess spread is typically low,
as liability costs are also likely to be high, but the
pull-to-par and subsequent sale of the portfolio
can potentially generate very attractive returns.

4. Equity investors are the foundation of all

CLOs, which brings with it influential rights
and responsibilities, the use of which impacts
the ultimate equity return. Typically, there will
be a majority (>51%) investor in the equity
tranche, whose voting rights will ultimately
carry a number of important decisions. Once
a warehouse has been opened, collateral
purchased and deal priced (the timing of
which majority equity investors typically have
significant influence over), the key decisions
are when to refinance, reset and call the deal.

After the ~18 month non-call period expires on the

liability notes the majority investor could chose to
refinance some, or all, of the liabilities, if current market
rates are cheaper that at the time of the original issue.
This would enhance the excess spread going forwards.
Resetting the deal goes a step further and not only
refinances the notes, but can also amend documentation
terms, reset the reinvestment period back to day one
and amend the capital structure. This is a powerful tool
to enhance the running spread and potentially re-lever
the structure to de-risk equity capital. The most absolute
and final lever majority equity can pull is to ‘call’ the deal,
at which point the assets are sold, liabilities are repaid
and the equity investor receives the residual proceeds.
The timing of the call can have a substantial impact of
returns and it is important professional oversight works
in collaboration with the CLO Manager to optimise the
realised value of the underlying assets.
Where does CLO equity fit CLO Equity Private Equity

in a portfolio? CLO portfolio is highly diversified PE fund is concentrated

CLO equity is genuinely a hybrid investment with a case Front-loaded returns are driven Back-ended returns are driven
by quarterly net payments by equity valuation expansion
to be made to sit alongside; fixed income investments of interest on senior loans and realisation via sale/exit of
(excess cashflows paid as a quarterly coupon on a in underlying portfolio plus a company
total return enhancement of
subordinated debt note); private equity (first loss in that portfolio that is flushed
the capital structure and beneficiary of capital upside); to equity at various points
(overcollateralization)
or other alternative strategies (diversifying, term-
Loans in CLO portfolio are liquid PE investments are illiquid
levered investment in underlying senior secured loans).
and can be sold into active and require favourable market
Given the buyer base for CLO equity being broad secondary market, permitting conditions to permit realisation
across investor type (eg asset managers, endowments, portfolio repositioning in of value via exit
response to market conditions
pension funds, family offices, etc), but currently lacks
Term, non M2M leverage of the Inherent leverage of investee
depth in any one pocket, portfolio placement is varied portfolio magnifies returns (and company magnifies returns
and idiosyncratic. Increasingly however, we observe potential loss) for CLO equity- for private equity-holder. Use
holder of NAV financing can increase
that CLO equity is being thought of by investors as a
investor risk and reduce IRRs
compliment to Private Equity allocations. This is notably
Management fees are clear Fees are higher, multi-layered
driven by several years of suppressed M&A activity, and simple and opaque
which has lengthened PE holding periods and left a
gap in investor portfolios for a high returning, but cash
generative, smoothing investment. M&G’s history in the Loan Market
Over the long-term the returns of both CLO and Private M&G Leveraged Finance Assets Under Management *
Equity have ended up in a similar (mid-teens) place, but
Internal funds Segregated mandates Article 8 Funds
have taken two very separate, potentially complimentary, Pooled Funds CLOs/CDOs
paths to get there. CLO equity returns are very much (€m)
front-loaded, with cash returned to de-risk investors in
10,000
the early years of the investment. In contrast, Private
Equity returns typically follow a ‘J-curve’, with investor 8000
capital and investment return delivered towards the
end of the investment, without much in the way of 6000

ongoing cash returns. A summary of the similarities

4000
and differences with Private Equity are shown in the
table below;
2000

0
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024

Source: M&G Investments, January 2024

* as at January 2024

M&G was one of the first institutional investors to enter

the Bank Loan Market all the way back in 1999, which
combined with c.€8bn AUM today, makes M&G one
of the largest and most established participants in the
market. We have a large team dedicated to the product,
including three Fund Managers, an Assistant Fund
Manager, CLO Structurer, secondary market Dealer and
13 Credit Analysts. Our extensive relationships enable us
to actively manage portfolios with strong access to both
primary and secondary markets, which has resulted in
a strong risk adjusted returns with low default loss over
the long-term.
“ To borrow a phrase from The value of investments will fluctuate, which will
cause prices to fall as well as rise and you may not
Howard Marks, CLO get back the original amount you invested. The views

Equity can be described expressed in this document should not be taken as a

recommendation, advice or forecast. Past performance
as an “uncomfortably is not a guide to future performance.

idiosyncratic” investment.
It is certainly not suitable
for all investors. However,
in part because of that,
it can provide a relatively
untapped and attractive
source of value and
diversification, for those
willing and able to do the “
work and bear the risk.
Thomas Lane, Fund Manager

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