CLO equity: Where does it fit in investor allocations?

2023

CLO equity: Where does it t

in investor allocations?

HIGHLIGHTS

• Classifying CLO equity – xed income, equity

or something else entirely

• Allocating CLO equity to investment portfolios

by investor type, objectives and risk tolerance

CLO equity has garnered increasing levels of

investor interest, primarily due to the potential

for high returns driven by a robust yield prole.

Many investors view CLO equity as one of

the few remaining pockets of ineciency in

the nancial markets, since many otherwise-

sophisticated investors shun the asset class

due to perceived complexity, opacity, and

(erroneous) connections with the toxic CDOs

that became synonymous with the 2008 global

nancial crisis.

For investors able to move past these biases

and consider CLO equity as a viable investment

alternative, the next question is often: how

should CLO equity be classied? Is it a xed

income instrument? An equity investment, as

the name suggests? Or something else entirely?

Choosing the right “bucket” for CLO equity

is critical for investors seeking to optimize

portfolio allocations.

CLO EQUITY SITS AT THE

INTERSECTION OF AT LEAST THREE

KEY ASSET GROUPINGS

1. Fixed income: Since CLOs eectively

bundle together corporate loans into

diversied portfolios, they are closely linked

with the ups and downs of the leveraged

nance market, which is a subset of the

broader xed income space. CLO equity

also pays regular quarterly distributions

to investors, generating a yield-based

return prole similar to other xed

income instruments.

2. Equity: Although they are ultimately

composed of debt instruments, CLOs are

also securitization vehicles with their own

Choosing the right “bucket” for CLO equity

is critical for investors seeking to optimize

portfolio allocations.

OPINION PIECE. PLEASE SEE IMPORTANT DISCLOSURES IN THE ENDNOTES.

CLO equity: Where does it t in investor allocations?

What is a CLO?

Collateralized loan obligations (CLO) are highly diversied, actively managed portfolios of

rst lien, senior secured loans with non-recourse, non-mark-to-market (MTM) leverage.

• A CLO borrows money (liabilities), it invests in collateral (bank loan assets) and has residual

value (equity).

• CLO equity investors prot from any gains on the CLO’s loan positions as well as from the cash

ow arbitrage, generated by the dierence between the yield on the collateral (loans) and cost of

nancing for the liabilities.

CLO liabilities & equity

AAA-rated notes:

63% of structure

AA-rated notes: 12%

A-rated notes: 6%

BBB-rated notes: 5%

BB-rated notes: 4%

CLO equity: 10%

CLO loan assets

Actively

managed

portfolio of

senior loans

1 Some broadly syndicated loan CLOs may include up to 10% second lien senior secured loans. CLOs have credit event triggers that may have MTM impacts.

2 Illustrative CLO structure.

Principal &

interest

Cash flows

Typical companies

held in a CLO portfolio

Source: Nuveen

capital structures consisting of rated debt

tranches all the way down to unrated equity.

Risk levels increase with every step down in

the capital structure, and when investor risk

appetite decreases, CLO equity valuations

often move in tandem with broader equity

markets. However, the underlying risk in

a CLO consists of senior secured loans to

corporations, eectively limiting downside

risk relative to “pure” equity markets

exposure. The quarterly distributions paid by

CLO equity tranches also serve to stabilize the

return prole relative to equities.

3. Alternatives: Alternatives are a “broad

brush” category which can refer to everything

from private equity funds to distressed debt to

opportunistic credit. CLO equity often falls into

this classication due to illiquidity, complexity

or other shared features with the universe of

alternative investment options.

OPINION PIECE. PLEASE SEE IMPORTANT DISCLOSURES IN THE ENDNOTES.

CLO equity: Where does it t in investor allocations?

WHICH CLASSIFICATION IS

APPROPRIATE?

As a manager of CLOs since the early days of

the market, Nuveen has gathered input from

a wide universe of CLO equity investors, and

the answer is: it depends. The answer varies

based on investor type, portfolio objectives and

risk tolerance.

Option one: Idiosyncratic or

opportunistic credit

Many sophisticated institutional investors,

such as larger-scale ($10B+) pension investors,

consider CLO equity as an “idiosyncratic” credit

allocation, similar to specialty nance, distressed

investments, or esoteric ABS. This is motivated

by a number of factors.

Similar to other non-traditional credit betas,

CLO equity combines foundational credit

characteristics with other idiosyncratic factors

not typically found in “mainstream” asset classes.

In particular, CLO equity eectively contains an

embedded call option on credit spreads, driven

by the term nancing structure of CLO vehicles.

Although it may sound counter-intuitive, a CLO

equity investor can potentially benet from

periods of widening credit spreads — provided

they are invested with a CLO manager skilled

enough to minimize losses due to defaults. This

is because CLOs are actively managed vehicles

which can reinvest into new, higher-yielding

bank loans when spreads widen.

CLO equity investors can benet from an

improved arbitrage given that the liabilities

issued by a CLO (the CLO debt), is issued at

coupons which stay xed for the ~12-year life

of the CLO. The most powerful proof statement

of this phenomenon is the returns of CLOs

issued immediately prior to the GFC, which far

outstripped all other vintages of CLOs.

Option two: The alternatives bucket

Another popular destination for CLO equity is in

the alternatives bucket alongside private equity

vehicles, such as LBO funds, private capital

vehicles or venture capital funds. This tends

to be the favored approach with many family

oce investors as well as public pensions, for a

number of reasons.

Where does CLO equity t in a portfolio?

In June 2021, Nuveen hosted a discussion

with members of the institutional investor and

consultant communities exploring the role of

CLO equity in broader investment portfolios,

among other topics. During this discussion,

we held an informal survey asking participants

where they would consider allocating CLO

equity within their portfolios. Below is a

breakdown of the responses on this topic.

Survey was conducted informally and offered to internal Nuveen personnel as well

as non-Nuveen attendees on a fully anonymous basis on 29 Jun 2021. Due to the

survey’s informal nature and small sample size, no specic conclusions can be

drawn from the results and no representation is made as to the applicability of

these results.

Opportunistic credit 79%

Broad alternatives 14%

Fixed income 7%

Median equity IRRs of fully realized U.S. CLOs (%)

1.0 Med20132012201120072006200520042003

5.9

11.7

16.3

20.3

21.2

19.2

12.8

7.5

14.4

Data sources: Bank of America Global Research and Intex as of 11 Feb 2023. Past performance does

not guarantee future results.

OPINION PIECE. PLEASE SEE IMPORTANT DISCLOSURES IN THE ENDNOTES.

CLO equity: Where does it t in investor allocations?

Firstly, these investors tend to view CLO equity

as a longer-term investment similar to traditional

private equity funds which have 5+ year return

horizons. CLO equity also tends to be considered

an illiquid investment similar to a closed-end

private fund. In addition, CLO equity typically

targets a mid-teens return prole similar to

alternative asset classes such as private equity –

checking another box in this classication

matrix. However, the return prole of CLO equity

diers from that of traditional private equity

investments due to its lack of J-curve. CLO

equity returns are driven by quarterly cashows

beginning shortly after inception, unlike private

equity funds, which can take multiple years to

begin returning capital to investors. From this

perspective, CLO equity can provide an attractive

pairing for these longer-dated investments, front-

loading cashows and serving to smooth out the

overall return prole of the broader alternatives

bucket. This is of particular importance to

pension-based investors who seek a consistent

stream of cashow-based returns in order to

meet the needs of their plan constituents.

Some investors allocating CLO equity to the PE

bucket point to an additional rationale, since

many of the debt instruments held by a CLO are

eectively loans to PE-backed companies. From

this perspective, it can be argued that the equity

tranche of a CLO eectively recreates the equity

exposure held by private equity funds, since they

are both eectively leveraged investments in

corporations. However, unlike the concentrated

portfolios of PE fund vehicles, CLOs are built

around diversied portfolios of anywhere

from 150 to 200+ underlying positions. Many

investors view this as an important source

of diversication in alternatives buckets,

particularly in investment programs seeking

to limit manager count or to reduce manager

concentration risk. As an added benet, the

underlying portfolios of CLOs consist of

relatively liquid bank loans which can be actively

managed, unlike traditional PE funds. Managers

have the exibility to reposition exposures based

on changing markets and risk appetites.

Option three: The xed income bucket

For other investors, CLO equity sits within

the xed income bucket, sometimes alongside

bank loans and high yield bonds or within a

securitized sub-allocation. This is often the

preferred approach of insurance-based investors,

particularly those entities that purchase CLO

equity directly rather than taking exposure via

commingled private fund vehicles. Insurance

entities, particularly reinsurance investors,

may also gain exposure to CLO equity via

non-payment insurance arrangements,

eectively insuring the risk of loss for a funding

counterparty in exchange for the return upside.

Investors who classify CLO equity within a

xed income allocation are often motivated by

longer-term objectives which are aligned with

the broader xed income universe, particularly

the theme of consistent income. And since CLO

equity is essentially a oating rate instrument

(given the oating rate nature of underlying CLO

portfolios), it can also serve to reduce overall

duration risk in a xed income portfolio – an

added benet for investors concerned about the

longer-term risk of rising rates.

CONCLUSION

Our intentions for the future shape

our decisions in the present; an

investor’s allocation decision with respect

to CLO equity is ultimately underpinned

by broader investment objectives. Since

CLO equity can bring multiple benets to

a diversied portfolio, investors are often

driven by a variety of objectives which in

turn lead to multiple allocation options.

For this reason, we nd that there are many

potential homes for CLO equity within

investor portfolios, underscoring the multi-

faceted nature of this enigmatic asset class.

OPINION PIECE. PLEASE SEE IMPORTANT DISCLOSURES IN THE ENDNOTES.

GWP-2793709PR-E0223P 533223

For more information, please visit us at nuveen.com.

Endnotes

This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not

provided in a duciary capacity. The information provided does not take into account the specic objectives or circumstances of any particular investor, or suggest any specic

course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her nancial professionals. The views

and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous

factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-

looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed

or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented

herein by way of example. Past performance is no guarantee of future results.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy,

reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

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are registered trademarks owned by CFA Institute.

A word on risk

All investments carry a certain degree of risk, including loss of principal, and there is no assurance that an investment will provide positive performance over any period of

time. Any investment in collateralized loan obligations or other structured vehicles involves signicant risks not associated with more conventional investment alternatives. The

portfolios described herein are dynamic and may change over time. Use of the investment process tools and techniques described herein is no guarantee of investment success

or positive performance.

This information does not constitute investment research as dened under MiFID.

Nuveen Asset Management, LLC is a registered investment adviser and an afliate of Nuveen, LLC.