How does the CLO equity tranche actually make money?

Question

AcadiFi · Accepted Answer

CLO equity earns the arbitrage spread between the weighted average interest earned on the loan pool and the weighted average cost of the CLO debt tranches, plus manager skill on reinvestment, minus defaults and fees.

Simplified math for a $500M CLO:

- Loan pool yield: SOFR + 400 bp on $500M
- Weighted average cost of debt tranches: SOFR + 180 bp on $435M
- Equity tranche: $65M

Annual arbitrage:
- Pool interest: 5.3% + 4.00% = 9.3% on $500M = $46.5M
- Debt interest: 5.3% + 1.80% = 7.10% on $435M = $30.9M
- Gross spread to equity: $15.6M on $65M equity = 24% gross yield

From this, subtract:
- Expected annual defaults × loss given default: 2% × 40% × $500M = $4M
- Manager fees: 40 bp on $500M = $2M
- Senior fees: $0.5M

Net equity distribution: approximately $9.1M, or 14% cash-on-cash yield.

Add: reinvestment returns (buying loans at discounts during stress) can lift IRR by 200-400 bp in a vintage that sees mid-cycle volatility.

Historical CLO equity IRRs by vintage (post-2010): 12-16% median, with top-quartile managers delivering 18-22%. Pre-crisis vintages (2005-2007) experienced 8-10% IRRs due to default shocks.

Risks: O/C test failures divert cash flow to senior tranches, starving equity for quarters or years. Defaults clustering in one vintage can crush returns.

How does the CLO equity tranche actually make money?

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