Have you ever shopped for a new car and suddenly started noticing that exact car everywhere? It’s a well-documented phenomenon: our brains are wired to direct our limited attention selectively.
Well, CLOs are like that for me lately (no, I’m not shopping one, thanks for asking).
Last fall, when First Brands filed for bankruptcy, I wrote about CLO mechanics (the fun stuff: the tranching, the waterfall, the difference between BSL and middle-market collateral).
If you missed that piece, start here:
Today’s piece is the companion. We’ll tackle a different question: why they work (and where they don’t).
‼️ CLOs, CDOs (collateralized debt obligations), CFOs (collateralized fund obligations) and a slew of other structured financial products are all the same species. No, they are not the same (think chihuahua vs. German shepherd: you won’t mistake one for another, but they are both dogs). Once you understand the mechanics, you'll be able to grasp newfangled wonders of finance, like the recent Apollo equity structuring (stay tuned, more on this in a separate post). And maybe you’ll start seeing them everywhere too…
TL;DR:
The global CLO market has doubled in a decade and now exceeds $1.3 trillion.
AAA-rated CLO tranches have a perfect loss record: zero principal losses since the early 1990s. Every pitch deck highlights this statistic. But that number is of limited relevance to you, unless you are an insurance company.
Why? Because most retail-facing vehicles aren’t buying AAA. They’re buying equity and junior mezzanine tranches, either directly through dedicated CLO funds or indirectly through private vehicles buried inside middle-market lending funds.
📚 In the interest of keeping you awake, this article is fairly high-level. If you suffer from insomnia (or are dying to learn more about OC ratios for mezzanine tranches) I’ve included further reading at the end. Let’s get into it..
A Very Quick CLO Refresher
A typical broadly syndicated loan CLO issues six to seven rated debt tranches plus unrated equity. The AAA tranche (the largest slice, up to ~64% of the deal) gets paid first and benefits from substantial subordination beneath it.
That subordination means more than a third of the underlying loan portfolio would need to default with zero recovery before the AAA tranche loses a dollar.
Now look at the bottom of the stack (the dark blue equity slice in the chart above). The equity tranche has no guaranteed return. It collects whatever cash is left after every debt tranche above it has been paid (and after management fees, trustee expenses, etc).
In good years, that residual can deliver 15–25% cash-on-cash distributions. In bad years, overcollateralization tests fail, the waterfall redirects cash upward to senior debt tranches, and equity distributions stop entirely.
The median unlevered IRR for CLO equity vintages from 2003 through 2023 is approximately 11%. But median numbers only tell part of the story: deals priced at wide loan spreads (2008–2009, 2020) significantly outperformed, while tight-spread vintages (2014, 2021) delivered lower returns.
We’ve published case studies on several funds that hold CLO debt and equity on the books:
One important caveat: everything above describes broadly syndicated loan (BSL) CLOs. Private credit CLOs (sometimes called middle-market CLOs) are a slightly different animal. The underlying loans are to smaller, often unrated borrowers, with less liquidity, less transparency, and historically higher default rates.
To compensate, private credit CLOs are built with thicker cushions at the bottom: the AAA tranche is a smaller share of the deal, and the equity and junior mezzanine slices are proportionally larger. Spreads are roughly 200 bps wider than BSL equivalents. More on that here.
What Protects Senior Tranches
So how do you take a pool of below-investment-grade loans and turn them into AAA-rated securities?