Captive equity fuels CLO growth

IN the US$1.3 trillion market for collateralised loan obligations (CLOs) – where money managers sell bonds to finance buying pools of buyout loans – ugly math used to kill a deal.

Less so now.

Money managers are increasingly raising special funds known as captive equity: pools of capital they control that buy any and all CLO equity a firm might sell.

By becoming their own guaranteed buyer of the deal’s riskiest portion, managers can quickly launch CLOs without needing to prove immediate profitability to the broader market – a hurdle that could have swiftly torpedoed an offering.

That helps them take advantage of volatility, like the current artificial intelligence-driven loan selloff.

This shift has allowed CLO issuance to hit record levels, but many argue it has also muted some investor profits and diminished loan market discipline without external equity buyers pressuring CLO managers to scrutinise loan documents for loose provisions that could hurt recoveries in a default. 

“Captive equity can help grow the market and bring in more capital, but it weakens that external check,” says Ben Rockmuller, a senior portfolio manager at Curasset Capital Management, which invests in CLOs.

Over time, that can leave loan portfolios exposed to aggressive debt manoeuvres and lower credit quality, he says.

Because fund managers can use captive funds to create CLOs even when potential loan returns are relatively weak, they’re driving up demand for that debt.

That’s happening at a time when leveraged buyout activity has been lagging, cutting into new loan supply.

With more CLO managers chasing fewer loans, returns on that debt are shrinking, and the critical CLO arbitrage – the gap between what the vehicle earns on its loans and what it pays out to bondholders – is struggling to recover.

Beyond sluggish returns, these vehicles could also skew incentives, critics argue.

Managers earn fees based on the volume of deals they oversee, not just CLO performance, which compels them to create deals to expand assets under management (AUM). 

Managers reject this criticism. 

“We want the clients to continuously come back to us – it’s alternative credit investment,” says Himani Trivedi, head of structured credit at Nuveen Asset Management. “It’s not for AUM growth or anything.”

For managers, captive funds ensure they have plenty of CLOs already in place to buy up loans when markets get turbulent – a situation that also happened around 2023 that ultimately delivered strong returns for managers that created CLOs that year.

Third-party equity investors, who have to do their own calculations, may not be able to move so fast which risks missing the opportunity, according to Trivedi.

“Within that period of time, the opportunity is gone,” she says. “Captive funds essentially took that out of the equation and tried to create these funds that can approach the pockets much more nimbly and really think about a longer-term perspective.”

Her firm transitioned from using 100% third-party equity for its CLOs before 2020 to now launching all of them with captive funds, she says.

Several CLO managers that launched deals with captive equity recently include Oak Hill Advisors and GoldenTree Asset Management, according to people familiar with the matter who asked not to be identified discussing private information.

Blue Owl Capital Inc has also done so, another person says. 

Representatives for Blue Owl, Oak Hill and GoldenTree declined to comment.

‘Cowboy’ assets

For institutional investors, captive funds offer a way to access CLO equity without needing expertise in the complex asset class, as well as the prospect of quick cash distributions.

“CLO equity has traditionally been seen as a cowboy asset class, but now with captives it’s been turned into a more formal and more widely available product for investors like pension funds and sovereign wealth funds,” Tracy Chen, a portfolio manager at Brandywine Global Investment Management, says.

While exact numbers on the vehicles are limited, Fitch Ratings’ data on hundreds of CLOs shows that the share of deals where managers retained half or more of the equity was about 70% in 2024, compared with 17% in 2012.

Some of the biggest CLO managers to launch the vehicles include Carlyle Group Inc and CVC Credit Partners. 

Although volatility from the software loan selloff could soon pry open more profits, the arbitrage has languished near multi-year lows for over a year, according to data from Citigroup Inc.

Some traditional investors say captive funds are partially to blame because they’re distorting the market’s natural mechanics. 

“The CLO market was used to a feedback loop that supported third-party equity returns,” says Liza Crawford, a portfolio manager at TCW Group.

But captives are “disrupting the traditional feedback loop – resulting in loans staying tight and equity getting squeezed.”  

‘Substantial majority’

CLOs are the biggest buyers of US leveraged loans, so steady issuance enables companies to obtain new loans or refinance debt – which helps them expand.

But deals printing at sub-optimal projected returns can harm profitability across the market, according to Shiloh Bates, the chief investment officer at Flat Rock Global.

“While captive equity funds are attractive businesses for CLO managers and bankers, their proliferation has weighed on returns for CLO equity investors more broadly,” Bates says, noting that captive funds purchased the “substantial majority” of the equity in CLOs created last year.

CLO equity holders wield near-veto power over deals because their capital acts like the final green light to launch a new vehicle. This leverage allows them to negotiate lower management fees and maintain the right to remove the deal’s manager for poor performance.

External equity investors are more inclined to “call” deals with souring loans, because, unlike managers, they’re paid purely based on performance. 

“If you’re controlling your own destiny and you can control when you reset, when you refinance, and when you call a deal, that’s super important to the ultimate return profile,” says Matt Bloomfield, a portfolio manager for Palmer Square’s US CLO management platform. — Bloomberg