Captive CLO Equity Funds
One structural challenge for CLO equity investors in the years ahead is the growing prevalence of captive CLO equity funds, which purchased a substantial majority of the equity in CLOs created last year.
A third party CLO investor is not tied to deals from one CLO manager. Rather, they seek attractive risk-adjusted returns across an investible universe of a broad universe of CLOs managed by numerous managers. That could include new issue CLOs, secondary market CLOs, mezzanine debt, and warehouse positions.
By contrast, captive CLO equity funds typically invest exclusively in the next several deals of a single CLO manager. A captive fund participating in four new CLOs would represent a small fraction of the broader CLO market and would be concentrated in transactions managed by a single CLO manager. A public-equity analogue would be a fund that invests only in the next few IPOs underwritten by a single investment bank, irrespective of valuation or business model.
Certain newly issued CLOs in 2025 featured projected equity returns that were materially lower than those available through comparable secondary-market investments. Importantly, CLO managers earn management fees when new CLOs are created, regardless of the projected returns to equity investors. In our view, this structure may create potential incentive misalignment between CLO managers and captive equity fund investors.
The impact of captive equity issuance extends beyond individual CLOs. By supporting CLO formation at suboptimal projected equity returns, we believe that captive funds increase demand for leveraged loans, contributing to tighter loan spreads. At the same time, elevated CLO issuance places upward pressure on CLO financing costs. The combination reduces CLO equity profitability across the market. While captive equity funds are attractive businesses for CLO managers and bankers, their proliferation has weighed on returns for CLO equity investors more broadly.
Captive CLO equity funds are often marketed on the basis of access to a scarce asset — namely, the manager’s own CLOs — and the promise of lower fees. In my experience, truly constrained access to primary CLO equity opportunities is rare. CLO management is fundamentally an assets-under-management business, and broadly syndicated CLO managers typically find ways to accommodate new capital when economic incentives align.
The lower fee argument also warrants scrutiny. While captive funds may advertise discounted CLO management fees, such fees have long been heavily negotiated across the industry, and the broader trend has been downward. It is true that captive equity fund investors avoid the incremental fund-level expenses charged by third-party CLO equity investors. However, those savings come at the cost of limited investable universe and reduced portfolio diversification.
Two questions investors may wish to ask captive CLO equity fund managers are:
- Would the CLO equity recently issued have been attractive to non-captive CLO equity investors?
- If the portfolio were marked-to-market using recent secondary-market trades, what would be the fund’s current fair value?
The word ‘captive’ is defined by the Meriam Webster dictionary as something or someone taken prisoner. In the case of captive equity funds, it’s not clear if the prisoner is the Fund’s investors or the entire CLO market.
Shiloh Bates
CIO, Flat Rock Global
This commentary reflects the views of Flat Rock Global as of the date indicated and is subject to change. The information provided is for informational purposes only and does not constitute investment advice of an offer to buy or sell any security. Past performance is not indicative of future results. Investments in CLO equity involve significant risks, including market risk, credit risk, structural risk, and potential loss of principal.
