CLO (Collateralized Loan Obligation) investors may have recovery avenues for their losses. These complex investments are only suitable for the most sophisticated investors willing to assume the high risk of these investments. Investors who are less sophisticated or who seek only investments or looking for only moderate risk investments cannot legally be sold these investments. For a consultation, please call 1-866-817-0201.
The financial industry is governed by rules concerning whether certain investments can be sold to investors. One such limitation is that securities broker, financial advisors and investment advisors may only sell investments that are suitable, or investments that are consistent with an investors level of sophistication, investment objectives and tolerance for risk. Complex investments that carry a high risk potential are unsuitable for your average investor looking for growth or income with a tolerance for moderate risk.
As identified by FINRA, the Financial Industry Regulatory Authority, a CLO is very complex and risky investment. A CLO is a security made up of loans to corporations that usually have relatively lower credit ratings. Leveraged buyouts, in which a private equity firm typically borrows money to purchase a controlling stake in a company, are a common for CLO loans. After the loans are made, they’re sold off to a manager, who bundles them together and then manages the consolidations, buying and selling loans as he or she sees fit.
A CLO manager raises money to buy the loans by selling debt and equity stakes to outside investors in slices of the total collection according to risk level.
FINRA gives an example to demonstrate how tranches work. Think of everyone who owns a piece of the loan pool as standing in a long line. Those at the front of the line would get repaid first if any of the loans in the pool go into default, but they receive lower interest payments than those at the back of the line. The people further back are paid more for taking a greater risk that they would not be repaid in the event of losses in the underlying loan pool.
Typically, a CLO includes both debt tranches and equity tranches. The debt tranches are similar to bonds – they have credit ratings and offer regular coupon payments for a period of several years. Interest rates may be set or “floating,” meaning they vary with prevailing interest rates.
Debt tranches have first dibs on payments from the underlying loans, though here again, there are important differences within the group. Senior tranches have a higher-priority claim to payments (and receive lower interest payments) than junior tranches (which receive higher interest payments).
Equity tranches are the riskiest piece of the CLO puzzle. They have no credit ratings, are last in line for payment, and thus are the first to suffer losses if the underlying loan portfolio falters. Though equity tranche investors are simply paid whatever cash is left over after the debt investors have received their interest payments, they typically earn a higher return than debt tranche investors do.
FINRA is not alone. The Wall Street Journal has also identified these investments as risky and complex. The Journal points out that the race to provide higher returns has led to an even greater sales of such investments, and that such investments hit a record in 2017.
Unless you are a very sophisticated investor willing to speculate the money invested in CLOs, you should seek legal representation for losses sustained.