I have been trying to wrap my arms around the Equity Tranche in the CDOs. I understand the part that equity tranche gets whatever is leftover after paying senior tranches as it is first in the line while abosorbing losees etc. What I am looking for is actual illustration with the numbers. For example, let’s say there is a $1Billion CDO with $50Million Equity trache. What I am looking for is how do investors recoup of this original $50Million investment? Assume life of CDO is 10years, let’s even assume there are no defaults whatsoever over the 10years. In that case what “leftover” cash / hurdle rate investors will be looking over 10years? I have read some places that typical hurdle rates are 13% -15% but seems low to me. Because back of the paper analysis tells me investors in this tranche will get paid only 15%*10 years = 150% over the life of the CLO in the form of the returns. I guess my question is do investors get paid that original $50Million back? Is there a balloon at the end of the 10th year or how does that work? Please advise.
equity trance holders get paid all residual until a hurdle rate is reach. usally the hurdle rate is 12% irr. you can google XIRR and thats how they calculate how much the hurdle is. after the hurlde rate is reached, the residaul is split between collateral manager and equit holders (usually 20-25% former and 75-80% for the latter)
CDO equity is very simply just non-recourse levered borrowing. Let’s say I invest 50mm, and I borrow 950mm at say 5% and then I buy 1bn in assets earning 6%. In 5 years let’s say all 1bn of assets pay off. At that time, I pay off my 950mm in borrowing and get 50mm back myself.
Over five years, I’ve invested 50mm and gotten 50mm back (0% yield) and earned 6% on 1bn while paying 5% on 950mm. That’s a return of 20% p.a. (1% excess spread x 20x leverage).
If the 1bn in assets suffers losses, I take the hit first. So if in 5 years the assets pay back 970mm, I lose 30mm of my 50mm investment, since I have to pay back the 950mm in borrowing first.