Many CDO noteholders tend to look at the equity portion of a CDO solely as a part of their subordination, rather than as an independent investment in its own right. However, with spreads on the underlying collateral quite wide (on a historical basis) and new deal activity constrained by lack of an equity bid - timing is good for investors to start thinking about buying equity in CDO tranches.
The most common way to evaluate equity on deals is via the internal rate of return (IRR), under different default and recovery scenarios. For example, in a sample CDO (in this case Duke Funding I, which closed in November 2000) at 0.3% CDR/annum (CDR = constant default rate) and 30% recovery, the equity cash flows have an IRR of 19.01%. At 1.0% defaults they yield 6.24%. In this deal, the equity cash flows have an IRR of 0% only if annual default rates rise to between 1.2% and 1.3%; higher default rates will generate negative IRRs.