Introduction of Collateralized Fund Obligations (CFOs)

Today, many people are familiar with Mortgage-Backed Securities (MBS) and their significant role in the financial crisis of 2008. However, fewer are acquainted with their private market counterpart, known as "Collateralized Fund Obligations" (CFO). Unlike MBS, CFOs do not replicate the exact structure but incorporate elements such as Net Asset Value (NAV) facilities, which introduce additional layers of complexity.

Historically, whenever financial products become excessively complex, the risk of potential disaster escalates. In the case of CFOs, it remains uncertain whether they will prove to be a successful innovation in financial intermediation or face challenges leading to widespread failure.

Motivation Behind the CFOs:

Early Payback to LP & GP

Limited Partners (LPs) in private credit are often characterized as long-term investors, committing their capital for 8-12 years with the expectation of returns. However, delays in distributions are common, leading to extended holding periods for invested capital. CFOs play a crucial role in bridging this gap by distributing proceeds generated from various notes issued within the CFO structure.

In addition to providing liquidity, CFOs enable General Partners (GPs) to retrieve a substantial portion of their initial investments early on while maintaining control over the underlying private equity funds. This feature enhances the flexibility and financial management capabilities of GPs, contributing to the attractiveness of CFOs as a structured financial vehicle in private markets.

Regulatory Arbitrage

Institutional investors, including pension funds and insurance companies, are subject to statutory Risk Weighted Asset (RWA) compliance requirements when investing directly in private equity (PE) firms. These requirements aim to ensure capital adequacy and manage risk exposures effectively.

Investing in notes or bonds issued by rated CFO offers institutional investors a regulatory advantage. According to current laws, these investments typically carry lower RWA compared to direct equity investments in PE firms. By opting for rated CFO securities, institutional investors can achieve exposure to PE assets while potentially reducing their overall RWA burden. This approach not only supports portfolio diversification but also aligns with regulatory compliance frameworks designed to optimize capital efficiency and risk management within financial institutions.

U.S. Net Risk Retention Rule Relaxation

U.S. risk retention rules typically require sponsors to retain at least 5% of the securitized assets in certain financial products. However, these rules apply specifically to "asset-backed securities," defined as securities backed by "self-liquidating" financial assets. This means the assets should convert to cash within a set period, as is the case with loans, mortgages, or receivables, where regular payments gradually convert the asset to cash.

CFOs, however, are primarily backed by Limited Partnership (LP) interests in private funds. These interests do not typically convert to cash in a predictable, finite timeframe and are not considered "self-liquidating" in the same way as a loan or mortgage. Due to this crucial difference, many CFO sponsors argue that their products do not fit the definition of "asset-backed securities" under these rules. As a result, they believe that U.S. risk retention requirements do not apply to their CFO transactions.

In the rest of this article, we will review the structure of CFOs, the roles and interests of different stakeholders, and the risks and potential benefits of this structure.

CFO Structure

Sponsor

Most CFOs are sponsored by a consortium of private equity managers who pool limited partner interests from various funds into the newly formed Asset Holding Company (HoldCo). In some instances, a portion of general partner interests may also be transferred. Early payments from CFO structures enable sponsors to enhance the internal rate of return (IRR) of their funds or provide liquidity for reinvestment purposes. CFOs can also serve to mitigate exposure to sectors that sponsors wish to reduce their holdings in.

Sponsors have the flexibility to transfer interests from various asset classes to HoldCo, including venture capital funds, real estate funds, hedge funds, CLO equity, broadly syndicated loans, and ABS funds.

This strategic use of CFOs allows sponsors to optimize their portfolio management strategies, improve liquidity management, and potentially enhance overall fund performance through efficient capital deployment and sector diversification.

CFO Issuer

The CFO issuer is a special purpose company established solely to issue notes or bonds. In addition to issuing these securities, the issuer owns the HoldCo, which in turn holds various fund investments.

Typically, the issuer does not hold substantial assets beyond its equity in the Asset-Owning Company, loans extended to the HoldCo, funds in its bank accounts, and other permissible investments. This streamlined asset structure helps to isolate the risks associated with the CFO's operations and investments, ensuring clarity and separation from other financial activities.

This setup allows the CFO to efficiently raise capital through the issuance of bonds while ensuring that its operations remain focused on managing the assets held by the HoldCo.

Asset Holding Company (HoldCo)

In a Collateralized Financial Obligation (CFO), the issuer is typically a bankruptcy-remote entity that acquires various private LP & GP interests. These assets are financed by issuing different tranches of rated notes, along with an equity tranche. The private interests may be owned by a sponsor or an alternative platform and transferred to the CFO to gain liquidity, or they may be acquired using the proceeds from the CFO's issuance.

All the financial assets, whether sponsor-owned or third-party purchased, are transferred to a HoldCo in a Collateralized Financial Obligation (CFO) structure. While the assets of the HoldCo are not pledged as security, the equity interests in the HoldCo are pledged to secure the repayment of the CFO's notes and obligations. Additionally, the HoldCo may also guarantee the obligations issued by the CFO.

This arrangement allows for the securitization of assets without directly pledging them as security, leveraging the equity interests in HoldCo to provide security for investors in the CFO. It provides a structured approach to financing and liquidity management while maintaining flexibility in asset ownership and management.

Management Firms

In the structure of a CFO and its associated HoldCo, management firms are appointed with key responsibilities. These firms oversee the management of funds and collateral, ensuring the smooth operation of the CFO. They play a pivotal role in several critical tasks:

They approve Capital Calls, ensuring timely payment by investors as per the CFO's strategy. They provide crucial compliance support to the Issuer (CFO) and the Asset-Owning Company (HoldCo), ensuring adherence to regulatory requirements. They manage the distribution of cash received from underlying PE funds according to the CFO's strategy. They obtain audited and unaudited financial statements, capital account statements, and other relevant information from the GPs of Fund Investments, ensuring transparency and accountability in financial reporting.

Overall, these management firms are instrumental in the efficient operation and regulatory compliance of CFO structures, facilitating effective communication and management of assets.

Liquidity

Liquidity management is a significant concern within the CFO structure. Unlike Asset-Backed Securities (ABS) or Collateralized Loan Obligation (CLO) transactions, the private financial assets in a CFO do not have set maturity dates or regular interest payments. Therefore, it is crucial to maintain sources of short-term liquidity to ensure the CFO issuer can make timely payments of interest, fees, expenses, and meet any capital calls from the underlying funds held by the Asset HoldCo.

Typically, CFOs maintain a portion of their funds in cash equivalents or other liquid instruments. However, these funds alone may not be sufficient. To attain a desired credit rating, CFOs often secure a revolving loan facility from a third party. While these credit facilities can occasionally be used to make interest payments on the notes, this is not a standard feature.

In some cases, sponsors may provide an implied commitment to cover capital calls. It's important to note that such commitments do not legally bind sponsors to make capital call payments. Instead, they signify an intent or expectation, which can bolster confidence but do not replace the CFO's obligation to manage its liquidity effectively.

Managing liquidity effectively is essential to maintaining the stability and functionality of CFO structures, ensuring they meet their financial obligations and operate smoothly under varying market conditions.

CFO’s Underlying Portfolios

Identified and Blind Pools

As the name suggests, in identified pools, sponsors transfer specific assets or interests in identified funds into the HoldCo. This structure provides clarity to investors about the assets backing the CFO, which generally reduces perceived risk. Identified pools are favored for their transparency and predictability, often resulting in favorable credit ratings from credit agencies. This structure is typically used to monetize specific assets, providing a clear strategy and purpose.

In contrast, blind pools do not disclose to investors which assets will be transferred into the HoldCo. This lack of transparency increases risk as investors do not have visibility into the underlying assets initially. However, blind pools offer greater flexibility to CFO managers, allowing them to add assets after the fund's closing date based on market conditions and investment opportunities. Despite the higher risk, blind pools provide autonomy to CFO managers in asset selection.

In both identified and blind pools, investors do not have information about the specific underlying companies or investments held by the LP interests in the funds. These characteristic underscores the importance of due diligence and trust in the sponsor's management and strategy for investors considering CFO investments.

Single or Numerous Underlying Funds

?In CFO transactions, the number of funds involved can vary significantly. Some CFO structures may involve only one fund, while others can include investments from numerous funds. There is no strict upper limit, so a CFO could potentially include assets from as few as one fund to upwards of a hundred or more.

The flexibility in the number of funds allows sponsors to tailor the CFO structure to their specific investment strategy and portfolio diversification goals. It also provides opportunities for investors to access a broad range of assets and sectors through a single securitized vehicle.

This variability underscores the adaptability of CFO structures in accommodating different investment scenarios and the diverse needs of investors and sponsors alike.

Fund Vintage

In some CFOs, private financial assets with vintage years are combined strategically to balance cash flow over time. This approach mixes older assets that are closer to maturity and generating cash flows with newer assets that have longer investment horizons. For instance, a CFO might allocate 40% of its underlying fund interests to assets from a 2015-2019 vintage funds, while the remaining 60% comes from funds with vintage years of 2020 or later.

By blending assets from different vintage years, CFO managers aim to achieve a smoother and more predictable cash flow profile. The older assets provide immediate cash flows in the early years, while the newer assets contribute to cash flows over a longer term. This strategy helps manage liquidity needs and enhances the overall stability and performance of the CFO structure.

This approach also reflects the flexibility of CFOs in adapting to varying maturity profiles and investor preferences, thereby optimizing returns and risk management across different market conditions.

Third Party or Affiliated Funds

In the realm of CFO structures, there is variability in the types of funds that may be included. Some CFOs exclusively invest in funds that are directly or indirectly managed by the sponsor. This approach allows sponsors to consolidate their own funds or those closely affiliated with their operations, leveraging their expertise and control over the investment strategy.

On the other hand, other CFOs may invest in funds managed by third parties. This diversification strategy enables CFOs to access a broader range of investment opportunities and potentially benefit from specialized expertise offered by external fund managers.

Additionally, there are CFO structures that combine both sponsor-managed and third party managed funds. This hybrid approach allows for flexibility in portfolio construction, balancing the advantages of internal expertise with external opportunities and diversification.

The choice of whether to include sponsor-managed, third party managed, or a combination of both types of funds in a CFO depends on various factors, including the sponsor's investment strategy, risk tolerance, and the desired portfolio diversification for investors. Each approach offers distinct advantages and considerations in managing the CFO's investment portfolio effectively.

Fully vs Partial Drawn Underlying Interest

In the scenario where financial interests transferred to a HoldCo can be fully drawn down with no remaining capital calls pending, the CFO structure is straightforward. However, in cases where only partially drawn-down interests are transferred to the CFO, ensuring liquidity becomes critical. The CFO must demonstrate the availability of liquid assets capable of funding capital calls as they arise.

To bolster its credit rating and ensure liquidity adequacy, CFOs typically secure a credit facility or obtain a commitment from sponsors. These measures provide assurances that the CFO can meet its financial obligations, including capital calls, even when only a portion of the transferred interests have been drawn down.

Diverse Investment Strategies of CFO

Collateralized Fund Obligations (CFOs) have a broad mandate to invest in a diverse array of assets, including hedge funds, private equity funds, mutual funds, real estate investment trusts (REITs), exchange-traded funds (ETFs), credit funds, commodities funds, and derivatives. This wide-ranging investment strategy offers several key advantages.

CFOs benefit from the potential for yield and growth across various market conditions. Different asset classes may perform differently under different economic scenarios, allowing CFOs to capitalize on opportunities for income generation and capital appreciation across the investment landscape.

Conceptual Illustration of the Priority of Payments

In a Collateralized Fund Obligation (CFO), the cash flow distribution follows a structured sequence to ensure financial obligations are met and funds are allocated effectively:

The distribution begins by covering essential operating expenses such as taxes, general operating costs, and management company expenses. Next, interest payments on credit facilities and any unpaid commitment fees are prioritized, followed by the repayment of the principal amount of the credit facility.

Interest payments on Class A and Class B notes are then made, with a priority given to Class A. Funds are allocated to the Class A reserve account until it reaches its required funding level or contractual cap, after which the same process applies to Class B notes.

In the event of any breaches in leverage covenants, remaining funds are directed towards adjusting Loan-to-Value (LTV) ratios to comply with CFO conditions and maintain financial stability.

Pending capital calls are addressed subsequently, utilizing the credit facility if necessary to ensure timely funding obligations. Finally, any remaining funds are distributed to equity holders, providing returns on investments once all other financial obligations have been fulfilled.

This structured approach to cash flow distribution in CFOs aims to prioritize financial stability, compliance with covenant requirements, and timely distribution of returns to investors.

Key Risk Factors in CFO Investment

Investing in Collateralized Fund Obligations (CFOs) entails several significant risks that investors should consider:

Uncertain Distributions: There is no certainty regarding the amount or timing of distributions from CFO Investments, and there is no assurance that these investments will generate sufficient cash flows to repay the Notes.

Illiquidity of Fund Investments: CFO Investments are highly illiquid and not readily tradable, with no secondary market available. Proceeds from the sale of CFO Investments may be less than their net asset value.

Leverage and Collateral Use: The use of leverage and assets as collateral by Portfolio PE Funds increases their risk of loss and subjects their assets to creditor claims.

Dependence on GP Performance: The performance of underlying PE Funds heavily relies on the abilities of the relevant General Partners (GPs).

Key Personnel Risk: The success of Portfolio PE Funds is highly dependent on key private equity professionals, and their absence could adversely affect fund performance.

Investment Success Uncertainty: There is no assurance that investments made by PE Funds will be successful.

Market and Economic Factors: The performance of Investee Companies (firms in which PE fund invested) can be impacted by political, socio-economic, and other market-related factors.

Leverage Effects: The use of leverage may increase the exposure of Investee Companies to adverse financial or economic conditions, potentially impairing their ability to finance operational and capital needs.

Concentration Risk: High concentration of CFO Investments in PE Funds employing a Buyout strategy, with a geographical focus on a single country, increases risk exposure.

Capital Call Risks: The Asset-Owning Company may face substantial penalties for failing to satisfy Capital Calls and may be required to make additional capital contributions in the event of default by other investors.

Limited Management Rights: The Asset-Owning Company has no rights to participate in the management of Portfolio PE Funds or Investee Companies.

Distribution Liability: The Asset-Owning Company may be liable for the return of certain distributions from PE Funds.

Conflicts of Interest: Conflicts of interest involving GPs, or their affiliates may arise, potentially impacting decision-making processes.

Limited Trading Market: There may be a limited trading market for the Notes, requiring prospective Notes/Bond holders to hold their investments until maturity.

Capital and Liquidity Requirements: The Issuer may have substantial Capital Call or liquidity funding requirements, subjecting them to the performance and credit risks of the Credit Facility Provider.

These risk factors highlight the complexities and potential vulnerabilities associated with investing in CFOs, necessitating thorough due diligence and risk assessment by prospective investors.