Securitizing Private Equity and Hedge Funds: Collateralized Fund Obligations
Book: Structured Finance and Insurance: The ART of Managing Capital and Risk Author: Christopher L. Culp Publisher: Wiley Finance, 2006 ISBN: 978-0-471-70631-1
Chapter 20 asks a seemingly strange question: can you securitize a hedge fund? Or a private equity fund? The answer is yes. And the products are called collateralized fund obligations, or CFOs.
At first glance, this feels circular. Hedge funds and PE funds are already investment vehicles. Why would you take an investment pool and repackage it into another investment product? But once you think about the limitations of traditional fund structures, it starts to make a lot of sense.
Why Bother Securitizing Funds?
Most hedge funds and PE funds are partnerships. Investors buy limited partner (LP) interests. Everyone bears a proportional share of all the risks. There’s no tranching, no subordination, no risk selection. If the fund is down 20 percent, every investor is down 20 percent.
This creates three problems. First, investors who might want exposure to part of a fund’s risk profile but not all of it can’t participate. Second, the partnership structure shuts out smaller retail investors who can’t meet high minimums. Third, institutional investors with constraints (like pension plans that can’t invest in securities without principal protection, or funds with leverage limits) are locked out entirely.
CDO technology solves all three problems. By running fund interests through a structured vehicle with tranched liabilities, you can offer different investors different risk profiles on the same underlying assets. Senior tranche buyers get lower returns but principal protection. Equity tranche buyers get the upside but take the first losses. And the structured notes can be listed, rated, and sized for different investor types.
The Unique Challenges of Fund Collateral
Hedge funds and PE funds are very different animals, and each creates its own structuring headaches.
Hedge funds have the classic issues: restricted LP interests, long lockup periods, limited redemption windows, and the ever-present risk of a total loss of principal. For institutional investors that can’t afford to lose principal, this is a dealbreaker without some form of protection.
Private equity has an additional problem: the J-curve. PE funds require large capital calls early in their life while generating basically no distributions for years. The net cash flow dips sharply negative before eventually recovering. From a structuring perspective, this means you need serious liquidity support. If your SPE issues bonds that need regular interest payments but the underlying PE fund isn’t producing cash yet, you have a timing problem.
Almost all CFOs to date have been market value CDOs. This makes sense because managed funds don’t produce the kind of predictable cash flows that work well for cash flow CDO tests. Instead, the rating agency tests are based on mark-to-market values of the collateral.
First Generation: Capital-Protected Notes
The earliest CFOs weren’t really CDOs at all. They were single-tranche capital-protected notes (CPNs). The idea was simple: issue a note at par, invest the present value of the principal in zero-coupon Treasuries, and put whatever’s left into the hedge fund.
For example, if the three-year Treasury rate is 5 percent, you take $1 million from investors, put $863,800 into a three-year zero (which will grow back to $1 million at maturity), and invest the remaining $136,200 in hedge fund shares. Principal is guaranteed. The only upside comes from the hedge fund piece.
The problem? The upside was too small. You’re only putting 14 percent of the money into the actual hedge fund. Not very exciting.
Second-generation CPNs replaced direct fund investment with options on fund shares. This gave investors more gearing through embedded leverage. You could buy out-of-the-money options or in-the-money options and adjust the participation rate accordingly. Some structures used Asian-style options. But the hedge fund options market was (and probably still is) quite thin, creating basis risk problems for the dealers writing those options.
A third approach used constant proportional portfolio insurance (CPPI). Instead of locking in a fixed allocation between Treasuries and fund shares, the SPE dynamically rebalances. When fund values rise, more money goes into the fund. When they fall, more goes into Treasuries. A multiplier determines how aggressively the allocation shifts. It’s synthetic options through dynamic rebalancing, the same technique that became infamous after the 1987 crash.
Financial Guarantees: The Swiss Re Connection
Rather than sacrificing upside for principal protection through Treasuries, or relying on illiquid hedge fund options, some deals just bought insurance.
The Princess Private Equity deal from June 1999 was the first major PE CFO. An SPE in Guernsey, jointly owned by Swiss Re and Partners Group, invested in 17 PE partnerships. The sole liability was a single tranche of zero-coupon convertible bonds. Swiss Re provided a financial guarantee that wrapped the whole thing to AAA (through a subsidiary called Princess Management and Insurance). The cost was 300 to 500 basis points per year.
This was considered a big success. Small denomination ($1,000 face value) meant retail investors could participate. By turning equity into debt, institutional investors who could buy bonds but not PE partnerships could now play. And the structure started fully funded, avoiding the usual PE ramp-up problem.
Pearl followed in September 2000 with a similar structure. Same Guernsey SPE approach, 33 PE partnerships, Swiss Re wrap (this time at 180 basis points through European International Reinsurance). Pearl was coupon-bearing at 2 percent, kept deliberately low to manage J-curve risk. Rated AA+.
True CDO Structures: Multiclass CFOs
Starting in 2001, real CDO technology arrived in the CFO space with multiclass structures offering different risk-return profiles to different investors.
The Prime Edge deal in June 2001 was the first. Three classes of notes against a diversified pool of PE funds of funds. Senior tranche at EURIBOR+100, junior tranche, and equity tranche. Allianz Risk Transfer wrapped both the senior and junior notes. A 160 percent overcollateralization helped manage J-curve risk.
For hedge funds, the Diversified Strategies deal in May 2002 (Credit Suisse First Boston, sponsored by Investcorp) raised $250 million against a diversified fund of hedge funds. Four rated tranches from AAA to BBB plus a $67.5 million equity piece partially retained by Investcorp.
The MAST deal from JPMorgan and Man Group was similar in spirit but bigger ($550 million) and more complex, with four rated tranches split across fixed and floating rate options plus subordinated and equity pieces. It was successful enough to spawn MAST 2 a year later.
SVG Diamond: The Full CDO Treatment
The SVG Diamond deal from August 2004 represents the state of the art. It’s a double-securitization structure. SVG Diamond Holdings (a Channel Islands SPE) invests in the actual PE funds and issues PEI Notes. Those PEI Notes are bought exclusively by SVG Diamond Private Equity (an Ireland SPE), which in turn issues notes to end investors.
The PE portfolio consisted of LP interests in about 40 funds representing roughly 500 underlying companies, diversified across vintages, geographies, and fund types (mostly buyout, with limits on venture and mezzanine exposure).
The liabilities included three classes of senior debt and one mezzanine issue, all floating rate, with a sequential-pay waterfall. There was also $140 million in preferred equity that functioned like contingent capital. It was undrawn at issue and could be called when cash was needed for capital calls or non-deferrable obligations. AIG provided an additional $100 million liquidity support facility.
The structure had extensive performance tests covering cash levels, commitment capacity, gearing ratios, asset erosion, and equity thresholds. If tests were breached, reinvestment could be halted or cash flows redirected to protect senior note holders.
My Take
This chapter shows how versatile CDO technology really is. The same tranching, waterfall, and credit enhancement toolkit that works for corporate bonds, residential mortgages, and synthetic credit also works for hedge funds and private equity. Different collateral, same structural logic.
But the real insight is about the limitations of traditional fund structures. PE and hedge fund partnerships force a one-size-fits-all approach to investor participation. Everyone gets the same risk, the same illiquidity, the same lockup. Structured products let you break that apart and offer different pieces to different buyers.
The J-curve problem in PE is a great example of where structuring adds genuine value. By combining careful liquidity planning, contingent capital, reserve accounts, and staggered maturities, a CFO can smooth out cash flow timing problems that would otherwise make PE unattractive to many investors.
Whether the CFO market ever achieved the scale of the broader CDO market is doubtful. But as Culp notes, even a niche product can be very useful to the investors and fund managers who need it.