Structured finance transactions, whether of the CLO or CDO variety, are highly regulated today, following the losses certain types of these products suffered in and around the 2008 financial crisis. Nevertheless, with the strong performance of the leveraged finance market, the market for CLOs has rebounded strongly in the intervening years. At the same time, certain other structures are still less common and might have been overlooked by investors in recent years. One of these is the collateralized fund obligation (CFO).
How are CFOs different?
In other structured finance or securitization transactions, the transaction sponsor creates a pool of income-producing assets that are designed to produce cash flow on a regular, predictable schedule. One key variable could be the speed of prepayments, in cases where the underlying assets are susceptible to prepayment, but otherwise the portfolio generates interest and principal payments on a fixed timetable, subject to delinquencies and defaults of the underlying obligors. While lease payments or commercial trade receivables might not generate payments in the nature of principal or interest, they still comprise obligations of a fixed amount with a legally enforceable due date. In all cases, the cash flow then supports payment of principal and interest on the asset owner’s asset-backed securities.
In contrast, CFOs are backed by a portfolio of private investment fund interests. The underlying funds might have a fixed investment period and fixed duration, but there is no fixed amount that is guaranteed to be returned to the fund interest owner, and funds that are distributed to the owner are not distributed on a schedule that is determined in advance. Unlike other asset classes, private fund investments are typically not “self-liquidating” as they do not automatically generate cash proceeds in the same way a debt obligation does. The amount and timing of payments on a private fund depend on the decisions made by the fund manager and on the performance of the underlying investments in which the fund is invested. Payments by the fund only occur once a “liquidity event” occurs, such as a sale or IPO of a company in the fund’s portfolio.
What are the advantages of CFOs?
For owners of portfolios of private investment funds, CFOs provide liquidity without having to sell fund interests. The secondary market for private fund interests is not particularly liquid and may result in material disagreements on price, as between sellers and buyers. Sellers faced with the possibility of selling at a discount may well prefer to retain the fund asset and use a CFO to raise funds. The CFO enables fundraising at a significant percentage or reported NAV, while the owner retains the remaining upside. CFOs are nonrecourse to the sponsor, so the sponsor’s risk does not extend beyond losing its remaining residual interest in the fund, which is a risk the sponsor was already taking as the owner of the fund interest. In addition, for fund interest owners that are regulated financial institutions, the opportunity exists for the fund interest owner to retain some of the asset-backed notes issued in the CFO, for which its regulatory capital charge would be significantly reduced.
For investors, CFOs provide an opportunity to diversify investments in structured products. The blend of fund strategies represented in a portfolio backing a CFO can represent exposure to a diverse group of fund managers and a range of underlying investments. In a modestly sized portfolio of 30 investment funds, with each fund making 10 investments, the CFO has exposure to 300 underlying assets. The credit or investment risk inherent in this pool could respond very differently to economic shifts than investments found in CLOs, CDOs or securitized products, especially those backed by consumer finance. For investors exposed to private investment funds as a limited partner, the CFO allows an opportunity to invest in the same risk profile but as a senior lender holding a rated note.
What are the risks?
Not surprisingly, the risks of investing in a CFO flow directly from the nature of the underlying assets. If the investment fund interests do not pay out sufficient proceeds over the expected life of the notes, the note investors will suffer a loss. However, as a result of this obvious conundrum, CFOs tend to be structured conservatively in order to obtain the desired rating. There will typically be a significant amount of residual expected equity value in the pool, supporting the payment of debt service on the senior notes. In addition, a highly rated bank will provide a liquidity facility to support the timely payment of interest, in case proceeds are insufficient in any period to pay interest and senior expenses in full. An investor is also exposed to the risk that ongoing capital calls might not be funded when called, but again, the bank liquidity facility can cover this risk if the transaction sponsor is itself not a highly rated entity.
Taking the structural protections of the CFO into account, sponsors and their advisors find it possible to create investment grade tranches of notes in a manner closely resembling the way in which CLOs, CDOs and securitizations are put together. As a result, the parties take something unfamiliar (investment fund interests) and turn them into something familiar — structured notes backed by diverse collateral with a liquidity reserve and careful risk allocation. CFOs are finding traction among issuers and investors and represent a challenging but rewarding part of the structured finance landscape.