08 November 2023
Private funds and structured finance professionals are increasingly looking for innovative ways to reconcile fund managers’ desire to access new sources of capital with insurance companies’ growing appetite for private fund investments. Two of the most common structures used to address these needs are collateralized fund obligations (CFOs) and rated note issuers (RNFs). This article discusses these related structures and how they can be effectively implemented by market participants.
CFOs and RNFs involve issuing debt instruments backed by limited partnership units in a single underlying fund or portfolio of underlying funds. In both structures, securitization technology allows sponsors to raise funding through a feeder fund or remote special purpose vehicle (SPV), which invests the investor’s capital in the sponsor’s private equity or alternative strategy funds. Insurance companies and other asset managers who are limited in the asset classes they can invest in are offered rated debt instruments, an asset class they are generally permitted and incentivized to hold.
Careful transaction structuring and the use of payment cascades enable the creation of different tranches of notes, with each tranche structured to meet the specific needs of investors. Senior tranches offer the fixed returns expected by debt investors. Returns on subordinated or equity tranches, in turn, may vary in accordance with gains or losses on the underlying investments.
Senior tranches in CFO and RNF structures are generally rated to significantly reduce capital retention requirements for regulated investors, compared to direct participations in underlying funds. Such favorable treatment of regulatory capital makes senior tranches a particularly attractive investment for insurance companies and sovereign wealth funds.
CFOs and RNFs have overlapping characteristics as both allow regulated investors to invest in funds or fund-like products through a rated debt instrument that provides better risk-based capital treatment than an equity investment. However, RNFs are primarily private funds with (usually) a single pool of directly held assets (or indirectly through a master-feeder structure), while CFOs resemble fund-of-funds structures.
Additionally, CFOs are typically designed to use return-enhancing funds. In contrast, RNFs, although they have the inherent leverage created by the notes, are less often used for leverage purposes. Funds using RNFs typically obtain additional leverage through separate reverse leverage mechanisms (such as repo lines and loan-to-loan facilities in the context of CRE debt).
Both RNFs and CFOs should be carefully reviewed by legal counsel to determine whether they constitute a securitization for regulatory purposes. The bonds issued in the RNF are usually unsecured, while the CFO is backed by a security interest in the equity of the asset holding company.
In the US context, since the repayment of the CFO’s bonds depends primarily on the limited partnership (LP) interests, and most LP interests are not “self-liquidating” (ie, interests in private funds, especially equity funds , do not turn into cash within a limited period of time), most sponsors take the position that US risk retention rules do not apply to CFO transactions.
In the case of a US RNF secured by an LP interest in a private credit fund, the parties must determine whether the structure resembles an open market CLO to which no credit risk retention requirements apply. Each structure must, of course, be carefully considered based on its specific characteristics.
Different considerations apply in Europe due to UK and EU securitization regulations which require due diligence by both CFOs and RNFs at the structuring stage, particularly in relation to issues such as risk retention, transparency and disclosure obligations.
For US insurers, the characteristics of a particular RNF or CFO will need to be evaluated under applicable National Association of Insurance Commissioners (NAIC) guidelines and statutory accounting principles to ensure that rated bonds qualify for regulatory capital treatment as “bonds”.
Although these guidelines and principles are currently undergoing significant modifications, it is likely that a security that has equity-like characteristics or simply represents an ownership interest in the issuer does not constitute a sufficient creditor relationship for bond treatment.
The NAIC also appears likely to adopt a rebuttable presumption that a debt instrument secured solely by equity interests does not constitute a creditor relationship sufficient for debenture treatment. If so, this presumption will need to be overcome by demonstrating (and documenting) that the characteristics of the underlying capital interests lend themselves to the production of predictable cash flows and that the underlying capital risks have been sufficiently redistributed through the issuer’s capital structure.
Another consideration applicable to these structures is the capital calls triggered at the level of the fund’s underlying investments. Where underlying funds may require capital to pay fees or investments, the structure should provide structural features to address possible cash shortfalls.
This is especially true for CFOs, which are typically backed by LP interests in mutual funds (where cash flows are periodic and dependent on a major release or liquidity event), as opposed to RNFs, which are typically backed by an LP interest in a private credit fund (where there should be periodic cash flows flowing up through the structure from the principal loans received by the fund). Similar considerations apply where underlying funds allow recycling of commitments.
Since payments could otherwise not be recouped by debt investors once they are paid out according to the priority of the payment cascade, the additional cash needed for reinvestment must be found elsewhere in the structure – for example, through a designated cash reserve, through short-term liquidity facilities, either by structuring the notes as delayed drawdown notes or, as is typical of RNFs, as variable-funding notes that allow cash to be withdrawn (or re-drawn) at an appropriate time.
What else distinguishes CFOs from RNFs? All things being equal, RNFs are relatively easier to structure and allow sponsors to offer newly raised funds to insurers in a capital efficient manner. Both CFOs and RNFs will contain securitization-style cascades, with trigger events such as loan-to-value tests or liquidity tests, the failure of which diverts money from the equity tranche. Both CFOs and RNFs generally provide for interest deferrals on senior positions to the extent that there is insufficient cash flow to service the required payments.
RNFs use special feeder funds or SPVs (created by the sponsor) that issue rated bonds to underwriters and use the proceeds to invest in the sponsor’s newly created master fund. Such RNFs typically provide the investor with access to one or more master funds through, for example, a single bond or multiple bond tranches, as well as an equity tranche.
CFOs, on the other hand, are more like traditional securitizations in that they offer investors access to a diversified set of different limited partnership fund interests that are used as collateral for debt securities issued by the SPV. Using different senior, mezzanine and junior tranches allows CFOs to offer bonds with a diverse risk-return profile that can appeal to a broad base of investors.
Both CFOs and RNFs offer innovative ways for regulated investors such as insurance companies and other asset managers to invest in private funds. Market participants will recognize many of the structural features of these deals from securitizations.
Although CFO and RNF deals can be more expensive and time-consuming to structure than direct investments in a private fund, the regulatory capital advantages for investors are significant to the extent that the investment in the structure is debt-rated (corresponding to the requirements to be treated as a “bond” for US insurers in the US context). Sponsors, in return, can expect to attract financing at favorable interest rates.