Collateralised fund obligations: How private equity securitised itself

US hospital operator Envision Healthcare, which is owned by private equity firm KKR, has the lowest possible junk-grade credit rating and is at risk of bankruptcy, according to Moody’s.

But the ownership stake in Envision, combined with stakes in hundreds of other privately held companies, has morphed into a financial security marketed to ordinary savers as a safe investment with an excellent credit rating.

The product is known as a “guaranteed funds commitment” and its goal is to diversify risk by segmenting companies that offer returns. CMOs are, in some ways, a private equity variant of CDOs, packages of mortgage-backed securities that only hit the public consciousness when they wreaked havoc during the 2008 financial crisis.

So far, financial bosses have largely flown under the radar. Although some of the biggest private equity names like Blackstone, KKR, Ares, and specialist firm Coller Capital have staged releases, this is often done privately without publicly disclosing the contents of the vehicle—or even, in some cases, its contents. presence, making it almost impossible to get a complete picture of who is exposed and on what scale.

CFOs are introducing a new layer of leverage into a private capital industry already built on debt. Their rise is one example of how post-crisis regulation, rather than ending the use of esoteric structures and risky leverage, has turned it into a quieter, more regulated corner of the financial world.

US hospital operator Envision Healthcare, owned by private equity firm KKR, has the lowest junk credit rating. © Dana Neely / Getty Images

Even as the leveraged buyout boom falters and regulators turn their attention to the risks involved in so-called “shadow banking,” there are signs that their use is on the rise.

“We represent 50 of the world’s largest asset managers and several large private equity firms, and this is the most important incoming call we get,” said John Temperio, partner at law firm Deckert that advises on financial managers.

In marketing materials, Deckert describes CFOs as “the technical dream class of fund finance.”

How it works

The Envision show vehicle is one of several CFOs launched by Azalea, an independently managed unit of Singapore state-owned investor Temasek. It’s more transparent than most because it’s offered to retail investors, though Azalea doesn’t tell these investors which portfolio companies they’re exposed to, citing “obligations of confidentiality.”

In fact, the CFO is a fund with stakes in 38 private equity and growth funds that Azalea has committed money to. The funds are managed by many of the biggest names in the industry including Blackstone, KKR, Carlyle and General Atlantic.

When the CFO was released in May, the money held stakes in 982 companies, including British defense group Cobham, Blackstone-owned casino operator Circa, veterinary business IVC Evidensia and debt collector Lowell, which in 2020 needed a cash injection of $100,000. 600 million pounds sterling. from the owners.

The CFO issues large and small bonds, which can be purchased by retail investors and which offer fixed interest payments of 4.1 percent and 6 percent. When the 38 funds deliver cash to their investors, the CFO uses it to make interest payments, then holds some in a reserve account designed to eventually pay off the principal.

Any money left over, after debts and expenses are paid off, goes to the equity holders in the CFO, in this case Azalea herself. Owning shares is “nothing more than a backed investment in private equity,” says Jeff Johnston, president of the Fund Finance Association.

S&P Global and Fitch have rated Azalea’s CFO’s senior bond A+, an investment-grade rating that means it’s unlikely to default, well above the junk-grade ratings typical of individual private equity firms.

Azalea told the Financial Times it had structured the transactions “with downside risk mitigation in mind”, using “conservative” loan-to-value ratios and putting in place “various structural safeguards” to protect investors.

The company added that it has a “diverse portfolio of high-quality private equity funds,” saying that “focusing on the performance of individual underlying companies can lead to losing sight of the power of a portfolio approach.” Corporate filings show that the KKR fund that owns Envision, one of the funds in the CFO, made 1.9 times its money as of September.

Private equity flowchart showing the structure operated by Azalea, a unit of Temasek Corporation in Singapore

CFOs for private equity firms are very much a vehicle for raising money, and they work a little differently. The company would pool stakes in several of its own funds and convert them into a security, offering bonds and stocks to investors. These packages sometimes include stakes in trusts, real estate and infrastructure, as well as private equity.

KKR, Coller and Ares have not publicly disclosed details of their financial directors, even when Ares issued one worth about $1 billion last year according to a person familiar with the deal. Collier has released two — one this year and one in 2020 — and KKR has released at least two. The companies, which are not required to disclose the transactions, declined to comment.

CFOs typically issue bonds worth between 50 and 75 percent of the value of the holdings in the underlying funds, according to several people familiar with the deals. Azalea CFO’s leverage is lower, at 39.6 percent when it was first issued, according to the prospectus.

Leverage layers

The CFO model was first used in the early 2000s. Six private equity issues totaling $3.6 billion were issued between 2003 and 2006, according to rating agency Fitch.

Fitch said some of these CFOs were downgraded or restructured during the downturn, even though they eventually paid their rated bonds in full. None were issued in the six years from 2007 when “there was limited market appetite for non-traditional securitization”.

Private equity is starting to use the structure again during a long era of cheap money. It’s just one of the ways new layers of leverage were being introduced at the time.

Over the past decade, buyout groups have increasingly leveraged not only their portfolio companies but also the money they buy through them – often at rapidly rising floating interest rates.

Many use “subscription lines,” which are actually a short-term loan in exchange for the ability for pension funds and other investors to hand over the money they’ve committed to a buyout fund. Some use a tool known as “NAV lending,” which is a loan to the fund that is secured against the value of equity in the companies it owns.

Here, too, little information is available. Only 8 percent of the 5,350 funds tracked by Preqin will tell the data provider whether or not they use subscription lines. Loans can inflate the return numbers that buying groups disclose to their investors, by making it appear as if the profits were made in a shorter period of time.

Still, it costs investors, says James Albertus, assistant professor of finance at Carnegie Mellon University’s Tepper School of Business: “Interest expense reduces the distributions that go to the ultimate beneficiaries — the teachers who rely on public pension funds.”

Financial managers can be built on top of that leverage. The Singaporean investor group said some money in Azalea’s chief financial officer had already borrowed against investor obligations, warning that lenders to private equity funds could claim the funds’ assets, which could negatively affect the cash flows available “to pay bondholders.”

CFOs have good credit ratings, in part because they are a diversified bet on cash flows from private equity funds, an asset class that has rebounded and benefited from a long period of rising valuations and cheap debt.

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But the conditions that fueled the private equity boom took the opposite direction. Buy funds have been on a deal-making spree for several years, buying record numbers of companies at dizzying valuations, and some now face an uncertain future as the economic downturn sets in and borrowing costs soar.

So far there is little data available on whether or how much payments from private equity funds to their investors have slowed this year as deal-making has stalled. Figures from Breckin show that the returns of private equity funds raised in the years leading up to the 2008 crisis were the worst in the industry in the past two decades.

Regulators sound a warning

So far, CFOs have evaded much regulatory scrutiny, in part because they are private offerings that require little in terms of public filings.

But at the Applied Law Institute’s Finance Conference this month, Larry Hamilton, president of law firm Meyer Brown’s US Insurance Regulation and Enforcement Group, warned that at least one regulator is starting to pay attention.

The National Association of Insurance Commissioners, a US regulatory group, is working on reform proposals that could reclassify some financial managers from debt to equity investments, because they are ultimately backed by stakes in companies. This can increase the cost of maintaining and applying them retroactively to CFOs that have already been issued.

“It was bothering some people at the NAIC . . . that you could take out interest money, kind of pool it, securitize it, issue a secured fund obligation, and you’d see you go from a private equity investment with 30 percent equity to something very preferable with a lower capital fee. said Hamilton.

A banker who worked for CFOs said buyout groups are keeping quiet about their use, in part because NAIC interest has emerged because insurers sometimes invest in structures.

“NAIC finds out about these things through informational articles, so most of them [private equity firms] You don’t want to be public” about the CFOs, he said. “Some are very worried about where the NAIC is going to come out… You don’t want to bring attention to it because you don’t want to be one-on-one.”

New models also suffer PE

The banker said that at least two US government pension plans are separately considering creating financial managers as a way to free up cash. But “no one wants to be the first mover.”

As it becomes more difficult to raise money, private equity firms are looking for more sophisticated types of financial managers as a possible solution.

Ahmet Yetis, managing director at Evercore, told the conference panel about some of the “latest technologies we’re working on.”

Under this model, the investor in a private equity fund — such as a pension scheme — would sell his stake in the fund to a new instrument, a type of financial manager called a “guaranteed going concern fund commitment.” The CCFO will be managed by the private equity firm managing the original fund.

The investor will receive some cash and an equity stake in the CCFO. The CCFO will issue bonds, committing the proceeds to the private equity firm’s new funds.

Hearing the description of the complex series of financial transactions that would bring new cash to the buyout industry at a difficult moment, one of Yates’ teammates said, “You really are the magician.”

Additional reporting by Robert Smith

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