Back to the Future: Collateralized Fund Obligations Make a Reappearance
BY: Jacob Chaas, RBFL Editor
The laboratory of financial engineering’s latest concoction has received mixed reviews by pundits. Lauded by some as a “Technicolor Dreamcoat” and criticized as a “Frankenstein” by others, the collateralized fund obligation (“CFO”) transaction has seen an explosion in popularity in recent years. Naturally, these novel transactions raise new concerns for regulators and risk managers alike.
Over the past decade, as private equity became an increasingly important part of financial markets, fund managers and other organizations sought increasingly cryptic financing arrangements to raise capital for new funds. Simultaneously, both retail and institutional investors were looking for new ways to invest in private markets and take advantage of the higher returns available to private equity investors. CFO capitalize on these parallel trends and, as such, have been elevated to a new position of relevance.
The CFO is not necessarily new, however. Some of the first rated CFOs came to market in the early 2000s. Reports suggest that there were only about half a dozen CFO transactions before the great financial crisis. During the financial crisis, investors’ interest in complex derivative products – and likely anything with “collateralized” in the name – dried up, and very few CFOs were issued for the early years following the crisis. The ability of CFOs to provide levered returns and generally higher yields than other equity investment instruments have attracted sophisticated yield-hungry investors to the CFO market.
CFOs make use of some of the key structural elements present in other collateralized asset-backed securities. The most infamous of these securities is the collateralized debt obligation, most famous for its role in propagating the sub-prime mortgage crisis of 2007-2009 throughout the broader financial sector. Similarly, CFOs securitize the cash flows from private equity investments and allow investors to invest in these cash flows by purchasing structured notes, arranged in tranches with different positions in the cash flow waterfall and correspondingly different yields. Each tranche gives investors an opportunity to make an investment that most closely aligns to their risk tolerance and preferred rate of return.
CFOs raise three important regulatory and risk management issues. First, since many CFOs are private arrangements among and within private equity funds, issuers are not required to disclose which fund interests comprise that CFO or what investments each fund is making. This makes understanding the risk inherent to each CFO transaction very difficult. Second, CFO issuers generally don’t need to retain any interest in the underlying fund and can entirely liquidate the CFO. This could encourage conflicts of interest between issuers and end buyers. Finally, CFOs allow regulated investors to transform what would otherwise be an equity interest in a debt interest by means of financial engineering, allowing them to get around the more stringent capital requirements associated with holding equities.
Within the next few years, regulators will likely step in to provide more certainty on each of these points. In the meantime, the scope of the burgeoning CFO market will only be restrained by the creativity of the financial laboratory’s engineers.