CFO renaissance

Private equity securitisation as a fundraising technique had all but disappeared from view. Then two collateralised debt obligations, SVG's Diamond and Tenzing from Invesco Private Capital, braved the market in 2004. Will there be others, asks Philip Borel

Fundraisers should take notice: private equity collateralised fund obligations, or CFOs, are staging a quiet comeback.

CFOs tap the fixed income markets by issuing bonds that are secured against the cash flows coming out of private equity limited partnership interests. Because these cash flows are volatile and unpredictable relative to other asset classes, persuading investors to buy these securities is no mean feat, especially if the underlying collateral is a blind pool of assets to be acquired by the CFO manager after the CFO is done.

To date, only a handful of so-called arbitrage CFOs have been completed. And for a while it looked as though this fledgling market had not survived its infancy. Until CFOs came back last year, it almost looked as though Prime Edge, a $175 million transaction closed in June 2001, would be remembered as the last deal of its kind.

Unlike a small number of similar transactions before it, Prime Edge had achieved an “A” credit rating from Standard & Poor's without using an insurance wrap to protect investors from potential losses – a breakthrough at the time. Marketed at the height of the private equity boom, the deal seemed to herald a bright future for private equity CFOs.

But then the market turned sour. In late 2001, private equity performance nosedived and confidence in the asset class collapsed, especially among non-specialist investors. After a brief day in the sun, securitisation as a private equity fundraising tool all but disappeared from view.

To be sure, collateralised debt applications continued to be used in other parts of the private equity world. A number of successful securitisations of existing, partially funded private equity portfolios have taken place in recent years, most notably the $1 billion Pine Street 1 offering from AIG in 2003, followed by Silver Leaf, a $467 million transaction brought by Deutsche Bank soon after. These so-called balance sheet CFOs enabled their issuers to move parts of their private equity exposure off their books, either for strategic reasons, to free up capital or in order to accommodate regulators.

The partially funded investments securitised in a balance sheet deal typically provide enough visibility on cash flows to make them suitable collateral for bond investors.

However, tapping fixed interest capital without the benefit of cash flow visibility is more ambitious – which is one reason for the drought of new offerings that followed the foray of Prime Edge in 2001.

But in the second half of last year, arbitrage CFOs came back to life. In September, London-based fund of funds manager SVG Capital raised €400 million through SVG Diamond, a structure comprising €260 million of investment grade bonds and a €140 million equity strip. In December, Invesco Private Capital in New York came through with Tenzing CFO, a $222 million deal featuring four tranches of dollar-and euro-denominated rated bonds as well as an equity piece accounting for 30 percent of the capital structure.

For SVG Capital CEO Andrew Williams, getting Diamond over the finish line marked the end of a five-year period of personal persistence.

At the outset, Williams was certain that in one fundamental respect, private equity was no different from any other type of collateral – the idea that in principle, a diversified asset pool such as a portfolio of European buyout fund investments would reduce risk and correlation to other asset classes sufficiently to be securitised. So despite the market having turned into an obstacle course in the fall of 2001, Williams remained confident that SVG would eventually be able to raise capital using a CFO.

SVG initially assumed that protecting the structure by way of an insurance wrap would be crucial to get the rating agencies on board. When it became clear that the insurance market wouldn't support the project, SVG changed course: “We realised in 2002 that there was in fact no need to wrap the deal if we could demonstrate the credit quality of the underlying assets to the rating agencies,” Williams recalls.

Specifically, the rating agencies would require reassurances that the lumpy cash flows coming out of the fund interests that Diamond would purchase wouldn't hamper the manager's ability to service its obligations to the bond holders. To achieve this, a number of strategic and structural features were introduced to give the rating agencies comfort:

  • in order to generate cash distributions from underlying investments as early on as possible, SVG agreed to invest no more than €100 million of Diamond's capital in primary funds before purchasing a portfolio of partially funded secondary interest.
  • an overcommitment strategy was put in place supported by a €100 million liquidity facility provided by AIG in order to ramp up the portfolio to a total investment capacity of €533 million or 133 percent of total funds raised. (CFOs typically use overcommitment provisions to compensate for the fact that the underlying funds will take years to draw down the committed capital, rather than put it to work it all at once.)
  • Diamond also said it would draw down the equity in the capital structure “just in time” so as to avoid overcapitalisation early on in the vehicle's life. (In non-private equity CDOs, the bond holders typically insist on an equity cushion that is fully drawn at the outset.) In addition, during a seven-year re-investment period, excess cash coming back to Diamond would be reinvested immediately so as to maximise the potential upside.
  • Demonstrating to the rating agencies how overcommitment and reinvestment would smooth out Diamond's expected cash flows required extensive modelling. SVG hired Nomura to structure and arrange the deal, a critical part of which was to construct the stochastic model. Key Capital, a Dublin-based boutique, provided corporate finance advice.

    Says Williams: “When we started out, we thought there was about a 20 percent chance we'd succeed. Still, we were confident that the transaction risk could be controlled. The modelling took hundreds of man hours, Nomura's computers ran for entire weekends.”

    The effort paid off: all the bonds were rated, and placing them with a range of institutional investors in Europe and the US was relatively straightforward, says James Witter, head of private equity in the debt capital markets group at Nomura.

    Invesco's Tenzing, which was structured and distributed by BNP Paribas in London, also went through a long gestation period.

    Parag Saxena, head of Invesco Private Capital in New York, says that at the beginning of the process, he and his colleagues needed convincing that raising money through a CFO would make sense. “When BNP Paribas first presented the idea, we didn't think it was for us. All we could see was an investment bank getting rich on all the fees. It took us a good 18 months to get comfortable with the product. Now we think our clients will get rich.”

    Saxena says Invesco decided to move forward once it recognised that certain characteristics of a CFO would be of interest to investors, particularly the higher interest payments generated by the leverage effect. As for the fees, he says BNP's Joydip Gosh, who worked on the deal, earned every penny.

    Arguably the main hurdle that both Diamond and Tenzing needed to clear was to get equity capital into their structures. Where to put the equity tranche has in fact been the key challenge for any private equity securitisation, arbitrage or balance sheet, to have come to market to date.

    In the case of the balance sheet CFOs, the equity remained on the issuers' balance sheet. In partially keeping with this tradition, SVG and Invesco held on to a portion of the equity as well, €50 million worth in the case of SVG. But both groups also sold some equity to third parties.

    Says Williams: “We started off where others had finished, securing the equity first and building upwards, as opposed to getting the bonds done and then running around to find some equity. This gave Nomura the confidence that the opportunity cost of working on the deal done was justified.”

    We're yet to see a genuine equity distribution of an arbitrage CFO

    Two third party investors, whose identity SVG won't disclose for legal reasons, agreed to acquire Diamond shares. “The equity wasn't for people new to the game. We sold it to a group of good institutional friends, with a positive disposition towards private equity. What they needed was a working structure to feel secure.”

    Saxena says the Tenzing shares not retained by Invesco were sold “early and relatively easily” to a group of existing clients including insurance companies, pension funds, high net worth individuals and endowments. Several investors buying into the equity also purchased a piece of the debt, he notes. And, like those backing Diamond, Tenzing's equity holders are “investors with confidence in the asset class”.

    What both transactions indicate is that in the current environment, CFO equity is no longer considered downright toxic, which used to be the case in the early days. (Neither Pine Street nor Silver Leaf for example sold any equity to outside investors.)

    But they also show that it is still difficult to sell CFO equity to anyone who isn't already a private equity enthusiast, or at least a loyal supporter of the fund manager in question.

    “For new investors in private equity to buy leveraged private equity deals is a difficult leap of faith given the recent recovery of the asset class,” says Jeffrey D'Souza, the London-based head of alternative assets at Deutsche Bank.

    Another CFO pioneer, Tom Kubr at Capital Dynamics, points out: “What we're now looking for is another genuine equity distribution of an arbitrage CFO. There is plenty of opportunity going forward and it will come again.”

    The challenge is to persuade investors of the benefits of sitting at the top of a CFO structure.

    “People ask, “what will the equity really return?””, says Neil Basu, head of CDOs at Nomura who worked on Diamond alongside James Witter's team. “Assume an underlying portfolio of 40 to 50 funds, on average returning 15 percent. The leveraged CFO equity will turn that into a seven times money multiple and a 26 percent IRR. These are attractive numbers even from a private equity investor perspective.”

    This is the key message that needs to get across if private equity CFOS are to proliferate. For that to happen, deals like Diamond and Tenzing must deliver.

    Encouraging news came out of New York recently, where we learned from a source close to AIG's Pine Street 1 that the equity strip of that deal has been benefiting hugely from the strong cash flows coming out of the underlying partnership (see also Stateside on p. 20).

    Saxena says Invesco is keen to see how Tenzing will perform, and if and how it can be improved upon. He says the group will of course continue to organise conventional funds of funds, but if Tenzing works out, securitisation is likely to play a part in the group's future fundraising strategy as well.

    Market participants are unanimous that both deals have already done much to revive interest in private equity securitisation on the buy side. “We're seeing a great deal of interest among investors”, says Chandrajit Chakraborty, who worked on Tenzing whilst at Fitch Ratings before joining Nomura's CDO team at the beginning of this year. “There won't be an avalanche of CFO-based fundraisings. Unlike standard CDOs, private equity transactions tend to have specific requirements and take a long time to complete. But we certainly expect more deals like Tenzing and Diamond to come to market going forward.”

    In the meantime, it isn't just fundraising that private equity minded structured finance specialists have in their sight. There are plenty of other applications to work on: for example, balance sheet restructurings are likely to continue, and deals involving dedicated secondary buyers are increasingly drawing on structured finance technology too, to help buyers and sellers meet half way.

    Securitisation may not have found its place in private equity quite yet. But it is getting ever closer. A number of other private equity CFOs are currently in the works, practitioners say, and if the asset class continues to do well, these deals may soon be coming to the market.