Swap it, don't sell it

The total return swap has been used across a host of asset classes, letting one party secure stable returns whilst the other can acquire exposure to volatile but possibly far superior returns. Could it be done in private equity? To a growing number of advisers, the answer is yes.

At times when returns from many private equity portfolios have moved from stellar to stumbling and alternative asset allocators are hoping their investment committees are still supportive, active management of private equity programmes has become far more relevant. No longer need this simply mean the discounted sale of some or all of your private equity assets to a secondary buyer, although the distressed may still reckon the slug of capital such an exit can deliver outweighs the cost of such a discounted sale. There are alternatives. Among them is a new breed of synthetic product that lets the active manager rework their private equity risk and remap their returns over a predetermined period. And all of this without the need to ditch their portfolio at 60 cents to the dollar.

The instrument that some are predicting will move from the relatively obscure to the mainstream is the total return swap (TRS). Although only one tool in the active private equity management toolbox, the TRS seems to be ideally suited for counterparties wanting to adjust their private equity exposure quickly and creatively. As one investment banker advising limited partners on their liquidity options commented: ?Limited partners are realising that there's more to life than a secondary sale, and capital market people and products like TRSs are helping them see alternative ways to manage their portfolio.?

A total return swap is an over the counter (i.e. not exchange traded) contract between two parties to exchange the economic performance of one asset for the economic performance of another. Put another way, a TRS is where one party agrees to pay the other the ?total return? from a defined underlying asset (such as interest, dividends, fees and capital gains or losses), in return for receiving a stream of LIBOR-based cash flows. Legal title to the assets is not transferred though and it is worth remembering too that for the TRS user, the economic benefits of asset ownership are achieved without utilising their balance sheet. A TRS can be applied to equity indices, single stocks, bonds as well as defined portfolios of loans and mortgages. And a number of people who have worked with these products in these other asset classes can now see the TRS being a valuable tool to enhance liquidity for private equity portfolios.

With a private equity TRS, the two participating counterparties will be looking for two distinct types of cash flow. The one who owns the private equity portfolio will be looking for the stable, predictable returns (either fixed or floating) that are typical of fixed income products. The other counterparty is prepared to deliver this type of regular return in exchange for the much less regular and variable cash flows that come out of the private equity assets. In other words, the former wants to lock in to a safe return by foregoing the potentially significant upside that the latter wants to have exposure to via the private equity portfolio.

Matching the right counterparties
It's not difficult to come up with a profile for someone looking for stable, if reduced, returns. It could be an institutional investor that has made a number of significant commitments to a range of private equity funds (their portfolio needs to be large and diversified enough to construct an appropriate basket of private equity assets to use for the swap), and whose appetite for the asset class has been reducing coincident with GPs reporting markedly weaker performance of the underlying investments. The heady days of rapid-fire distributions have gone and the investment committee are asking what should be expected in terms of income from the private equity allocation for next year and beyond. Although there is a temptation for the investment manager to hold hands with their GPs and hope for better times, the absence of any substantial distributions and the likelihood of further write downs may well be leaving the LP feeling too exposed.

What to do? The prospect of selling these investments to a secondary buyer may not appeal ? the fund is not so desperate for a return of capital at any price and besides, the rigmarole of undertaking a secondary is off-putting, given the time and expense involved in getting GP approvals and waiting for the buyer's due diligence. And as a noted secondary buyer commented: ?There are some LPs who find the prospect of selling to a secondary buyer a painful exercise because it crystallises their loss. That can be a personal as well as a professional problem.?

predetermined period (probably for quite a significant period such as five years upwards) instead of waiting for the pain – or gain – from those private equity investments becomes especially appealing in this context. By using a TRS, the LP has secured stability of return without entirely foregoing the possibility of receiving some additional returns in the future when the swap expires.

On the other side of this equation there needs to be a counterparty looking to increase their exposure to private equity, and the TRS gives them the chance to do so without having to commit significant amounts of capital. Again there's a profile of a typical counterparty here: whilst no pension fund would be comfortable taking on this kind of increased risk ? they are far more likely to be in the other camp looking to hedge their private equity risk ? other investors, such as hedge funds, are prepared to take much more aggressive positions.

Dale Meyer, a partner at alternative investment advisor Probitas Partners, who was formally group head of JP Morgan's private funds group, can see the private equity TRS gaining significant ground amongst this group: ?Not only are these guys familiar with the concept but a TRS against a private equity pool leverages up a deal in just the way they like.?

Too good to be true?
According to its exponents, a TRS is particularly attractive as it can be undertaken quickly and confidentially. That assumes that the right counterparties have connected though. Counterparty X must have that large, diversified private equity portfolio and Counterparty Y needs to deliver fixed or floating returns to X of say LIBOR +200 basis points. Both must also be creditworthy.

Crucially, counterparty Y doesn't have to commit any capital to do the transaction. Counterparty X remains in charge of funding any uncalled commitments. As Meyer remarks, ?because in a TRS the counterparties are only exchanging cash flows without committing any principal, the returns are quite leveraged and potentially very high.? If this sounds too good to be true, it is worth remembering that counterparty Y is taking on some significant risk: in particular, it will have to undertake to compensate X for any write downs. Although the exact terms of this will be negotiable, it is safe to assume that most LPs will require coverage from the counterparty for when the portfolio drops in value below a predetermined NAV set for the private equity pool being used in the swap.

This last point raises a critical question about a private equity TRS. Whilst other TRSs have gained relative orthodoxy, such as when they are applied to public equity indices or stocks, in no small part because of the ease by which a value of these underlying assets can be established, valuing a pool of private equity assets is much more difficult. And if any rigorous attempt to establish a NAV figure is made, it seems more than likely that counterparty Y (who is taking on this risk) will want to undertake some due diligence on the asset pool that will need to involve the funds' GPs. In this case the speed and discreetness of the TRS would seem to be significantly reduced.

One investment banker who applauds the advent of liquidity enhancing tools such as TRS nonetheless sees this as a sticking point: ?The counterparty swapping into private equity is bound to want to take a close look at the underlying funds and this must oblige them to talk to the general partners. That may not be an insurmountable obstacle but it will complicate the process.? Because many LPs are reluctant to see their name being linked with news that they are changing their private equity exposure and given that GPs are always going to be jumpy when they hear that one of their LPs is effectively leaving the fund and an unknown counterparty has turned up asking questions, anyone planning a private equity TRS is going to have to tread carefully.

Another reason why the nature of the asset class makes a private equity TRS far more of a challenge is the potential for the administration of the cash flows to turn into a record keeping nightmare ? for counterparty X in particular. Unsurprisingly, the other counterparty will want to see every movement of cash relating to the asset pool and counterparty X is responsible for accounting for this. If the pool is made up of 10 to 20 different funds each of which may have at least 10 portfolio companies then you can begin to see how much information will need to be collected and reported.

People like Meyer see these issues as wholly surmountable and he reports that those who have swapped into private equity via a TRS have enjoyed compelling returns. ?Particularly in a low interest rate environment [6 month LIBOR is currently 1.5 per cent], those investors willing to assume private equity portfolio risk and return can print money,? he says. Others are more circumspect, suggesting that few actual deals have to their knowledge yet been done. But even to these people the writing is on the wall, not least for the orthodox private equity secondary buyers who they predict are going to have to offer LPs these kind of creative liquidity solutions ? because if they don't there'll be someone next to them who will.