Time to deliver

Limited partners' search for liquidity in private equity has provided structured product specialists with their best opportunity yet to prove they can change the face of the asset class. Expectations are running high, but what's needed next is evidence that private equity securitisation really works. Now is the time for the industry to deliver the deals. Philip Borel reports.

Securitisation specialists operating in the still remote private equity corner of the asset-backed securities market are fond of talking about mortgages. In particular, they like to reminisce about the rise of mortgage-backed bonds, which in the early 1980s went from being the ugly ducklings of their industry to becoming much sought-after instruments trading in a highly liquid, multi-trillion dollar marketplace.

When Lewie Ranieri, the Salomon Brothers bond trader immortalised in Liars Poker, Michael Lewis' colourful account of the mortgage-backed securities boom of the 1980s, was asked to build up the first mortgage trading desk on Wall Street, he had trouble finding staff, let alone business. Ranieri persisted and invested in know-how and infrastructure. By the time the market took off seemingly over night, his traders were so far ahead of the game that huge amounts of money kept rolling in for years.

It's easy to see why the advocates of private equity securitisation are fond of this particular chapter of recent capital market history. They too have been labouring hard to introduce investors to a new type of asset, amid much market scepticism towards their project. And they too hope to be compensated handsomely for this laborious and complex task. Private equity today is a $500bn asset class. Imagine just 10 per cent of these assets being used as collateral to issue debt ? that's enough business to feed a much larger community of specialists than exists today.

But this prospect is still a mile off. In sharp contrast to mortgages, private equity is an illiquid, buy-to-hold asset class that generates highly volatile and irregular cashflows. Since 1999, when Swiss pioneers Partners Group structured Princess, the first private equity-backed, principal-protected convertible bond, just a handful of private equity securitisations have been completed (see Chronology on page 27). ?It's hard to say where this market is headed; it's still extremely fluid,? says a US funds of funds manager who takes a keen interest in private equity securitisation. ?Securitisation is trying to find its place in this asset class, but it hasn't found it yet.?

Nevertheless, there is a sense in the market today that securitisation is currently in the midst of its biggest test yet, that it's been handed a big opportunity to prove that it can do to private equity at least some of what it has done with other types of assets. According to those involved in the market, it's show time.

Thereby the main question on practitioners' minds at the moment is not so much whether securitisation can be an effective tool for raising new capital. Liquidity is far more the issue. In January, Swiss private equity boutique Capvent took the market by surprise with the announcement of a new principal-protected private equity fund of funds designed to attract investors with little previous experience in the asset class. Capvent's foray was unexpected for two reasons. One, because in the current climate raising new private equity capital is considered tough even when the much more orthodox limited partnership structure is used to sell private equity to investors who already know their way around the asset class. Two, where securitisation is generally expected to have most of an impact in the near future is not so much fundraising, but in creating palatable product fit to trade.

Hunting the CPO
Balance sheet deals is where it's at in today's environment. The recent turmoil facing investors in private equity and other asset classes has prompted owners of limited partnership interests, especially banks and insurance companies that are holding large amounts of such investments on their balance sheets, to turn to securitisation as a means of reducing their exposure to the asset class. The investments in questions are typically held either at cost or at general partner valuations, making it difficult for their owners to sell them outright in the secondaries market – the discounts they'd be asked to accommodate would be too painful. Instead, several LPs are reportedly preparing to sell part of their positions in the form of collateralised debt, issued against the projected returns generated by an underlying pool of private equity funds and sold in various tranches, each with a distinct risk and return profile.

It has been suggested that there are over a dozen owners of sizeable private equity fund investment portfolios currently developing such collateralised private equity obligations (CPOs). However, trying to establish precisely how many of these balance sheet transactions are going to enter the market is like pulling teeth. Most structuring specialists and rating agents will tell you they are working on at least one relevant transaction, and most are clearly keen to talk about recent progress. Yet no one interviewed for this article would be drawn on any specifics for fear of breaking SEC regulations governing the marketing of debt collateral in the US, violating confidentiality agreements with clients and other affiliated parties or, worst of all, prematurely trumpeting a deal that may yet fail to materialise.

Nevertheless, several sources pointed to at least three CPO-style balance sheet transactions slated to be completed well within the first quarter. Reportedly the most advanced vehicle about to be announced in the market is a $1bn CPO based on fund investments owned by Deutsche Bank, which is said to have secured a triple-A rating from Standard & Poor's for the most senior layers of the debt which is to be sold to outside investors.

Tellingly, none of the mooted balance sheet deals are expected to involve any of the equity being transferred to third parties. This is in part a result of the vendors' professed determination to hold on to any potential upside that the underlying assets may generate going forward. However, selling the equity would also be enormously difficult, particularly in the current environment. By definition, the equity holder is last in line in a deal's repayment structure. Buying into a first loss position may require less of a leap of faith in a bull market, when strong fundamentals mean that there is a good chance of the underlying assets performing well enough to compensate both debt and equity holders. But in a depressed market like today's, betting on the equity is a lot more ambitious. ?Selling the equity strip is every sponsor's dream, but it's not going to happen any time soon,? says a structured products sales person at a London-based investment bank.

For the time being, therefore, CPO sponsors will be concentrating on marketing the senior pieces of a capital structure. However, selling the debt will not be straightforward either. ?Marketing unwrapped senior debt will be a key challenge going forward,? says Teimuraz Barbakadze, head of the Structured Credit Group at Merrill Lynch in London.

Senior debt issued without an insurance wrap was part of a $450m balance sheet transaction structured by Aon Capital Partners on behalf of its parent, Aon, in early 2002. The product was rated by Standard & Poor's and underwritten by CIBC World Markets with a view to being sold to outside parties later on. According to market insiders, no takers for the bonds have been found to date.

To be sure, the fact that 2002 has brought a lot of pain to the CDO market generally hasn't made the task of distributing exotic products such as private equity backed structures any easier. ?The traditional buyers of asset-backed securities, having incurred significant losses particularly in the credit markets, have become a lot more sceptical towards new product,? says Jeffrey D'Souza at Deutsche Bank in London.

Another challenge is that asset-backed investors are typically not familiar with the asset class. ?The buyside is still cautious,? says a structuring expert. ?To compensate for their lack of private equity expertise, investors will demand product of the highest quality in terms of the underlying investment portfolio and its manager, and they will also need to be comfortable with the vendor. Knowing where the assets have come from is still important.?

Unsurprisingly therefore, educating the buyside, together with deal origination, is where marketers are currently concentrating much of their efforts. The technology required to structure transactions is more or less in place today. ?Until last year, private equity securitisation was still a bit of a geek's market, but now the structuring is becoming more straightforward,? says D'Souza. ?We're going to focus on persuading sponsors to do deals, while at the same time educating the buyside.?

Michael Romer, senior director of European Structured Finance at FitchRatings who is involved in developing the agency's private equity ratings methodology, agrees that structuring is no longer the black box it used to be, even though there remains room for further innovation. ?Structuring hasn't become commoditised yet. There are creative ways of providing liquidity support in a structure, and hence there is still a role for the structurer.?

The rating agencies are also playing a key role in helping securitisers to create a market for themselves in private equity ? and the industry is thanking them for it. ?The agencies have made it clear in a very determined fashion that they will do their bit to help deals getting done,? says D'Souza. The agencies have worked hard to develop proprietary modelling techniques designed to accommodate the specific characteristics of private equity as part of their evaluation of a structured products.

Significant progress has been made since Capital Dynamics' Prime Edge, a $150m private equity instrument issued without principal protection, in 2001 secured a double-A rating from Standard & Poor's. The rating for Prime Edge relied in part on a market value trigger which, in the event of the portfolio's NAV dropping below a certain threshold – typically the amount of cover needed to repay the debt ? will require a portion of the portfolio's assets to be liquidated in order for the NAV to be brought back up. Both rating professionals and structurers agree that the market value methodology, a standard approach in other asset classes, doesn't suit private equity, where the absence of a liquid secondary market makes it difficult to make the required short-term adjustments to the underlying asset base if- NAV decreases. Instead, the agencies have moved towards using cash flow based modelling techniques based on the assumption that the underlying assets are bought and held for the duration, and taking into account the specific characteristics of a private equity portfolio.

According to practitioners like D'Souza, who was involved in structuring the Prime Edge transaction, this is a big step forward. ?Today the agencies are way beyond Prime Edge. Volatility is now less of a concern to them. Eliminating the market value trigger is a great improvement.? The emergence of unwrapped triple-A rated senior debt paper, as in the case of Deutsche Bank's pending transaction, is a reflection of the agencies' support for this product, and should suitably impress fixed income investors when it comes to market.

Show me the money
Private equity securitisation stands to gain immense credibility should the market respond well to the expected flurry of CPO-shaped liquidity-driven transactions. And success would encourage further innovation. D'Souza predicts that the next challenge that securitisers will get their teeth into will be the development of liquidity solutions for proprietors of single fund portfolios, as opposed to more widely diversified funds of funds. Structuring specialists say they already have blueprints on the drawing boards setting out how to structure so-called exchanger funds, i.e. CPOs bundling up several private equity funds owned by different investors where the debt is sold and the equity strip is bundled up and handed back to the respective owners of the assets on a pro rata basis.

This could be attractive to general partners flirting with the idea of using securitisation on a portfolio level to exit tail-end positions. Some are also keen to diversify their investor base and secure at least part of their funding on an evergreen basis. Several private equity firms, including Apollo and Bain Capital in the US and Duke Street and Alchemy Partners in the UK, already own CDO operations that bolster their fundraising, as do several mezzanine providers, while other players such as 3i are thought to be eager to put seed capital into new CDO managers for similar purposes. But these ideas are not of equal appeal to all managers. Says a GP who manages several international funds of funds: ?There is a real split among general partners right now vis-à-vis securitisation as a fundrasing tool. Some are intrigued, others are put off, seeing it as a threat to limited partnerships, a structure that has worked extremely well for them.?

Similar mixed feelings prevail among the secondaries funds, although on the face of it their attitudes towards securitisation are predominantly hostile. Understandably: securitisers are predicting they will do more business than the secondaries this year. Thus challenged, secondary players, hoping to protect a franchise that has proved lucrative at least to those who have managed to execute deals, tend to talk down the viability of securitisation as a liquidity alternative on the grounds of it being too cumbersome, too time consuming and too expensive.

To what extent such dismissals are largely tactical is an open question. ?Regardless of what they may be saying in public, all the secondary players are studying securitisation at the moment, particularly those that have been offered to buy equity in a CPO,? says a source. ?They're looking at this either as a return feature or simply in order to get their heads around the product.? The point is consistent with the position often taken by the more diplomatic securitisation practitioners: that secondaries and securitisers, offering answers to different problems, should be working in tandem where appropriate. Why, for instance, shouldn't a secondary fund buying a collection of fund investments work with a securitisation specialist to refinance the capital outlay by issuing structured debt against the assets purchased?

This seems indeed plausible. As does the idea that in the end it may well fall to a secondary buyer to help private equity structured finance to pass the ultimate challenge: selling the equity to a return-driven investor.

The likelihood is that achieving this will end the credibility debate once and for all. Says an observer: ?For securitisation to change private equity in the way it has changed mortgages, what we need now is a transaction where an outside investor with a meaningful quantity of capital comes in to buy some equity in a securitisation because they want to buy it.?

There it is again. The evolution of the mortgage market clearly seems to be the benchmark. It's a tall order, but 2003 could well be the year when private equity securitisation begins to manifest the same characteristics as that now massive marketplace.

Securitising private equity – a short chronology
Private equity securitisation is a relatively new phenomenon, but there have been some noteworthy milestones. Here is a list of some of those watershed moments, according to securitisation professionals.

• May 1999: Partners Group establishes Princess Private Equity Holding. The Zug, Switzerland-based group places nearly $720m of zero-coupon convertible bonds that can be exchanged for shares in a private equity-backed vehicle in 2007. The bonds receive an undisclosed investment-grade rating from Fitch, which is boosted by a Swiss Re insurance wrapper.

•August 2000: Partners Group establishes Pearl Holding Ltd. The firm completes the 660m Pearl deal, which bears a structure similar to that of Princess, and offers a guaranteed 2 per cent coupon.

•Summer 2000: JP Morgan Partners begins work on $800m Porter Global Private Equity. The private equity giant, in consultation with Partners Group, markets the offering with help from Merrill Lynch, but the bonds never get off the ground. They feature a 2.5 per cent sponsorship fee and a Swiss Re wrapper, but the funds backing the vehicle are relatively young, putting too much risk into the equation for most investors. The offering may be restructured and put back on the market eventually.

•June 2001: Capital Dynamics establishes Prime Edge. Ex-Partners Group professional Thomas Kubr's new firm teams with Hamilton Lane and Swiss fund manager Rainer Marc Frey to raise a €150m bond backed by private equity fund investments. The product is the first of its kind to receive a credit rating – a double-A status from Standard & Poor's.

•January 2002: Aon Corp. securitises $450m of private equity fund interests. The transaction, titled Private Equity Partnership Structures I, was the first to receive a standalone credit rating from Standard & Poor's for a vehicle based on an existing limited partnership portfolio.

•January 2003: Capvent launches principal-protected vehicle backed by private equity funds. The Swiss fundof-funds manager offers various levels of risk and liquidity lockups from a securitised bundle of private equity funds from various vintage years.

As securitisation becomes an increasingly viable liquidity solution, a handful of people have emerged as pioneers of the technique. Some are with firms that have successfully placed securitisation products, while others are with the agencies that give the products credit ratings. Below is a list, in alphabetical order, of some of those trendsetters as chosen by industry insiders.

•John Casey, President, and Paul Schultz, Executive Vice President, Aon Capital Partners. Aon Capital acted as financial adviser to insurance giant Aon's securitisation of $450m of funded and unfunded private equity interests, which was the first to receive a stand-alone credit rating for private equity investments already made.

•Jeffrey D'Souza, Director, Deutsche Bank. The German banking giant led the placement of Prime Edge, and is currently involved in a number of other securitisation efforts. D'Souza, based in London, their a noted expert on the subject.

•Rainer-Marc Frey, CEO, RMF Investment Group. Frey's Zurich-based firm group helped develop Prime Edge with Capital Dynamics and Hamilton Lane. RMF specialises in structured products, secondary trading and leveraged finance.

•Mario Giannini, CEO, Hamilton Lane. Giannini's Pennsylvania-based firm helped set up Prime Edge with Capital Dynamics and RMF Investment Group. Hamilton Lane provides private equity advisory services to major institutional investors.

•Chris Howley, Director, and Vivek Kapoor, Associate Director, Standard & Poor's. Howley leads the rating agency's rating process for securitised private equity, focusing on legal aspects of securitisation and client relationships. Kapoor leads the agency's efforts to develop risk analysis of cash flow in private equity securitisations.

•Thomas Kubr, CEO, Co-Founder, Capital Dynamics. Formerly with Partners Group, Kubr has been involved in private equity securitisation from the beginning. Zug, Switzerland-based Capital Dynamics structured the €150m Prime Edge product, which was the first securitised private equity vehicle to achieve a stand-alone credit rating. His firm, founded in 1999, continues to be active in the space.

•Dennis Murray and Francis Devine, Co-Founders, Murray, Devine & Co. Co-heads of Philadelphia valuation agency that valued Aon's securitisation, which included 250 private equity fund interests.

•Michael O'Connor, Senior Vice President, Moody's Investor Service. O'Connor is Moody's lead analyst for private equity securitisations. He develops the quantitative analysis the agency uses to rate products, and makes sure all risks are addressed before a new product is presented to a committee.

Michael Romer, Senior Director European Structured Finance, Fitch Ratings. Romer heads up a team based in London that is currently fine-tuning, alongside several dedicated colleagues in New York, Fitch Ratings' approach to evaluating private equity securitisations.

Urs Wietlisbach, Partner, Co-Founder, Partners Group. Wietlisbach, a Swiss national and former Goldman Sachs executive, co-founded Partners Group in 1996. His firm has placed two influential securitised products, Princess Private Equity Holding Ltd. and Pearl Holding Ltd. Partners Group has offices in Zug, Switzerland, New York and the Channel Islands.