The structural revolution

What is the biggest drawback of private equity as an asset class? Opinions vary, but the fact that until relatively recently many investors deemed it illiquid enough not to deserve the label ?asset class? at all must be contender. Such skeptics argued that private equity's lack of liquidity was inherent, that this made it a flawed investment destination and that little or nothing could be done to remedy this.

Today there are fewer such skeptics around, as the market has worked to create a solution to this ?inherent? flaw. Securitising private equity portfolios may still be in its infancy, but those close to current market developments are confident that it is now a question of when rather than if investors will be able to buy and sell private equity-based debt products in a fully liquid market place. In doing so, say enthusiasts, buyers and sellers of these products will soon be able to utilise the full range of sophisticated derivatives that are available in other asset classes.

It all began with Princess, the private equity fund of funds launched by Zug-based structured finance house Partners Group in 1999. Princess had a relatively simple single-tranche structure and relied on an insurance wrap provided by Swiss Re to obtain an investment grade rating of AAAp (the ?p? refers to principal only) from Standard & Poor's (S&P), the ratings agency. The high quality rating was vital to give investors comfort, but Princess' main achievement was to demonstrate for the first time that private equity interests could indeed serve as collateral for an asset backed security. Initially looking to raise up to $1bn, with a minimum target of $500m, Partners Group sold over $700m worth of 12-year zero-coupon bonds that in 2007 could be exchanged for shares in private equity investments held by Princess.

Another milestone was passed in 2001 with the launch of Prime Edge, the first leveraged private equity funds of funds to introduce CDO-style tranching and to receive a stand-alone credit rating from Standard & Poor's. Capital Dynamics, another Zug-based boutique and the brainchild of former Partners employee Thomas Kubr, teamed up with US investment consultant Hamilton Lane Advisors and Rainer Marc Frey, the hedge fund manager, to do the deal which closed at $175m on 15 February 2002.

Capital Dynamics takes credit for being the first to succeed in adapting existing CDO technology to private equity. Tranching the deal meant that a low-risk fixed income product could be delivered to one part of the market and a concentrated leveraged private equity risk to another, thus meeting different requirements for different types of investors. But according to Kubr, the real coup was to get the rating agency on board. ?Getting the stand-alone rating was the fundamental element that Prime Edge achieved,? says Kubr. ?Rating private equity for the first time gave people transparency on the risks underlying this asset class in a way that was understandable to everyone. Rating levels carry quantifiable risk cost in the shape of spreads to LIBOR and, of course, there's a large and liquid market for rated bonds.?

Kubr says preparing for the rating took nine months and a series of meetings with S&P during which the basic principles of a suitable methodology for rating the deal was established. The close co-operation that existed between issuer and rating agency is a common feature of all attempts, past and present, to make private equity-based products use structures and methodologies to be found in the CDO market. And a lot of work remains to be done. Says Kubr: ?In terms of developing the methodology, we are not at all done yet. There isn't just one way of doing this, and all the rating agencies are looking at ways of cracking the problem. It is good to see that different approaches are now producing consistent results.?

One key task when analysing a deal is to assess the basket of private equity funds that generate the distributions ? the essential cashflows that back the securitisation. By tradition these can be notoriously uneven and therefore a securitised product needs to consist of a wide variety of funds representing a broad spectrum of vintage years, stages and styles in order to try and even out the cash flows. This inevitably makes the rating process more complex, as the rating agency has to profile each of the funds included. (For more detail on how S&P have developed their rating methodology for these products, have a look at the boxed item accompanying this article.)

Kubr, for one, is also keen to encourage the adoption of a distinct lexicon for these products. By rights, he say, the asset class should be labelled CPO, standing for Collateralized Private Equity Obligation. ?The reference to CDOs should only be used because they are similar to them and we are building on CDO technology,? he says.

Securitisation spreads its wings
With the basic methodological framework in place, practitioners are now in a position to fine-tune the structural efficiency of future transactions and develop their marketing capabilities to fully deliver on the promises that securitisation holds. Kubr, who led the Princess transaction for Partners before setting up Capital Dynamics, says Princess gave an inkling of what securitisation could achieve in private equity, although much of the potential was hidden inside the insurance process. Prime Edge took the technology to the next level, but the interest it attracted in the market place has as much to do with the obstacles it overcame as it did with the possibilities for future development that it hinted at. ?It was good to see that Prime Edge got done, but it would have been nice had the deal been bigger, so as to not give the impression that securitising private equity was on the wrong track, which clearly it wasn't,? says one observer.

Kubr agrees that Prime Edge leaves plenty to build on. ?It was a first-time product, and when we took it to the market, there was a lot or pragmatism involved. In the interest of getting the deal done, we didn't become too fancy. We think we know what Prime Edge 10 will look like, but we'll take it in stages.?

Part of the challenge now is to widen the scope of what securitisation can resolve when it comes to private equity investing. Princess, Partners Group 2001 follow-on product Pearl and Prime Edge were all blind-pool transactions, in part designed to introduce the asset class to a new breed of (mainly European) investors who had previously been prevented from investing in private equity for reasons of regulatory and tax compliance. Prime Edge received two thirds of total commitments from first-time investors in private equity, a fact that highlights the technology's potential in terms of opening up the ABS market as a new source of funding for private equity managers.

But channeling new money from hitherto untapped sources into private equity is just one way in which securitisation can change the face of the industry. Allowing limited partners to actively manage their private equity risk is another, which US institutions are particularly keen on at present.

Earlier this year Aon, the insurance broker, announced the first securitisation of an existing portfolio of limited partnership interests, a move that several other large investors are also now contemplating. The firm securitised a bundle of 53 funded and unfunded commitments to limited partnerships with a net asset value of $450m, owned by the group's insurance underwriting businesses, Combined Insurance Company of America and Virginia Surety Company, Inc. The deal was part of Aon's preparations for spinning off the two subsidiaries later this year. In doing the transaction, the group's most fundamental objective was to reduce the earnings volatility that the portfolio generated on the companies' income statements without relinquishing the economic upside that resides in the private equity assets.

?We were looking for better capital treatment and a certain amount of liquidity?, says John Casey of Aon Capital Partners, which advised its parent on the transaction. ?We wanted to address the short-term volatility issue without throwing the baby out with the bathwater.? In other words an outright sale of the partnership interests to a secondary buyer, for instance, was not an option.

When the deal was completed, Aon's insurance businesses effectively sold 40 per cent of the portfolio's Net Asset Value (NAV) as debt and received $180m in cash. The remaining 60 per cent, taking the form of securities issued by Private Equity Partnership Structures I (PEPS), the deal's special purpose vehicle, are retained as equity, investment grade notes and rated preferred notes.

Among the alternatives Aon was looking at whilst preparing the deal were proposals to use an insurance wrap, but that, says Casey, would have been too costly, as it would effectively have meant converting the private equity portfolio into a low-yielding bond. ?That just didn't seem appropriate. We're long-term investors in the class, and we wanted the long-term economic benefits.? Other proposals, brought to Aon by a number of banks, focused on accounting issues, but again, the likely benefits invariably failed to justify the cost. ?It would have been too cumbersome and too expensive just to address accounting issues. You would end up with some odd residual equity interest where you couldn't get favourable capital treatment on it so you'd end up hurting yourself more from a capital standpoint. Or you had to give a certain amount of the upside over a certain threshold to some kind of counterparty.?

Kubr: Stand-alone rating a fundamental achievement

Instead Aon settled for the kind of CDO structure that Prime Edge had introduced to the market. Knowing that S&P would have an appetite for this type of transaction, Aon decided to approach the rating agency directly to secure a stand-alone rating. As it had done with Prime Edge previously, S&P worked closely with the Aon advisers, and over a six month period new valuation and modeling methodologies were developed that would allow for a stand-alone rating to be obtained and the deal's underlying risks to be monitored on a forward-looking basis post closure.

Whilst S&P was getting comfortable with the risk characteristics of the underlying collateral as well as the structural features of the product, Aon worked with CIBC World Markets, the investment bank, to make sure the debt portion of the transaction would be distributable in the ABS market. CIBC provided the liquidity facility needed to make the somewhat lumpy private equity cashflows conform to a CDOtype structure and agreed to underwrite the transaction in full.

Another critical job that had to get done was to make sure that the general partners managing Aon's private equity investments would buy into the deal. Kristin Adams, who negotiated the transfer agreements, says that it was vital to secure the consent of all 53 GPs involved in the deal: ?We wanted this to be a GP-friendly transaction. Limited partners obviously are entitled to sell their interest in a partnership, but they must understand what is important to the GP, and they can't sell to just anyone?, she says.

The fact that no two partnership agreements are identical meant that Aon effectively had to negotiate 53 individual asset transfers. GPs demanded assurances that no violation of any confidentiality agreements would occur, who the new partner would be and, most importantly, that the $170m of outstanding commitments would be honoured in full as and when future capital calls would be made.

?The risk of loss is greater through sale today than through securitisation?

?These weren't easy conversations initially, but at the end of the day it was relatively straightforward to explain what we wanted to do?, says Casey. What helped was the fact that the insurance companies stayed involved at the equity level, ensuring the relationship with the GPs would remain strong.

The upside for GPs and LPs
From a GP perspective in general, securitisation also has the significant advantage that for an LP to default on one commitment is to jeopardise the entire equity basket of partnerships that it is part of. For unfunded limited partner commitments to be transferred into a securitisation structure can therefore be extremely attractive to GPs. ?In this environment, LPs are walking away from commitments, because they just don't want to fund, but if we were to do that now, we would risk defaulting on the whole portfolio?, says Casey. The additional point that once an interest is part of a CPO structure it will not get shopped around in the secondaries market is also rarely lost on GPs.

Given such strong incentives, it seems certain that the general partner community will respond positively should more and more institutional investors turn to securitisation techniques to manage their private equity assets as efficiently as possible. And it's clearly the case that institutions are keen to find out more about what securitisation might be doing for them. Says one banker who has been involved in marketing the debt portion of a recent CPO: ?We were talking to life companies who also own bunches of private equity interests. All the ABS investors at the life companies said we should talk to the guy next door who had bought all these private equity interests and would like to do something with them.?

Thomas Kubr at Capital Dynamics says that large institutions with diversified private equity holdings are right to be intrigued by what has been achieved to date. But many also remain cautious: ?The worlds of private equity and CDOs are quite different, and right now the two sides are sniffing around each other to get a better understanding of what is happening.?

The traditional buyers of ABS products are part of this learning process too, and many of these are taking a conservative stance as well. In June 2001 JP Morgan Chase ran into a wall with Porter Global Private Equity, an $800m securitised private equity fund of funds offering that investors balked at. Blaming adverse market conditions, the bank put the marketing of the deal on hold and said it would revise its structure. It is not clear at present whether Porter will return to the market any time soon.

A key challenge for future transactions will be to increase efficiency by achieving greater participation further down the risk structure. Selling the equity tranche is the hard part, and transactions that, unlike Aon, are designed to achieve at least a partial risk transfer and sell some of the economic upside to bond investors will have to demonstrate that the junior tranches of a private equity asset pool are also saleable. This will, at least to a degree, depend on how quickly the rating agencies can adjust their methodologies to the specific requirements of private equity and award credit ratings to the more junior elements of a structure. It will also require for bond investors to keep learning about the risks they are buying when purchasing private equity backed paper. Ratings and insurance wraps can take off some of the edge, but it is nevertheless going to be crucial that institutions understand the basic risk characteristics of this new product.

Outlook
Whether the US market will see a flood of Aon-style balance sheet transactions may depend on ongoing developments on the regulatory side. For some time US banks, anticipating changes to federal legislation that would require them to increase their regulatory capital to match a greater portion of the private equity exposure on their balance sheet, have been looking at securitisation to reduce this exposure. However, there are now signs that the new rules, to be disclosed later this year, may also force banks to apply a significant dollar for dollar provision of regulatory capital to any residual equity holding they may retain on their balance sheet following a securitisation.

Observers say the jury is out on how this will affect future deal flow. However, ?there is a sense on Wall Street at the moment that many deal structures that merchant banks have been looking at in recent months will not work because of the pending changes?, says a source. There are also fears that the current debate surrounding the collapse of Enron will provoke a legislative backlash against securitisation that will significantly hamper deal flow. ?What went wrong at Enron had nothing to do with securitisation, but because of the way this debate is going, insiders worry that there may be an overreaction against it?, adds the same source.

?What went wrong at Enron had nothing to do with securitisation?

Should US banks indeed find that part of their securitisation plans for private equity get blocked, it might fall to insurance companies and unregulated institutions such as pension funds to further advance the use of securitisation as a risk management tool in private equity investment. It could also mean that a greater proportion of future transactions will be done to address fiscal and regulatory issues for investors particularly outside the US in the way Prime Edge, Pearl and Princess have done, with less attention being devoted to solving balance sheet problems.

Kubr at Capital Dynamics sees CPO technology having relevance across a wide range objectives amongst both LPs and GPs. Besides financing primary deals and balance sheet transactions, the CPO technology could also be used to finance secondary pools, provide early liquidity for existing funds and add risk transparency for private equity exposure at banks, insurance companies and pension funds by helping to deal with value at risk measures, reserve accounting and regulatory accounting.

But in the meantime, US banks wrestling with their private equity exposure may well be obliged to turn to secondary funds to offload their private equity holdings, which many regard as a deeply unattractive alternative, particularly in the current market climate where discounts are steep.

Institutions with large and well-diversified private equity holdings, looking for liquidity and having had a taste of what securitisation is promising to bring them, will be reluctant to sell out to secondaries. Investors who remain committed to the long-term benefits of private equity will work hard to avoid taking this step, and many predict that for this reason the days when secondary funds were able to pick up large portfolios on the cheap will be over soon. Says Aon's Casey: ?I don't believe sellers are looking for pure risk transfer in today's market. If one can achieve between 50 and 70 per cent liquidity through securitisation, one must evaluate the marginal benefits of additional risk transfer against the cost. Portfolio risk is finite, and I would suggest the risk of loss is greater through sale today than through securitisation.?

Secondary buyers offering risk transfer at a discount will in all probability continue to dominate the part of the market where smaller investors are looking for a way out of the private equity commitments ahead of schedule. And they may start buying into securitised transactions themselves, as had been the plan of at least one such buyer with JP Morgan Chase's Porter Global before the offering fell through. But, as a general partner puts it, ?large and well-diversified LPs have come to recognise that securitisation offers a number of benefits that outweigh the appeal of selling one's exposure at 60 cents to the dollar to a secondary.?

Rating private equity&#42
Developing a framework for rating private equity assets was a key requirement for applying securitisation techniques to the asset class. Here Standard & Poor's, the rating agency, outlines the basics of its approach to rating private equity funds of funds.

Standard & Poor's now rates debt backed by a diversified portfolio of private equity funds. The rating analysis is based on the diversity of the portfolio, investment horizon, and on the underwriting and track record of the fund of funds manager, as well as on the structure of the financing. Structural characteristics are key in offsetting the lack of liquidity in the underlying collateral. Periodic mark to market and interim volatility in valuations are risks that the structure eliminates by relying only on the long-term behavior of private equity investments. Diversification includes investments over a number of vintage years and across a range of managers using different strategies, and investing in different regions and industries.

The securitisation process brings together the asset-backed market and investments in private equity fund of funds. In securitisation, a fund of funds and its sponsor, using a special-purpose vehicle, raise capital in the form of rated notes and equity. Then, the fund of funds manager invests by committing the note proceeds across a range of managers with expertise in different types of private equity funds. In this process, Standard & Poor's provides credit ratings by analysing the risk level of the notes linked to the long-term return performance of the private equity fund of funds.

The main economic motivation of securitisation is to create an alternative-funding source through an enormous asset-backed market for not only new commitments but also for acquisitions of private equity partnerships in the secondary market ? known as secondaries. Efficient balance-sheet management or capital relief is another motivation often mentioned when a portfolio of private equity funds from an institution's balance sheet is securitised and refinanced through the asset-backed market.

Rating Methodology
Standard & Poor's employs a stochastic rating framework for evaluating the risk level of the notes backed by a portfolio of private equity funds. The primary reason for the use of a sophisticated rating approach is due to the fact that risk is multidimensional. Thus, many structural as well as private equity characteristics need to be quantified in a probabilistic sense. It is also theorised that a private equity rating model is the same as the proposed structure itself; as a result, the model needs to reflect all the structural features and the asset characteristics so that the risk to the note investors can easily be translated into the Standard & Poor's credit rating scale.

Data Benchmarking
There are three important steps in finalising a rating model for a given transaction. They are: data benchmarking, market value simulation, and sensitivity analysis. A main step in developing a stochastic rating framework starts with the analysis of private equity performance data. Standard & Poor's relies on various data sources in order to understand the risk and return characteristics of private equity fund investments. They include public equity markets, the Venture Economics database, exchange-listed closed-end private equity funds, historical data obtained from various funds of funds, and the Merrill Lynch Private Equity Benchmark Index.

Simulation
Standard & Poor's credit rating on the structured notes is linked to the long-term performance of a private equity fund of funds as well as other structural enhancements in the transaction. Market value simulation is a tool that helps judge credit risk on rated notes. In general, the rating approach is consistent with the long-term return behavior of public equity markets. In other words, investing with a long-term view or buy-and-hold strategy results in, on average, positive expected returns with reduced downside risk.

The rating approach involves the use of a simulation model that incorporates numerous risk factors in a probabilistic sense in order to establish an entire distribution of possible payment outcomes for the rated notes. The outcomes are provided in a binary form ? default or no default ? so that the modeled default rate for each rated note can easily be compared to the benchmark default rates for rating consideration.

In the model, the quarterly returns for each return path of investment period (usually 10 to 15 years) are simulated from the benchmark index by assuming a random-walk model. That is, quarterly returns are assumed to be independent of each other. The model combines the return paths, the distribution assumption, commitments and drawdown assumptions, debt obligation paths, the use of the liquidity facility, and finally currency and interest rate assumptions. It then establishes a distribution of payment paths and an expected default rate for the rated notes. Unlike the return paths, other inputs such as the distribution rate are assumed to be more deterministic in nature. However, the deterministic inputs are tested thoroughly in a sensitivity analysis platform in order to make sure that the assumptions reflect reality.

Risk Factors
Risk Factors

Various questions highlight the multidimensional aspect of these risk factors. For example: What is the expected return and return volatility on the portfolio of private equity funds? Is the portfolio expected to perform any differently than the private equity market? What is the timing and magnitude of cash distributions? Is overcommitment risk eliminated? What will be the impact of commitment and drawdown patterns on the portfolio's performance? Is a redemption restriction a risk factor? Is the fund age a risk factor? In short, the risk factors incorporated in a market value simulation are:

  • ? Expected returns,
  • ? Return volatility,
  • ? Distributions,
  • ? Commitments,
  • ? Overcommitments,
  • ? Drawdowns,
  • ? Liquidity needs,
  • ? Redemptions or early liquidation,
  • ? Fund seasoning, and
  • ? Interest and currency rates.
  • Sensitivity Analysis
    Standard & Poor's tests the robustness of the rating model through various sensitivity analyses. By changing many inputs in the model, various payment outcomes and default rates are obtained to see how sensitive the outcome is to changes in various inputs. The following sensitivity tests are examined:

  • ? Increase in return volatility,
  • ? Longer/shorter commitments,
  • ? Longer drawdowns,
  • ? Lower distributions,
  • ? Longer drawdowns and lower distributions combined,
  • ? Use of liquidity facility,
  • ? Change in interest rate,
  • ? Change in exchange rate, and
  • ? Increase in liquidity haircut due to early liquidation.
  • Conclusion
    Private equity funds of funds, as a growing asset class, have entered the world of structured finance. Standard & Poor's rating approach will rely on the long-term performance of the fund of funds to offset the lack of liquidity in the underlying collateral. Therefore, the rating process will focus on three important components. They are: (1) business review of the fund of funds manager and visits to a selected number of funds, (2) structural considerations such as the use of a liquidity facility, and finally (3) development of a stochastic rating model that reflects the structure and the characteristics of the asset class, as well as sensitivity analysis of various assumptions in order to measure the credit risk on rated notes.