Secondaries: Park Hill on CFOs – expert comment

adrian millan park hill 180
Adrian Millan

Calo Pablo 180 
Pablo Calo

Since 2009, growth in the secondary market has been driven by a series of catalysts that have expanded the market both from the number of participants as well as the amount of capital available to finance transactions. Financial regulation, record secondary fundraising, greater buy-side interest in new asset classes, growth in third-party leverage and GP-led transactions have each contributed to the prolific growth in the secondary market. We believe LP portfolio securitisations, also known as collateralised fund obligations (CFOs) could be another such driver of further market expansion. These types of liquidity solutions provide prospective secondary sellers with a compelling alternative to an outright sale and bring more capital to the secondary market from yield-oriented credit investors.

CFO TRANSACTION OVERVIEW
A CFO is a structured form of asset-backed financing analogous to a collateralised loan obligation where the debt issuance is supported by a portfolio of LP interests instead of pools of traditional loans. Typically, a CFO is structured where the current LP (the sponsor) sells a portfolio of LP interests into a special purpose vehicle (SPV), which in turn is owned by a newly established issuer SPV (the issuer).

Depending on the structure, in exchange for the contribution of assets the sponsor subsequently receives a 100 percent ownership stake in the issuer, providing indirect ownership of the original portfolio. The issuer then issues several tranches of debt (the notes) generating an array of new investment securities with unique risk and return profiles, some of which may be rated. The result is that the sponsor has converted a diverse private equity portfolio of LP interests into a series of notes and equity interests in the issuer, which can be retained or sold in the capital markets.

SPONSOR VALUE PROPOSITION
As with any securitisation, a CFO allows the sponsor to accelerate and monetise the future cashflow streams of its private equity investments, which may represent a compelling alternative to traditional LP sales. Once established, the CFO framework provides a permanent in-house liquidity mechanism for future issuances thereby expanding the sponsor’s long-term portfolio management capabilities. Furthermore, the notes are non-recourse to the sponsor and the tranched structure can facilitate a significant capital raise in the range of ~40-60 percent of the portfolio’s NAV on attractive terms.

This can provide sponsors with a viable financing alternative to traditional specialist private equity lenders who often require some form of recourse or more restrictive covenants. Additional sponsor benefits include: i) portfolio liquidity based on current NAVs and not at discounted values ii) the retained equity is poised to receive an enhanced return through leverage iii) the sponsor maintains their GP relationships iv) potential off-balance sheet treatment of the transaction v) potential regulatory risk-weighted asset relief.

As an alternative to directly sponsoring a CFO, existing LPs may also have an opportunity to contribute private equity assets to a third party CFO platform in exchange for cash and or CFO securities. This may be appealing for LPs who would like to reduce their private equity exposure but who would prefer to receive turn-key CFO securities as opposed to cash in order to avoid reinvestment risk.

INDUSTRY BENEFITS
Private equity has traditionally been difficult to access for many non-institutional investors due to the asset class’s long-term investment horizon, illiquidity, minimum investment requirements and committed capital structure. A CFO, however, can mitigate many of these challenges, especially for smaller institutional or retail investors, by providing exposure to private equity on more defined, predictable and digestible terms. From a cashflow perspective, the CFO notes are fully funded (ie, they bear no future unfunded obligations) and investors are provided with a menu of return profiles ranging from highly visible fixed income coupons, to reinvesting PIK interest, to equity kickers. Similarly, the tranched nature of the notes provides a range of expected maturities for investors with varying investment horizons.

From a liquidity perspective, the notes can either be listed, providing a direct secondary market, or they can be rated which provides a reference valuation against other securities of comparable ratings. As CFO adoption continues, the combination of heightened LP liquidity for reinvestment and greater capital market participation should result in an increased velocity of capital for the private equity industry as a whole.

PORTFOLIO CONSTRUCTION
An appropriately constructed CFO portfolio pools the discrete and irregular cashflows of individual private equity funds into a smoothed distribution curve which can be effectively modelled. To accomplish this aim, the LP portfolio must be constructed with thoughtful diversification and seasoning, both at the fund and look-through portfolio company levels. Proper diversification starts at the fund level, where a suitable portfolio should be well diversified by fund, manager, strategy, vintage and geography.

On a look-through basis, the underlying portfolio companies should be well diversified by industry, geography, holding period and individual company concentration, with most historic CFOs including several hundred underlying portfolio companies. Appropriate diversification helps mitigate the idiosyncratic risks associated with a single company or market.

Proper seasoning also starts at the fund level, where the average fund should be beyond its commitment period, which usually concludes at the end of year five or six, and is in the harvest phase. This also serves the purpose of limiting the unfunded commitments of the portfolio which will need to be fully provisioned to the satisfaction of both the portfolio GPs and ratings agencies. On a look-through basis, the average holding period and private vs public status will also have to be carefully examined. Appropriate seasoning positions the portfolio to deliver sufficient net distributions per period to adequately service the CFO waterfall.

STRUCTURING & RATING AGENCY PROCESS
Once the LP portfolio has been selected a bespoke CFO structure is then customised to the portfolio’s expected cashflow pattern. This process includes developing the CFO’s priority of payments waterfall and note terms, stress testing the cashflows and structure, appointing service providers and executing the requisite governing and operating legal documents. In a typical CFO, some or all of the notes, and particularly the senior tranches, are rated by a credit rating agency. These ratings provide an independent third party assessment of the credit quality of the notes incorporating an analysis of the assets, the financial and legal integrity of the structure, and the operating capabilities of the manager and service providers among other factors. Additionally, the ratings provide investors with a framework of comparative risk between other similarly rated securities which generally facilitates tighter pricing and broader market demand.

LOOKING AHEAD
As the secondary market continues to mature, the need for customised liquidity solutions like CFOs should continue to become more relevant to a broad base of LPs. The largest post-crisis CFO was recently completed by Singaporean state-controlled Astrea III, comprising a portfolio of more than $1 billion and the debt issuance was vastly over-subscribed. Given the broad base of private equity and other alternative assets held by LPs globally and the many benefits these structures afford sponsors, CFOs could address more market liquidity needs going forward. ?

Adrian Millan and Pablo Caló are managing directors on the secondary advisory team at Park Hill Group. Park Hill is a division of PJT Partners, a global advisory-focused investment bank

This article is sponsored by Park Hill. It was published in the September 2016 issue of Private Equity International