By Andrew Woodman, PitchBook's London Bureau Chief who oversees news coverage from Europe.
With the global economy looking more fragile than it has in a long time, comparisons to past crises are inevitable. The search is already on for the financial villain that will trigger the next market cataclysm. In the 2008 crisis, it was the collateralized debt obligation—a financial instrument essentially used to disguise subprime mortgages as AAA-rated products.
Since then, any financial instrument starting with a "C" and ending with an "O" has been treated with suspicion. It is little wonder then that the recent proliferation of the similar-sounding collateralized fund obligation in the private markets is raising more than a few eyebrows. But is the alarm warranted?
The exotic-sounding CFO may have a superficial resemblance to the justifiably maligned CDO, but it is also different in some important ways, both in terms of the assets that underpin it and the amount of leverage they use. Moreover, CFO usage is comparatively niche.
On the other hand, there are valid concerns—particularly with regard to new types of CFOs being issued by GPs that have not been tested by a downturn. The market for CFOs, as small as it is, is growing while it remains relatively opaque. As a result, it can be hard to measure what kind of systemic risk CFOs present, if any. For these reasons, CFOs warrant closer examination.
The concept of a CFO is not entirely new. It is a piece of creative finance that has been around since the early 2000s, when the technique originally developed for CDOs started to be used to securitize private equity and hedge fund portfolios. For much of their history, CFOs have been highly specialized in their usage, but they have gained greater traction with the growth of the private equity secondaries market.
The main purpose for CFOs is to generate liquidity. For a fund sponsor—the GP—they are a means of raising capital without having to sell fund interests. In this respect, CFOs are closely related to subscription lines or net asset value financing: loans secured against LP commitments or the value of the fund's portfolio, respectively. For LPs, the instrument offers access to a diverse portfolio of private market assets in a structured, capital-efficient, rated product. It can also be an effective means to manage their private market allocations.
"A recent use of CFOs is by endowments and pension funds who have large PE exposures, and are trying to manage the volatility," explained Paul Forrester, a corporate finance lawyer with Mayer Brown who has been working with CFOs since before the global financial crisis. "If [portfolio valuations] are going up, it pushes them into their investment limits, so they create a CFO so they can take the money off the table."
A notable example of LPs using CFOs was in May and involved Astrea Capital, a unit of Azalea Asset Management, which is in turn owned by Singapore's state-backed fund Temasek. The CFO comprised $1.9 billion in NAV of funded commitments and $250 million of unfunded capital commitments across 38 funds. This particular CFO is exceptional in that it is being used as a means of offering private markets investment to Azalea's retail investors and, as a result, is more transparent.
It was this product that was singled out in a recent article in the Financial Times, which suggested that CFOs, like CDOs before them, can obfuscate the risk of underlying assets. While Astrea's CFO has an A+ investment grade rating, individual underlying investments—in this case a single KKR portfolio company, Envision Healthcare—have a junk-grade credit rating.
It is worth pointing out here that underperforming portfolio companies are common, even expected, in PE. What matters more is the overall performance of a fund. In Astrea's case, the CFO is comprised of 38 funds managed by some of the biggest names in PE, including KKR, Blackstone and General Atlantic—all of which have invested through several cycles, including the 2008 crisis. At this scale, the underperformance of one portfolio company out of hundreds is almost immaterial. However, as mentioned, this is not the only use case for CFOs.
Greg Fayvilevich, head of the global funds group at Fitch Ratings, explains that PE CFOs can roughly be divided into two categories. Much like the secondaries market includes LP-led secondaries and GP-led secondaries, the same can be said of CFOs. The former are issued by LPs with existing portfolios, that are looking to generate liquidity; the latter, meanwhile, is driven by GPs seeking to raise new capital, in some cases for follow-on vehicles. It is this second portion that is cause for greater concern, as they tend to be more highly leveraged, less transparent and largely untested by volatile economic conditions.
"They're a relatively new vehicle and really started proliferating quite a bit in the last one to three years, so the market hasn't really seen many of them go through any type of stress, and so we think that's a risk," said Fayvilevich. "I think there are concerns broadly with tranched pools of alternative investments funds but—given their private nature—it will be hard to assess their performance over the cycle because, unlike for the publicly rated CFOs, you have no visibility."
About the Author:
Andrew Woodman is PitchBook's London Bureau Chief and oversees news coverage from Europe. Andrew has been reporting on the private markets since 2012. He was previously an editor with Private Equity International and with the Asian Venture Capital Journal. A Japanese speaker, he spent the best part of a decade in Asia, living and working in both Japan and Hong Kong.