Everything You Need to Know About Collateralised Fund Obligations ('CFOs')

By Chris Mundey, Managing Director, Friday Capital 

The recent collapse and subsequent bail-out of Silicon Valley Bank brought back some anxious memories of August 2008 for those of us who rode the wave of the global financial crisis. Thankfully, many of the lessons learned through that time were put to good use as US regulators toiled over what to do with SVB. However, it got us thinking about what lessons from the GFC were not learnt so well, and one of them has been the growing popularity of an obscure financial instrument known as a Collateralised Fund Obligation or CFO for short. In this newsletter, we will introduce you to these CFOs and let’s hope they don’t turn out to be the financial weapons of mass destruction that their ugly cousin the Collateralised Debt Obligation (CDO) did in 2008.

Leverage on leverage – the arcane world of collateralised fund obligations (‘CFOs’)

We have all heard about ‘collateralised debt obligations’ (CDOs), the most common of which is a packaged bundle of mortgage-backed securities (e.g. home loans) that can be traded between investors, and the likes of which became infamous for playing a big part in the 2008 global financial crisis. But what about ‘collateralised fund obligations’ (CFOs)? What are they, why are they created and what are some of the pitfalls for investors in this lightly regulated corner of the financial world?

The use of CFOs is becoming increasingly popular in private capital markets. They are the private equity equivalent of CDOs and represent a securitised bundle of equity stakes in private equity funds. The very first CFOs were created in 2003 but with only a few issued between 2003 and 2006, the market quickly lost steam as the financial world began to wobble in 2007, but recently they have started a comeback.

CFOs are usually created by PE funds to free up liquidity so that capital can be returned to investors early and enhance the IRR performance of their funds. However, it’s also becoming popular for third parties to aggregate positions in PE funds and issue their own CFOs.

The CFO issuer uses the equity positions in the PE fund as collateral for a Bond which is issued to investors with a fixed interest rate. When the private equity funds make payments to its equity investors (either from dividends or asset sales), the CFO issuer uses the funds it receives to pay its interest obligations, while holding some funds in reserve to ultimately pay the principal to bondholders at maturity. Any cash remaining after debt repayments and expenses goes to the holders of the CFOs’ equity which in some cases will be the CFO issuer. CFO issuers typically issue bonds totalling between 50% and 75% of the value of the holdings in the underlying funds.

If at this point you are thinking that CFO instruments are another way of introducing a new layer of leverage into a private capital market that is already underpinned by debt, then you are correct. There is an arcane nature about these instruments and many large PE funds including Blackstone, KKR and Ares, who have created them, have done so privately with little or no public disclosure.

But what is their purpose and why do PE funds create CFOs? PE funds have two key objectives in creating and issuing CFO-type securities. Firstly, by bundling a portfolio of assets with varying levels of performance into a single securitised asset, they are offering a diversified portfolio of assets to investors which are collateralised by future cash flow returns from the fund. This lowers the perceived risk of each asset and affords better pricing from bond investors than if PE funds were to try raising the debt at the individual company level. Secondly, they are creating liquidity from their existing portfolio of companies, so they are able to return capital early to their fund investors, enhancing the overall Internal Rate of Return performance of the fund and increasing the fund's velocity.

So where is the risk in CFOs? The resurgence of CFOs came during a time of rising asset valuations and cheap debt, however, runaway inflation, increasing interest rates and future economic uncertainty are putting downward pressure on asset values. This ultimately puts pressure on their fund returns and therefore returns for CFO investors. Furthermore, CFO-related bonds are effectively leveraged on leverage, meaning that many of the investee companies and the very funds that own them are likely to already have a layer of debt funding in their capital structure and as the CFO is secured against Equity returns, it has the same risk profile as equity.

It will be interesting to see what the outcome will be from CFOs, the PE funds that issue them and the investors that invest in them over the next couple of years as global investment markets go through more turbulent times. CFO regulation and public disclosure are currently very limited although we may also see this change, particularly if more CFOs are brought to market for retail investors. If you are wanting to read more about CFOs, check out this great article from the Financial Times.