Private funds and structured finance professionals increasingly seek innovative ways to reconcile fund managers’ desire to access new sources of capital with insurance companies’ growing appetite for investments into private funds. Two of the most common structures used to bridge these needs are collateralised fund obligations (CFOs) and rated note feeders (RNFs). This article discusses these related structures and how they might be effectively deployed by market participants.
CFOs and RNFs involve the issuance of debt instruments, supported by limited partnership interests in either a single master fund or portfolio of underlying funds. In both structures, securitisation technology allows sponsors to raise financing through a feeder fund or a bankruptcy remote special purpose vehicle (SPV), which invests the investor’s capital into the sponsor’s private equity or alternative strategy funds. Insurance companies and other asset managers, who are restricted in the asset classes that they can invest in, are offered rated debt instruments—an asset class that they are typically permitted and incentivised to hold.
Careful deal structuring and the use of payment waterfalls enable the creation of different tranches of notes, each tranche structured to meet specific investor needs. Senior tranches offer the fixed returns expected by debt investors. The returns on subordinated or equity tranches, in turn, can vary in line with gains or losses on the underlying investments.
Senior tranches in CFO and RNF structures are typically rated so as to considerably reduce the capital retention requirements for regulated investors, when compared to direct participations in the underlying funds. Such favourable regulatory capital treatment makes the senior tranches a particularly attractive investment to insurance companies and sovereign wealth funds.
CFOs and RNFs have overlapping features, in that they both allow regulated investors to invest in funds or fund-like products via a rated debt instrument, which provides for a better risk-based capital treatment than an equity investment. However, RNFs are first and foremost private funds with (generally) a single pool of directly held assets (or indirectly via a master-feeder structure), whereas CFOs resemble fund of funds structures.
Additionally, CFOs are generally intended as leveraging vehicles aiming to enhance returns. In contrast, RNFs, despite having inherent leverage created by the notes, are less often deployed for leveraging purposes. Funds using RNFs typically obtain additional leverage via separate back leverage facilities (such as repo lines and loan-on-loan facilities in a CRE debt context).
Risk Retention
Both RNFs and CFOs should be carefully scrutinised by legal counsel to ascertain whether they constitute a securitisation for regulatory purposes. The notes issued in an RNF are typically unsecured, whereas a CFO is supported by a security interest in the equity of the asset holding company.
In the US context, since repayment of the CFO notes primarily depends on limited partnership (LP) interests, and most LP interests are not “self-liquidating” (i.e., interests in private funds, especially private equity funds, do not convert into cash within a finite period of time), most sponsors take the position that the US risk retention rules do not apply to CFO transactions.
In the case of a US RNF backed by an LP interest in a private credit fund, the parties must determine whether the structure resembles an open-market CLO, to which credit risk retention requirements do not apply. Each structure should, of course, be scrutinised based on its particular features.
Different considerations apply in Europe due to the UK and EU Securitisation Regulations, requiring careful analysis of both CFOs and RNFs at the structuring stage, particularly in relation to matters such as risk retention, transparency, and disclosure obligations.
NAIC Scrutiny
For US insurers, the features of a particular RNF or CFO will need to be evaluated under the applicable National Association of Insurance Commissioners (NAIC) guidance and statutory accounting principles to ensure that the rated notes qualify for regulatory capital treatment as a “bond.”
Although these guidelines and principles are currently undergoing substantial modifications, it is likely that a security that possesses equity-like characteristics or simply represents an ownership interest in the issuer will not represent a creditor relationship sufficient for bond treatment.
The NAIC also appears likely to adopt a rebuttable presumption that a debt instrument collateralised solely by equity interests does not represent a creditor relationship sufficient for bond treatment. If so, this presumption will need to be overcome by demonstrating (and documenting) that the characteristics of the underlying equity interests lend themselves to the production of predictable cash flows and the underlying equity risks have been sufficiently redistributed through the capital structure of the issuer.
Capital Calls
Another consideration applicable to these structures is capital calls, triggered at the level of the underlying fund investments. Where underlying funds can call capital to pay for fees or investments, the structure needs to provide for structural features to address the possible cash shortfalls.
This is especially the case for CFOs, which are typically backed by LP interests in private equity funds (where cashflows are intermittent and reliant on an underlying disposal or liquidity event), as opposed to RNFs, which are typically backed by an LP interest in a private credit fund (where there should be periodic cashflows flowing up through the structure from the underlying loans originated by the fund). Similar considerations also apply when the underlying funds allow the recycling of commitments.
As payments would not otherwise be recoverable from debt investors once they are paid out under the priority of payments waterfall, the additional cash required for reinvestments must be found elsewhere in the structure—for instance, through a designated cash reserve, via short-term liquidity facilities, or by structuring the notes as either delayed draw notes or, as is typical for RNFs, as variable funding notes, allowing cash to be drawn (or redrawn) at the appropriate time.
What else distinguishes CFOs and RNFs? All things being equal, RNFs are relatively easier to structure and allow sponsors to offer newly launched funds to insurers in a capital-efficient manner. Both CFOs and RNFs will contain securitisation-style waterfalls, with trigger events such as loan-to-value tests or liquidity tests, the failure of which diverts cash away from the equity tranche. Both CFOs and RNFs will typically provide for senior interest to be deferred to the extent there is insufficient cashflow to service the required payments.
RNFs use dedicated feeder funds or SPVs (set up by the sponsor) that issue rated notes to insurers and use the proceeds to invest in the sponsor’s newly established master fund. Such RNFs typically provide the investor access to one or more master funds through, for instance, a single note or multiple tranches of notes as well as an equity tranche.
CFOs, in turn, more closely resemble traditional securitisations in that they offer investors access to a diversified pool of different limited partnership fund interests, which are used as collateral for the debt securities issued by the SPV. The use of different senior, mezzanine and junior tranches allows CFOs to offer notes with a varied risk-return profile, which can appeal to a wide investor base.
Both CFOs and RNFs offer innovative ways for regulated investors such as insurance companies and other asset managers to invest in private funds. Market participants will recognise many of the structural characteristics of these trades from securitisations.
While CFO and RNF trades can be more expensive and time consuming to structure than direct investments into a private fund, the regulatory capital advantages to investors are considerable to the extent that the investment into the structure is rated debt (qualifying for treatment as a “bond” for US insurers in the US context). Sponsors, in return, can expect to raise financing at favourable rates.
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