Tavakoli Structured Finance LLC

Ultimate Leverage: Collateralized Fund Obligations

HedgeWorld’s Accredited Investor, June 2004. Tavakoli Structured Finance Retains the copyright for this article.

By Janet Tavakoli

What are collateralized fund obligations and why hasn’t the publicly rated CFO market lived up to the 2002 growth hype? When both Man Glenwood Alternative Strategies I and Diversified Strategies CFO S.A. (managed by Investcorp with Credit Suisse First Boston as the sole lead and book runner) hit the market in 2002, pundits predicted an exponential growth trajectory for these products, but the pundits failed to check in with investors.

As we’ll see, CFOs are interesting structured finance products, but from an investor’s point of view, they are low-value-added products. CFOs have introduced specialized new jargon to the financial markets, but impressing colleagues with buzzwords doesn’t necessarily add cash to the investment portfolio. Nonetheless, CFOs generate more fees for bank arrangers and for the managers of the CFO, so we should expect to see more attempts to create a market for these investments.

If the idea is that fund of funds managers are more effective at diversifying hedge fund investments, an investor in either the fund of funds or the CFO should ask themselves how a manager reasonably can assess the variety of strategies employed by hedge funds when they are diversifying. The reality is that a fund of funds manager cannot. It is not clear whether fund of funds managers who have done well were lucky or skilled.

A CFO is a type of collateralized debt obligation, commonly known as a CDO. A CDO issues securities or notes backed by a pool of loans, bonds, receivables, future flows, or any type of cash flow stream that can be identified and isolated. CFOs issue notes backed by a pool of hedge fund investments. Often a special purchase entity purchases the pool of underlying hedge fund investments, which are then used as collateral to back the notes.

The asset-backed notes are also called tranches. While CFOs can be rated public CFOs, private (unrated) CFOs, or private equity CFOs, we’ll focus on the publicly rated CFOs, because these are the deals that offer the most potential for a false sense of security.

The most senior tranche is usually rated AAA and is credit enhanced due to the subordination of the lower tranches. This means that the lowest tranche, the equity tranche, absorbs losses first. When the equity tranche is exhausted, the next lowest tranche begins absorbing losses. A CFO may have a AAA rated tranche, an AA rated tranche, a single A rated tranche, a BBB rated tranche, and an equity tranche. The following schematic shows a prototype of a CFO structure.

Collateralized Fund Obligation

CFOs are Market Value Deals

CDOs are either market value deals or cash flow deals. Cash flow CDOs pass principal and interest payments generated by cash flows of the underlying collateral pool through to the investors. For a cash flow deal to be successful, the cash flow from the collateral pool must meet all deal liabilities including the interest and principal obligations from the notes issued by the CDO.

CFOs are market value deals. Unlike cash flow deals, the underlying asset pool for market value deals is marked-to-market. The market value CFO meets principal (if applicable) and interest liabilities by generating cash from trading assets and from interest or dividends on invested assets. Investors who must mark their assets to market often prefer market value structures, since market value CDO managers must mark the CDO’s portfolio to market.

Since the CFO collateral pool consists of investments in a pool of hedge fund assets, the market value structure is the only logical structure. Hedge fund assets do not generate predictable cash flow streams, but have significant market value upside potential as well as significant downside potential. Market Value deal managers trade actively and aggressively and can employ leverage. Of course, not every trade results in a gain.

The ratio of the market value of assets to the face value of liabilities is a key risk metric of a market value CFO. The amount of debt or note tranches that a CFO can issue as a percentage of market value is limited by a “haircut” to maintain a set level of theoretical overcollateralization. This permitted debt percentage is called the “advance rate.” Although this jargon is unique to the CFO market, the concept of overcollateralization or haircuts are well known in the financial markets.

The overcollateralization protects investors from asset price volatility due to changes in general interest rate movements, general credit spread movements, or other general market movements. Market value CDOs require maintenance of a minimum overcollateralization level. If the advance rate is breached, the assets must be sold to pay down liabilities (the notes) or the assets must be sold and exchanged for highly rated liquid instruments. This is known as a “trigger event.” The rating agencies monitor the debt coverage ratios. The performance of a market value CDO depends upon the manager’s trading ability.

At least that is the theory. The trouble with a theory that has been developed for a class of assets, such as the rating agencies’ core expertise in corporate credit risk, is that it doesn’t always translate well across all asset classes.

The Management Myth

A fund of funds is a pool of hedge fund interests chosen by the manager. The collateral is a diversified portfolio of hedge fund securities. These hedge fund interests are used as collateral for publicly rated CFOs. Hedge fund of funds managers are issuers of CFOs. CFOs are actively managed, market value CDOs. The perceived experience and track record of the manager is key to a successful launch of a CFO.

Unlike the investment in a fund of funds, CFOs issue rated tranches. This seems to be an advantage to investors who must own assets with explicit ratings, and who cannot otherwise invest in hedge fund of fund products, but why should an investor buy the rated tranche of a CFO versus the rated tranche of a CDO backed by a different asset class? If there is no price advantage, there is little reason beyond wanting to diversify asset classes. One reason not to invest is that the rating of a CFO can’t be taken seriously.

Diversification is not a guarantee against loss; it is only a hedge against the probability of taking a large instantaneous loss. The hedge fund universe is opaque and illiquid. Hedge funds can employ a variety of core strategies. Various types of hedge funds include the following: leveraged equity, convertible arbitrage, distressed assets, short sellers, emerging markets, private equity, sector funds, merger arbitrage, CDOs, fixed income arbitrage, and equity market neutral funds.

Hedge funds can make leveraged interest rate and currency bets in addition to their core strategies. Hedge funds can radically change their core strategies. Sometimes this change in core strategy represents “competence drift” as opposed to style drift. CFO managers cannot easily track this and have no power to prevent it.

If the idea is that fund of fund managers are more effective at diversifying hedge fund investments, an investor in either the fund of funds or the CFO should ask themselves how a manager can reasonably assess the variety of strategies employed by hedge funds when they are diversifying. The reality is that a fund of fund manager cannot. It is not clear whether hedge fund of fund managers who have done well were lucky or skilled.

Besides assessing the efficacy of hedge fund strategies, hedge funds of fund managers – and therefore CFO managers – face other pitfalls.

Almost any fund that hedges risk can call itself a hedge fund, and anyone can start a hedge fund. You’ll need enough money to hire an accountant and a lawyer. You may wish to apply for credit from a prime broker to leverage your assets. If you have enough cash and can get a margin account, you can even skip the step of having a prime broker.

My personal investment portfolio meets the definition of a hedge fund. Hedge funds are private funds, and true to hedge fund form, I will not disclose my holdings or my strategy.

Some hedge funds make limited disclosure filings with the Commodity Futures Trading Commission (CFTC), but that only applies to hedge funds that invest in products regulated by the CFTC. Some venues outside the U.S. require principal guaranteed structures. The only other hedge fund regulation is that the fund must either have less than 99 investors worth at least $1 million each, or they can sign up to 500 investors each worth at least $5 million each. Some hedge funds have minimum net worth requirements greater than these guidelines, however.

Most financial professionals feel the defining characteristic of a hedge fund is the heavy use of leverage. Managers of smaller hedge funds may not be able to live off of the management fee, so they have to take leverage risk in an attempt to capture incentive fees. Leverage can make even a mediocre manager look good in the short run if the manager is lucky. A hedge fund does not need to disclose its degree of leverage, and some hedge funds use no leverage at all.

In pursuit of diversity, a hedge fund of fund manager may diversify into suboptimal investments. Long Term Capital Management (“LCTM”) was rated AAA just prior to its steep fall from grace. The managers at LCTM were meant to be among the best financial minds in the business, and they probably were. Myron Scholes and Robert Merton, co-winners of the 1998 Nobel Prize in Economics, pioneered equity option model pricing. John Meriwether, former head of Salomon’s arbitrage group, and David Mullins, a former Federal Reserve Bank Vice-Chairman, were also partners. In August 1998, LCTM, founded in 1993, lost around $2 billion after Russia defaulted on short-term government debt obligations and the ruble was devalued. Among other strategies, LCTM leveraged investments using total return swaps. LTCM managers refused to disclose positions or trades. They claimed they had to keep their transactions proprietary to protect their trading positions. In the end, others were probably grateful they couldn’t copy LCTM’s strategies. After several years of 40%+ returns, and shortly after the Russia crisis, LCTM’s net asset value (NAV) was down about 44%, meaning investors lost about 44% of their money if they were original investors. What hedge fund of fund manager would have predicted that?

Leverage can make even a mediocre manager look good in the short run if the manager is lucky.

Beacon Hill, one of the largest hedge funds after LCTM had a stellar reputation until the SEC alleged that the hedge fund managers had wildly overvalued the hedge fund portfolio’s illiquid mortgage-backed securities assets. Coincidentally, the overpricing occurred just after the fund managers negotiated an increase in management performance fees. What fund of funds manager can protect against this type of alleged fraud?

Ratings Mythology

Rating agencies rightly claim that market value deals rarely have ratings downgrades relative to cash flow deals. Ratings are merely evidence that steps were taken to evaluate cash flows from public documents. Rating agencies don’t take losses, investors do.

In December 2003, after the recent Parmalat alleged fraud was uncovered, and after S&P’s instantaneous ten-notch downgrade of Parmalat, Francois Veverka, an Executive Managing Director at Standard and Poor’s, wrote the Financial Times that it is unfair to expect rating agencies to unearth fraud. Rating agencies have made it abundantly clear they will not perform due diligence for investors.

It would be nice to believe that credit ratings bring greater transparency to structures like CFOs, but it isn’t true. As Alan Greenspan, the Federal Reserve chairman pointed out, disclosure is not the same thing as transparency.

Since the hedge fund strategies vary so much, the key to their ratings is the CFO’s structural protections. The problem is that no one knows how much is enough. The theory is that the degree of structural protection required should be sufficient to make the ratings pari passu with more conventionally understood CDO structures.

Unique Characteristics

CFOs incorporate many of the structural features of other CDOs, but the following are uniquely characteristic of CFOs.

The unrated equity tranches of these deals tend to be much greater in size than even the equity tranches of high-yield backed CDOs. Equity subordination is often 30% and higher for CFOs, whereas CDOs backed by high-yield debt may only have a 10%-12% equity tranche, and CDOs backed by investment-grade credit risk may have an equity tranche as low as 1.5% of the deal. The AAA tranches of CFOs make up only about 40-45% of the deal, as opposed to less than 10% for a CDO backed by investment-grade corporate credit risk.

As mentioned previously, CFOs must maintain a specified advance rate, which is expressed as the percentage of debt versus the market value of the underlying assets. The CFO will also have a volatility test. If the volatility on a rolling 12-month calculation exceeds a pre-set threshold, or if volatility exceeds a pre-set threshold for three consecutive months, the CFO must pass overcollateralization tests based on a second set of advance rates. CFO assets are marked-to-market monthly, and the advance rate is recalculated to see if the deal is in compliance. Just as one might expect, the cure is either to inject more cash collateral, redeem hedge funds, or reduce leverage by paying down tranches in order of seniority.

CFOs also have collateral quality tests (CQTs) with cures similar to that of the advance rate. Losses in excess of around 15% will usually start triggering CQTs. The overcollateralization test is a deleveraging trigger and requires the NAV times the advance rate to be greater than the remaining principal amount plus accrued and certain other senior liabilities (for instance, hedge costs, if applicable). If the overcollateralization test fails, the manager will have to switch some investments to cash (if possible at a profit to increase NAV), add capital, or delever until the deal passes the CQT.

The minimum net worth test is an unwind trigger in the extreme scenario. The CFO must exceed the pre-specified minimum net worth requirement or else it must inject additional capital. If additional capital injection sufficient to pass the test isn’t possible, the deal must be liquidated.

Ratings Reality

Rating agencies will usually only rate a CFO if the fund of funds manager has a successful 3-5 year audited track record of selecting a “diversified” portfolio of hedge funds. They take into account concentration limitations, risk-adjusted returns, and the volatility of net asset values.

The methodology suggests that there is more science to the procedure than the ratings merit. Due to the illiquidity and opacity of the hedge fund market, the ratings of CFO tranches cannot be relied on in the same way as the ratings for more conventional CDOs backed by corporate credit risk. Ironically, even the latter have experienced unprecedented ratings volatility.

CFOs may not experience ratings volatility, but that may be due to the fact that no one is sure how to rate them in the first place, much less reassess the ratings. The large equity tranche and high degree of subordination should give the senior tranche investors some comfort that they are unlikely to lose principal if they hold the asset to maturity. If an investor wants to sell the asset prior to maturity, however, he will find that the liquidity for this asset is severely limited and may not be able to sell the asset near the purchase level.

There is no incentive for investors to prefer a rated tranche of a CFO over the rated tranche of any other type of CDO other than price. In other words, an investor in a rated tranche of a CFO should ask for a higher spread over the same rated tranche in a conventional CDO to compensate for the uncertainty in the integrity of the rating. No one has the answer for how much more spread is adequate compensation.

Untapped Potential

The CFO manager is usually happy to retain the leveraged equity portion and may repackage it and sell it in the form of a principle protected note. This seems to be a wasted opportunity. Investors in hedge funds who are looking for a leveraged play on this already leveraged asset class may wish to invest in the equity of the CFO. This is a pure bet, but if an investor wants to risk some mad money (or a small percentage of alternative asset investment funds), it is worth a look. However, the investor should expect a very high return with this strategy. Consider that in the past two years, an investor could buy the equity tranche of a synthetic CDO backed by investment-grade corporate credits at more than a 60% IRR (it is now closer to 15%); opportunity is always relative.

See also: Structured Finance & Collateralized Debt Obligations, by Janet Tavakoli, John Wiley & Sons, 2008

Structured Finance and Collateralized Debt Obligations by Janet Tavakoli
Credit Derivatives & Securitization 3rd Edition by Janet Tavakoli

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