More on collateralized fund obligations
CFOs are long-term managed structured finance products issued by a fund of hedge funds manager. The CFO issues several tranches of differently rated debt securities, and then equity securities, offering different risk-return trade-offs. Performance is based on the pool of underlying hedge fund assets.
For example, in February P&G Alternative Investments, a fund of hedge funds and CDO group based in Italy, launched a €150 million CFO called Zoo HF 3. Zoo HF 3 has an underlying pool of 52 hedge funds and 14 different strategies. The CFO comprises five classes of debt ranging from triple A-rated to double B-rated, and one unrated equity class. The debt investors receive semi-annual coupons ranging from six-month Euribor plus 40 basis points to six-month Euribor plus 600bp.
The benefits to a fund of hedge funds in raising assets through a CFO are clear. Fabrice Susini, European head of securitization at BNP Paribas, which put together the Zoo CFO, says: "The management costs are lower than in funds of hedge funds, yes, but the main benefit to a fund of hedge funds manager is that, given the maturity of the CFO being seven to 10 years, he can look at investments as long-term without the worry of redemptions by investors." The long-term financing also means that the fund of hedge funds manager can invest in less liquid underlying strategies. Prime brokers, which traditionally provide finance to fund of hedge funds managers, can be uncomfortable with illiquid strategies.
The cost of issuing CFOs has also become more attractive. The average cost of funding for Zoo HF 3 was Euribor plus 90bp, for example. Grace Wu, head of new products at Merrill Lynch, says: "Traditionally, funds of hedge funds would get leverage from their broker dealer through a total return swap (TRS), a repo or an option on a one-year rolling basis. Such financing is usually around Libor plus 100bp for 2x leverage. Now that credit spreads are low, pricing for CFOs has come down and, being longer-term in nature, is very competitive. The first CFO was priced at Libor plus 140bp for 3x leverage, but now that is around Libor plus 80bp."
In the current market, there is a ready supply of investors, with different types being attracted to CFOs. "CFOs offer an opportunity to access hedge fund returns for those investors who cannot invest directly, or for those investors that do not want the bother of putting together and managing their own diversified portfolio," says Susini.
The higher-rated tranches of the capital structure tend to attract institutional investors that want access to alternative assets but need a rating to be able to invest.
| CFO financing is becoming more attractive to FoHFs |
| CFO financing versus total return swaps (TRS) and repo financing |
| Financing method |
CFO |
TRS |
Repo |
| Term |
7 to 10 years |
2 to 7 years |
Less than one year |
| Collateral |
No collateral posting |
Collateral posting |
Collateral posting |
| requirement |
required |
required |
required |
| Control |
Manager/fund retains control of the assets |
The TRS counterparty has legal rights to the assets and controls the assets |
The repo counterparty has legal rights to the assets and |
| Source: Euromoney |
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CFOs also offer diversification for traditional leveraged loan or CDO buyers. The equity part of CFOs attracts investors looking for greater returns, and who are more familiar with hedge funds. In the case of Zoo HF 3, Fabiana Gambarota, chief investment officer and partner at P&G Alternative Investments, says: "We saw two types of investor buying the equity piece of the structure: traditional buyers of CDOs who wanted to diversify away from CLOs, the asset class of 2006, and then traditional investors in funds of hedge funds that wanted leverage." In some cases, investors participate in more than one piece of the capital structure. Hedge funds were cited as one investor base in Zoo HF 3 CFO.
Indeed the leverage that a CFO enables the issuer to apply can offer attractive returns to end investors. Wu says: "Fund of hedge funds returns have come down and tend to average 8% to 9%, but volatility is less than 3%. It makes sense to consider applying light leverage to enhance the returns. Through a CFO, investors can get returns in the mid to high teens."
"The problem with leverage is that it can be at times dangerous because of the multiple risks," says Margolis. "So when you craft leverage you should do it in most conservative and least risky way."
Not every fund of hedge funds will be able to issue a CFO, however, and Georges Duponcheele, head of product development and quantitative structuring at BNP Paribas, says this should prevent a tidal wave of issues hitting the market. "Funds of hedge funds that take this route have to demonstrate a steady management style to the ratings agencies, and have to have a diversified pool of underlying assets to reduce risk," says Duponcheele. Gambarota adds: "The ratings agencies rate the CFO by running simulations, stress testing the volatility and correlation of the funds, and then rating the different tranches based on their expected losses."
At the same time, it is important to let managers have the flexibility to carry out their jobs, points out Jean Luc Bourrin, structurer at BNP Paribas. Zoo HF 3 has such flexibility. The portfolio is dynamic and constantly traded. "It pays semi-annually, and to meet that we either have to redeem funds for an amount equal to performance, change the portfolio composition or use our liquidity facility with BNP Paribas. Empirical evidence has shown that in the rare case of a fund blow-up, the recovery rate is not far away from those experienced in the leveraged loan market. But obviously we are analysing the funds constantly to limit being hit by such blow-ups. It is quite a conservative capital structure, with much less leverage than traditional CDOs. You would have to run dramatic scenarios to have the most junior-rated tranche impacted by any loss," says Gambarota.
The long maturities of CFOs imply a confidence in the hedge fund industry that some are still questioning. Gambarota firmly believes that there will always be a market for hedge funds. "There are always going to be different ways of creating alpha. By changing our allocation to funds and strategies over the life of the CFO we will make sure we adapt to new developments, market and instruments as the hedge fund industry evolves."