As more investors have started looking at hedge funds the methods of gaining exposure have also increased. The derivatives market started by offering traditional instruments, such as secured loans, non-recourse total return swaps and call options to leverage hedge fund investments, but so-called collateralized fund obligations or CDOs of hedge funds have also increased in popularity. Aside from bringing enhanced potential returns by taking advantage of the current environment of low interest rates, CFO structures have also opened the gate to alternative investments for new classes of investors.
The capital structure is similar to traditional CDOs, in that CFOs allow investors to benefit from a risk-tranching approach to gain exposure to a wide spectrum of rated or unrated debt securities and equity interests. The use of the securitization framework and more specifically the CDO techniques have provided leveraged hedge-fund linked structures with (i) a new source of non-recourse financing and (ii) more market standards, and cause CFOs to be one of the most efficient forms of leverage for structures linked to alternative investments.
Structural Features
Establishment of a bankruptcy-remote SPE, in a jurisdiction chosen for its tax and legal efficiency. The SPE purchases and holds a diversified portfolio of hedge funds and issues securities collateralized by these assets: investment-grade liabilities with a senior/subordination scheme and a single class of equity. Proceeds from issuance of debt and equity securities are invested in the underlying portfolio of hedge funds, the collateral.
* Debt tranches: Investment-grade senior/subordinated liabilities which represents the source of leverage for the equity. Rated or unrated (therefore called "privately rated" transactions) these securities are securitized by a diversified pool of funds and have scheduled fixed or floating interests together with principal payments at maturity. Investors in debt securities are essentially lending money to the equity tranche, which represent the hedge fund investment. Priced similarly to equivalent rated corporate debt they offer, to a broader range of investors, a fixed income exposure to equity type assets, hedge funds, with credit protection.
* Equity tranche: Unrated leverage investments in the source of collateral which targets a high rate of return but takes the first loss on the underlying investment. The debt securities are designed to provide equity investors with a cost efficient and stable financed leverage to increase the participation rate to the underlying funds. The financing of the leverage is optimized thanks to the tranching and the distribution of the debt securities to specialized investors, with different risk return profiles. Expected return depends on the collateral performance and the debt securities flow structure.
The collateral is managed dynamically over the investment duration, by the manager, according to pre-defined investment guidelines which are also constitutive of the terms of the debt securities. The source of leverage and therefore the level of debt outstanding over time is either static (knock-out type structures) or managed dynamically (resrikable option and dynamic allocation).
Cash-Flow & Loss Distribution
A top down distribution of cash flows (from Senior down to Equity)
A bottom up distribution of losses (from Equity up to Senior)
Hedging Methods
Static Leverage With Knock-Out Structures
The amount of leverage is fixed from the inception date and remains unadjusted over the entire investment duration, unless there is a knock-out trigger event, in which case the structure is terminated prior to maturity.
In most of the structures, the management of the principal protection given to the most senior debt holders is in fact implemented through the use of pre-defined levels and not using a single knock-out level. These levels are designed to trigger progressive adjustments of the leverage amount to prevent early termination events. The de-leveraging of the fund exposure and therefore the participation rate of the equity securities is triggered by liquidating a pre-defined amount of hedge fund underlying assets, whenever the fund fails to comply with the over-collateralization ratio with respect to a certain class of debt. The proceeds from such a liquidation are used to either reduce the debt outstanding by the equivalent amount or to increase the liquidity allocation, in both cases to reduce the risk and get the ratio back to an acceptable level. Under certain conditions of fund recovery, the structure may be re-leveraged or additional senior asset classes would be re-issued.
Certain scenarios such as a severe depreciation, could knock-out the structure, leading to early redemption.
Dynamic Leverage using Restrikable Options
The amount of leverage is constantly adjusted over the investment duration. Assets are allocated between (i) riskless assets and (ii) equity interests. The amount allocated to the riskless assets corresponds to the amount necessary to fully defease the payment obligation given to the debt holders at maturity. This is used to purchase zero-coupon type instruments or equivalent. No change in the investment in the riskless assets occurs until maturity, regardless of the funds' performance. The outstanding amount of the proceeds, together with a fixed amount of additional proceeds (the leveraged amount, equal to a fixed multiple of the outstanding proceeds), from the issuance of the debt securities, is invested in the collateral to generate the return on the equity securities. Thereafter, the allocation to the fund is systematically adjusted up or down, depending on the collateral performance and the over-collateralization ratio requirements.
Due to the nature of the riskless assets allocation, this structure is sensitive to interest rate levels from a mark-to-market prospective and would suffer in a rising interest rate environment.
Dynamic Leverage Using Dynamic Allocation
The leverage amount given to the equity investors depends on a pre-defined formula and performed dynamically through the use of portfolio insurance techniques.
The principal protection given to the senior debt securities is granted at maturity, through the implementation of dynamic rebalancing operations between two different classes of assets: (i) trading assets (fund shares) and (ii) liquid assets (money market instruments). The portion allocated to fund shares at any time is equal to the "leverage factor" multiplied by the difference between (i) the net-asset value of the collateral and (ii) the value of the riskless assets that would be required to defease the principal amount of the most senior debt securities at maturity. The leverage depends on factors such as the collateral volatility, liquidity and transparency and is decided at inception. The value of the riskless assets is re-calculated on each rebalancing date and a function of the interest rate for the time remaining to maturity.
Such path-dependent structures have no sensitivity to interest rates from a mark-to-market standpoint.
CFO Indicators & Parameters
The rating is either explicit (given by rating agencies) or implicit (given by the nature and rating of the guarantor). European/Asian CFOs are not always rated, whereas in the U.S. a rating is often required. Unlike U.S. structures, primarily wrapped by monoliners, European and Asian "privately rated" CFOs are usually insured by large entities using their own internal rating. They do not therefore require a separate stand-alone rating from a rating agency.
The advance rate corresponds to the percentage of assets required as collateral to issue rated debt. The class of debt investments that has the higher advanced rate shall be the BBB rated notes: having the lower rating, more collateral is needed. The sum of the assets market value times the advance rate shall remain greater than the total outstanding principal plus interests, otherwise the manager has to adjust back the portfolio over a so called "cure period" to get the collateralization test back within the predefined limits.
The over-collateralization ratio is used to improve the credit enhancement of the debt tranches. It is defined at transaction inception, by the rating agency (rated) or the debt issuer (unrated), as the ratio of (a) the fund's net-assets value and (b) the sum of (i) the outstanding amount of a certain class of debt, (ii) the aggregate outstanding amount of all the other classes of debt tranches senior to the said class of debt and (iii) all applicable accrued and unpaid expenses and interest costs of the fund. A test failure leads to the diversion of subordinated cash flows to restore the ratio within acceptable limits.
The waterfall defines the priority of payments between the different tranches and therefore the credit enhancement. Interest waterfall: the payment of interest to a tranche is subordinated to the payment of interest to the senior classes, and Principal waterfall: the redemption of a tranche is done only if the senior notes have been fully redeemed. (1) fund fees and expenses, (2) all classes of debt accrued and unpaid interests, and principal on redemption date, following the strict application of the senior/subordination order scheme (3) partial or full redemption of the debt securities following de-leveraging triggers (4) followed by distribution, if any, of all the outstanding proceeds, to redeem the equity portion.
The breakeven rate of return is the internal rate of return level required on the underlying assets to extract a real benefit from the leverage, meaning to cover at least the weight and costs of the funding as well as the other costs of the CFO structure.
This week's Learning Curve was written by Fabien Labouret, managing director and head of structured alternative investments in Asia at CDC IXIS Capital Markets in Tokyo.
