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Collateralised debt obligations in private equity

Private equity collateralised debt obligations (CDOs) will allow portfolio investors a greater opportunity to participate in private equity markets and will bring additional liquidity, transparency and discipline to such markets. J Paul Forrester of Mayer, Brown, Rowe & Maw reviews the structures and features of a CDO, and why private equity is an attractive asset for a CDO.

What?

Collateralised debt obligations (CDOs) and its more specific siblings, collateralised bond obligations (CBOs) and collateralised loan obligations (CLOs), are a successful application of sophisticated securitisation techniques originally developed for collateralised mortgage-backed securities (CMBS) to facilitate the resolution of the Savings and Loan crisis in the US in the 1980s. According to recent Banc of America Securities research, there were over $209bn of CDOs in 2001, making CDOs the second largest type of asset-backed security (ABS) after credit card ABS. While the vast majority of CDOs have underlying debt assets (bank loans and bonds, including structured financial assets (for example, CMBS, RMBS, ABS and similar securities) and project finance), there are examples of non-debt CDOs - trust preferred (a debt/equity hybrid) CDOs and CDOs of CDOs. The CDO market continues to refer to these transactions as CDOs even though the underlying assets are not debt. This article follows this convention.

The core concept of CDOs is that a pool of defined financial assets will perform in a predictable manner (that is, with default rates, loss severity/recovery amounts and recovery periods that can be reliably forecast) and, with appropriate levels of credit enhancement applied thereto, can be financed in a cost-efficient fashion that reveals and captures the arbitrage between the interest and yield return received on the CDO's assets, and the interest and yield expense of the securities (CDO securities) issued to finance them. Each of the recognised rating agencies (Fitch, Moody's and Standard & Poor's) have developed CDO criteria and statistical methodologies and analyses to ‘stress' a pool of specified CDO assets to determine the level of credit enhancement required for their respective credit ratings for the CDO securities to finance such pools.

Typically, CDOs require the CDO assets to meet certain eligibility criteria (including, in the case of bank loans and bonds, diversity, weighted average rating, weighted average maturity, and weighted average spread/coupon). A CDO will allocate the interest and principal proceeds of such assets on periodic distribution dates according to certain collateral quality tests (typically an overcollateralisation ratio and an interest coverage ratio). CDO securities are usually issued in several tranches. Each tranche (other than the most junior tranche) has a seniority or priority over one or more other tranches, with ‘tighter' collateral quality tests set to trigger a diversion of interest and principal proceeds that would otherwise be allocable to more junior tranches that will then be used to redeem or otherwise retire more senior tranches. The junior-most CDO securities are effectively ‘equity' (and for accounting reasons that require legal form equity are often preferred shares) and receive the residual cash flows from the CDO assets after all senior payments and distributions. The resulting subordination of such junior tranches constitutes the required credit enhancement for the more senior tranches and allows the CDO securities of such senior tranches to receive a credit rating that reflects such seniority or priority. Some CDOs use insurance ‘wraps' for the same effect.

CDOs often allow principal proceeds to be reinvested in additional eligible CDO assets during a specified reinvestment period.

In addition, the CDO is usually managed by a collateral manager, who must identify eligible CDO assets and monitor them for the CDO. Most CDOs allow a portion of the CDO assets to be traded annually, which allows an adept collateral manager to enhance the arbitrage opportunity of the CDO.

Generally, CDOs are either ‘balance sheet' CDOs or ‘arbitrage' CDOs. Balance sheet CDOs are transactions structured as ‘sales' for accounting and regulatory capital purposes but are ‘debt' for tax purposes. Commercial banks use balance sheet CDOs primarily for portfolio management and regulatory capital efficiency. By contrast, arbitrage CDOs are structured as sales for all purposes, including tax.

Arbitrage CDOs are either ‘cash flow' CDOs or ‘market value' CDOs, and are distinguished by an overcollateralisation ratio determined by reference to the par or principal amount of the CDO assets (adjusted for defaulted CDO assets), in the case of a cash flow CDO, or to the market value of the CDO assets, in the case of a market value CDO.

Typically, a market value CDO will require more equity than a cash flow CDO, but will allow greater trading by the collateral manager. To facilitate such trading, the capital structure of a market value CDO usually includes a substantial revolving credit facility to allow the collateral manager to efficiently manage the capital of the CDO and to trade CDO assets more easily. However, as one would expect, market value CDOs require timely and reliable price reporting to establish market values of the underlying CDO assets. This reporting exists for bank loans and bonds, but currently does not exist for private equity, which is characterised by limited liquidity and transparency.

While balance sheet CDOs are an important portfolio management and regulatory capital tool, especially for commercial banks, the remainder of this article will discuss typical arbitrage CDOs.

The growth of the CDO market has been due in part to the significant participation of non-US investors (especially foreign insurance companies) seeking exposure to US assets to which they are underweighted. These foreign investors are attracted to the professional management of CDOs and the ability, through an investment in the junior CDO tranches, to gain leveraged exposure.

To facilitate non-US investors in CDO equity, the CDO issuer for most CDO assets is usually established outside of the US (for example, the Cayman Islands) and must not be engaged in trade or business in the US in order to avoid US taxation. This often requires that the activities of the CDO issuer (and the collateral manager on its behalf) be restricted to ensure this result.

However, for US private equity CDOs, the CDO issuer will probably be a domestic LP or
LLC, since the underlying CDO assets will include partnership interests in US partnerships.
Foreign CDO equity investors will have to invest ‘synthetically' (e.g., through a credit-linked note or total return swap) or through a separate offshore ‘conduit' entity.

The offering of CDO securities must be carefully structured to satisfy other applicable legal requirements, including (but not limited to):

• the perfection of the collateral lien on, and security interest in, the CDO assets;

• the exemption of such offering from registration requirements under applicable US securities laws and similar laws of other jurisdictions in which such CDO securities are offered;

• the avoidance of registration under the US Investment Company Act; and

• the exemption from adverse consequences under ERISA,

which requirements, together with a description of the innumerable variations of and refinements to the CDO structures described here, are beyond the scope of this article.

Why?

Some recent CDO transactions (namely the Princess, Pearl, Porter Global and Prime Edge transactions) demonstrate the opportunity to apply CDO technology (with appropriate adjustments) to private equity. In another extension of CDO technology, other current pending CDO transactions will cover hedge funds and closely replicate so-called ‘fund of funds'.

Historically, CDOs have had a dramatic affect on the pre-existing market for the underlying CDO assets. For example, CBOs have substantially affected the US high-yield market by adding substantial liquidity, which dampens price volatility. Similarly, CLOs have changed the US syndication practices for large leveraged loans. Arranging banks must first fund and then sell loans to CLOs in order to avoid the CLO being engaged in US trade or business and subject to US taxation.

CDOs of private equity would broaden the available investor base and allow portfolio investors a greater opportunity to invest in private equity. The tranched capital structure of a CDO allows an investor to determine its preferred risk/return investment and an opportunity in the junior CDO tranches for enhanced returns due to the leveraged structure of a CDO. Private equity CDOs would also add liquidity, transparency and discipline to this market. Transparency will likely result in greater benchmarking/indexing, but may pose a threat to inferior private equity managers as, over time, private equity CDOs will expose and differentiate them. Price transparency and increased liquidity might not be welcomed by private equity investors that use mark-to-market accounting, since they probably would introduce volatility to affected earnings.

Private equity CDOs will need to make appropriate adjustments to typical CDO structures, some due to the nature of the underlying CDO assets (private equity fund commitments and investments pursuant thereto) and some deriving from the evolving rating agency methodologies. The typical private equity fund requires an investor (in this case, the CDO issuer) to commit to make capital contributions to the fund in a maximum amount from time to time on or before a specified commitment termination date. As a result, unless fully funded prior to being acquired by the CDO issuer, the capital structure of the CDO must include available capital (a revolving credit facility or similar arrangement) with sufficient flexibility to allow the CDO issuer to make the required capital contributions.

The Prime Edge transaction reveals the rating agency methodology (at least in part) with its requirements for ‘diversity' of private equity investment by style (early/late stage venture, buy-out, general, special situation, etc.), by industry and by commitment vintages and for ‘quality' by requiring that such investments be managed by approved managers. As with other CDOs, the rating agency requirements for private equity CDOs will change and evolve as the agencies gain more experience with them. The Princess and Pearl transactions were ‘insured' deals and, accordingly, they do not reveal any rating agency methodology.

In addition, since many private equity fund investments are leveraged with senior secured debt, the dividends and other distributions on such investments are difficult to predict and model so the capital structure of the CDO issuer should not include significant capital with current payment requirements. This point is clearly indicated in the Princess and Pearl transactions, in which zero coupon and two per cent coupon debt, respectively, was issued. In contrast, the Prime Edge transaction utilized a liquidity facility to ‘smooth' cash flows.

Now?

Many institutional private equity investors have substantial private equity portfolios. Private equity CDOs would allow such investors to realign such portfolios, freeing up capacity for additional investments with favoured private equity managers or rebalance such portfolios to desired styles, industries or vintages. CDOs are powerful financial tools that have significantly affected the pre-existing markets for the underlying CDO assets. Private equity CDOs would similarly affect current private equity markets and add substantial liquidity, transparency and discipline as well as expanding the available investor base to include foreign investors and providing opportunities for enhanced investment returns through a CDO's leveraged structure.

Only time will tell whether the substantial promise of private equity CDOs will be realised, but results to date are encouraging.

Copyright © 2002 Mayer, Brown, Rowe & Maw

J Paul Forrester is a partner with law firm Mayer, Brown, Rowe & Maw

In February 2002, Mayer, Brown & Platt combined with the UK-based Rowe & Maw to form Mayer, Brown, Rowe & Maw, the tenth largest law firm in the world with over 1,300 lawyers in 13 offices across the US and Europe. For more information please visit www.mayerbrown.com