Recent offerings of securities collateralized by pools of limited partnership interests in private equity funds have created growing interest from issuers, investors and other market participants in the potential for providing liquidity to the private equity market and an alternative exit route for private equity investments.
A private equity securitization provides several benefits for sponsors of such transactions:
(1) Efficient early monetization of their investments through the sale of debt backed by these investments to third party investors
(2) Reduction in cash needed for investment programs through the use of such securitized leverage
(3) An alternative means of improving the liquidity of investments without incurring the typical steep discount of a sale in a secondary transaction
Overview of a Securitization
Securitization involves aggregating cash-producing assets into a pool and then issuing rated and unrated securities backed by this pool. Such asset-backed securities are part of a large and deep market and have been common financing tools for financial institutions for the past two decades.
A Collateralized Debt Obligation (CDO) is a securitization technique used to repackage the risks and rewards of various financial assets through a special purpose vehicle domiciled in a “tax-friendly” jurisdiction. This special purpose vehicle will issue securities in different classes that are rated from AAA down to B and one or more classes of unrated securities which may be established as equity or subordinated notes.
The asset pool is serviced by a professional asset manager such as a fund manager, insurance company, commercial bank affiliate or other financial intermediary.
Historically private equity interests were not conducive to securitization because of their unpredictable cash flows and the volatility associated with their market value. However, fund sponsors have taken several steps necessary to allow rating agencies, law firms, administrators, trustees and investment banks such as Deutsche Bank to structure such transactions for clients.
The beneficial owner (Sponsor) of the limited partnerships creates a single or several Special Purpose Vehicles (SPVs) to which it then transfers a selected portfolio of its private equity investments. The SPV will generate cash to pay for the purchase of these investments by issuing rated (Senior) and unrated (subordinated) securities to investors.
The Sponsor is typically expected to take back all the unrated Subordinated notes in the capital structure. In our recent discussions with the rating agencies, indications are that the subordinated notes (often referred to as the “equity”) typically should be between 25% to 40% of the capital structure.
There are six components to the execution process for a CDO:
* structuring/modeling the deal
* marketing the deal
* transferring and valuing the portfolio
* obtaining ratings from the agencies
* completing documentation for the deal
* settling the deal
We will also touch on the post closing work, which continues through the life of the deal.
Structuring the deal
One of the most important aspects of structuring the deal is the portfolio selection process. In general, leveraged buyout and mezzanine funds will create the most securitizable portfolio because of the cash generative nature of LBO investments and the coupon income of mezzanine investments. However, significant amounts of venture capital and other types of funds (e.g., managers targeting the distressed market) can also be included in the portfolio. The mix of fund types used, seasoning of the funds and the total number of funds (and underlying investments) will significantly effect the tranching of the portfolio.
A good rule of thumb for the minimum number of funds needed is 25, and if the sponsor does not own this number, investment banks such as Deutsche Bank assist in aggregating these funds with other sponsors to create a pooled transaction.
A liquidity facility will be required to mitigate the unpredictable nature of cash flow from the underlying investments as debt coupons must be paid regardless of such variability. Rating agency stress testing requires a significantly larger liquidity facility than other ABS deals, and the size of this facility increases as debt investors make certain demands, (e.g., non-PIKable BBB debt).
The rating agency process for these deals typically involves measuring the portfolio against a benchmark portfolio index to measure how closely the portfolio tracks market expectations. This then helps determine tranching and ratings for these tranches. The initial indications of rating are always subject to a full review of the documentation and modeling assumptions of the deal.
The rating agencies will conduct a thorough due diligence of the asset manager. They will look at performance history and experience, organizational structure and staffing, your internal controls and systems and portfolio monitoring infrastructure and methods.
Assuming all this is in order, a documentation review is also conducted by the rating agencies as part of their analysis.
Transferring the Portfolio
The General Partners must provide consent to the transfer of the limited partnership interests to the SPVs involved in the securitization. In addition, the debt investors and the rating agencies will typically want to review the valuations at which the interests are transferred into the vehicle. Such review is undertaken by a third party valuation agent acceptable to the rating agencies involved.
Marketing the deal
The advisor together with the sponsor will start preparing marketing materials (a “pitch book”) almost immediately after being engaged.
The pitch book should consist of an overview, performance versus benchmark indices, assets under management, organizational structure and investment processes. In addition, managers should include other performance data such as prior distributions from the funds, volatility of returns, distressed sales and anecdotal information on the selection process.
The pitch book should also include the transaction structure and the indicative spreads the underwriter will offer for the debt tranches.
Most debt buyers will want face-to-face meetings and in general will want to review the offering memorandum and a term sheet as early as possible before making any decision.
Debt investors will also focus more on the ability of the transaction (and the organization) to survive stresses.
CDOs attract a broad group of investors from across the globe. For example, the highest rated notes (AAA and AA) are typically purchased by banks, credit hedge funds, asset-backed commercial paper conduits and insurance companies.
The mezzanine notes (A and BBB) are purchased by insurance companies and sometimes by other fund managers.
The lower rated notes (BB and B) are purchased by high yield investors. And lastly, the equity is purchased by insurance companies, alternative asset investors, very high net worth investors, and occasionally by hedge funds and pension funds.
Documenting the deal
The following documentation is typically required throughout the process:
* An initial engagement letter, which defines the terms of the relationship between the sponsor and the advisor, and outlines the general terms of the deal;
* A servicing agreement which defines the asset manager’s rights and responsibilities as a servicer of the limited partnerships, transferred into the SPV for the CDO;
* An indenture which governs the terms and conditions of the bonds;
* An offering circular and term sheet is prepared and is thoroughly reviewed by investors before investing in the deal.
Various other documents govern the deal, but your attention should be on the above documents, which constitute the core of your intentions for undertaking this transaction.
Closing the deal
Debt marketing takes between two to four weeks for such a complex transaction. Once the debt has been circled or placed, the settlement process begins. Limited partnership interests must be transferred (consent for these should already have been granted by the time debt marketing is underway). SPVs must be completely documented and the offering circular must be finalized and sent to investors prior to closing. The valuation process must be completed prior to the closing and various other steps (including confirming the accounting treatment) also have to be completed.
The typical process of settlement should allow for three to four weeks from pricing the debt to formal completion of the transaction.
Once the deal is done
Once the deal is completed, the sponsor has assets to be serviced, investors, a trustee who monitors their actions and rating agencies who monitor the deal. The sponsor discover that not only do you have to service assets, but you have to service investors who own different risk profiles in this deal and have varying needs and interests somewhat dissimilar to managing a private equity fund of funds.
Usually, the trustee prepares monthly reports which may not be suitable for quick reviews of the deal. The advisor should have a website which summarizes pertinent facts related to the deal and its performance. The sponsor will need to prepare a quarterly investment manager letter that reviews market conditions, deal performance and outlook. The sponsor will conduct periodic investor calls explaining these documents and getting to know your investors better. Once a year, an annual audit is performed by an independent CPA. In addition, a tax summary is also prepared. Lastly, the rating agencies conduct an annual rating review.
Jeffrey D’Souza is based in London and is Managing Director, Global Markets, which is a division of Deutsche Bank. Chuck Flynn is based in New York and is Managing Director, DB Capital Partners, which is the private equity arm of Deutsche Bank.
For further information, please contact Deutsche Bank +44 20 7547 6006.