Thomas Kubr knows the flight from Zurich, Switzerland, to New York as well as anyone. It’s eight and a half hours to fly to here and seven to get back, because of the jet stream, says the former aerospace engineer.
Kubr, chief executive of Switzerland-based Capital Dynamics, was in New York almost every week last month working on his latest deal. Capital Dynamics is one of the few companies that has closed a private equity securitization, and it’s the only firm that’s focusing all its attention on the new product, which wraps private equity investments in a credit-rated product similar to a collateralized debt obligation.
Estimating the asset base of North American private equity at $400 billion, unfunded North American commitments as high as $150 billion and the combined international private equity market as high as $150 billion, Kubr says he expects the new vehicle to have a considerable opportunity to expand.
Kubr has a dozen folks working with him in Zug, but he does so much business in New York that after a few more deals close, he’s shipping a crew to the Big Apple. His assistant correctly describes him as “tall and very Swiss,” but he speaks faultless English, polished by degrees from the University of Michigan and CalTech.
Early last month, Kubr squeezed out a few minutes to meet with Senior Editor Charles Fellers in the lobby of New York’s Plaza Hotel and to expound on his favorite subject.
How did you get interested in securitization?
Private equity on an individual deal level is a highly risky thing. There is a very high chance that you can lose money on an individual deal, and you see this reflected in the paperwork. You start out with pages and pages of disclaimers on how you can lose all your money, and “Make sure you can afford to lose all your money, because otherwise we don’t want you as an investor.” However, then comes management’s discussion of the opportunities, and there what you see is pages and pages of how rich you will get if you invest in this thing. There is a complete dichotomy between the possibility of losing everything and becoming filthy rich.
By the time you start diversifying massively-and we are talking about something like several hundred companies in a portfolio-a lot of things become highly predictable. You can start predicting when money gets drawn, and you can start predicting when and how much money comes back, within sufficient statistical certainty to allow securitization to happen. Then, private equity becomes just like mortgages or car loans or credit cards or anything else that has a funky feature to it, and by securitizing it, suddenly you generate something that the capital markets will like.
What sorts of people are getting interested in securitization?
Basically, holders of large asset pools. Securitization is not an alternative to secondary sales. It is a different way of reformatting the way you hold private equity that solves different problems than a secondary sale would. A secondary sale allows you liquidation, and you basically walk away from the assets. You forego potential upside for quick liquidity.
A securitization can do a whole lot more than just give liquidity. All securitizations should deliver some amount of cash back to the seller, but the seller has the option of retaining the upside and the exposure to the assets. If the current holder is a regulated entity, which usually banks and insurance companies are, securitization can bring transparency to their capital treatment and thus effectively make the funding requirements cheaper.
Using a secondary sale to solve these issues is almost like using a hand grenade in a porcelain shop. You do a lot of damage without delivering the benefit of what the client used to have. The securitization can be much more finely tuned to the individual requirements of a sponsor or seller of a transaction.
What is the process of getting an issue rated?
You need a pretty good idea of what your portfolio is. How does it stand in the asset class? Be able to provide modeling not only of your own assets but also show how that stacks up with the rest of the asset class. Of course, to have access to a deep data pool that allows you to do that is very important.
There are several different rating methodologies that are being used. All have their pros and cons. At Capital Dynamics, we are currently distinguishing four fundamentally different rating methodologies that can be used.
What will it take for a liquid market for securitized private equity to develop?
A couple things need to happen. Number one: The asset class needs to develop a wider audience that recognizes that it is an asset class. Unfortunately, there have been far more announced attempts than there have been deals closed. I would expect that to change in the next few months.
The second thing is sheer deal volume. It’s not enough to have one or two deals. You need to have several deals coming out every year. Hopefully, we will have something like five to eight deals every year being printed, and that will start to create a pool of choice for each rating class.
And, the last item is just providing more transparency of how the asset class works. We’ve done a lot of fundamental work in the last couple years on answering basic questions about private equity as an asset class: what is the true liquidity of this asset, how fast is liquidity, the diversification impact, volatility, comparison to public markets, etc.
Usually private equity is compared to public equity. The big insight of the last couple of years is that we’ve started comparing private equity to a bond portfolio.
What concerns do you get from GPs involved in securitizations?
One of the first concerns is, Well, who’s going to fund my unfundeds?’ The funny thing is that when GPs really go and look at the credit quality of the counterparties, what they find is that the majority of the counterparties are actually not even investment grade. Of course, if you have a structure with AAA-rated notes in it, you can be sure that the funding requirement is up to snuff to a AAA level. With the exception of very few counterparties, securitization actually enhances the certainty of unfunded calls being met.
The next level of concerns we have are a whole lot of legal and securities law issues: the 1940 Act, etc.-issues that have been worked out [so that we can answer those concerns promptly]. (The Investment Company Act of 1940 regulates the registration and activities of investment companies.)
The third set of concerns is about confidentiality. Obviously, in private equity that situation is in flux. In general, transparency is good. However in private equity, I’m a firm believer that the intransparency is actually a key feature of the asset class that should not be broached unless you have some very specific, real reasons. We need to find a clever line where the legitimate interests of the GPs are protected; however, the legitimate information requirements of the potential investors are met.
What do you normally disclose to potential investors?
Aggregate information of the portfolio: diversification in stage, vintage year, geography, currency, industry, names of the GPs, etc. Then some size information i.e., how much of a certain GP is in a deal.
Do you typically give underlying information about the portfolio companies?
No. That, I think, is where the line is being stepped over.
What do you think we’ll be talking about in five years in reference to securitization?
I hope in five years we have 50 deals on the books and maybe total volume well north of $30 billion. I may be dreaming here, but it’s not unrealistic. The deals that will be printed in five years will be deals that are more sophisticated-that are able to remove some of the early blocks that we couldn’t get around at this time.
And, we’ll have a liquid market, and anybody who wants to buy and sell securities in any tranche can do so. There will be market-making out there.
We’ll probably start seeing deals where we have less diversification.
We may actually see transactions being done where highly-diversified individual funds (like Warburg Pincus, Apax or Advent) raise a significant portion of a partnership through debt.
Another thing is pairing private equity with other asset classes. Anybody that has been looking at that has already come up with the idea of, “Why don’t we combine hedge funds with private equity?” And, we can keep on dreaming up other potential combinations.
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