Securitisation: an alternative to secondaries?

Deutsche Bank’s DB Capital Partners group has been left somewhat in limbo recently apparently looking to sell the direct investments made off its balance sheet. Royal Bank of Scotland has refocused and downsized Royal Bank Private Equity. Some of the US banks didn’t fare any better they grabbed a lot of column inches during 2001 when they spent a lot of time red-faced from writing off TMT venture commitments.

Write-offs are only good in the sense that it’s done and dusted and the only thing left is to move on. What’s prompting a lot of speculation among the private equity community at the moment is how are the banks that no longer want to be so involved in private equity going to achieve an exit? Private equity investing is after all a long term game typically a four to five year turnaround for your money, seven to eight when you invest in venture, but possibly longer for both categories now.

Secondaries many cry. But realistically that’s not going to solve many people’s problems. Secondary players like to buy assets that are four, five or six years old and come at a heavy discount to value. Few secondary players will not look at unfunded commitments unless those make up the minority of the asset group for sale and certainly not a significant minority. The age of the portfolio is important because secondary players are seeking assets that can be managed to exit straight away. If those aims are achieved on a solid set of underlying assets the yields can excite institutional investors to the point where they commit double the size of your target at your next fund raising as happened to secondary investor Coller Capital recently. (See NEWS this issue.)

What’s happening in the secondaries market is business as usual. There are the big secondaries players buying groups of assets and there are the fund-of-funds and other institutional investors that take advantage of secondary openings on a small scale and opportunistic basis. There is a lot of activity involving institutional investors in a fund that on seeking an early exit are being replaced at cost by other investors in the fund. Typically these deals are brokered either by placement agents lending

a helping hand or the GPs in the funds concerned.

When these deals occur it’s seen as a win-win by both sides since the new investor (or one that has upped its existing commitment) gets to buy in at par, not value. For its part the exiting investor gets the book value of its money back and doesn’t have to record a write down, of course the opportunity cost of the capital is an issue but not one that seems to be dwelt upon.

But such piecemeal deals are not going to provide an exit solution for the many banks and other institutions in the market. Bulk purchasing by the well-funded secondary investors will again answer the prayers of just a few due to the selective nature of these buyers. With secondary investors not the catch all solution, securitisation is being mooted as a possible answer.

The concept of securitisation is not new to private equity although the emphasis has been on creating a new group of private equity investors rather than solving an existing investor’s exposure problem. The first such structure to come onto the market was Princess Private Equity, which was a convertible bond launched in 1999 that raised $700 million. Partners Group was behind this vehicle. Investors liked the vehicle because it came with an investment grade rating thanks to an insurance wrap.

There were some huffy comments from the wider private equity community perhaps from fund-of-funds and those firms out fund raising without a cast iron returns promise – that it just wasn’t cricket. The rationale being that a large part of the buzz of private equity investing was to have the skill to pick top quartile funds and enjoy 20 per cent to 30 per cent plus returns. But some investors didn’t agree. This enabled Partners Group to hold a final close on its follow up vehicle Pearl Holding Limited last year. Pearl is a Luxembourg-listed fund-of-funds convertible bond vehicle, which was rated AAA by Standard & Poor’s and also came with an insurance wrap.

For the most part the money raised from selling these bonds is invested in new vintage funds, although Pearl has some $150 million in pre 1997 funds as a result of its managers buying a share of Chase Manhattan’s secondary portfolio in December 2000. Pearl reached its first close of EURO485 million (it eventually raised EURO660 million) in September 2000, enabling it to begin making commitments to private equity investments from then on.

Next came the Prime Edge collaterised private equity obligation, with a CDO type structure, launched last year and closed in March this year at EURO175 million. Structured by Capital Dynamics this product also included an insurance wrap. Until the launch of Prime Edge, CDOs (collaterised debt obligations), when they appeared on the private equity scene, lived up to their name and invested purely in debt and mezzanine paper. Duke Street’s Duchess CDO being the largest by value to date, although Intermediate Capital Group pioneered in this space as part of a diversification strategy in the late 1990s.

The aim of the strategy is to invest in high yield bond issuance, which at that time was tipped as a cheaper alternative to mezzanine finance. The European high yield bond market remains as lumpy and illiquid as ever meaning Intermediate Capital Group’s CDOs (there are three in existence) invest for the most part in debt and mezzanine paper. Mezzanine, by contrast, has seen an explosion of new funds and undoubtedly ranks as one of the fastest growing investor groups.

The recent past only really demonstrates that private equity investors can be widened beyond those comfortable with the illiquid and typical ten year limited partnership structure. Thomas Kubr at Capital Dynamics, who structured the Prime Edge CDO, says: “Professional long term investors assess how they can best manage their portfolio to earn a progressive upside – typically through a split of fixed income and equity worked out on an optmised risk /return basis. One of the better ways to quantify risk /return is bond ratings because everybody understands these since the price is a reflection of the risk inherent in the rating. Securitisation gives the private equity asset class a risk/ return profile.”

“Historically private equity is an all or nothing game. On the one hand in the PPM the first six pages are covered with disclaimers warning that investors can lose all their money. Then you have the meat where the fund’s managers tell you they will make three, four, ten times your money. It’s a complete dichotomy: lose all or make loads, there’s nothing in between,” says Kubr.

For this reason many investors have avoided the asset class it’s illiquid and lacking in transparency and no amount of skill in picking managers is going to provide a guarantee of top quartile portfolio performance. Obviously one way to attract those abstaining investors is to limit the downside by offering a securitised fixed income product.

“On the demand side you potentially have investors who by the nature of their mandate are limited in what [assets] they can buy and who typically could not buy PE because they are not mandated to do so. By buying rated notes backed by [Private equity], they are able to diversify their existing portfolio and some investors think this will bring them new points on the efficient frontier curve of their portfolio,” says Marc Freydefont, vice president senior analyst structured finance at Moody’s.

That goes some way to explaining the motivations on the buy side. But what of the sell side? Princess, Pearl and Prime Edge appeared in the market at the instigation of the sell side but their motivation was to seek funding for private equity investment from a new investor base. The question many people in private equity want answered is will the concept of securitisation assist banks and financial institutions in exiting the private equity businesses?

Well, it has already worked for one institutional investor: insurance company Aon. In December last year Moody’s rated the PEPS I transaction, which is a $285 million securitisation of Aon’s fund-of-funds portfolio, which was largely invested in ten year limited partnerships. It seems there any plenty of others considering dipping their toes in the water.

“We have been approached by structuring teams from investment banks to rate funds of PE funds and portfolios of direct PE interests. We have been asked to look at a variety of possibilities from fully funded [portfolios], i.e. portfolios where the investments where 100 per cent drawn down, partially funded and those that are not at all funded. In that case, the noteholders will have to rely on the PE manager to invest the money over the next five years,” says Freydefont.

The secret of success

Success depends on what you are selling. While it’s clearly possible to securitise cash flows the make-up of the underlying assets will present the main hurdle. Henry Tabe, vice president senior analyst structured finance at Moody’s, says: “If a single investment in a fund defaults or does not return anything, in the case of a fund-of-funds the impact would not be felt. Whereas if you were exposed to a single direct investment that defaulted you might suffer a loss or at least the impact would be felt more strongly. That risk would be reflected in the structure’s enhancement levels if direct investments were included in the underlying assets.”

Liquidity facilities and insurance wraps built into the structures will also help get things off the ground. A liquidity facility is a given and is a lesson learned from vehicles such as Pantheon International Participations, the oldest secondary and fund-of-funds listed vehicle on the market.

Insurance wraps are arguably less of a prerequisite. There is a view that their inclusion is largely the result of a push from the investment banks that sell this paper because the syndication process is made easier with a slightly higher investment grade rating. For the issuer insurance is probably only worth pursuing if the insurance costs are equal to or lower than the reduction in the coupon on the issued paper that results from a higher rating.

Although it is possible to securitise a private equity portfolio the party attempting to get the assets off its balance sheet ends up holding the subordinated paper, which can be as much as 50 per cent of the transaction value. Although exact figures depend on the funded, partially funded or unfunded nature of the portfolio clearly monies not yet invested have a higher risk factor than those invested in assets that can be valued. Left holding much of the downside exposure to the underlying assets the bank or institution will typically have to continue managing the portfolio. “A lot of the [ongoing] analysis relies on the continued ability of the fund manager to manage the portfolio. Although it could be placed with a third party fund manager that has expertise and experience in managing these types of investments,” says Tabe.

Securitisation may provide an answer for banks and institutions wishing to reduce their private equity exposure but probably not an outright exit. “People speak with confidence about [private equity] being the new frontier in the CDO sector but we have not seen that many deals. Going by the hype alone it’s something that will pick up,” notes Tabe.