Securitisation: Still early days

Although poles apart in the capital markets, it seems attempts to synchronise private equity and securitisation are slowly coming to fruition. Four major issues have been publicly rated and sold in the past few years and there is talk of more in the pipeline. A landmark transaction was in September 2001 when Capital Dynamics’ collaterised private equity obligation Prime Edge Capital raised $175m to fund new investments. With a vehicle such as Prime Edge the door opened to a whole new pool of investors who do not normally buy private equity. Then came PEPS I, the $285m securitisation of Aon’s fund-of-funds portfolio. And it was almost two years later that Deutsche Bank’s Silver Leaf and AIG’s Pine Street 1 came to the market; also looking to securitise existing private equity portfolios. The securitisation market is still coming to terms with the risk attached to private equity, but these recent deals show there is scope for these transactions, albeit at a price. Angela Sormani reports.

In a securitisation a pool of assets with an income stream is repackaged and, based on the income of those assets, a set of bonds is issued. Each bondholder then gets a fixed amount on maturity of the bond and also benefits from interest payments on fixed dates. The issuer therefore needs to guarantee enough capital to meet these repayments. Fundamentally, private equity does not lend itself to this sort of transaction: private equity does not guarantee a fixed amount back at the end of a fixed period and you’ve no idea when or even if you will get a return on your investment. So, in essence, the prerequisite for a securitisation is missing.

Simon Ovenden of international law firm Linklaters says: “The idea that you might get your interest and you don’t actually know when your bond is going to be repaid is unfamiliar to bond investors who are used to bullet repayments and therefore is something that needs to be factored into cash flows. One of the problems we face is that in the vast majority of private equity investments you don’t really know when you’re going to get your payments.”

A big issue is how you deal with putting together a bullet repayment mechanism and working with a private equity fund manager who is less reliant on the concept. The vast majority of eurobonds are based on the idea that if you buy a bond in 2004 you know it is to be repaid on its stated maturity.

Ovenden says: “The private equity market is one that accepts high risk and uncertainty of return and is familiar with that fact. When you introduce the bond class in, they definitely want their money back. By introducing private equity, their life is getting riskier. They might lose more than they would going down the securitisation route, but on the other hand their profits might be stellar.”

But the private equity market is always on the look out for new sources of capital and the bond market has until recently been untapped by private equity funds. Now private equity players are looking to the institutional buyers and asking: ‘how can we turn private equity into something these people can invest in?’

There are three main drivers for entering into a private equity securitisation. First, financial institutions may wish to reduce their exposure to private equity while still retaining some upside. Second, an investor may wish to obtain regulatory capital relief. And third, a securitisation may be used to generate new money, which can then be invested in new private equity transactions.

In the event of a securitisation a special purpose vehicle (SPV) is set up which will issue a series of both rated and unrated notes for cash. The bulk of the proceeds are then used by the SPV to purchase the portfolio of private equity assets. In order to attract a typical capital markets investor base, the notes are structured in such a way to be instantly familiar to capital markets investors. So the senior notes obtain a superior rating as they will rank higher in the order of priorities in the case of default. It may be that the notes will need to be listed and rated at investment grade to be eligible for purchase by certain institutions.

The last piece of the securitisation in these deals is tougher to sell because of the risk attached. The junior notes are typically unrated and rank last in the hierarchy and, from an economic perspective, perform more like an equity interest. However, the vendor often doesn’t want to accept the price investors offer for this speculative end product, so the seller of the portfolio normally holds the junior notes.

Jonathan Blake of international law firm SJ Berwin says: “These are complex deals. At the heart of it all you have an illiquid investment in an unquoted company and yet if you package enough of them together you can get a triple A rating, but the part of the total that is triple A is the small slice of senior debt at the top. While it is easy to sell off the top slice, it gets tougher the further down you go and the bottom slice, which can account for up to 50% of the deal, there is currently not much of a market for and so the seller has to hold on to it.”

This type of product has to be rated before it can be sold. The challenge in a private equity securitisation is to convince investors it will produce enough capital for repayments. In addition, a bank has to positively guarantee the bonds. To obtain an attractive rating for all or some of the notes, the issuer will also need to comply with the evolving requirements of the ratings agencies. And so, as well as the legal, regulatory and tax requirements, it is the rating agencies requirements that drive much of the final structure of these deals.

Making the grade

Capital Dynamics’ $1bn securitisation of AIG’s Pine Street portfolio is the first time there has been a triple A rating against a private equity portfolio. In the first half of this year the deal is reported to have returned $80m cash and the majority of the portfolio should be liquidated after 10 years when all the tranches have been paid off.

The AIG portfolio is 60% drawn and was invested in 64 partnerships, all US dollar denominated with a well-balanced mix of buyout (60%), venture (15%) mezzanine and real estate. Around 70% of the investments have a vintage of 1998 to 2000. The deal has six different tranches. The most senior is $250m rated AAA by Moody’s and Standard & Poor’s and was completely sold to the market.

AIG sold the $250m of triple A rated bonds for 125bp, but kept the B, C, D, E and F tranches. The B and C tranches are funding notes $250m and $140m, respectively, which will pay out fees to the triple A tranche when needed. They must be held by AIG or a double A rated entity. The D, E and F tranches are $60m, $160m and $140m, respectively, and are held by AIG, for the time being.

Deutsche Bank also chose the private equity fund securitisation route earlier this year closing a transaction with a total volume of $467m. The securitisation will further reduce the book value of the bank’s private equity fund investments by around $125m. The collaterised fund obligation (CFO) is called Silver Leaf CFO I SCA and is the securitisation of the bank’s fund-of-funds investment portfolio, which is approximately 70% funded.

Of the securitisation 60% is in rated notes and Deutsche Bank retains the 40% equity in the transaction. Of the rated portion $145m is class A with a AAA rating, $99m is class B with a AA rating, $52m is class C with an A rating and $52m is class D with a BBB rating.

The Silver Leaf deal has significant structural differences from the Pine Street transaction both in terms of credit structure and the underlying portfolio, but the ratings approach to the portfolio remains the same, as does the need for strong support from the originator, in this case Deutsche Bank.

The collateral for Silver Leaf is 65 private equity funds, the majority of which are US-based funds with over 700 underlying portfolio company investments. The latest maturity of any fund in the portfolio is June 2010. The Silver Leaf portfolio has a lower number of venture capital investments than Pine Street with 87% in leveraged buyout and has a slightly older vintage with most (70%) dating from 1997 to 1999. Historically, LBOs have a better record of performance than venture and pre-bubble vintages are expected to perform better than the bubble years of 1998 to 2000.

From a purchaser’s perspective diversity of the portfolio is important. A private equity securitisation should focus on ensuring a portfolio is sufficiently large and diverse. There are strict minimum numbers of private equity investments, which must be included in the portfolio, and guidelines relating to the various types of private equity, geographical spread, vintage years, industry sectors and over-commitment strategy.

Michael Romer, senior director European structured finance at Fitch Ratings, says: “Advantages for note holders in a private equity securitisation is that they get a huge diversification and a very broad base of exposure to different sectors. The benefit is in the capital structure. We’ve had to do a lot of research and model building in order to reflect the true type of risk in this type of transaction.”

Timothy Spangler of law firm Berwin Leighton Paisner compares this type of transaction to investing in a fund-of-funds product: “The collateralised notes would provide many of the same benefits of fund-of-funds, such as diversification and access to funds in which they might not otherwise be able to participate. In addition, these notes can have leveraging and bespoke risk profiles suited to very particular investor demands. In theory, a tremendously powerful product although not inexpensive.”

Jonathan de Lance Holmes of Linklaters uses the logic behind P123, Permira’s fund-of-funds, which invests solely in Permira funds, to illustrate how a securitisation of a private equity portfolio might work – see EVCJ April 2003, page 16. “A securitisation is like borrowing on the basis of your portfolio. P123 is made up of different vintages and is put together in a vehicle to produce a blended return. When you have a range of different vintages, it becomes easier to do a securitisation,” he says. “What it comes down to is averaging. Diversification is key. It may be that one private equity fund will give you no return, but if you’ve got a mixture of European, US, buyout and venture then statistically among those funds they should produce enough income to service a certain amount of interest payments each year and enough capital to pay back bonds in the future.”

Michael Romer says: “These transactions are generally pretty large portfolios normally with at least 50 funds broken down into hundreds of companies. And so for all of these funds to underperform [particularly if you have a good manager selection process] you would have to be in a pretty bad situation. You do get some comfort from that.”

In a private equity securitisation a liquidity facility will generally be built into the structure in order to overcome the mismatch between the illiquid underlying portfolio and the need to make timely payments of interest and principal on the notes. In the Silver Leaf transaction, for example, a cash reserve account was set up to accumulate throughout the life of the structure through cash or in-kind distributions from the collateral assets. A minimum balance equal to around 20% of the issuer’s initial capitalisation must remain in the cash reserve account upon any release of amounts to amortise note principal during the amortisation period. This will help ensure adequate liquidity from the issuer’s own balances for ongoing payment of interest and expenses and reduce the dependence on external liquidity support.

A drawdown reserve account may also be funded at the closing of such a transaction to be available for capital calls on the remaining unfunded, or undrawn commitment obligations. This drawdown reserve account will generally cover the full amount of undrawn commitments remaining in the partnerships in the portfolio. It is funded with the proceeds from the issuance of the notes.

According to Michael Romer, strict criteria are established for the eligibility of investments in any liquid reserve accounts such as the cash reserve or drawdown reserve accounts to ensure these contain cash equivalent assets of the highest credit quality and with limited potential for market value losses.

“For the ratings agencies, it is important to recognise the risks as well as the benefits of a private equity securitisation,” says Romer. Fitch, for example, has developed a conservative approach for assigning credit ratings to notes issued from such structures. Some of the risks associated with securitising a portfolio of private equity funds include problems with cash management and ongoing debt service, particularly timing mismatches between the current liabilities of the SPV and cash distributions; the prolonged investment period and implications for the efficient use of capital; the illiquidity of underlying investments and limited amount of information and the accuracy of data benchmarking and the associated difficulties in gauging the extent of potential losses on the asset pool.

Monitoring these transactions is tough because it is private equity, says Romer. “Private equity is very different because there is no contractual arrangement that the GP will return ‘x ‘amount over a given period. There is also uncertainty on the economic impact of the SPV missing a capital call. These transactions are hard to model, but they can be modelled. Ratings agencies have to be comfortable with the over-commitment strategy.” Over-commitment is a major issue in these transactions. Agencies are looking at accepting a certain amount of over-commitment on the understanding that not all the commitments will be drawn down.

But these deals are still tough to close and are definitely far from standardisation. With a private equity securitisation there is a significant premium on notes compared to a standard securitisation. This reflects the amount of work the investor has to do. Romer says: “If you’re doing a sale into an SPV, it is a lot of work. The LP has to approach each GP in his portfolio and if you have invested in over 50 GPs this can be time consuming.”

Simon Ovenden of Linklaters stresses: “The financial modelling is very complex. You have to look at the past performance of funds and the expected income streams on the private equity investments and the bonds and merge the two. It will only work if you have a model people are very comfortable with.”

Iona Levine of SJ Berwin sees scope for this type of transaction, but also envisages a steep learning curve ahead: “As ratings agencies do more of these deals they will become less stringent, but they are very costly deals to put together. Legally they are very intensive. It takes a lot of management time and so there has to be a real desire to do it.”

Securitisations are expensive both in terms of transaction costs and in terms of the cost of management time. The cost of obtaining a rating is in the region of nine basis points of the face value amount of the issue with a minimum cost of around $500,000.

In addition, having invested the necessary cost, time and expense in order to obtain a satisfactory rating, the issuer must take steps to maintain the rating by meeting the rating agency’s ongoing compliance requirements. The rating agency will also charge an ongoing annual fee of at least $50,000.

Securitisation versus secondary?

“Securitisation is a technique that has its place, as do secondaries, but I don’t think one would ever eclipse the other,” says Jonathan Blake. Reducing exposure via securitisation is an alternative to low value asset sales and in doing a securitisation added liquidity can be injected into investments. But as the markets improve, secondary discounts may not be as harsh and that may shift the balance somewhat in favour of the secondary market as opposed to a securitisation alternative.

Take UBS’ recent sale of its private equity portfolio. The bank was looking for a way to liquidate its investments, but chose not to go down the securitisation route. HarbourVest Partners, a leading fund-of-funds and secondaries player and UBS recently completed a structured secondary transaction to create a single joint venture to acquire more than 50 limited partnership interests from UBS. The portfolio was large and diversified enough to qualify for the kind of private equity securitisation that institutions such as Aon, AIG and Deutsche Bank have brought to market.

Securitisation typically serves a different strategic need to a secondaries transaction. While private equity securitisations are still fledgling and as a consequence evolving, they typically require a much larger pool of diversified assets, and achieve a balance sheet effect, often leveraging assets or changing the nature of risk. Secondaries on the other hand allow for more detailed pruning of a portfolio such as reducing, or increasing, exposure to venture versus buyout, or redistributing geographical exposure.

Thomas Kubr of Capital Dynamics predicts more of the latter type of deal: “There are different reasons institutions are selling. For those that want to exit the asset class completely, a secondary sale is a suitable option. But for those with capital accounting, legal or liquidity issues, for example, and who want to remain in the asset class, securitisation may be a better option.”

Capital Dynamic’s €175m collateralized private equity obligation Prime Edge gives investors access to European private equity funds through an innovative private equity investment vehicle. The fund was a pioneer in its niche and it is a structure that has yet to be repeated. The vehicle is now almost two years old and has yet to prove itself with around 20% uninvested capital. But the deal was a landmark in that it introduced rating agencies to the concept of private equity securitsations and was the first such transaction without an insurance wrap to receive a triple A rating. The vehicle was funded on a 70/30 debt equity basis. The securitised debt is split between a single A rated tranche (48%) and a triple B rated tranche (22%). In addition there is a €30m, 20% liquidity facility provided by ART Zurich.

Kubr has confidence in the investment model. “This is no longer an exercise in can it be done, it’s an exercise in can we do it better? It is a matter of investors getting used to backing private equity products and understanding the private equity mindset.”

Simon Ovenden concludes: “I think we will see more interest in this area as part of a greater convergence of the capital markets with the funds world. We have seen this in recent years with people repackaging investment funds and hedge funds through bonds and other debt products.” But standardisation is a long way off. “At the moment these deals are for cutting edge managers and investors. The jury is out. I don’t see them going away, but I don’t see over the next few years the bond market being swamped by private equity players,” he says.

Timothy Spangler is also sceptical about a convergence between the two markets: “It’s difficult to get a feel of the actual success that these structures have had with investors. Much is said and written about them, but it remains unclear as to whether there is a general desire for these instruments or whether they are a problem in search of a solution.”