Private equity portfolios and asset-backed securities might not be as incompatible as oil and water, but they aren’t exactly peas in a pod either. The former is defined by high-risk speculation, while the latter is a credit rated, and sometimes insured, asset class that attracts some of the most conservative investors.
But despite serving as the hybrid of seemingly strange bedfellows, private equity securitization has become a hot topic in both the private equity and ABS markets. Entire industry conferences have been devoted to the subject, and the tiny European trial balloon offerings of yesteryear have given way to mega-offerings from leading domestic institutions like Chicago-based Aon Corp.
“It’s really about figuring out the mousetrap,” explains Michael O’Connor, a senior vice president with Moody’s Investors Service. “It’s a very difficult thing to do, but there is definitely an increasing number of people who are interested in trying.”
What O’Connor admits he doesn’t know, however, is whether or not the recent surge is sustainable. On the one hand, private equity securitization can serve as an attractive alternative to dumping certain private equity portfolios on the traditional secondary market. Conversely, securitization may be a flash in the pan sparked by an intersection of circumstantial interests that will be forgotten once market conditions improve.
“It’s hard to predict whether this is just a bubble, or the beginning of something significant in the long term,” O’Connor says. “Maybe it will end up falling somewhere in between.”
In The Beginning
Private equity securitization is still an infant asset class, even if measured against its emerging peers.
The first attempt at selling bonds backed by private equity partnership interests was made in 1999, when Swiss investment bank Partners Group sold $719.4 million of zero-coupon convertible notes that, in 2007, can be exchanged for shares in a private equity vehicle named Princess Private Equity Holdings Ltd. The bonds received a stand-alone credit rating from Fitch IBCA, which was then boosted by an insurance wrap from Swiss Re. (An insurance wrap provides an unconditional guarantee of timely interest payments and ultimate principal payment.)
By the following summer, a subsequent 500 million euro Partners Group vehicle named Pearl Holding Inc. was being outshone by an $800 million offer from J.P. Morgan (then known as Chase). Named the Porter bonds, the J.P. Morgan deal was similar to the Partners Group deals in terms of structure, but not in terms of intent. Both Princess and Pearl were attempts to benefit from long-term private equity largess, and buyers responded enthusiastically. The Porter bonds, however, were mostly born of J.P. Morgan’s desire to rid itself of stakes in young and struggling private equity partnerships (a scenario now repeating itself at the private equity-burdened bank) and, consequently, failed to attract priced-out buyers.
More recent milestones have come from: Capital Dynamics, a European group launched in 2001 by former Partners Group manager Thomas Kubr (see Q&A on page 36), whose Prime Edge bonds received stand-along ratings from S&P and Moody’s; and Aon Corp., whose successful PEPS I vehicle improved on earlier models by promising to meet future cash flow calls.
Why Here, Why Now?
The vast majority of new entrants into the private equity securitization game have been financial institutions. Not only is Deutsche Bank in the market with what is reported to be a $500 million deal, but sources at both J.P. Morgan and FleetBoston have acknowledged the possibility of future offerings.
“When you look at J.P. Morgan or Deutsche Bank, they both want to exit the private equity business, or at least significantly reduce their holdings,” says Richard Gugliada, a managing director with S&P. “They’re sitting there looking at securitization as making the best economic sense because it provides a floor on where you get out, plus gives longer upside potential than the outright loss you’d be almost guaranteed of on a secondaries sale.”
Not only are banks bailing on private equity due to poor fund performance and credit rating implications, but new accounting regulations have promoted the reduction of certain equity holdings. Even if a bank continues to hold a significant portion of what is securitized, it can avoid some tricky situations just by virtue of no longer having so much “pure” private equity on its books.
“The real question in all this is whether or not there will be much private equity securitization if, and when, the banks get their deals done,” says a private debt professional familiar with some of the more recent offerings. “I assume we’ll see more from groups like Capital Dynamics, but I don’t know if there are enough other groups out there to keep [private equity securitization] on our radar screens over the next one or two years.”
Colin McGrady, a managing partner with Dallas-based Cogent Partners, believes that the future of private equity securitization will be determined as much by the potential buyers as by the potential sellers. One of the real stumbling blocks, he argues, is that private equity and ABS investors are relatively ignorant of each other’s asset classes.
“The people right now who best understand how to price private equity portfolios are the secondary buyers, but they aren’t people who generally understand securitization very well,” McGrady explains. “Also, [ABS] investors have difficulty getting around the great cash flow uncertainty.”
McGrady, agreeing with everyone else interviewed for this piece, says that a good checkpoint for gauging the viability of private equity securitization will come a year from now, when the current crop of banking deals are off the table and a new generation has, or hasn’t, filled the void. Perhaps then the private equity market will learn if it has a new exit strategy in place, or just another flash in the pan.
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