Private equity has become the place not to be seen. The market is flooded with assets, and the prospect of selling into a buyers' market at a discount of anywhere up to 25% is about as appealing as root canal treatment. The fact that many investors have already watched the value of their investments dwindle over the last year is certainly no anesthetic.

Given such unappealing conditions, borrowing against the assets via a securitization has become an idea whose time has arrived. "If an institutional investor in a private equity fund needs liquidity, for allocation reasons or general dissatisfaction with the state of its private equity fund investments. . . if somebody's going to lend against a portfolio at a reasonable value, it becomes interesting," said Larry Graev, president and chief executive of New York-based merchant banking firm the GlenRock Group LLC.

Structuring the right type of deal, which requires the use of special purpose vehicles that have become tarnished given their abuse in the hands of Enron Corp. and PNC Financial Services Group, is a complicated endeavor.

However, a $450 million securitization of limited partnership interests for Aon Corp. has managed to pull it off. The assets were previously held by the company's insurance underwriting units, which it plans to spin off this spring. As part of the transaction, Aon has just sold 53 limited partnership interests to special purpose vehicle (SPV), Private Equity Partnership Structures I LLC. In return, Aon's insurance underwriting units received about 40% of the asset value in cash and the rest in securities issued by the SPV.

Aon unwrapped

Unlike previous deals, Aon's came with no insurance guarantee, or "wrap". This cuts out the middleman, allowing the issuer to sell assets to a newly created company (owned by Aon) that then issues securities against them. Where a wrap is involved, the issuer effectively sells the assets to the balance sheet of the guarantor in return for a guarantee that the principal will be protected, say bankers familiar with the structure.

Such guarantees were necessary in the past to achieve the kind of rating needed to attract investors to a new product, as wrapped issues carry the guarantor's balance sheet rating. Aon's is the first securitization of limited partnership interests to receive stand-alone credit ratings from Standard & Poor's (albeit a private one) without the benefit of a guarantee.

A similar deal issued for Prime Edge Capital in Europe last summer bore the double-A rating of reinsurer Swiss Re. Without it, the deal tranches would have been rated single-A and a triple-B respectively. This would have made them difficult to place at the time given the relative novelty of the structure. But with a handful of deals under its belt, the market is now mature enough to abandon its security blanket. Aon is understood to have achieved similar rating levels with its new deal without a wrap.

"The wrap becomes less important as the market gets more familiar with this type of transaction," said Jeffrey D'Souza, co-head of global credit derivatives at Deutsche Bank, which arranged and placed the Prime Edge bonds. The structure that D'Souza's team is working now does not feature an insurance guarantee.

Avoiding SPV paranoia

Foregoing sponsorship means more work for both issuer and rating agency, as there are many underlying investment companies to evaluate-700 in Aon's case. But the effort is worthwhile, said bankers. Not only does it mean freedom from guarantor ties, it also offers a degree of comfort to an investor community that is increasingly wary of off-balance-sheet mechanisms. By acknowledging that its underlying investment companies have irregular distribution of profits and cash, and subjecting them to rating agency scrutiny, issuers can avoid being tarred with the same brush as troubled SPV users such as Enron and PNC Financial.

"We were not looking to hide the volatility-it's still there on the balance sheet" by virtue of Aon's ownership of the securities, said John Casey, president of Aon Capital Partners Inc., which acted as financial adviser to its parent company. "What we're doing is smoothing the recognition of that by having these bonds that do pay current interest and, because we own equity at the bottom, at the end of the day we're eating our own cooking."

The transaction is also general partner-friendly, said Casey, in that it does not interrupt the relationships that exist between the GP and the underlying investors because the insurance companies own a meaningful part of the residual equity. In contrast, those deals that have featured insurance company guarantees have also included provisions allowing the guarantor to liquidate the assets should their value decline within a specified period.

Most of the issuing interest for this product comes from those with risk-based capital issues, such as banks. For such investors, it's much more efficient to securitize these assets rather than hold them as individual partnership interests that have capital requirements. In the U.S. those requirements were increased last year.

In addition, regulation-constrained pension fund issuers can securitize their private equity investments, raise cash, and use that money to invest in more private equity. That way, they can increase the percent of their portfolio that is in private equity without hitting up against regulatory ceilings. "Private equity valuations have troughed," said one eager investor, "So why not leverage up your portfolio at a lower relative financing cost and make new investments here?"

By shifting these assets off their balance sheet, companies also can stabilize their income - something that will have broad appeal for those companies that accumulated large positions in the late 1990s that are now performingly poorly. "But these are non-cash earnings - just market values of assets that are an important feature of the balance sheet, but not the income statement," said an official at one such firm.

But while investors may be more familiar with this strategy now that there are examples in the market, simplicity seems to be the key. J.P. Morgan Partners was forced to shelve plans to securitize its own private equity portfolio last summer when investors shunned the deal, some citing its complexity and fee structure among their reasons. There was also a suggestion that the bank wanted to get others to take on risk it wasn't comfortable with.

Issuers say that's not typically the reason for doing a deal. "The bottom line is that few people are really looking for risk transfer," said Aon Capital's Casey. "They're looking for liquidity and a way to retain the equity upside, and that's very simply what Aon is doing. It's a complicated asset class but it's not such a complicated securitization."

While the gestation period for such deals still runs to several months because of the sheer amount of work involved, players still expect private equity portfolio securitizations to flourish in 2002. JPMP is working to restructure its deal and there are several other transactions in the works, they say. "There's going to be less new fundraising in the private equity market through this type of vehicle - it's going to be essentially securitizing existing assets that are underwater. And there's a lot of potential for that type of business," said a banker looking to grab a piece of the action.

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