While the securitization of hedge funds might not be the newest concept on the block, it's certainly an area that has seen limited expansion in Europe. However, as investors gain an appetite for this paper, the sector is expected to see more growth in 2007.
"CFO CDOs seem to becoming slightly more familiar within the European CDO market with three deals pricing last year and one in 2004," Dresdner Kleinwort analysts said in a report. At a Moody's Investors Service conference held in London earlier this year, analysts said they expected a good year for collateralized fund obligations (CFOs) with the increased investor interest in hedge fund products and new structures in the pipeline.
Growing appetite for this paper comes from investors that have a lot of their cash invested into CLOs - CFO CDOs allow these buyers access to much sought after diversification. "The ratings process is different than a CLO - CFOs are still considered an exotic product, although these products help investors diversify money away from traditional products," a banker from BNP Paribas said. When compared to cash CLOs, these products offer higher spreads, thinner triple-A tranches and thicker equity tranches.
BNP completed its first CFO of hedge funds earlier this month, ZOO HF 3 Plc, which is a 150 million ($197 million) transaction, managed by P&G Alternative Investments (P&G) in Italy. The main difference with ZOO HF 3 compared with the other CFOs that have come to market is that it uses external European hedge funds. Usually CFO managers use their own hedge funds.
According to Dresdner analysts, the last CFO deal to price was SCIENS CFO I in December 2006. Compared with ZOO, SCIENS spreads were slightly tighter, although the triple-A tranche from SCIENS did price at the same level as ZOO at 40 basis points. Further down the capital structure, at the mezzanine and junior levels, ZOO priced slightly wider with the double-A from ZOO pricing at 80 basis points versus 75 basis points from SCIENS, single-A at 135 basis points versus 130 basis points from SCIENS, and the single-B at 600 basis points versus 475 basis points. However, a spokesperson at BNP Paribas working on the ZOO transaction said he expected pricing to tighten in trading.
Rating agencies take historical volatility of hedge fund strategies into account when rating these CFOs. According to Dresdner analysts, the steadily increasing leverage of these products over the past four years might suggest that the that the underlying hedge fund strategies have become less volatile, therefore decreasing the amount of equity that is required.
"The quality of the underlyings [in the ZOO transaction] enabled us to provide an efficient capital structure for the vehicle, with a very attractive equity component," said Georges Duponcheele, head of product development and quantitative structuring at BNP Paribas. "One of the strengths of this structure is the various sets of triggers that have been calibrated, and assessed by Fitch Ratings and Standard & Poor's, in order to provide both the manager with flexibility and the noteholders with appropriate protection. Another strength is the presence of a balance-guaranteed swap, providing protection against adverse interest rate movements, but which will not create any downside risk to the noteholders, in an event of deleverage." Duponcheele added that BNP planned to offer more of these deals later in the year.
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