Everquest's IPO will give equity investors one of their first opportunities to take a concentrated stake in the fast-growing CDO market, provided they can muster trust in the company's CDO valuations.
Everquest, set up last September by Bear Stearns and CDO manager Stone Tower, filed for its IPO in early May, and Bear Stearns is underwriting the deal. Proceeds from the IPO are slated to pay down a $200 million credit facility provided by Citigroup, acquire more interests in CDOs, and support general corporate purposes. Bear Stearns did not respond to inquires about Everquest or the status of the IPO, noting that deal remains in the quiet period.
The Everquest IPO follows in the footsteps of similar transactions aimed at turning future credit-market revenue streams into current cash. "In general, fixed-income money managers have been looking for ways to monetize future earnings in some fashion, whether through a REIT vehicle or through this IPO route," said Vince Matsui, a senior director at Fitch Ratings.
Highland Financial Partners (HFP), set up by CDO manager Highland Capital, is pursuing a similar offering. HFP's prospectus notes that the fair values of its CDO loan investments will be determined using price estimates provided by an unnamed independent pricing service. But, Everquest is asking equity investors to rely entirely on Everquest's executives to provide those valuations, and their time will be split between managing Everquest CDOs as well as those at Bear Stearns and at six-year-old Stone Tower, which manages $8 billion in CDO assets.
The CDO market has already demonstrated strong growth, with issuance increasing by 31% annually since 1996, according to Moody's Investors Service. Everquest and HFP could benefit from that growth, and their returns have been especially attractive in recent years' low-rate environment. The prospectus notes that as of December 31, 2006, the weighted average annualized cash return of the seven CDOs managed by Bear Stearns' asset management team was 12.3%, or 19.9% on an adjusted gross basis before deducting management fees, and the weighted average annualized cash return of the 17 CDO equity tranches that Everquest purchased was 24.5%.
But few anticipate such a high rate of issuance continuing. "It's hard to see how anything can retain a 30% growth rate," Fitch's Matsui said, although even a sizable drop would likely still give Everquest's CDO managers plenty of new assets to choose from. The bigger leap of faith for Everquest's investors involves relying on the firm's own valuations of the assets it manages, especially when those valuations determine a large part of management's compensation.
A hedge fund manager who buys leveraged credits and who has also managed CDOs, said that equity-like assets in CDOs usually are marked to market, at their fair values, when they're purchased for the fund. They're then typically held at that value until they are sold, often when the asset has run into trouble. "As an equity investor in CDOs, you never know whether the value of the assets is going up or down, and therefore whether the investment is doing well or at great risk," he said.
He added that in an extreme case, if investors in CDO equity tranches discover the CDO has lost 20% of its value, and the fund is leveraged 10-fold, the value of those tranches will have been wiped out. Those dynamics are magnified by CDOs that invest in other CDOs, since they are using leverage to invest in already leveraged investments, stretching the equity even further and compounding the likelihood that a drop in asset values will wipe it out. Parapet, a Bear Stearns CDO of CDOs makes up 53% of Everquest's assets.
"I'm a credit guy, and I always think about the worst. But in an environment where a lot of people think the CDO and loan markets are overheated, and the subprime market is falling apart, investors will be buying into this with no transparency at valuations that the issuer is setting," the fund manager said.
Everquest states that it plans to value assets monthly, but nearly six months have passed since the valuation of total assets stated in the prospectus - $726 million - was determined. At least one underlying asset class, residential mortgages, has deteriorated significantly since then.
The fund manager noted that both Stone Tower and Bear Stearns are well respected in the CDO management realm. Nevertheless, Everquest is enabling those firms to shift risky parts of the CDOs they manage off their books and receive compensation for them. For example, the prospectus notes that Bear Stearns transferred to Everquest the equity in 10 CDOs, including Parapet, for a purchase price of $548.8 million, and in return the new company issued 16 million shares to the investment bank and paid it $148.8 million in cash.
Janet Tavakoli, a consultant to institutional investors and president of Chicago-based Tavakoli Structured Finance, pointed to the prospectus, which states that "the substantial majority" of Everquest's ABS CDOs have invested in RMBS, the majority of which are backed by subprime mortgages.
The prospectus adds that as of year-end 2006, ABS CDOs accounted for 16.2% of total assets and 18.3% of revenue. Meanwhile, 42.8% of Parapet's CDOs are invested in preference-share and income-note tranches of ABS CDOs, the portions that take the first hits when the CDOs' underlying assets run into trouble.
The prospectus does note that the investment-grade ratings on the CDO's RMBS range from A2' to Ba2'. It qualifies, however, that those tranches could suffer material losses if the underlying collateral pools deteriorate. Tavakoli has seen recent signs that such deterioration is underway.
"We have a seller of $7 million of this ABS issue at a price of 55, obviously distressed, although still rated AA-'. The collateral is second mortgages, which have gotten crushed," stated an unsolicited offering she recently received from a "desperate" broker. "Even highly rated deals backed by subprime seem to be in deep trouble. This is typical of what is happening in the sub prime market, but one has to consider each deal on its own merits," Tavakoli added.
However, equity investors in Everquest's CDO assets - especially retail investors expected to purchase shares - will find it difficult to make those considerations, given the lack of information about CDO assets that's publicly available. Instead, they will have to rely on Everquest. The prospectus states that Everquest employs a three-step, discounted cash flow methodology to estimate the monthly fair value of its CDO equity, first forecasting expected cash flows, followed by calculating the discount rate and the fair value. For the first step, it uses software from third-party vendor Intex to forecast the timing and amount of cash flows the firm expects to receive. Everquest makes clear, however, that its management provides the assumptions fed into the software, based on "observable market parameters and standard industry practice."
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