Selling equity for multi-tranche hedge fund collateralized fund obligations (CFOs) has proved to be quite a challenge, as competing firms race to find the structure that will allow investors to minimize potential significant tax liabilities.

Currently hedge fund CFO equity is virtually impossible to place in U.S. market, thanks to our friends at the Internal Revenue Service (IRS) and other regulators. In an all past transactions, CFO equity has been placed outside in the international markets, such as Man Glenwood and Investcorp's CFOs last summer, according to market sources. This is why finding an issuer with a strong European and Asian customer base is critical for underwriters. Issuers and underwriters are required to have strong distribution in private equity distribution, as and a sales force with ties to high net-worth individuals.

Professionals explained that for this market to fly, issuers, their affiliates and clients will be required to take down the equity at the outset, or be able to distribute to their high-networth clients, a trend becoming more prevalent in the overall CDO market.

Equity returns on the hedge fund CFOs apparently pale in comparison to that of the equity in your traditional CDOs, such as structure finance backed deals that have base case returns in the 20% to 25% internal rate of return area. Another obvious challenge to the hedge fund CFOs has been poor performance over the past year in the sector, making traditional fund of fund marketing difficult, let alone a brand new asset class.

Only a top tier issuer will be able to successfully complete a deal, sources said. Theoretically, the debt for such an issue will see decent demand, as was seen in the Man Glenwood transaction, when triple-A's cleared at 70 basis points over the six-month Libor.

The weighted average cost of debt for hedge fund CFOs is looking at the 150 basis point area at least, compared to the high 90 to low 100 basis point area for collateralized loan obligations.

CFOs are also limited in terms of how leveraged they can be. According to sources, hedge fund CFOs can leverage up to four times using 25 percent equity support, versus a CLO, which may have 12 times leverage.

Also, funding via a market value CDO is not as attractive as a cash flow transaction to many investors, which is why a handful of hedge fund's have set up cash flow CBO teams; e.g. Coast Asset Management.

One of the few market value hedge CFOs currently marketing is a $100 million single strategy relative value deal. Salomon Smith Barney is underwriting the transaction for Concordia Advisors. Salomon also has a $400 million to $500 million deal for hedge fund manager in Europe. That deal is scheduled for first quarter. No issuers or underwriters could be reached for comment.

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