Presentation by David Graubard, senior analyst, structured finance, Thomson Financial
As a result of recent underperformance in the equity and bond markets, the alternative investment sector has been booming, but a need for medium-term, stable financing still remains for hedge funds. Thus, savvy Wall Street bankers and rating agencies are courting hedge funds to dip into the term financing markets via securitization. The pitch is that the securitization panacea would allow dealers to help their hedge fund clients increase the growth of assets under management, give access to stable five-year area term financings, while the client earns lucrative annual management fees in the millions on each deal per annum.
The main target for hedge fund CDOs are hedge fund-of-fund managers, which are portfolios of hedge funds earning a total return from a diverse mix of strategies.
A driver for hedge funds to use rating agencies and tangible, transparent, structured transactions is that institutional investors need to justify the safety of their investments. And while the number of institutions looking to gain access to hedge funds continues to expand, a general nervousness still remains around the product, exasperated by the fall of Long Term Capital Management and extreme tales of funds building up to 100 times leverage using derivatives.
Securitization
Hedge funds such as The Clinton Group in New York, and Chicago-based Deerfield Capital have issued in numerous cashflow collateralized debt obligations via small teams of investment-grade, high-yield, and structured finance portfolio managers earning lucratitive fees for the respective firm.
In the private markets, market-value CDO technology has been applied to managed, hedge fund-of-funds, which are generally termed collateralized fund obligations (CFOs).
In the past these transactions have typically been placed with a very small group of investors that take big chunks of each deal. The most common structure seen to-date are two-tranche senior/junior deals.
Using the two tranche structure, the senior notes are rated to that of the firm or insurance company providing the guarantee, which frequently ensures the senior investor that they will can get their principal back.
Zurich Re and CDC are insurers said to be players in these types of CDOs.
The market is also seeing interest in market-value multi-tranche CFOs that enable a larger deal, a broader distribution of investors, and typically do not have any insurance.
The frequent stumbling block for many CDOs is placing the pivotal first-loss equity piece, which may hold the growth of the market-value multi-tranche CFO asset class to as few as the three to four deals per year, according to one senior rating agency official.
The U.S. only saw six visible traditional market value CDOs close in 2001 and zero after Sept. 11, according to CSFB research, adding up to a par amount of $3 billion.
Deals coming to market
Currently nine multi-tranche CFO transactions are in various stages of marketing and structuring. Credit Suisse Asset Management (CSAM), Goldman Sachs Asset Management (GSAM), Bear Stearns, Merrill Lynch, and Deutsche Bank, are all in various stages of structuring CFO deals. GSAM and CSAM reportedly both have fund-of-fund families that will manage deals. Merrill and Bear are believed to have mandates with third-party clients.
Sept. 11 derailed the most promising CFO transaction to print during the fourth quarter. Ivy Asset Management, a subsidiary of Bank of New York, still has its $300 million transaction in the queue via JPM.
After Sept. 11 the key equity investors' risk tolerance changed and walked away.
Nevertheless, JPMorgan and Chase AG closed a multiple-class offering of a fund of hedge funds for Ivy that was placed largely in Germany. The funding combined modest term leverage and principal protection. Distribution was in the form of fund shares, notes and indexed "schuldscheine" securities, which have been described as a German form of a securitized loan.
Although Ivy reportedly has enough equity placed to do a $80 million to $100 million transaction, JPM is committed to bring a $300 million area transaction, buyside sources familiar with the situation said. The deal is being restructured to lower the risk parameters for investors.
One investor described the Ivy CFO like this: In the Ivy deal investors are essentially taking a bet on the returns of a group of twenty to thirty different hedge funds, where Ivy Asset Management acts as the fund-of-funds manager or advisor. Exposure to each hedge fund will be limited to around 5% and there is expected to be 10-20% caps on exposure to each fund strategy; e.g. long/short equity, relative value, or convertible arbitrage. The SPV acts as limited partner investor in each fund while Ivy Asset Management is the general partner.
As of about two weeks ago, Ivy's $300 million multi-tranche CFO is structured as a six tranche, five-year bullet FRN, with $90 million in equity. Both Moody's Investors Service and Standard & Poor's are rating the issue. The transaction will largely involve Ivy's long-short equity fund, Rising Star, and its flagship relative value fund, Rosewood Associates.
Ivy has a second CFO in the pipe for this year although limited details are known.
Hot on the heels of JPM for the bragging rights of printing the tombstone on the first visible multi-tranche hedge fund CFO is CSFB with a $500 million deal, the Bahrain based Invest Corp. CSFB is marketing this deal hard via joint venture between the firm's London ABS team and its hedge fund group. Rating sources appear confident this deal maybe the first multi-tranche, uninsured CFO to close.
Invest Corp. has offices in London and New York and several billion dollars under management. Like Ivy this market value CFO is a four tranche, 5-year bullet, with a $125 million equity tranche.
Morgan Stanley is prepping a $300 million area market value, hedge fund-of-funds CDO for Grosvenor Capital Management, L.P. that is slated to launch during the first quarter. Grosvenor's deal will be backed by the returns of a diverse group of hedge funds that use various strategies.
Greenwich, Conn.-based fund-of-funds manager Ferrell Capital has a single-tranche tranche principal guaranteed CFO in the pipeline for the first half called Concert Guaranteed Ltd.
Zurich Re is understood to be providing the guarantee of principal on the senior notes Concert Guarantee. Six to 12 hedge funds will be involved using various strategies: long-short equity, yield curve arbitrage, fixed income and foreign exchange. The deal is still being structured and tenor should be around five years. Ferrell will calculate the Value at Risk of all the funds positions on a daily basis that will be available in an aggregated form on a regular basis to investors. Further, the NAV of the fund-of-funds will also be calculated daily.
Placement challenges
While cashflow investors by nature are not fond of market-value CDOs, the added risk and lack of transparency of market-value hedge fund-of-funds CDOs or CFOs makes many run the other direction.
Said one CDO portfolio manager at a major SIV in London: "The premium for investing in the market-value hedge fund-of-fund deals, even at the senior-note level, is not much better than a second tier arb cashflow CDO. We don't feel the return is worth the risk."
This particular investor attended Invest Corp.'s roadshow via CSFB last fall in London.
"Any institution that is largely concerned with downgrade risk likely wouldn't be interested in a hedge fund-of-fund CDO - however, some insurance companies and money managers are likely buying in size," said one of Europe's biggest market-value investors.
Said a large European CDO equity investor who closely looked at both Ivy and Invest Corp's deals, said: "We would be willing to buy multi-tranche CFO senior notes, but the mezzanine bonds are too volatile for us. We'd consider paying around +60 area/Libor for a triple-A."
Reportedly the equity on the multi-tranche CFOs are being marketed at about a 20-25% total return.
Furthermore, in the secondary market, equity in cashflow arbitrage emerging market CDOs can sometimes be found with a total return of around 30% and 35-40% for a story credit.
Also, competing with CFO equity are more traditional market-value CBOs; i.e. Tannebaum & Co. reportedly has a $1 billion market-value CDO with $350 million in equity that has been seen pitched at a total return of 35% using standard base-case assumptions, according to an equity investor who looked at the transaction.
The assets backing the trade are more risky than many market value deals seen in the past - 30% distressed debt, 40% B/BB HY bonds, 20% mezzanine, 10% equity.
Going forward
We are likely to see the first visible multi-tranche hedge fund-of-fund CDO in the first half of 2002 and possibly three to four such deals for the year. Fund-of-fund managers such as Ferrell Capital are likely to take the path of least resistance and issue principal-protected CFOs.
Regarding placement, a sufficient premium for investors will need to be presented over the underlying assets and competing CDOs. Lastly, the concern of investors that there is a lack of transparency in the hedge fund CFOs will need to be addressed before we see meaningful deal flow.
