In the last year or so, venture capital players have been seriously eyeing the ABS market as a potential source of funding, evidenced by the growing contingent of private equity and VC professionals at the various securitization conferences.
At the same time, arbitrage-savvy structures are closely watching the price mismatch in the secondary limited partnership (LP) market, as firms - once bullish on technology and other venture capital hotspots - are trying to pare down exposures to these highly illiquid assets for various reasons.
The latter companies (wanting to pare down positions) are eyeing the CDO structure as a potential way to lift LPs off their balance sheets. Apparently, the rating agencies have been increasingly fielding inquiries from different segments of the financial markets, though, admittedly, such "buzz" in the securitization market does not always bring deals.
At least one private equity professional, who has been part of the PE securitization effort, estimates that between 20 and 30 deals are pending.
With the PE CDOs, there have already been a few success stories, such as Capital Dynamics' Prime Edge private equity CDO of summer 2001, or Aon Corp.'s $450 million CDO, called PEPs (for Private Equity Partnership Structures), which closed late last year.
The two deals, Prime Edge and PEPS, are indicative of parallel trends, mimicking the roots of the conventional high-yield bond CDO market. Along the lines of a traditional arbitrage cashflow CDO, Swiss collateral manager Capital Dynamics used funds raised by Prime Edge to ramp up a portfolio of assets. Aon, on the other hand, motivated by a corporate restructuring, used securitization to divest previously established portfolios of LP interests, a deal characteristically similar to a balance-sheet CLO. Here, the portfolio of LP interests would have been less economical if sold piecemeal.
According to sources, potential securitizers include the private equity arms of JPMorgan, AIG, Bank of America, Fleet Bank, GE Credit, Credit Suisse First Boston, Wachovia, and a slew of smaller players.
Moody's Investors Service is currently working on three deals that look promising, plus roughly 10 more proposals at various stages of development, said Michael O'Connor of the new assets group at Moody's.
"There's an enormous amount of interest in these structures," O'Connor said. "There are people calling up and asking about this stuff all the time."
So what would they call these deals, should they actually take flight? CPOs, CPEOs, CVCOs? How about C-3POs?
Equity unto debt
As mentioned, banks and insurance companies and other firms with large investments in these partnerships are currently motivated to pare down positions, for regulatory reasons, underperformance, diversification, and other factors.
For banks specifically, the federal regulators recently upped the required capital held against private equity interests from 6% to as much as 25%, said Dale Meyer of Probitas Partners. Meyers formerly worked at J.P. Morgan Partners, which launched an $800 million quasi-securitized offering in 2000 (a bond exchange for shares in private equity offerings).
There are several roadblocks, however, that make selling out of an LP interest a difficult option. First, as these are complicated legal agreements, a sale is often subject to the approval from the general partner (GP), who is essentially the VC fund manager. Also, the LP is usually in a confidentiality agreement with the GP, which makes it difficult to market the position to potential investors.
Still, a secondary market has developed over the last two years, although, as Meyer said, "There's an immense amount of product for sale out there, and only the truly desperate trades get done."
Using securitization technology, these companies are trying to fund their positions without actually having to sell them individually. Also, by securitizing, they can maintain the management fees without having to book the assets.
For the Prime Edge-type deal - which raised funds for a ramp up - securitization is also a natural course. As venture capital dried up, the question might have been, "Where do you find an investor, schooled in the principles of ramp up', savvy on future cashflows derived from a complex statistical pool analysis?" Where else but the CDO market?
What you end up with is highly rated, coupon paying classes with exposure to markets traditionally starved of what is ultimately debt financing - which, for the venturous debt investor could be viewed as an opportunity to diversify. On the bottom, you have a highly leveraged equity class, that sort of becomes an equity-of-equity. According to Meyer, this will be the most challenging part of the deal to place, unless the seller retains it.
That's an easier solution for the balance-sheet, Aon-type deals. "Here, the equity investor will often turn out to be the party who already had the LP interest," Moody's O'Connor said, adding, "The asset class is something that people are very interested in, but we'll have to see if investors are really going to have appetite for it, and if the equity can actually get placed."
Structural challenges
From the rating standpoint, particularly if trying to apply a CDO cashflow methodology, the few deals have required modified rating approaches. In a venture capital partnership, the LP is not only required to put down the initial investment, but is committed to potential future capital infusions up to a certain capped amount. Of course, this two-way flow characteristic places some serious hurdles in front of a standard securitization analysis.
Also, these LP interests characteristically do not have scheduled payments associated with them. "The problem with private equity is that the cash flows are very inconsistent," Meyer said. "You need a very large portfolio to develop any kind of consistency.
"You put together 10 bonds, and you can get a coupon payment every week," he added. "You can put together 10 private equity portfolios, and you can go eight months without any cashflow."
On the other hand, because these investments are so illiquid and trade very infrequently, a market value analysis falls just as short.
"The valuation is most often the book value, which is generally the purchase price that the general partner made for the assets," O'Connor said. The book value will stay at the initial investment amount until an event happens that forces the GP to revaluate the assets, such as another round of funding, an IPO, or a sale. Over the last year, more often than not, VC firms have been writing down their portfolio values.
"Since neither the market value or the cashflow analysis work for these structures, you end up with more of a stochastic analysis," Moody's O'Connor said.
The first few private equity-backed CDOs, such as Princess Private Equity Holding and Pearl Holding, were actually principal-protected with an insurance component, which allowed the investors some upside potential in the underlying assets without risk of principal loss.
Currently, the pipeline is trending toward unwrapped structures with risk tied more intimately to the underlying returns, sources said.
