Collateralized Fund Obligations: The Advantages of CFOs

CFOs have become an increasingly popular alternative investment vehicle. They offer a way for portfolio investors, secondary funds, and funds of funds to layer their investment strategy with investments that have enhanced credit ratings, favorable returns, and diversified collateral. Although CFOs have a complex structure, they offer several benefits.

What to Know About the Benefits of CFOs

Among the main advantages of CFOs are:

1. Diversification of financing sources.
   Because the CFO issuer issues bonds with varying risk and return profiles and acquires interests in several funds, portfolios, and funds of funds, fund sponsors and investors can maximize diversification of funding and financing sources.
2. Bespoke structures and terms.
   The specific terms and structure of the CFO can be tailored to accommodate the needs of the fund investors and CFO issuer. Since there is no one-size-fits-all approach to CFOs, the CFO can be designed in a way that is most likely to be successful and take into account any specific regulatory, capital and/or tax requirements of the CFO issuer or investors.
3. Alternative to financing in bank markets.
   With a CFO, fund investors can realign their portfolios by freeing up capital for additional investments with preferred sponsors or rebalancing their portfolios to desired investment styles, industries, or vintages.
4. May offer advantages to CLOs, rated note funds, and NAV facilities.
   CFOs have similarities to collateralized loan obligations (“CLOs”), rated note funds, and net asset value (“NAV”) facilities, with a few key differences. For instance, in a CLO, the collateral is a pool of corporate loans with stable cash flows, whereas a CFO can accommodate a collateral pool with less predictable cash flows, such as interests in funds holding equity investments in various portfolio companies. A rated fund is a private fund with a single pool of directly held assets, whereas a CFO is a fund of funds. And NAV facilities typically involve a single lender, without tranches of notes or a separate equity tranche, and typically have a shorter maturity and lower advance rates. Depending on the collateral, the parties involved and the investment strategy, a CFO may be more suitable than these other options.
5. More favorable returns on investment.
   Because a CFO offers more favorable interest rates and advance rates than shorter-term financings executed in the private market, fund investors may obtain more desirable returns on their investments.
6. Collateral diversification.
   CFOs can be collateralized with various financial assets, such as private equity funds, pension funds, credit opportunity funds, buy-out funds, infrastructure funds, real estate funds, private credit funds, co-investments, asset-based securitizations, and residuals in CLOs and other securitizations.
7. Advantages for regulated investors.
   The structural credit enhancement features of a CFO, including over-collateralization and liquidity support, permit some CFOs to achieve investment grade ratings on up to 75 percent of their capital stack. Accordingly, regulated or institutional investors, such as insurers or pension funds, can satisfy applicable risk-based capital requirements with CFO securities in the form of rated notes rather than holding the investments individually and directly (with a lower credit rating).
8. Enhanced credit rating.
   Because the CFO is overcollateralized, primarily through eligibility and concentration limits, it generally has a more favorable credit rating than its individual investments. The rating agency methodologies in certain CFO transactions may require (at least in part) that investments have a minimum tenor and be sponsored by fund managers with a history of favorable performance. Additionally, rating agencies often look for diversity of investments by style, industry, and vintage.
9. Fewer regulatory requirements than securitizations.
   If a CFO holds underlying fund interests that are not "self-liquidating assets" (assets that convert to cash within a finite period of time), the securities issued by the CFO will not constitute "asset-backed securities" of the type that trigger applicability of the US risk retention rules, and accordingly the sponsor of such a CFO will not be required to retain a US risk retention interest.

Next Steps

There are many advantages of CFOs for investors interested in alternative financing vehicles. For additional information on CFOs, you can read the following legal updates:

• Collateralized Fund Obligations: A Primer
• Collateralized Fund Obligations: A Growing CDO/CLO and Fund Finance Liquidity Solution

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Michael P. Gaffney, Partner
Jennifer T. Hartnett, Partner
Arthur S. Rublin, Partner
Ryan Suda, Partner
Sagi Tamir, Partner
J. Paul Forrester, Senior Counsel

Fund Finance:
Kiel A. Bowen, Partner and Global Co-Head of Lending
Todd N. Bundrant, Partner
Mark C. Dempsey, Partner
Ann Richardson Knox, Partner

Insurance Regulatory:
Lawrence R. Hamilton, Partner