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CFO: Applying Securitization Technology To Hedge Funds


Collateralized fund obligations (CFOs) represent the latest application of securitization technology to a new asset class--hedge funds--and offer investors debt and equity classes backed by a diversified portfolio of funds managed by a fund-of-hedge-funds manager. Financing investments in hedge funds is nothing new. Banks have financed hedge funds for many years. But financing the investment using securitization technology and tapping institutional investors is new, with the first two publicly rated deals having closed this past summer, and a growing pipeline at dealers and rating agencies. Relative to the collateral backing conventional CDOs, a CFO's underlying hedge fund collateral is much more diversified, having high risk-adjusted returns and very low correlation to traditional equity and fixed income asset classes. These features, together with low historic return volatility and relatively low absolute losses, even in distressed markets, make hedge funds both an attractive addition to an investment portfolio and an attractive asset class to securitize. Investment in a CFO provides equity investors with efficient, non-recourse leverage, and offers debt investors with an opportunity to lend against an asset class less correlated with credit markets. The universe of hedge funds includes as many as 5,000 hedge funds managing in excess of USD550 billion in assets. Hedge fund investment strategies may be grouped broadly into 12 to 15 different styles, such as merger arbitrage and distressed situations. Fund of funds managers strive to assemble a portfolio of hedge funds that is resistant to event risk by employing multiple managers having diverse investment strategies, with the goal of achieving "equity-like returns with bond-like volatility." CFOs offer portfolio managers with another way to increase assets under management and diversify funding sources, as well as provide longer term financing than bank lines.


Analyzing The Risk Of Hedge Fund Investing

Since investment returns, volatility, and risk vary enormously across different hedge fund strategies, it is critical to develop an understanding of the various hedge fund styles. The bulk of hedge funds seek stable, market neutral returns by pursuing defined and repeatable investment strategies to exploit market inefficiencies and isolate returns from risk, applying leverage as appropriate for their stated strategy. In the context of a CFO, the value a manager brings is the ability to sift through the overwhelming number of hedge funds and the diversity of investment strategies to construct a pool of hedge funds as collateral. Important issues to consider when structuring or evaluating a CFO include the following.


* The Portfolio Manager

The experience and quality of the CFO manager is the paramount consideration since investors must rely on the manager to select and monitor the hedge funds (anywhere from 20 to over 100) that comprise the CFO portfolio. Investors should scrutinize the portfolio manager's due diligence practices and its ability to select quality hedge funds and monitor against performance deterioration, style drift and the manager's access to quality hedge funds, many of which close their doors to new investors.


* Concentration Risk

A well-diversified portfolio of hedge funds with low correlation among the portfolio funds is the best defense against a single manager debacle. The investment guidelines of the CFO will limit allocations to funds, managers and investment styles to mitigate the risk that any single manager can greatly affect the performance of the CFO portfolio.


* Correlation To Existing Portfolio

Investors should consider the incremental exposure they will take to different market sectors via the CFO, and the impact on the investor's existing portfolio. Many hedge fund strategies offer little or even negative correlation to leading equity or bond indices and can help diversify a portfolio.


* Liquidity

Generally, hedge funds trade in liquid underlying assets. However, hedge funds protect themselves (and their strategy) from market events affecting liquidity through restrictive redemption provisions. Most hedge funds will not provide daily liquidity to investors, but instead require a redemption period of anywhere from one week to more than a year depending on the fund and the strategy. For example, a hedge fund may provide monthly liquidity on the last day of each month and require a 15-day notice period, meaning that the CFO may be exposed to a hedge fund for a full 45 days following the CFO portfolio manager's notice to redeem. An uncured failure of a collateral quality test, such as an overcollateralization test (OC test), may require the manager to liquidate collateral during adverse market conditions; the longer the exposure period, the higher the risk of loss.


CFO Structure And Rating Agency Approach

Each of Fitch Ratings, Moody's Investors Service and Standard & Poor's have rated CFO debt to a triple A rating, given appropriate structural protections and manager qualifications. Each agency conducts qualitative and quantitative analysis of the CFO structure in connection with the rating. Qualitatively, the rating process centers on the asset manager and the proposed CFO structure, and includes due diligence meetings with the CFO manager, focusing on the issues outlined below.

Staffing and resources of the manager relative to the assets they are managing as well as the experience, reputation, financial soundness and general business health of the key executives and professionals

Investment strategy and processes with respect to new manager selection and ongoing monitoring policies and practices

Operational systems and controls with respect to mid- and back-office operations, data sources and contingency plans

Risk management, transparency and reporting

Quantitatively, the rating agencies will model and stress the performance of the CFO assuming a range of portfolio returns and volatility paths. The performance of the CFO is dependent upon the market value of the underlying hedge fund collateral. Consequently, the rating agencies employ market value CDO technology to analyze and stress the CFO. Market value technology relies on the advance rate concept, which specifies the amount of debt which can be advanced as a percentage of the market value of the hedge fund collateral.

Typical Collateral Advance Rates

In combination with the advance rates, a CFO will incorporate OC tests and, in some cases, a minimum net worth test intended to ensure a minimum subordination cushion below the debt. An OC Test applies to each rated debt tranche and requires the product of the net asset value of the hedge fund portfolio and the applicable advance rate for a specific debt tranche to exceed the outstanding principal plus accrued interest of the specific debt tranche and all its senior tranches. If the OC test is failed, the portfolio manager will need to take one or more of the following corrective steps until the test is passed: (a) redeem hedge fund interests and increase cash equivalents, (b) reduce leverage by paying down the liabilities in order of seniority, or (c) call on equity holders to provide additional capital. A CFO may have a cure period of up to six months for OC tests, depending upon the liquidity profile of the portfolio assets and the periodicity of net-asset value calculations (usually monthly).

Similar to other types of CDOs, a CFO will also incorporate additional covenants and restrictions to protect investors. The CFO manager will need to comply with specified diversity and concentration requirements that will vary from deal to deal and reflect the relative strengths and experience of the CFO manager and the concerns of investors and the rating agencies. Unique to CFOs, rating agencies may impose a volatility test to protect investors against unexpected volatility in the CFO collateral. To mitigate the collateral liquidity risk, a rating agency will generally require a tiered liquidity profile, with a minimum percentage of the portfolio redeemable within a certain period of time for each tier, for example, 30% of the portfolio having monthly or better liquidity.

Hedge funds typically do not have scheduled distributions, so the CFO manager will need to redeem, or partially redeem, portfolio funds to pay interest to debt investors. To mitigate any timing mismatch between an interest payment date and receipt of redemption proceeds, the CFO may require a supplemental liquidity facility.

Index Correlation Coefficients
April 1995 – August 2002
  CSFB Tremont Hedge Funds S&P 500 MSCI European Stocks MSCI World Stocks Salomon High Yield Lehman Govt Bond Lehman Agg Bond
CSFB Tremont Hedge Funds 1 0.51 0.5 0.52 0.39 0.06 0.15
S&P 500   1 0.75 0.94 0.55 -0.08 0.03
MSCI European Stocks     1 0.88 0.5 -0.18 -0.09
MSCI World Stocks       1 0.55 -0.17 -0.06
Salomon High Yield         1 0.03 0.17
Lehman Govt Bond           1 0.97
Lehman Aggregate Bond             1
Source: Bloomberg and CSFB Tremont Index



 This week's Learning Curve was written by Dean Rostrom, a product manager in the structured products and derivatives marketing group atJPMorgan in New York.


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