Executive Summary

One of the hottest fund finance trends is an alternative
investment vehicle that has become increasingly popular. A close
sibling of collateralized debt obligations (“CDOs”),
collateralized fund obligations (“CFOs”) are a vehicle
for securitizing portfolios of alternative or real assets,
including interests in private equity funds, hedge funds, private
credit funds, infrastructure and real estate debt and equity, and
other similar investments (“Underlying Fund Interests”).
In this Legal Update, we explain the history, structure, and
variations of these alternative financing vehicles, so sponsors and
investors can determine if a CFO transaction aligns with their
business objectives.

Background and History

CFOs first emerged in the early 2000s, but were only
infrequently used. According to rating agency Fitch, between 2003
and 2006, six private equity versions of CFOs were issued. Our
first private equity CFO was in 2004, and our first hedge fund CFOs
were in 2006.

In the years following the financial crisis, from 2007 to 2013,
no CFOs were issued. Over the past decade, however, CFOs have been
issued with increased frequency as a way for portfolio investors,
secondary funds, and funds of funds (each, an “Investor”)
to layer rated capital markets financing vehicles on top of pools
of Underlying Fund Interests with diverse characteristics.
Additionally, CFOs can facilitate the monetization of certain
holdings in their investment portfolio earlier by generating
short-term liquidity without forgoing the longer-term upside of the
Underlying Fund Interests.

Discussion

What is a Collateralized Fund Obligation?

While CFOs can take various forms, they are essentially created
when a bankruptcy-remote special purpose entity (“CFO
Issuer”) acquires a diversified portfolio of Underlying Fund
Interests. To finance that acquisition, the CFO Issuer issues
tranches of rated notes and equity (collectively, “CFO
Securities”), which are secured by the Underlying Fund
Interests owned by the CFO Issuer or its subsidiary. More senior
tranches benefit from credit enhancement features, and, when
necessary, interest and principal payments that would otherwise be
allocated to junior tranches are redirected to the senior
tranches.

How are CFOs Structured?

In many ways, CFOs resemble a hybrid of a net-asset-value
(“NAV”) facility and a CDO. CFOs utilize the tranche and
collateral structure of CDOs while incorporating the loan-to-value
metrics found in NAV facilities.

In light of typical restrictions on transfer of limited partner
interests, the Underlying Fund Interests are typically held by a
subsidiary of the CFO Issuer (“Asset HoldCo”). In this
structure, the payments on the Securities are secured by a security
interest in the equity interests issued by the Asset HoldCo to the
CFO Issuer, rather than a direct pledge of the Underlying Fund
Interests.

Consider a sample CFO structure: An investment company-the CFO
Issuer-acquires a stake in a pool of private equity funds through
its subsidiary, Asset HoldCo. The CFO Issuer also acquires
interests in other portfolio assets, such as money market funds and
other liquid products.

View image in new tab

What are Some Variations of CFOs?

CFOs can be tailored to meet many different needs and
situations. Some of the more common variations include:

• Type of Underlying Investments and Strategies.
  Most CFO Underlying Fund Interests consist of limited partner (LP)
  interests in private equity funds, hedge funds, energy funds,
  infrastructure funds, and venture capital funds. In addition, some
  CFOs include a broader range of investments such as equity stakes
  in CLOs or other asset-backed securitizations, co-investments in
  portfolio companies or syndicated loan assets. Including fixed
  income assets in the portfolio can help to ensure sufficient
  regular cash flow to satisfy payments on the CFO’s liabilities
  and capital calls on the Underlying Fund Interests.




• Fixed Portfolio vs. Adjustable Portfolio. Some
  CFOs have a fixed portfolio at closing, and the CFO Issuer does not
  reinvest in other funds throughout the life cycle of the CFO. In
  other CFOs, the CFO Issuer may not have the intended final
  portfolio at closing, and may initially invest in liquid positions
  pending the identification and investment in such final portfolio.
  The CFO may be able to reinvest proceeds during a specified period
  post-closing (e.g., three years) to optimize the duration for the
  Underlying Fund Interests.




• Amortization and Repayment of Principal. Most
  CFOs have an amortization period of up to five years. During this
  time, the CFO Issuer will pay down its debt to Investors according
  to a pre-defined amortization schedule. If the CFO Issuer cannot
  pay down the principal as required, interest payments may be
  subject to a stated increase.




• Loan-To-Value Test Breaches. If the CFO Issuer
  breaches the specified loan-to-value (“LTV”) test, the
  CFO terms will likely require the CFO Issuer to restrict
  distributions to Investors in the equity or even mezzanine
  tranches. Typically, the LTV breach will not trigger a default
  under the terms of the CFO.




• Pool Breadth and Depth. Some CFOs acquire and
  hold Underlying Fund Interests only in funds managed by the CFO
  manager (or its affiliates) while others allow Underlying Fund
  Interests with third-party managers. CFOs can be structured
  variously with pool sizes ranging from fewer than ten Underlying
  Fund Interests up to a hundred or more Underlying Fund
  Interests.




• Maturity of Investment Pool. Underlying Fund
  Interests can also have a range of anticipated maturity dates.
  Older vintages will distribute cash early on in the life of the
  CFO; younger vintages will distribute cash later. A staggered
  vintage strategy supports consistent cash flow during the term of
  the CFO. For CFOs with Underlying Fund Interests that permit
  redemption, redeeming such funds may also provide required
  liquidity or available funds for scheduled payments or other
  distributions.




• Outstanding Capital Commitments of
  Investments. When some or all of the Underlying Fund
  Interests are not fully drawn and have outstanding capital
  commitments, the CFO Issuer typically must ensure ongoing available
  capital to fund the capital commitments through a capital call
  facility, delayed draw notes, or a cash reserve account.

Are there Any Structuring Challenges?

CFOs have two primary structuring challenges. First, since many
Underlying Fund Interests don’t have specified or consistent
periodic payments (and may themselves be leveraged with senior
secured and mezzanine debt), the timing of dividends and other
distributions paid to Investors on these investments are difficult
to predict. Accordingly, the capital structure of the CFO must
include the ability to defer or capitalize significant current
interest or other payment obligations otherwise owing.
Alternatively, a CFO might utilize a liquidity facility, cash flow
swap, or a similar arrangement to ensure timely payments of
scheduled principal and interest on CFO Securities. Delayed draw
notes, or a cash reserve account, can also help mitigate the risk
that cash flow disruptions could impede payments to Investors.

Second, most private equity investments require an investor to
commit to making capital contributions when called. Accordingly, in
a CFO, unless the Underlying Fund Interests are fully funded when
acquired by the CFO Issuer, the capital structure of the CFO must
include available capital with sufficient flexibility to allow the
CFO Issuer to make its required capital contributions. This
flexibility can also be obtained through a revolving liquidity
facility (discussed below), issuing delayed draw notes, or by
establishing a cash reserve account.

How are Funds Distributed?

As mentioned above, because the CFO may have variable liquidity,
interest and principal payments may be more variable than in a CLO
or ABS transaction. Additionally, a CFO has more restrictions on
distributions to the equity tranche. For instance, the terms of the
CFO may prohibit any distributions to equity tranche for the first
several years of the CFO. In addition, if the CFO allows the CFO
Issuer or CFO Manager to reinvest proceeds from Underlying Fund
Interests, distributions to the equity tranche may also be
deferred.

Depending on cash flow and the specific terms of the CFO
transaction, payments and distributions of the collections on the
Underlying Fund Interests are generally made according to a
priority structure similar to the below:

1st – Administrative expenses (and
management fees, if applicable), subject to a periodic cap

2nd – Fees, expenses, and interest payments of liquidity facility
(if one exists)

3rd – Principal payments of liquidity facility (if one
exists)

4th – Interest payments to noteholders

5th – Principal payments to noteholders (according to amortization
schedule and subject to deferral/capitalization if there is
insufficient available cash and no liquidity facility funds)

6th – Administrative expenses that remain unpaid due to the
cap

7th – Distributions to equity

How Does a CFO Access Required Funds and Short-Term
Liquidity?

Many CFOs provide that CFO Issuers are only required to make
interest payments on senior notes if there is adequate cash flow.
If the CFO Issuer lacks sufficient cash, the interest payments may
be deferred until the next payment date. However, some CFOs require
that the CFO Issuer-or Asset HoldCo, if one is used-hold some
percentage of its assets in money market funds or other lower-risk
liquid assets. Additionally, the CFO Issuer will often enter into a
revolving liquidity facility with a third-party lender, such as a
bank, to ensure that the CFO Issuer has adequate funds to make
scheduled interest payments to Investors if it lacks sufficient
cash.

Although the liquidity facility may not need to be fully
utilized, its availability reduces the risk that the CFO Issuer
won’t be able to make interest payments or meet its
amortization schedule. In addition, a liquidity facility protects
against default provisions and the adverse consequences of failing
to fund capital commitments on the Underlying Fund Interests.
Accordingly, a liquidity facility helps the CFO achieve its
enhanced credit ratings (and may be subject to counterparty rating
requirements imposed by the rating agency).

Next Steps

As CFOs become increasingly popular, investors will want to
understand the history, structure, and variations of these
alternative financing vehicles so they can determine if a CFO
transaction aligns with their investment strategy. For additional
information on CFOs, you can read the following Legal Updates:

Visit us at
mayerbrown.com

Mayer Brown is a global services provider comprising
associated legal practices that are separate entities, including
Mayer Brown LLP (Illinois, USA), Mayer Brown International LLP
(England & Wales), Mayer Brown (a Hong Kong partnership) and
Tauil & Chequer Advogados (a Brazilian law partnership) and
non-legal service providers, which provide consultancy services
(collectively, the “Mayer Brown Practices”). The Mayer
Brown Practices are established in various jurisdictions and may be
a legal person or a partnership. PK Wong & Nair LLC
(“PKWN”) is the constituent Singapore law practice of our
licensed joint law venture in Singapore, Mayer Brown PK Wong &
Nair Pte. Ltd. Details of the individual Mayer Brown Practices and
PKWN can be found in the Legal Notices section of our website.
“Mayer Brown” and the Mayer Brown logo are the trademarks
of Mayer Brown.

© Copyright 2023. The Mayer Brown Practices. All rights
reserved.

This
Mayer Brown article provides information and comments on legal
issues and developments of interest. The foregoing is not a
comprehensive treatment of the subject matter covered and is not
intended to provide legal advice. Readers should seek specific
legal advice before taking any action with respect to the matters
discussed herein.