Dechert LLP
September 2022 Page 1
Collateralized Fund Obligations (CFOs): The
Technicolor Dreamcoat of Fund Finance
September 2022 / Authored by: Jon Burke, Christopher P. Duerden, John M. Timperio, Lindsay Trapp, Mary Bear,
Elliott Kieffer, David Miller and Eric Zeng
Overview
Over the past several years as Collateralized Loan Obligations (“CLOs”) reached new and dizzying heights in
issuance volume, CFOs have been quietly, and under the radar, gaining market acceptance and momentum among
asset managers, owners and investors. The CFO is a transformational technology for vehicles designed to finance
limited partnership interests in private funds (“LP interests”) and other assets (together with LP interests, the “Private
Financial Assets”). CFOs have their roots in the early 2000s and had hitherto been more of a niche product focused
primarily on providing liquidity for limited partnership interests of private equity funds. However, a confluence of
factors have piqued interest in the product. Chief among these are (i) the growing (but still inefficient) secondaries
market which can make sales of LP interests unattractive, (ii) the ability to collateralize CFOs with a variety of
different financial assets (including credit opportunity funds, buy-out funds, infrastructure funds, real estate funds,
private credit funds, co-investments, asset-based securitizations (“ABS”), CLO equity, and residuals in
securitizations) and (iii) the desire of certain classes of investors such as insurers, sovereign wealth funds and other
regulated investors to gain exposure to Private Financial Assets in a structured and capital efficient rated format.
The Appeal of CFOs: Have your fund and monetize it too
Financing Private Financial Assets such as LP interests via a CFO offers a long-term capital markets execution on
terms which are more favorable with regard to interest rate and advance rate than shorter-term financings executed
in the private, bilateral/club market, such as net asset value (“NAV”) facilities. Moreover, for a platform that holds
Private Financial Assets, CFOs offer an attractive alternative to selling into the secondary market, thus allowing such
platform to re-allocate or re-balance its holdings without giving up the upside associated with such holdings. For
regulated investors subject to risk-based capital requirements (“Regulated Investors”), holding rated notes issued by
a CFO offers better capital treatment than holding Private Financial Assets individually and directly. This is primarily
due to the fact that CFOs benefit from a broad base of Private Financial Assets, overcollateralization, liquidity support
and other structural features which enable them to issue 65-75% of their capital structure in the form of investment
grade rated debt. We expect that as structures and collateral pools evolve that the percentage of rated debt (relative
to the equity portion) will increase.
Basic Structure: If a NAV Facility and a CLO had a baby
In a CFO, the issuer (“CFO Issuer”) is typically a bankruptcy-remote entity that acquires various Private Financial
Assets, which it finances by issuing tranches of rated notes as well as an “equity” tranche, which can take the form of
subordinated notes, limited liability company interests or limited partnership interests (the “Equity Tranche”).
Sometimes such Private Financial Assets are owned by a sponsor or alternatives platform and transferred into the
CFO as a means of gaining liquidity on such assets. In other instances, the CFO Issuer acquires such Private
Financial Assets with the proceeds of the closing. Since the terms of most Private Financial Assets may prohibit
them from being pledged to secure a financing without the consent of such Private Financial Asset’s general partner
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or investment manager, the Private Financial Assets can be held in a subsidiary of the CFO Issuer (“Asset HoldCo”).
The assets of the Asset HoldCo are not subject to a pledge or a security interest, but equity interests of the Asset
HoldCo are pledged to secure the repayment of the notes and other obligations of the CFO Issuer, and the Asset
HoldCo may guarantee the obligations issued by the CLO Issuer. See below for an illustrative CFO transaction.
One key structuring and modeling challenge of CFO transactions is the uncertainty regarding the timing and amount
of distributions on the underlying assets. Unlike an ABS or CLO transaction, the Private Financial Assets that
comprise the underlying assets of a CFO typically do not have any stated principal amount that matures on a set date
or an obligation to make interest payments regularly. Thus, sources of short-term liquidity, as well as structural
features built into the transaction, are necessary to ensure that the CFO Issuer can make timely payment of interest,
fees and expenses and that the Asset HoldCo can satisfy any capital calls from the underlying funds associated with
its Private Financial Assets.
Short-Term Liquidity. Unlike ABS or CLO transactions, in order to provide short-term liquidity for the CFO transaction,
the Asset HoldCo may be required to hold some percentage of its assets in money market funds as well as lower-
risk, liquid assets that can be redeemed within a relatively short period of time (but at least quarterly), such as
diversified bond funds. In addition, the CFO Issuer will usually enter into a revolving liquidity facility with a third-party
lender, as discussed further below. We note that the nature and amount of the liquidity facility can vary significantly,
and we have seen transactions that feature customized approaches designed to provide the CFO Issuer with the
requisite liquidity.
Structural Features. While CFOs are very much bespoke transactions that can come in as many flavors as the
underlying Private Financial Assets that are financed, they draw their structural inspiration from both NAV facilities
and CLOs. While they pull from CLO technology in terms of the structure and tranching of the debt issued by the CFO
Issuer, they also borrow loan-to-value or net-asset value mechanics from NAV facilities.
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Some CFOs will have a set portfolio at close and no ability or only a limited ability to reinvest,
1
whereas others have
an investment period of up to five years during which time proceeds of the offering can be deployed and reinvested.
In some CFOs, the manager may also have the ability to cause the Asset HoldCo to sell Private Financial Assets
(typically subject to an overall percent limitation) and reinvest the proceeds from such sales into new Private Financial
Assets. CFOs typically include an amortization period of up to another five years during which time the debt will be
paid down according to an amortization schedule to the extent cash proceeds are available (or, if not available, catch-
up payments would be made on subsequent payment dates); however, interest payments could step up in the event
of a failure to pay down a certain amount of principal by a certain time frame or to pay off all principal by the end of
the amortization schedule. Although CFOs usually have a loan-to-value test, any breach would typically restrict or cut
off distributions to the holders of the Equity Tranche, but would not necessarily result in an event of default. In
addition, in many CFO structures, interest payments on senior notes are only required if the CFO has adequate cash
flow; to the extent the CFO does not have sufficient cash to make interest payments, the interest payments would be
deferred until the next payment date (unless such CFO provides that the liquidity facility may be drawn to make
interest payments). CFOs also have a long maturity date relative to the underlying assets in order to ensure eventual
repayment of principal, typically at least 15 years.
In some cases, the CFO Issuer may issue delayed draw notes to help ensure it can make capital calls on the funds in
which it owns Private Financial Assets. In other cases, a cash reserve account may be established for such purpose.
Cash reserves may also be set up to ensure the CFO Issuer has sufficient amounts for fees, expenses and interest
for the next payment date. Finally, the sponsor or an affiliate may contractually agree to stand behind capital calls on
the Private Financial Assets held by the CFO, but only to the extent this does not impair the bankruptcy remoteness
of the CFO Issuer. Even absent a contractual obligation to make capital contributions required to satisfy capital calls
on Private Financial Assets, many CFOs allow the holder of the Equity Tranche to make capital contributions for
various reasons, including to satisfy capital calls.
Types of Portfolios
The portfolios of a CFO differ significantly in the type and diversity of assets:
Identified Pool vs Blind Pool: CFOs come in two flavors: (1) those with an identified pool of assets transferred
by a sponsor or alternatives platform and (2) those that are “blind pool” fundraising vehicles. Blind pools offer a
great deal of flexibility for the manager, as the CFO can add new funds after closing and are used generally for
fundraising purposes. On the other hand, identified pools offer less flexibility in terms of underlying assets but
are often easier for rating agencies and investors to evaluate, and are generally used as a method of
monetizing a specific pool of assets. In some cases, a CFO is a hybrid of the two, including some identified
assets at closing but also the ability to continue to buy new assets after closing.
Third-party vs affiliated funds: While some CFO transactions only contain Private Financial Assets in funds
managed by the CFO’s manager and/or its affiliates, others have significant portions (up to 100%) of the
portfolio comprised of Private Financial Assets managed by third parties.
1
Note that, even in a “static” CFO which does not contemplate active reinvestment, market participants should nonetheless
consider adding in the ability to recycle proceeds corresponding to the recycling that takes place at the underlying fund level.
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Number of funds: Some CFO transactions have only one fund or a handful (e.g., three to six) of different funds
in which they invest, while others invest in upwards of 100 funds.
Vintages: Some CFOs include staggered vintages of Private Financial Assets in which certain “older” Private
Financial Assets that are closer to their final distribution date are combined with other “newer” Private
Financial Assets that are several years away from their final distribution. This can help ensure adequate cash
flow during the life of the CFO, with older vintages distributing cash in early years and newer vintages
distributing cash during later years.
Fully drawn versus ongoing commitments: In some CFOs, the LP interests are fully drawn or almost fully
drawn, while in others there remain significant outstanding capital commitments. Those with outstanding
capital commitments generally require the Issuer (or an affiliate) to demonstrate ongoing liquidity to fund such
capital commitments via liquid products, a liquidity facility, delayed draw notes or otherwise. To the extent the
CFO issues delayed draw notes or relies on any kind of unfunded commitment from its investors, the ability of
such holders to fund will be a consideration that needs to be addressed, including by way of minimum ratings
requirements applicable to the holders of the delayed draw notes and any transferees.
Types of assets: While most Private Financial Assets consist of LP interests in private equity funds, venture
capital funds, credit funds, hedge funds, real estate funds, energy funds and infrastructure funds, CFO
transactions can also include interests in CLO equity and CLO equity funds, equity in ABS securitizations,
direct co-investment in portfolio companies, broadly syndicated loan assets and others. While some portfolios
are concentrated, a method to ensure cash is available for distribution includes adding a mixed portfolio of LP
interests in funds with credit or other income-bearing strategies combined with more equity or real-estate
concentrated portfolios. Furthermore, while most Private Financial Assets are comprised of minority
investments in underlying funds, some Private Financial Assets may be the sole interest in a “fund-of-one”.
CFOs can accommodate many different products and asset classes, so long as appropriate liquidity can be
demonstrated and stress tests can be satisfied.
To date, there has been no one “standard” for a CFO asset portfolio. As such, the CFO structure offers flexibility to a
sponsor or asset owner for fundraising and/or monetizing with respect to assets that do not fit neatly into any of the
more traditional channels.
Closing a CFO: Timing and execution
CFOs, unlike CLOs, do not feature any traditional warehousing of assets. Rather than a manager selecting assets,
financing them in a warehouse and then undertaking a take-out securitization, CFOs are initially conceived with a
sponsor meeting with the rating agency and investment bank and identifying a portfolio or a model for a portfolio.
Subject to confidentiality restrictions discussed in more detail below, investors and other parties to the CFO will often
diligence the underlying assets (i.e., the underlying funds) held by the CFO as if they were directly investing in such
assets; thus, there is significant time spent up-front agreeing upon a portfolio and a structure before going to market.
To the extent the manager or sponsor is not expecting to retain the Equity Tranche in the CFO transaction, it is also
imperative to have an investor lined up to either purchase or retain the equity of the CFO before launching, as the
CFO itself will likely never materialize without securing the equity piece. Although timing varies from deal to deal,
sponsors should expect the entire process to take anywhere from three months to nine months.
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In addition to a more extensive due diligence and structuring process, sponsors and their counsel must also
simultaneously undertake “onboarding” of the CFO’s assets. In CFOs which involve an established pool of assets, the
sponsor of a CFO will usually “seed” the CFO with existing Private Financial Assets it holds, receiving cash or equity
in the CFO (i.e., the Equity Tranche) or some combination of the two in exchange for such Private Financial Assets.
However, transferring Private Financial Assets to the Asset HoldCo of a CFO presents unique challenges and
considerations that are not present in CLOs or ABS transactions, including securities law, anti-money laundering and
KYC considerations, tax ramifications for the underlying fund and confidentiality. Given the interdisciplinary nature of
a CFO transaction and the complexities involved, it can require multiple separate work streams covering the
negotiations and documentation around the financing and the collateral transfer.
Some of the key considerations for general partners of transferring funds and CFO sponsors as transferring limited
partners include:
GP-Side Considerations:
Timing: Many private funds have set LP interest transfer windows, which could be quarterly, every six months
or yearly. The transaction parties need to track and manage the timing of each transfer in order to avoid
substantial delays. Some general partners of private funds (“GPs”) have placed the underlying LP interests in
escrow until the CFO Issuer’s relevant closing to help address timing offsets.
CFO Issuer and CFO Issuer Investor Representations: The CFO Issuer will need to make the required
securities law representations (e.g. “qualified purchaser” status) in order to hold the various underlying LP
interests. Transaction parties need to consider when these representations need to be made, as the vehicle
will not generally be sufficiently capitalized until the transfers take effect. Similar timing considerations arise
with respect to the AML/KYC representations that the CFO Issuer and the investors of the CFO Issuer will
need to make, particularly relating to ownership, as CFOs are often “orphan” vehicles and the equity tranche
owner will not technically hold the equity tranche until after the takeout. In addition, transaction parties need to
ensure that the CFO Issuer investors make the appropriate representations up their ownership chain.
Default: Subscription lines are typically used to cover capital calls made by underlying funds. Where there is
no subscription line, GPs often require transferring limited partners (“LPs”) to represent that they will cover
defaults of transferee LPs.
Subscription Lines: Many funds have a subscription line in which the original owner of the LP interest was part
of the borrowing base. The GP should discuss with the credit provider early in the process to determine if the
transfer would affect the borrowing base.
Tax Issues: GPs should consult tax counsel for the fund in order to analyze the implications of any change in
the investor’s domicile (e.g. if the CFO Issuer itself (or the Asset HoldCo) is a Cayman entity and the prior
investor was U.S. based).
Side Letters: GPs need to consider whether side letters with respect to the LP interests are transferred in full
or whether terms will be loosened, as well as the timing considerations involved with the re-negotiation of any
terms.
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LP-Side Considerations:
GP Consent; Confidentiality and Non-disclosure Agreements
A transfer of a limited partner’s interest in each fund will require consent from each GP. GPs can
withhold consent to the transfer of interests in a variety of ways pursuant to the respective fund’s
governing documents. Significant lead time and interfacing with the GPs will be required to achieve
consent to the transfers.
Pursuant to the fund’s confidentiality provisions in its limited partnership agreement (“LPA”), each GP
will likely require a non-disclosure agreement before providing any of the materials necessary for the
transfer of the interest. Significant lead time will be needed to negotiate these agreements with the
GP.
The sum of interests to be transferred and timing of the CFO securitization
Each GP likely has a secondary/transfer program where the GP is only willing to provide specific
effective dates that can be quarter-based, bi-annual or even annual. The timing and representations
made as part of the takeout need to be in line with the effective dates offered by the GP. If the timing
benchmarks required by the GP are not met, the transfer risks being moved to the subsequent
effective date.
Materials required for the transfers
Although generally similar in terms of material provisions, each fund has its own fund governing
documents consisting of a subscription agreement, an LPA, a private placement memorandum
(“PPM”) and, if initially negotiated, an associated side letter. Each fund’s transfer agreements and
subscription materials for the transfer of interest are borne out of these materials. The materials
therefore present with their own nuances and distinctions such as with respect to fund’s tax and
AML/KYC requirements.
For both tax and AML/KYC, the domicile of the transferee and the fund will present nuances and
challenges for the transferee to consider. For example, depending upon the size/sophistication of the
GP of a given fund, the GP will handle AML/KYC internally or outsource to a third party fund
administrator. Generally, third party fund administrators will present with more stringent AML/KYC
requirements
Interfacing with opposing counsel
Depending upon the sum of interests and the variety of GPs, a variety of opposing counsel will need
to be engaged representing general timing and transaction complexities.
Costs
Depending upon whether the GP engages their own counsel to effect the transfer, each transfer of
interest will likely incur legal costs to be borne by the transferring parties. These costs can be
relatively significant (in addition to the costs associated with the CFO itself) depending on how many
interests are being transferred.
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Disclosure vs Confidentiality
Given that a CFO includes underlying funds which themselves are subject to a panoply of risks, preparing a CFO’s
offering documents involves a delicate balancing act between maximizing disclosure and preserving confidentiality.
While including the names of each underlying fund and attaching the “risk factors” section from each private
placement memorandums for each such fund would provide investors with the most fulsome set of information, the
Private Financial Assets are often subject to confidentiality restrictions that prohibit sharing the PPM or even the
name of the fund and the manager. Moreover, some CFOs do not have all of the funds determined at the outset (or,
in the case of completely “blind” pools, would have none). Depending on the provisions of the LPA, consent may be
necessary to provide basic information about the CFO’s investments, such as the names of the funds in which the
CFO invests. Private funds may also be sensitive to sharing the fact that a CFO is one of its limited partners.
Obtaining consent to include the PPM’s risk factor section in a CFO’s offering documents can be even more difficult,
as such material is often considered highly proprietary. However, to the extent the CFO consists mainly or entirely of
funds affiliated with the sponsor, this may be a viable alternative.
In scenarios where the CFO Issuer cannot disclose the funds or attach PPM risk factors associated with each fund,
an alternative would be to summarize the primary risk factors associated with each asset class that the CFO is
investing in without disclosing specific funds. Many CFO sponsors may opt for a hybrid of the two approaches; for
instance, a CFO’s offering materials may attach the PPM’s risk factors for three or four of the largest funds
(measured as a percentage of the CFO’s aggregate investments), but include only a generic summary of risk factors
for the remaining funds included in the CFO’s portfolio. Additionally, in some cases, the CFO offering materials may
include anonymized data for the Private Financial Assets.
Sponsors considering utilizing new fund interests in a CFO should consider negotiating provisions similar to a fund of
funds or third party feeder fund in relation to confidentiality matters when investing.
Cash Distribution Mechanics
As a general matter, due to the unique liquidity considerations of a CFO transaction, interest and principal payments
to the noteholders are more variable than in CLO or ABS transactions (given that notes may PIK if insufficient funds
are available for any given payment date), and distributions to the Equity Tranche are more restricted. Furthermore, a
reserve account may be funded for the purpose of supporting the liquidity needs of a CFO prior to being available for
distribution.
In a CFO, the priority of payments typically provides for the following:
1. administrative expenses
2. management fees
2
3. fees, expenses and interest for the liquidity facility
4. mandatory repayment (if any) of principal outstanding on the liquidity facility
2
Management fees may not always be charged, particularly if the manager or an affiliate holds the Equity Tranche
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5. interest on the notes (in order of priority), subject to deferral if insufficient cash is available at this step
6. optional repayment of principal outstanding on the liquidity facility
7. during the amortization period (or while certain trigger events are continuing, such as a loan-to-value trigger),
scheduled amortization on the notes (in order of priority), subject to deferral if insufficient cash is available at
this step
8. administrative expense catch-up
9. payments on the Equity Tranche, subject to restrictions on timing (which is usually not allowed until at least
three years after closing date) and amount (which is usually limited relative to the loan-to-value ratio, liquid
asset balance and a percentage of initial principal balance on the Equity Tranche) to the extent such payments
are made prior to the payment in full of the senior notes, as well as reserve for senior fees, expenses and
interest for the next payment date
Additionally, to the extent the CFO has the ability to reinvest proceeds from Private Financial Assets into additional
Private Financial Assets or the obligation to fund further capital calls, cash may be diverted for such purposes in the
waterfall prior to any distributions to the Equity Tranche.
Liquidity Facilities
The CFO Issuer usually enters into a revolving liquidity facility that it can draw upon to fund capital commitments of
underlying funds and pay interest on notes and other fees and expenses of the CFO transaction. The liquidity lender,
typically an insurance company or bank, will charge an upfront fee and an ongoing commitment fee for the non-used
portion. Although it is generally not expected that these liquidity facilities will ever have to be fully utilized, having
access to a liquidity facility minimizes the likelihood the CFO Issuer will be unable to pay ongoing obligations and
protects the transaction from the punitive consequences of failing to fund capital commitments on underlying funds.
As such, ensuring there is adequate liquidity to support the transaction, including through the use of liquidity facilities,
is necessary to obtain the desired ratings on the CFO’s notes.
Although the terms of liquidity facilities vary, they generally have a term of three to five years (often aligning with the
reinvestment period of the CFO), subject to extension at the discretion of the liquidity lenders and upon payment of
an extension fee. Liquidity facilities usually terminate upon redemption, unless the CFO Issuer is able to negotiate a
feature in which the facility does not terminate if the CFO is subject to a refinancing. The commitment size is
generally 10-15% of total CFO issuance. In addition, given that the liquidity facility is often required to achieve the
desired ratings, rating agencies will require such facilities to include counterparty ratings requirements for the liquidity
lenders, along with mechanics for replacing downgraded liquidity lenders.
Rating Agency Considerations
Although different rating agencies employ different methodologies, the following are some of the key factors that most
rating agencies take into consideration when evaluating CFOs:
Manager track record: Rating agencies focus specifically on how funds managed by the general partner (“GP”)
or manager have performed historically, including their internal rate of return. This analysis looks separately at
how such manager or GP has fared among different vintages of funds, as well as different fund
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strategies/asset classes. Alignment of interest is also key: whether and how much of the GP’s own money is
employed in such funds is usually a positive indication of aligned interests.
Liquidity: Rating agencies take into account the CFO Issuer’s ongoing obligations and its ability to satisfy these
obligations through its expected sources of liquidity (liquid assets, liquidity facility, delayed draw notes, cash
reserve mechanics, etc.)
Loan-to-value / overcollateralization: Although there is no standard “haircut” that can be applied to any specific
Private Financial Assets or portfolio of Private Financial Assets, the rating agencies will examine the principal
balance of the notes and liquidity facility relative to the NAV of the underlying Private Financial Assets, liquid
products and other CFO assets.
Diversification: Rating agencies will evaluate the diversity of funds in terms of strategy (private equity, credit
fund, real estate, etc.), geography (U.S. vs non-U.S., developed markets vs undeveloped markets, etc.),
number of funds and vintage. Rating agencies may also take a look-through approach (looking through to the
assets held by the underlying funds) to determine concentration limits. Additional asset types and mixing of
underlying fund strategies can also assist with cash flow diversification.
U.S. Risk Retention Analysis
U.S. risk retention rules generally require the sponsor to retain at least 5% of the securitized assets in a securitization
involving the issuance of asset-backed securities. However, an “asset-backed security” is defined as a fixed-income
or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or
a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily
on cash flow from the asset. Since repayment of the CFO notes primarily depends on LP interests, and most LP
interests are not “self-liquidating” (i.e., interests in private funds do not convert to cash within a finite period of time),
most sponsors take the position that the U.S. risk retention rules do not apply to CFO transactions. However, given
that the structure of the CFO transaction and the notes issued utilize some of the technology and legal documentation
that are commonly seen in traditional securitization transactions, and given the lack of guidance on CFOs from any
rule-making authority, there remains some uncertainty on this subject. Furthermore, to the extent CFOs include
Private Financial Assets other than LP interests (for instance, ABS or CMBS notes, broadly-syndicated loans or other
debt-like investments), this would further complicate the analysis.
CFOs vs Similar Products
Rated Funds. CFO transactions are sometimes confused with the rated-note fund transaction (“Rated Funds”) since
both allow Regulated Investors to invest in a fund or fund-like products via a rated debt instrument which provides for
a better risk-based capital treatment than an equity investment. In a Rated Fund, a private fund may be established
as a standalone vehicle or it may implement a feeder fund which issues both rated debt and equity. This allows for a
Regulated Investor to invest in a private fund on a more capital-efficient basis by holding debt (and often the equity
as well, but this is not required) as opposed to a more typical equity-only investment in a private fund.
Rated Funds are first and foremost private funds with (generally) a single pool of directly held assets (or indirectly via
a master-feeder structure), whereas a CFO is more akin to a fund of funds. Additionally, a CFO is generally intended
as a leveraging vehicle with a goal of providing a levered return. In contrast, Rated Funds, despite having inherent
leverage created by the notes, are less often utilized for leveraging purposes, with funds seeking a levered return
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taking out separate asset backed leverage lines in order to enhance returns. Separately, Rated Funds are not a
securitization, in large part because the notes issued in a Rated Fund are typically unsecured, whereas a CFO is
supported by a security interest in the equity interests in the Asset HoldCo. However, the line between CFOs and
Rated Funds has become increasingly blurred; for instance, some CFOs only invest in one fund (making it more like
a Rated Fund), and Rated Funds are sometimes a “fund of funds” (making it more CFO-like). As CFOs and Rated
Note Transactions continue to evolve, we will likely see more overlapping characteristics.
NAV Facilities. Another close cousin of the CFO is the NAV facility. NAV facilities involve a bank or other financing
source lending against the value of the assets in a primary fund or the value of the LP interests in a fund or group of
funds. NAV facilities bear some structural resemblances: in both cases, the interests in the fund or group of funds is
held by a holdco, which is in turn held by a special purpose entity borrower. However, NAV facilities usually involve
fewer parties; they are often bilateral facilities with a single lender or a small syndicate of lenders, with no tranching
and no separate “equity” piece that can be sold to a third party investor. As such, there is generally less execution
risk and lower transaction costs. However, the term of the debt issued under a CFO is much longer than under a NAV
facility, the pricing is more favorable, and the ability to tranche a senior, mezzanine and equity piece allows the
sponsor to bring in a wider swath of interested investors with different investment goals.
NAIC Considerations for Insurance Investors
CFOs can offer an attractive risk based capital charge for insurance companies who invest in the senior (and to an
extent, the mezzanine) tranches issued by the CFO as compared to holding LP interests directly because LP
interests are generally considered full equity and receive the highest capital charge. As of the date of this OnPoint,
the National Association of Insurance Commissioners (“NAIC”) has been conducting a process which includes
updating the definition of “bond” for Schedule D purposes on a principles-based approach. Generally, it appears that
the definition of bond will (assuming the relevant principles are met) incorporate debt tranches issued by CFOs.
Separately, the NAIC is also considering residual tranches in structured products and whether such tranches should
be considered a type of debt or “pure” equity (thereby increasing the capital charge that may be associated with
certain residual tranches). Additionally, the NAIC has begun considerations in relation to potential risk based capital
arbitrage by insurance companies investing into structured products and are focused on ensuring rated debt tranches
are accurately reflective of the risks associated with the underlying investments in structured products. Such
considerations may lead asset managers of CFOs to diversify the underlying funds and asset types held in order to
ensure that risk of loss and liquidity concerns are better addressed in these types of portfolios than portfolios
comprising solely of non-credit assets. The NAIC’s definition of bond is expected to become effective in January 2024
(although they have openly stated this may slip to January 2025), and the considerations surrounding arbitrage and
residual tranches are not expected to have changes resulting to current practice until 2025 or later. While these
considerations could adversely affect CFOs and other similar products, the process of determining the bond definition
has demonstrated that the NAIC is mindful of the impact that regulatory changes would have on the market and is
supportive of an evolving market, which includes greater involvement of alternative asset managers. As such,
although there will be some changes to come, there is generally a feeling amongst market participants that such
potential changes will not dampen the market for these vehicles in the near future.
CFO Outlook: The 80s called, they want their yields back
The outlook for CFOs appears promising. On the investor side, CFO notes tend to offer higher interest rates than
traditional securitizations, and CFO equity is typically forecasted to provide better returns than equity investments in
other securitized products; in this sense, CFOs offer a key advantage in today’s yield-hungry environment (rising
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interest rates notwithstanding). Furthermore, CFOs offer flexibility and room for creativity for sponsors, as they lie
somewhere on the spectrum between more standardized products like CLOs, on the one end, and more bespoke
creatures of the private funds world, on the other end. As such, we expect this to be an area of continued creativity
and variety—with structures as variegated as the assets underlying the transactions—and demand driven by
sophisticated, regulated investors.
The current market is challenging. Conviction is in short supply. Concerns over credit conditions abound, yet CFOs
have a long history that pre-dates the 2008-2009 financial crisis and have a solid track record during economic
downturns, with no reported defaults on CFOs’ rated notes even during the financial crisis. As such, we expect to
see increased interest in CFO transactions as institutions go back to the future in an effort to navigate turbulent
economic times.
This update was authored by:
Jon Burke
Partner
New York
+1 212 641 5694
Christopher P. Duerden
Partner
Charlotte
+1 704 339 3113
John M. Timperio
Partner
Charlotte
+1 704 339 3180
Lindsay Trapp
Partner
Charlotte: +1 212 698 3810
Dublin: +353 1 436 8588
New York: +1 212 698 3500
Mary Bear
Consulting Attorney
Charlotte
+1 704 339 3162
Elliott M. Kieffer
Associate
New York
+1 646 731 6168
David E. Miller
Associate
Boston
+1 617 728 7115
Eric Zeng
Associate
Charlotte
+1 704 339 3119
Dechert LLP
September 2022 Page 12
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