CFO, CFOs: Collateralized Fund Obligations

 

 

Collateralized Fund Obligations or CFOs involve the securitization of private equity fund or hedge fund assets and the issuance of securities in several tranches. Most of these securities are debt securities with only a small proportion representing equity. Similar to Collateralized Debt Obligations (CDOs), CFOs were first introduced in June 2002 as a structured form of financing for diversified private equity portfolios.[br]

 

Risk Factors of CFO, CFOs: Collateralized Fund Obligations

Unlike traditional types of CDOs, which involve the securitization of bonds and loans, the assets securitized in CFOs are the shares of various hedge funds. Thus the risk factors associated with CDOs and CFOs differ.

 

While the performance of a CDO depends on the credit performance of the underlying pool of loans, the performance of a CFO depends on the net asset value or the NAV of the underlying shares as on the liquidation date. The NAV of hedge fund shares in turn depends on the performance of a wide variety of debt, equity, hybrid or derivative positions carrying varying levels of financial risks and rewards. The composition of the assets is thus a crucial factor in determining the NAV and thus the performance of a CFO.

 

CFOs are principally less liquid than CDOs. This is because the interest on the CFO securities has to be paid by the liquidation of some assets of the hedge fund as against in the case of CDOs wherein the assets pay a periodic interest which is adequate to service the interest on the securities issued. Many of the assets owned by a hedge fund are not freely redeemable on demand and may instead be subjected to initial lock up periods, thus increasing the liquidity risk associated with the underlying assets of a CFO.[br]

 

CFOs carry the risk of excessive leveraging in contrast to the traditional CDOs where the rating of the underlying assets captures such a risk. The transaction portfolio may become overleveraged due to a number of reasons such as a lack of transparency or oversight on the part of fund managers.

 

Rating agencies face some difficulty in rating the CFOs since the data made available to them for analyzing the underlying assets of CFOs is less comprehensive than that for other types of structured finance transactions including corporate bonds and mortgage backed securities.