Private capital firms are finding new ways to raise cash in a tough market for deals. They are increasingly turning to a specialized financial product known as collateralized fund obligations, or CFOs. These instruments allow firms to break down their private portfolios into bonds that often receive high ratings, making it easier for them to borrow against assets that are otherwise hard to sell.
Recently, several CFOs have hit the market, including offerings from Ares Management Corp. and Carlyle Group Inc.’s AlpInvest. The rise of CFOs is partly due to the ongoing slump in dealmaking, worsened by trade tensions this year. As traditional sources of cash flow dry up, private firms are looking for creative solutions. CFOs are becoming a popular option as they can help firms generate liquidity from their highly-leveraged assets.
Greg Fayvilevich, who leads Fitch Ratings’ fund and asset management group, noted that he receives new CFO proposals almost weekly, indicating strong interest in this market. Insurers have emerged as eager buyers of these bonds, especially after the National Association of Insurance Commissioners clarified regulations regarding their purchase. This change has opened up a new pool of capital for private firms, which is crucial in a challenging economic environment.
Jon Godfread, president of the NAIC, explained that CFOs are designed to help insurers meet their financial obligations, especially when public markets offer low yields. However, there are concerns about the risks involved. Some experts worry about the mix of unrated private funds bundled into these highly-rated instruments. The underlying assets can be difficult to liquidate, and the economic landscape remains uncertain, leading to increased scrutiny of these products.
In 2023, Fitch Ratings downgraded parts of a CFO managed by Nassau Alternative Investments, citing weakened performance due to market conditions. Ludovic Phalippou, a finance professor at the University of Oxford, expressed concerns about the lack of transparency in these products, comparing them to collateralized debt obligations (CDOs) that contributed to the 2008 financial crisis.
Despite these worries, CFOs have built-in safeguards. They typically include a first-loss equity portion that absorbs initial losses, and they may carry less risk from single issuers compared to other financial products. The current market for CFOs is still small, with Kroll Bond Rating Agency reporting that it has assigned ratings to $37.7 billion worth of CFOs since 2018, mostly in the last two years.
Recent deals also include a $2.4 billion CFO from Coller Capital, among others. Investors in private funds are increasingly using CFOs to adjust their exposure to private equity. Thrivent, a limited partner, raised a CFO earlier this year to maintain its activity in the space.
As the market for CFOs grows, Godfread emphasizes the importance of carefully assessing the risks associated with individual securities. While these products can offer attractive yields and diversification, it’s vital to ensure that they do not expose investors to hidden dangers.