Growth in CFOs and RNFs driven by ongoing demand from regulated investors

Hybrid products including rated note feeders (RNF) and collateralised fund obligations (CFO) are growing in prominence, as private capital fund managers look to increasingly tap into demand from insurance investors. But uncertainty remains as to whether such instruments will ultimately be treated as securitisations by insurance regulators in the medium and long term.

In a report released in early February, S&P Global Ratings said it is increasingly seeing private credit fund proposals that include credit tranching of some capital structures. The agency refers to the trend as “the blurring of private credit funds and CLOs”. It explains that, due to the innovative approaches being adopted, it does not rate structures explicitly using its alternative investment funds or global CLO and CDO criteria, but determines its approach on a “case-by-case basis depending on the structures risks and mitigants.”

White Rose and Churchill Asset Management were in the market with CFOs of US$400m and US$190m respectively in December, to invest across their private capital strategies. While the former issued a private equity CFO that will invest in vehicles managed by Thrivent, the latter will invest in the various private credit strategies of Nuveen subsidiaries Churchill and Arcmont Asset Management. 

When Churchill announced the closing of its deal, it said the transaction attracted “significant interest from insurance companies,” due to “the capital efficient nature of the transaction”. Though RNFs look to provide similar access to private capital for insurance investors, there are differences between how CFOs and RNFs are put together.

The CFO is a structured transaction backed by a pool of LP interests in investment funds and has been used as a private equity fund financing tool since the mid 2000s, making it particularly familiar and attractive. The pool of underlying fund investments are purchased by a special purpose entity and are then used as collateral to back both rated and unrated notes and loans.

Rated feeder funds, which are a far more recent innovation, provide similar access to private capital, but do so through a fund structure similar to a traditional feeder fund. They issue both equity and rated debt, which is tranched to suit the requirements of a spectrum of investors, with note purchase agreements governing the debt. The equity provides the subordination required to support the ratings of the debt, and the capital raised is in turn invested into a master fund.

Richard Hanson, a London-based partner at Morgan Lewis, says CFOs and RNFs are particularly interesting in the current market, while highlighting that both structures have overlapping features. Each offers regulated investors a route to invest in funds and fund-like products via securitisation technology. 

“I see these products as kind of a hybrid of fund finance and structured finance,” says Hanson. “It's a form of fundraising tool for the main fund to harness insurance company capital, doing it in a way that's beneficial for that type of investor, from a regulatory capital perspective.”

S&P says hybrid structures that mitigate the market value and refinancing risk typically associated with alternative investment funds “may have credit risk profiles that bear similarities to middle market CLO transactions”. It is a similarity that Hanson also draws.

“The features of the deal look very like a CLO,” Hanson says. “You'll have for example waterfalls, over-collateralisation tests, triggers that effectively mean cash is diverted away from junior tranches if something's not going well in the deal. Any securitisation lawyer will be familiar with all those kinds of structural features.”

In addition to broadening access to insurance capital, one of the key benefits of these structures for managers – particularly private credit managers – is that they can provide liquidity in a previously illiquid market. In January, JPMorgan’s Andrew Carter said the bank anticipates US$30bn of private credit secondaries transactions will take place in 2024, up from just US$3bn in 2019 and a sign of ever-growing demand for liquidity. This is further reflected in the number of high-profile managers – including Allianz Global Investors, Coller Capital, Pantheon and Apollo Global Management – to have launched secondary strategies in recent years.

“There are a lot of [primary] funds that have raised capital and have a lot of dry powder yet to be deployed,” says Hanson. “A CFO might be a long-term financing solution for funds with all types of strategies – debt, credit opportunities, real estate, etcetera – once they start deploying. Another way of looking at CFOs is that it's kind of like an alternative to tapping the secondaries market – another liquidity tool down the line for private credit managers in the context of this explosion of private credit that's happening.”

Regulatory uncertainty
Yet uncertainty remains among many market participants as to whether such transactions can justifiably be classified as securitisations. On this front, Hanson highlights that US structures and European structures differ. 

In the US, he says, while it is a grey area, rated feeders could be treated in the same way as open market CLOs. The argument therefore is that these would not be subject to the credit risk retention requirements under the Dodd–Frank Wall Street Reform and Consumer Protection Act because those organising and initiating the deal do not do so by transferring assets to the issuer. CFOs similarly are not considered securitisations because they are not backed by self-liquidating financial assets – an LP interest does not convert to cash within a finite period of time.

“In Europe, it's a little bit trickier,” says Hanson. “Typically in Europe, you might see these deals set up using a Luxembourg securitisation vehicle. Clients have to work with their advisers to analyse whether the transaction is a securitisation. Some may ask why everyone wouldn't just structure their securitisations through a fund structure to avoid falling within the securitisation regs.”

He adds: “But it’s not really the case that this is a way of circumventing the rules. Ultimately, the notes are designed to replicate a typical drawdown fund, but do it in a way which is a debt instrument. The whole point behind rated note feeders is just purely to attract a certain type of investor into the fund. The important thing for the insurance company is that they're not buying equity. They have to hold rated debt.”

From the investors’ point of view, Hanson explains, securitisation special purpose entities are excluded from the scope of the EU’s Alternative Investment Fund Managers Directive. That, he says, offers insurance companies reassurance that they are not buying an LP interest which would have different regulatory capital impact.

In the US, the National Association of Insurance Commissioners (NAIC) is focusing on RNFs and CFOs in a bid to ensure they do not act as equity disguised as debt, he explains. The NAIC’s guidelines and principles are currently undergoing substantial modifications and this is likely to have a pivotal impact on the future of such structures.

“Because of this regulatory scrutiny from the NAIC, there was a bit of a slowdown in deals around a year ago,” says Hanson. “People are more cautious because the NAIC is focused on structured equity and fund investments. So the concern from insurance company investors is that the NAIC deems all of these structures to be equity. It could have a knock-on punitive impact on insurance companies that have already invested in them, or are interested in investing in this way.”

Kenny Wastell