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....