Collateralized fund obligations (“CFOs”) emerged in the early 2000s as a means of applying securitization techniques developed for collateralized debt obligations (“CDOs”) to portfolios of hedge fund and private equity fund investments (each, an “Investment”).

CFOs allow portfolio investors, secondary funds and funds of funds (each, a “Fund Investor”) an alternative and diversified capital markets financing solution and, potentially, a means of earlier monetization of their holdings. This article reviews the basic structures and features of a CFO.

The core concept of a CDO is that a pool of defined financial assets will perform in a predictable manner (that is, with default rates, loss severity/recovery amounts and recovery periods that can be reliably forecast) and, with appropriate levels of credit enhancement applied thereto, can be financed in a cost-efficient fashion that captures the arbitrage between the interest and yield return received on the CDO’s assets, and the interest and yield expense of the securities (the “Securities”) issued to finance them. Each of Fitch, Moody’s, Standard & Poor’s and DBRS, Inc. have developed CDO criteria and statistical methodologies and analyses to ‘stress’ a pool of specified CDO assets to determine the level of credit enhancement required for their respective credit ratings for the Securities issued to finance such pools. These same concepts apply for CFOs and a number of CFOs were consummated prior to the financial crisis.

In a CFO, a bankruptcy-remote special purpose entity (the “CFO Issuer”) purchases (or acquires directly) and holds a diversified portfolio of Investments. To finance the purchase, the CFO Issuer issues tranches of Securities secured by these assets. The majority of the Securities issued are debt instruments, with only a small portion consisting of equity in the CFO Issuer. Each tranche (other than the junior most tranche) has a seniority or priority over the other...