Structured vehicle link to fund of funds to widen client base

CDOs have been restructured for the fund of hedge fund market

The first ratings of collateralised debt obligations (CDO) linked to a fund of hedge funds are about to be issued by Standard & Poor's and Moody's.

Among the ratings about to be issued are products being offered by Credit Suisse First Boston, Deutsche Bank and JP Morgan.

Expected to release the first of its ratings later this month, Standard & Poor's is working on a number of deals at the moment on both sides of the Atlantic. While much of the work is being done in the group's New York office, several of the funds looking for ratings are London and Europe-based.

An investment bank creates the CDO - a specially structured vehicle, similar to a stand alone company, which in turn buys a pool of assets, which are actively managed and can include the assets of a fund of hedge funds. The debt for the CDO is then tranched and rated by the ratings agencies.

Until now these pools of assets have mostly consisted of high yield or investment grade debt, credit derivatives, or asset backed securities. The development of the structure linked to hedge funds has been quite recent (see CDO development p17).

The fund of hedge fund market has been targeted with this scheme as a quick way of raising capital for the managers, while at the same time expanding its investment base. As CDOs typically have high investment minimums this does not mean the fund would then be open to, what many consider to be, the unattractive market of retail investors.

rating debt

The CDO is created as a separate product, using the portfolio of assets as the collateral. Jeffrey D'Souza, managing director of structured products at Deutsche Bank, said in a pool of high yield debt one can issue roughly 86% of different forms of rated liability, AAA, AA, BBB and so on. On a pool of investment grade debt one can issue up to 97% of rated liabilities, AAA down to BBB. 'Against hedge funds, what ratings agencies are permitting us to do is to issue, against a pool of hedge funds, 70%-75% of rated debt. That rated debt is then subjected to market value triggers. If the pool of hedge funds declines in value by more than a certain amount, and there are different thresholds depending on each class, the manager may be required to sell some of the collateral to bring the pool back into compliance.'

Each tranche of the CDO is rated, depending on how the banker structures the deal, so that it could emerge that there is a triple-A rated, A-rated, BBB and equity portion.

A bank structuring the deal will typically subject the manager to a due diligence process separate to that of the ratings agency. The bank will look at the pool of funds, the diversity, the breakdown of strategies and risk controls the manager uses.

On some deals currently going to amrket, the rating agencies are giving 70%-75% debt on the product, roughly 50% of which is AAA rated, 13%-14% will be A, 10%-11% is BBB and the rest consists of the unrated tranche.

The AAA rated will provide a price of Libor plus 50 to 60 basis points, the A rated is priced at around Libor plus 160 basis points, BBB paper is Libor plus 300 basis points and the equity portion will receive residual returns.


At the moment, because the hedge fund vehicle represents a new asset class within CDOs, the investment term is on the low side at five years, rather than the more typical 12 years for CDO products.

A liquidity facility on the CDO is put in place to enable the manager to pay the coupon, however, if market conditions cause the liquidity to be used, the manager may have to unwind some portfolio positions in order to pa, he notes. Another way to ensure the coupon can be paid is to only partially invest the portfolio and retain a cash balance, but D'Souza says this is a more expensive option and one would generally not be used.

The structure is appropriate for this type of fund as its entire purpose is to provide absolute returns, thereby establishing a relatively stable income stream. The ratings on the CDO will be higher for those funds, which have exposure to a wide range of underlying strategies in order to provide greater diversification. A single manager hedge fund, even one targeting absolute returns, is not considered to be as stable as a fund of funds vehicle as there is higher risk associated with a product backing the abilities of just one manager.

However, some banks and fund managers are believed to be considering using the same structure linked to single manager funds in the near future, thereby expanding the growing asset class.

Individual fund managers are getting interested in these deals but the structure of them is different from the fund of hedge funds. One of the differences in running a single manager CDO is that there are limitations on the shorting flexibility. Another is that while the financing is more secure in that it is a term arrangement so the bank cannot pull it away from the manager, the cost of leveraging is higher than in a hedge fund, D'Souza says.

On the fund of funds side, Sandy Johnson-Harris, of Standard & Poor's Global CDO group, says: 'For us and the market, this is a new asset class. We have been asked to look at to see if it is possible to rate these instruments. Hedge funds are more complicated than just short positions, they have synthetics, derivatives and different strategies ' any number of which are being employed and they all have different returns and correlations. It is a much more complicated animal than just including the shorts.'

Fund strategies

She admits Standard & Poor's, although close to issuing their first ratings, is still working out some of the ratings criteria. At the moment much of the decisions to rate the various tranches of the CDOs is ultimately based on the fund manager of the fund of hedge funds.

While the group does look below into the portfolio, the first step is often to establish the track record of the lead manager.

She adds: 'If you have a new manager who does not have an appropriate track record, we may not be able to rate the deal unless they contract the management out to someone who does have an appropriate track record.'

She considers at least five years and longer as a track record, although this only counts for the fund of funds manager.

The main manager, and not those of the underlying holdings, is then assessed on numerous points such as their asset allocation process and their monitoring of the holdings. Also, style drift, how it is detected, NAV reporting and how the manager detects when one of the funds is wandering away from what the manager expects the NAV to be, are also covered.

Johnson-Harris says: 'We take a close look at the manager, try to determine how they are operating and what their strategy is, what types of strategies they want to employ in their fund and how that compares to what they have been managing.'

While often managers like the flexibility a fund of funds structure provides, Johnson-Harris says a lot of times a manager will limit this flexibility within a structured product wrapper such as a CDO.

'As a result, they have to come up with what their portfolio guidelines will be in terms of how many managers will be in the pool, what strategies will be employed and what will be the ranges or guidelines for investments in those strategies.'

The group also examines the fund's redemption provisions are within the fund and what kind of liquidity covenants they are willing to sign up for. She says: 'All of that is taken into consideration in terms of trying to determine how diverse the underlying pool of assets is.'

While Standard & Poor's does not place limitation on the underlying pool of funds and does not mandate that all the funds must also have long track records, the group does examine it for portfolio risk.

Vivek Kapoor, also of S&P's New York structured finance department, adds: 'We are looking at a portfolio of many funds and we recognise that if you increase the number of funds and the number of managers, you can diversify away risks. But the rated risk, the portfolio risk, dissipating as a function of the increasing number of managers depends on what the managers are invested in. If a lot of the managers are invested in say, a long/short strategy compared to a market neutral strategy, they have more inherent risk. So the risk we ascribe to the portfolio depends upon the way the portfolio is distributed over different strategies.'

Correlation between strategies is another factor, he notes. As such, a better rating would be given to a fund of funds with a diverse number of holdings in a wide range of uncorrelated strategies. As part of the process, sometimes the ratings agency even meets with some of the underlying hedge fund managers to take some comfort from what they are doing and what the selection process has been.

Standard & Poor's admits the due diligence on such vehicles is very time consuming and the ratings process takes months.

Johnson-Harris says: 'We have several transactions that are trying to get rated this month (May). There may be a few more US fund of funds managers than European but I cannot tell at this point, but it is slightly more weighted towards the US but there is interest from Europe.'

The benefits of the rated CDOs and its various tranches means the hedge fund market could access an easier and more lucrative way of raising capital.

A highly-rated tranche could make the vehicle more attractive to a pension fund, which may have been hesitant to invest in hedge fund vehicles.

Another advantage the increase in popularity of this type of asset class may be that it will finally open up the hedge fund market to greater transparency. As part of the due diligence Standard & Poor's is conducting on the portfolios and the basis for the rating, they are automatically downgrading the historical and estimated returns achieved by the fund. This, according to Jim Halprin of S&P's New York structured finance department, is due to the fact that the reported NAV data cannot be accepted at face value.

The lack of transparency is endemic to this industry, as such Standard & Poor's attempts to quantitatively make adjustments for those issues, when assessing a product for rating of this kind.

Kapoor says: 'Although the alpha attributed to a hedge fund is one of their charms, in the ratings we reduce the amount of alpha one can attribute to them before we even get started. We are trying to also account for the survivorship bias and the volatility smoothing that we believe infects the databases.

Halprin adds: 'With respect to manager performance, history has shown us that managers can generate positive alpha over short-term horizons but we are not sure we can give them full credit for positive alpha over varying time horizons.'

In terms of the CDO structures, the ratings group will only accept self-reported data in a very small part of its transactions.

They then diminish the return expectations of hedge fund of fund managers because of the integrity of the data.Kapoor says: 'Certainly if the fund of funds managers or the structuring folks want optimal structures, and if they can have the trust of regulatory and ratings agencies or those agencies can be convinced of the NAV reporting that is attributed to it, there is a pay off for them. Indirectly we expect the hedge fund industry, the reporting or the comfort in an NAV, can only go up, although no one knows how long that will take.'

Key Points

The fund of hedge fund market has been targeted with this scheme as a quick way of raising capital, while at the same time expanding its investment base.

S&P may not be able to rate the deal unless they contract the fund management out to someone who has an appropriate track record.

This type of asset class may open up the hedge fund market to greater transparency.

As part of the due diligence, S&P are automatically downgrading the historical and estimated returns achieved by the fund.

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