S&P moves to rate hedge fund of funds

International rating agency Standard & Poor’s (S&P) has started to develop ratings criteria for securitisations of hedge fund of funds, due to growing interest in the past year from structured finance teams at investment banks.

Similar to market value collateralised debt obligations (CDOs), which issue debt and equity based on a portfolio of bonds or loans managed to specified guidelines, hedge fund of fund CDO securities issues are based on a portfolio of hedge fund investments, and the “credit enhancement” of a market value CDO provided by the equity holders in a fund of funds.

Equity holders in a hedge fund of funds win from appreciation in the total asset value of the portfolio, while hedge fund of funds CDO bondholders receive coupons from those funds in the portfolio that pay dividends. At least a half dozen hedge fund of fund securitisations are under review, said Standard & Poor’s, with the first rated issue likely by the end of the year.

Traditionally, hedge funds have raised capital through equity investment by wealthy individuals and institutional investors looking for portfolio diversification. For debt-finance capital, only short-term loan commitments, perhaps 30 days in length, have been available. With securitisation, hedge funds can obtain capital on a longer-term basis – up to 12 years – at a fixed rate. Of further advantage to capital-hungry hedge funds, in contrast to loan financing, securitisation capital is non-recourse.

The down side to securitisation capital for hedge fund of fund managers is loss of some flexibility in their investment approach by guidelines set at the time of a securitisation issue. Such guidelines would be concerned with maintenance of broadly distributing capital among numerous funds, and diversification by hedge fund investment style, industry and geographic concentration.

Investment banks are expected to take a strong role in hedge fund of fund securitisations. Jeffery D’Souza, head of Deutsche Bank’s structured products origination and distribution in Europe, said banks will gain from new securitisation deals through fee income for note placement. “The process is really driven by the distribution,” said D’Souza, who added that European investors interested in protecting principal invested in hedge funds typically use products combining the features of zero coupon bonds and equity.

D’Souza calls securitisations the next level of innovation. “It's hard to say how quickly the business will grow,” he said, citing caution after the September 11 terrorist attacks in the US. “The market is very exploratory right now,” he says.

The availability of hedge fund of fund securities is expected to widen the range of investors in the asset class. Institutional investors may be deterred from hedge fund investing by the liquidity risk posed by the minimum investment periods of a year or more required by many hedge fund managers. Other institutional investors who are restricted from hedge fund equity investment altogether would be able to gain exposure to the asset class for the first time with securitisations of hedge fund of fund.

Standard & Poor’s said it would continue to probe the ongoing securitisation potential of the hedge fund market, whose size it estimates at $300 billion. Standard & Poor’s is not the first to recognise the importance of the market, claimed Roger Merritt, managing director of the credit products group at debt rating agency Fitch IBCA, Duff & Phelps in New York. Merritt said Fitch has covered a handful of hedge fund of fund CDOs.

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