Structured Debt in Private Equity: Rated Feeder Funds and Collateral Fund Obligations

In this article, Dante MARRAMIERO (ESSEC Business School, Master in Strategy and Management of International Business (SMIB), 2022-2023) explains structured debt in Private Equity: Rated Feeder Funds and Collateral Fund Obligations. Such debt products open the market for insurance companies.

Structured Financing for Investment

In the intricate world of finance, innovative structures continually emerge to meet investor demands under the current regulatory framework. Among these structures are Rated Feeder Funds (RNFs) and Collateralized Fund Obligations (CFOs), which facilitate investments for investors with specific investment criteria. This happens particularly with insurance companies and asset managers, to access private equity or alternative strategy funds such as growth funds or private credit funds through rated debt instruments. However, structures like RNFs and CFOs are not without their complexities and regulatory scrutiny, especially in light of historical parallels to Collateralized Debt Obligations (CDOs) and the financial crisis of 2008. CFOs and CDOs have exactly the same structure but have different underlying assets: CDOs are based on debt, specifically mortgages while CFOs are based on Private Equity funds.

The two figures below represent the financial structure of RNFs and CFOs.

Figure 1. Financial structure of an RNF.

Source: the author.

Figure 2. Financial structure of a CFO.

Source: the author.

Rated Feeder Funds (RNFs) and Collateral Fund Obligations (CFOs) thus represent innovative approaches to structured financing, aiming to bridge the gap between investors and private equity or alternative strategy funds.

Why are CFOs and RNFs attracting insurance companies?

CFOs and RNFs are both characterized by a blend of debt and equity components. These vehicles raise capital by issuing debt securities, which are then used to invest in a diversified portfolio of assets across multiple funds. The presence of both debt and equity elements not only provides investors with exposure to various underlying assets (in which the various funds have invested) but also introduces a diversification effect that can attract capital seeking lower risk profiles. The debt issued by CFOs typically undergoes scrutiny by rating agencies to determine their creditworthiness, thereby providing assurance to investors regarding the quality of the investment.

On the other hand, RNFs operate through a structure where investors’ capital is channeled through a special purpose vehicle (SPV) or feeder fund. This feeder fund then invests in a master fund managed by the sponsor. This setup allows investors to gain exposure to the underlying assets of the master fund without directly participating in its operations. RNFs, similar to CFOs, offer rated debt instruments to investors, providing them with a regulated and transparent avenue to access private fund investments.

Regulatory Considerations and Risk Mitigation

One of the key attractions of RNFs and CFOs is the regulatory capital treatment they offer to institutional investors. By investing through rated debt instruments, regulated institutions such as insurance companies can benefit from reduced capital requirements compared to direct equity investments in underlying funds.

However, regulatory scrutiny is a critical aspect of these structures, particularly in jurisdictions like the United States and Europe. In the US, concerns have been raised regarding the applicability of risk retention rules, especially in CFO transactions where repayment primarily depends on limited partnership interests. Similarly, European regulations such as the UK and EU Securitization Regulations impose stringent requirements.

In the US, currently, the NAIC – National Association of Insurance Commissioners has blocked investments from insurance companies in CFOs but is working on possible ways to regulate the market and open the investment again in the future.

Conclusion: Balancing Innovation with Regulatory Compliance

Rated Feeder Funds (RNFs) and Collateral Fund Obligations (CFOs) represent innovative solutions for investors seeking exposure to private funds while optimizing regulatory capital requirements. However, their structural complexities and regulatory scrutiny, particularly in the aftermath of the 2008 financial crisis, underscore the importance of due diligence and compliance.

As financial markets evolve, the challenge lies in striking a balance between innovation and regulatory compliance. While RNFs and CFOs offer opportunities for capital efficiency and investment diversification, they must navigate a complex regulatory landscape to ensure stability and mitigate systemic risks. Only through careful consideration of lessons from history and adherence to regulatory guidelines can these structured financing solutions fulfill their promise in the modern financial ecosystem.

Example of precedent transaction: Tikehau raise a $300 million CFO

Tikehau Capital has raised $300 million collateralized fund obligation backed by cashflows from commitments to its direct lending and private debt secondary strategies. The CFO’s assets consisted of interests in Tikehau’s own debt funds as well as third-party managed private debt funds originated by the firm’s private debt secondaries strategy, according to a statement from Jefferies, which advised on the transaction.

Specifically, the CFO assets were largely Tikehau-managed funds: the direct lending and private debt secondaries which were held on the firm’s balance sheet. This transaction allowed Tikehau to raise capital from the big American insurance companies that otherwise would have considered investing in Tikehau’s funds as out of scope.

Why should I be interested in this post?

This post could be particularly intriguing for business students because it highlights diverse methods of fundraising within the private equity sector. This knowledge could benefit students aiming for careers in finance and those seeking to secure funding for their own ventures. Moreover, it provides valuable insights into the pivotal role that debt plays in financing strategies. Furthermore, it could be a good competitive advantage during Private Equity interviews to know about structured finance as it is an emerging topic in the Private Equity industry and not everyone is up to date with it!

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   ▶ Colombe BOITEUX Le métier de structureur

   ▶ Matisse FOY Key participants in the Private Equity ecosystem

   ▶ Lilian BALLOIS Discovering Private Equity: Behind the Scenes of Fund Strategies

   ▶ Alessandro MARRAS Top 5 Private Equity firms

Useful resources

Hanson R. (08/11/2023) Collateralised fund obligations and rated note feeders: options for structuring investment into private funds Morgan Lewis

Cadwalader Brief Primer on CFOs and Rated Feeder Funds

About the author

The article was written in May 2024 by Dante MARRAMIERO (ESSEC Business School, Master in Strategy and Management of International Business (SMIB), 2022-2023).

Private Equity and Italy, is it a nice combination?

In this article, Dante MARRAMIERO (ESSEC Business School, Master in Strategy and Management of International Business (SMIB), 2022-2024) explains about the peculiar situation of the Italian Private Equity market.

Italian conservative market is now opening up

Italy’s family-owned enterprises, steeped in tradition yet poised for transformation, stand at a crossroads of opportunity. For decades, these businesses have been the backbone of the country’s economy, rooted in principles of heritage and resilience. Yet, as the global marketplace evolves, so too must they. Enter private equity – once a distant concept, now a beacon of possibility, offering two distinct paths for growth: co-investment and external capital infusion.

As previously mentioned, family businesses dominate the Italian economy, with around 784,000 companies (nearly 85%) being family-owned according to AIDAF, the Italian Association of Family Businesses. These small and medium-sized enterprises are mainly active in sectors like fashion, mechanical engineering, and food, producing high-quality “Made in Italy” products.

One driver for ownership changes in Italian family businesses is succession planning, as many seek external capital to finance growth, international expansion, technology investments or innovations due to being undercapitalized. Private equity funds have stepped in to provide this capital, with Italy being one of Europe’s most mature private equity markets. As a confirmation of this, annual private equity investments in Italy correspond to around 0.36% of GDP, on par with Germany but lower than the UK, Netherlands, and France.

Key target sectors for Italian private equity include IT/communications and industrial goods. Around 14% of Italian family office assets are invested in private equity, with surveys suggesting most intend to increase these allocations. What could make the difference for the future is that younger generations of Italian wealth holders are expected to further drive family office investments into private equity and venture capital, being more interested in backing early-stage businesses, especially in technology. Their international outlook and experience abroad are also influencing asset allocation decisions.

Co-Investment: Fostering Collaboration for Shared Success

Traditionally, family businesses have been hesitant to engage with private equity, wary of relinquishing control and diluting their legacy. However, a paradigm shift is underway as a new wave of private equity firms sets its sights on these familial enterprises, offering tailored solutions to suit their diverse needs.

Co-investment, as mentioned earlier, represents one avenue for growth. Through co-investment, family businesses can partner with private equity firms to pursue inorganic growth opportunities while retaining operational control. This collaborative approach allows for shared risk and rewards, leveraging the strengths of both parties to unlock new synergies and market opportunities.

External Capital Infusion: Embracing Change for Accelerated Growth

Yet, co-investment is not the only path forward. Another emerging trend in Italy’s business landscape is the willingness of family businesses to open their doors to external capital funding, including partial divestment to private equity firms. While this option may involve ceding a degree of ownership and autonomy, it also presents an opportunity to access significant capital infusion and strategic guidance.

The decision between co-investment and external capital infusion is not a one-size-fits-all proposition. Each option carries its own set of benefits and considerations, depending on the unique circumstances and aspirations of the family business in question. Some may find co-investment to be a more palatable approach, allowing them to maintain a greater degree of control over their operations. Others may see external capital infusion as a means to accelerate growth and access new markets.

The Role of Family Offices

Integral to navigating these choices is the role of the family office – a trusted advisor tasked with safeguarding the financial interests of affluent families. Whether pursuing co-investment or external capital infusion, family offices play a crucial role in guiding decision-making and ensuring alignment with long-term goals.

As Italy’s family businesses chart a course toward the future, the convergence of private equity and family offices offers a wealth of opportunities for growth and revitalization. By embracing both co-investment and external capital infusion, these enterprises can leverage the strengths of private equity partnerships while preserving their unique identities and legacies.

Conclusion: Two Paths, One Destination

In conclusion, the dual paths of co-investment and external capital infusion represent two sides of the same coin for Italy’s family businesses. By carefully weighing the options and leveraging the expertise of family offices, these enterprises can navigate the complexities of modern business and chart a course towards sustainable success in an ever-changing world.

Why should I be interested in this post?

This post presents a valuable opportunity to better understand the unique characteristics of the Italian market, predominantly driven by family businesses, and to explore its evolving landscape as it embraces a new business paradigm: Private Equity. Studying this transition offers insights not only for academic enrichment but also for future career prospects in Private Equity. Understanding how Italy’s traditional family business-dominated market is adapting to and integrating Private Equity opens doors for both educational exploration and potential professional paths in this sector.

Related posts on the SimTrade blog

   ▶ Hélène VAGUET-AUBERT Private banking: evolving in a challenging environment

   ▶ Louis DETALLE A quick presentation of the Private Equity field…

   ▶ Lilian BALLOIS Discovering Private Equity.

   ▶ Matisse FOY Key participants in the Private Equity ecosystem

Useful resources

Bocconi Student Private Equity Club (2024) Overview: The Private Equity Market in Italy over the last 20 years

Deutsche Bateiligungus AG (2023) Private equity in Italy – an undervalued market

FamilyCapital (2020) The big private equity groups backed by families

AltiGlobal (2023) Italy’s next generation of wealth holders step up to grow family wealth while they wait for senior leadership roles

About the author

The article was written in May 2024 by Dante MARRAMIERO (ESSEC Business School, Master in Strategy and Management of International Business (SMIB), 2022-2024)

Discovering Private Equity: Behind the Scenes of Fund Strategies

In this article, Lilian BALLOIS (ESSEC Business School, Bachelor in Business Administration (BBA), 2019-2023) explains about Private Equity fund strategies.

Reminder: What is Private Equity?

Private Equity entails investors directing capital into privately held enterprises that are not publicly traded on stock exchanges. Private Equity firms manage investors’ funds, which are utilized to secure ownership stakes in these companies, fostering their growth, innovation, or resolution of financial challenges. In exchange, investors anticipate yielding profits upon exiting the investment, typically within a span of 5 to 8 years.

Private equity thus offers a way for companies to receive strategic financing and for investors to earn returns on their investments, in an alternative way to traditional investments.

But how do you know which funds to invest in?

Decoding Success: How to choose the perfect Private Equity Investment Strategy

Aligning Investments with the Company Lifecycle

Private equity investments are aligned with various stages of a company’s lifecycle (Cf. chart below). In the early stages, venture capital provides funding for startups to assist in innovation and growth. As companies mature, growth equity offers expansion capital to fuel further development and market penetration. In the maturity stage, private equity often engages in leveraged buyouts (LBOs) to acquire established companies, implementing operational enhancements and strategic changes to boost efficiency and profitability. Finally, distressed capital may be deployed to support struggling businesses, offering resources and expertise to facilitate turnaround efforts.

Company life cycle.

Source: The author

Venture Capital: at the Introduction Phase

Venture Capital is a private equity and financing approach focused on supporting early-stage startups and high-potential businesses. Investors, including affluent individuals, investment banks, and angel investors, contribute funds to fuel the growth of these companies. Apart from monetary contributions, investors may also offer technical or managerial expertise. An illustrative example of Venture Capital at work is Uber, which in 2010 received its initial major funding of $1.3 million led by First Round Capital. Shortly after, in early 2011, it raised $11 million in a Series A funding round led by Benchmark. With these funds, Uber expanded its operations to various cities in the United States and abroad, including Paris, where the concept originated. By December of 2011, Uber secured $37 million in Series B financing from Menlo Ventures, Jeff Bezos, and Goldman Sachs, further fuelling its global expansion and technological advancements.

Growth Equity: at the Growth Phase

Growth equity is a less speculative form of financing, aids companies in their expansion phase. Unlike venture capital, growth equity is directed at already profitable and mature businesses with minimal debt. This type of funding, commonly involving minority ownership through preferred shares, facilitates strategic business growth, such as entering new markets or acquiring other companies, with a balanced risk-return profile. Adyen, a prime example, initially self-funded, but experienced exponential growth after securing $250M in Series B funding led by General Atlantic in 2014. This injection of capital significantly accelerated Adyen’s trajectory, leading to its successful IPO on Euronext in June 2018, with a market capitalization of €7.1B. Adyen’s subsequent revenue surge to €721.7 million in 2022 further underscores the potency of growth equity in fuelling sustained business growth.

Leveraged Buyouts & Management Buyouts: during the Maturity Phase

Leveraged Buyouts

Leveraged Buyouts (LBOs) funds combine investment funds with borrowed capital to acquire companies, aiming to enhance profitability. By leveraging creditors’ and investors’ money, the fund manager has more capital to purchase larger companies, either outright or by securing a majority stake for strategic control. The term “leveraged buyout” reflects the use of borrowed funds to afford larger acquisitions, potentially resulting in substantial returns if the strategies pay off. An instance of an LBO is Elon Musk’s acquisition of Twitter, Inc. Despite initial resistance from Twitter’s board, who employed a “poison pill” strategy to deter hostile takeovers, Musk’s persistent pursuit led to the acceptance of his buyout offer of $44 billion on April 25.

Management Buyouts

Management Buyouts (MBOs) are transactions in which the existing management team of a company acquires a significant ownership stake or complete ownership of a business. In a MBO, the current managers collaborate with a private equity firm to purchase the business from its existing owners. This transaction is common when a company’s management team believes they can run the business more effectively or exploit growth opportunities better than the current ownership structure allows. The MBO of Dell Inc. in 2013 stands out as one of the largest and most significant in history. With a valuation reaching approximately $24.9 billion. The company’s founder, Michael Dell, partnered with Silver Lake Partners to reclaim control of the company he had founded. The move allowed Dell to implement long-term strategies and make pivotal decisions without the immediate pressures of quarterly earnings reports, facilitating a more nimble and adaptable approach to the rapidly evolving tech landscape.

Distressed Capital: at the Decline Phase

Distressed capital consists in lending to companies facing financial crises and to take control of businesses during bankruptcy or restructuring processes. The strategy involves purchasing distressed companies at a lower price, turn them around, and eventually sell them. Distressed capital carries inherent risk due to investing in financially challenged companies. For example, in May 2020, Hertz Global Holdings, filed for Chapter 11 bankruptcy due to the impact of the COVID-19 pandemic on its business, which saw a significant decline in travel demand. During its bankruptcy proceedings, Hertz secured funding from distressed debt investors to support their operations and restructuring efforts. This financing came from a consortium of lenders and institutional investors, providing Hertz with the liquidity needed to continue operations, pay essential expenses, and navigate the bankruptcy process.

Timeless Investing: Optimizing Portfolios through Vintage Year Diversity

What are “Vintage Years”?

“Vintage years” refer to specific time periods during which a fund was raised or initiated. Each vintage year represents a cohort of funds that were raised and deployed within a similar timeframe. These vintage years are often used by investors and analysts to track the performance of funds over time, as funds raised in the same vintage year may encounter similar market conditions and economic environments, which can affect their overall performance and returns.

Mitigating market cycles

Private equity has demonstrated superior performance compared to public equity throughout market cycles. However, returns are subject to fluctuations based on the phase of the business cycle. For instance, if a fund initiates investments during a downturn, it is likely to encounter a broader array of distressed and undervalued assets, with the potential for profitable exits when the market peaks. Conversely, a fund entering the market at its highpoint may face challenges as assets are likely to be expensive and may risk undervaluation upon entering public markets during the exit phase.

Given the unpredictability of market timing, diversification across vintages serves as a strategic approach to dampen this cyclical risk. This approach aims to create a more stable return profile that mirrors the overall characteristics of the asset class.

Establishing a self-sustaining portfolio

Company life cycle.

Source: The author

As written above, funds can diversify through various vintages. This strategy allows to generate returns from an earlier vintage, which are reinvested as commitments for a subsequent vintage. In doing so, a self-funding portfolio is cultivated, steadily appreciating in value over time.

Exploring Sectors of Private Equity Investments

In 2023, technology continued to lead private equity investments, capturing a significant 31% share of total investments. Cloud-related ventures, especially enterprise Software as a Service (SaaS), remained appealing, fueled by expectations of sustained growth. Additionally, the rapid adoption of machine learning, driven by global enterprises integrating generative Artificial Intelligence (GenAI) into operations, signaled a broader trend towards innovation.

Consumer-focused investments, accounting for 14% of total investments, saw a focus on low-risk ventures in the food and agribusiness sector. Sustainable farming, combined agriculture, and timber ventures stood out, driven by increasing emphasis on environmental sustainability and responsible resource management.

In addition, financial services (11%) and health sectors (9%) saw significant private equity activity. In finance, investments spanned various subsectors, reflecting a pursuit of diverse opportunities. Meanwhile, health sector niches like enterprise imaging solutions and voice-based diagnostics attracted attention, driven by innovation in medical technology platforms, highlighting the sector’s transformative potential.

Company life cycle.

Source: Moonfare

The private equity landscape in 2023 featured a diverse range of investment opportunities, with technology dominating while consumer, financial services, and health sectors also drew significant interest, providing distinct pathways for growth and value generation.

Why should I be interested in this post?

This post offers a comprehensive overview of private equity investing. It defines private equity and explores various investment strategies such as venture capital, growth equity, leveraged buyouts, management buyouts, and distressed capital, providing practical insights into their roles at different stages of a company’s lifecycle. Additionally, the post discusses the concept of vintage years and their significance in tracking fund performance over time, highlighting the importance of portfolio diversification and risk management.

Related posts on the SimTrade blog

   ▶ Louis DETALLE A quick presentation of the Private Equity field…

   ▶ Louis DETALLE A quick review of the Growth Capital…

   ▶ Louis DETALLE A quick review of the Venture Capitalist’s job…

   ▶ Matisse FOY Key participants in the Private Equity ecosystem

   ▶ Marie POFF Film analysis: The Wolf of Wall Street

Useful resources

Academic References

Martin, J. and R. Manac (2022) Varieties of funds and performance: the case of private equity, The European Journal of Finance, 28(18) 1819–1866.

EVCA (2007) Guide on Private Equity and Venture Capital for Entrepreneurs

Caselli, S. and M. Zava (2022) Private Equity and Venture Capital Markets in Europe

Specialized Press

Investment Strategies in private equity

Barber F. and M. Goold (2023) The strategic secret of private equity Harvard Business Review

Private Equity Pulse: key takeaways from Q4 2023

Financial Times Private Equity

Wall Street Journal Private Equity

About the author

The article was written in February 2024 by Lilian BALLOIS (ESSEC Business School, Bachelor in Business Administration (BBA), 2019-2023).

Key participants in the Private Equity ecosystem

In this article, Matisse FOY (ESSEC Business School, Bachelor in Business Administration (BBA), 2019-2023) explains who the key participants in Private Equity (PE) are, and what are their role in the PE ecosystem.

Private Equity is an increasingly important model of financing for companies at different scales. Whether you’re simply interested in the subject or want to find a professional experience, here is a list of the main participants in the PE ecosystem and their function.

Key participants in the Private Equity ecosystem

Source: production by the author

A glossary of the participants

Private Equity funds

PE funds are the central actors in the private equity ecosystem, pooling capital from various sources (mainly from Limited Partners and Investment Banks) and invest this money in private companies, meaning companies whose shares cannot be freely bought and sold on the stock market.

The employees of PE funds are responsible for sourcing, evaluating, and managing investments in “Portfolio Companies”.

Their objective is to enhance the performance of those Portfolio Companies. By doing so, they aim to sell these firms later and generate profit. This profit is primarily derived from the investment capital provided by their investors, from which they take a percentage as their fee.

General Partners (GPs)

These are the managers of the PE fund who make the investment decisions. They have a fiduciary duty to act in the best interest of the LPs.

GPs are typically compensated through a management fee, which is a fixed annual fee for the fund’s operation, and a performance fee (also known as “carry”), which is a percentage of the profits of the fund.

Limited Partners (LP)

Limited Partners are the investors in a PE fund. They include institutional investors like pension funds, university endowments (like Harvard University endowment), insurance companies (e.g., AXA, Allianz), and sovereign wealth funds, as well as high net worth individuals.

Limited Partners provide the capital that the PE funds invest and expect a return on their investment.

Portfolio Companies

Portfolio Companies are the companies in which PE funds invest. They are often in need of capital for growth, restructuring, or as part of a strategy to transition the company from public to private.

The goal of PE funds is to take a share in these companies, improve their performance and sell them for a profit.

Investment Banks

Investment Banks often play a crucial role in the PE ecosystem, especially with regards to the acquisition and sale of portfolio companies by PE funds. They can help PE funds identify potential investment opportunities, facilitate transactions, and provide financing by leveraging Limited Partners’ equity. Moreover, they can help portfolio companies go public when they are sold.

Law Firms and Consultants

These professional service providers support PE funds throughout the investment process:

• Law firms help with legal aspects of transactions, including drafting and reviewing contracts, to ensure compliance with relevant laws and regulations, and advising on the structure of deals to minimize legal risks and tax liabilities.
• Consultants, on the other hand, assist with due diligence and the development of strategies for improving the performance of portfolio companies. They might also be delegated the sourcing and contact with portfolio companies by PE funds.

Regulators

Regulators oversee and govern the operations of PE funds. They aim to protect the interests of investors and the integrity of the financial markets, in order for the local environment to be as attractive to invest in as possible.

Why should I be interested in this post?

Private Equity is a wide ecosystem. Knowing about its different participants is very important when deciding to work in one of them, in order to understand their importance (who knows, maybe you will be asked questions about these actors will be asked to you in your next interview).

Related posts on the SimTrade blog

   ▶ Louis DETALLE A quick review of the Venture Capitalist’s job…

   ▶ Louis DETALLE A quick presentation of the Private Equity field…

   ▶ Anna BARBERO Career in Finance

Useful resources

The Financial Times Private Equity

Wall Street Journal Private Equity

Coursera’s MOOC Private Equity and Venture Capital

About the author

The article was written in May 2023 by Matisse FOY (ESSEC Business School, Bachelor in Business Administration (BBA), 2019-2023).