Structured Hedge Fund Products

Traditionally, hedge funds and private equity funds have raised money from the limited universe of equity investors interested in "alternative investments." However, recent financial innovations have given private funds access to the much larger universe of fixed income investors in the capital markets. Structured notes, including "principal protected" offerings, are being used to raise money for many types of hedge funds and, to a lesser extent, private equity funds. Collateralized fund obligations ("CFOs") have emerged as a tool to enable managers to market fund assets to capital markets investors. Structured notes and CFOs are referred to in this article generically as "structured securities."

The advantages of the capital markets for fund sponsors are evident: reduced cost of funds, "locked up" or "sticky" money, term leverage, and access to a new investor base. Not only do structured securities give a fund access to fixed income investors (usually through an investment bank), but they also enable investors to invest indirectly in a fund where there are legal, tax, currency or regulatory barriers to a direct investment in the fund.

To gain access to the capital markets, a fund must issue securities (usually in the form of notes) structured to appeal to fixed income investors, and must satisfy the requirements established by the rating agencies, placement agents, the exchanges and providers of principal protection products.

In a structured note, the payments of principal and interest are referenced to the performance of another investment. A note where the return is determined by reference to the performance of a specified fund would be one type of structured note. A note issued by a Cayman company or trust whose sole asset is an investment in a fund would be another. A trust certificate or trust unit may be issued instead of a structured note.

For an investor that is unable to make an investment directly in an existing fund due to tax, regulatory, accounting, foreign exposure or other concerns, a structured note or trust product can be the solution. In order to accommodate such an investor's needs, a special purpose vehicle ("SPV") could issue to the investor a structured note or trust certificate with a return tied to the fund's performance. Where a group of investors needs to invest in a fund indirectly through a structured note, the SPV issuing the structured note could act as a "feeder" to the fund. In either case, the net proceeds from the sale of the note would go directly or indirectly (through a dealer) to the fund.

The proceeds of a structured note may be invested in a new fund created for this purpose and managed by a manager whose expertise the investors want. Alternatively, the proceeds of the structured note may be invested in a series of existing funds, so that the structured note program operates as a type of "fund of funds." In another variation, the proceeds of the structured note can be used to purchase a portfolio of existing investments in "seasoned" private equity funds, thereby providing liquidity to the owner of the portfolio, or to originate new investments in private equity funds.

For those investors that want protection against the risk of loss of their investment in the fund and, in return, are willing to give up part of the potential "upside" of an investment in a fund, "principal protected" notes (or trust certificates) are available. Principal protection can mean many things: for example, a guaranteed return of the original investment on a specified future date, or a sliding scale which ensures the investor the return of a lower percentage of his original investment if he chooses to withdraw from the fund in early years, rising to 100% at "maturity."

The three most common methods used to provide principal protection to investors in structured notes are:

• The issuer of the structured note may acquire highly rated zero coupon securities which are sufficient to repay 100% of the principal amount of the structured note on the maturity date. The net proceeds of the structured notes are allocated first to purchase the zero coupon securities and then the remainder is invested in the fund, with the result that the investor has an indirect investment in the fund which is much less than his total investment in the structured note.
• A third party (e.g., an insurer, reinsurer, bank, etc.) may act as the "principal protection provider" by agreeing to purchase or repay the structured notes at par on the stated maturity date. Such principal protection may take many forms, including a put option, a "defeasance" swap, an insurance policy, a letter of credit, a guarantee or a guaranteed investment contract.

• Often, a combination of the first two methods is used, so that investors have the benefit of a principal protection agreement with a third party and the investment portfolio consists of a combination of fund investments and zero coupon securities.

As interest has grown in using structured note and trust products to raise money for funds, investment banks have adapted the structures used in the Collateralized Debt Obligation ("CDO") market (described below) to serve this new purpose.

In a typical CDO, an SPV (often, a Bermuda or Cayman company or a Delaware limited liability company or limited partnership) is formed to acquire a portfolio of fixed income assets selected by an investment manager. The SPV finances its portfolio with a combination of risk capital (in the form of equity or deeply subordinated notes) provided by investors, notes sold by a placement agent in the investment grade debt markets and, in some cases, borrowings and commercial paper. In some CDOs the portfolio is fixed at closing, but most CDOs are "blind pools" in which a portion of the portfolio is acquired before the closing (but not disclosed to investors) and the remainder of the portfolio is acquired during a "ramp up" period after the closing.

Traditionally, the investment guidelines for a CDO limited it to one, or some combination, of four basic types of portfolios:

• bank loans
• high yield or investment grade corporate bonds
• asset backed securities
• emerging market debt securities and loans

Recently, many new types of CDO portfolios have been introduced, including, for example, CDOs that hold portfolios of CDO securities, bank capital securities, distressed assets or convertible securities.

One of the distinguishing characteristics of a CDO is that the SPV issues several tranches of senior and subordinated debt securities that are rated by at least one of the rating agencies. The rating usually is based on the investment guidelines of the CDO, the subordination of the "equity" class to the rated notes, and the subordination of mezzanine classes of notes to more senior classes of notes. As a result, a CDO gives a manager access to the investment grade debt market.

Many types of rated debt securities can be issued in a CDO, including term notes, notes with put options, commercial paper, revolving notes, principal protected notes and "combination notes." But the typical CDO security is a term note that bears interest at a fixed rate or at a spread over LIBOR and has no scheduled amortization. Unlike typical investors in a hedge fund, investors who purchase CDO notes often are "locked up" for five years or more. The notes are issued by the SPV under an indenture, with a bank acting as trustee for the noteholders.

A number of new capital markets products have been introduced in 2001 that apply "market value" CDO structures to funds. These new products have come to be known as collateralized fund obligations or CFOs. A market value CDO closely resembles a private investment fund. In a market value CDO, the manager selects a portfolio for the CDO in accordance with detailed guidelines and concentration limitations specified in the indenture. The manager may trade actively, provided that the trading complies with these guidelines and limitations. Typically, the indenture will limit the leverage of the SPV, and require the SPV to maintain minimum levels of overcollateralization (the value of the portfolio in excess of the principal amount of each class of notes issued by the SPV). Hedging and liquidity requirements and duration limitations also may be imposed. The manager may charge fees similar to those in a hedge fund: a management fee based on the value of the portfolio, plus an incentive fee or allocation based on the gain in the portfolio. The CFO is a form of market value CDO in which the SPV issues multiple tranches of rated notes and uses the proceeds to purchase either (1) a portfolio of hedge fund interests or private equity fund interests or (2) an investment in a single hedge fund or a managed account. Many CFOs have provided principal protection for the notes or, if there are multiple classes of notes, the most senior class of notes. However, some recent offerings either do not provide principal protection for the junior class of notes or do not provide such protection for any classes of notes. In CFOs, the typical restrictions and covenants in a market value CDO (including liquidity, overcollateralization and leverage) have been adapted to take into account the characteristics of hedge fund investments or fund of fund investments.

With the growth in structured securities and the recent application of CDO technology to private investment funds, private equity and hedge fund managers have gained access to a new investor base. For managers willing to learn the practices and the jargon of the capital markets, structured notes and CDOs can be used to increase the assets under their management. But these new products are appropriate only for managers that conform their investment and trading guidelines to the requirements of the rating agencies and the principal protection providers and that implement systems and controls to monitor their compliance with these requirements on an ongoing basis.