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Recently, there has been a discussion regarding the rise of collateralized fund obligations (CFOs), which pool together multiple private equity funds and issue securities backed by them. In this post, I summarize my brief investigation of their prevalence, economic motives behind their rise, and future research questions that may be of interest.

The Rise of CFOs

The concept of CFOs is not new; apparently in the early 2000s, there were many products that had hedge funds as their underlying assets.

Structure of CFOs

The structure of CFOs mirrors that of CLOs. Both use a multi-tiered tranche structure to distribute risk and return to investors and rely on a special purpose vehicle (SPV) for tax purposes.

Source: Tavakoli Structured Finance, “Ultimate Leverage: Collateralized Fund Obligations”

Unfortunately, this is a segment of the market that is practically unknown but has growing interest from both investors and regulators.

• In fact, NAIC (a pseudo-regulatory body for U.S. insurance companies) has been working on reform proposal that could reclassify some CFOs from debt to equity (more on that below).

Comparison of the C-Suite

The table below summarizes the comparison of CDOs, CLOs, and CFOs:

Source: My Own Research

• Like CLOs, CFOs feature good diversification (across PE firms, that is) and features partial securitization of the underlying assets, which may alleviate adverse selection problem (Benmelech, Dlugosz, and Ivashina, 2012).