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Executive Summary
Collateralized fund obligations (“CFOs”) have garnered
attention recently, becoming increasingly popular within the fund
finance market as a way to generate liquidity. CFOs have several
benefits, as we explained in a previous Legal Update, but that does not mean they are
not without risks or complications. In this Legal Update, we share
some of the considerations for fund general partners and limited
partners when engaging in a CFO transaction.
Background
Collateralized fund obligations (“CFOs”) have garnered
attention recently as they gain popularity within the fund finance
market as a way to generate liquidity. A fund
sponsor—typically the general partner (“GP”) of a
fund—can bundle various fund interests and raise capital by
using them as collateral without selling the fund interests to
third parties. Limited partner (“LP”) investors are also
attracted to CFOs because the vehicle provides access to a bundled
pool of investments with an enhanced credit rating and can also be
used to manage market volatility in existing portfolios of private
equity exposures.
What GPs and LPs Need to Know
What Are Considerations for GPs?
- Does the transaction’s timing align with the
required representations? Fund LPs (including the CFO
Issuer or its subsidiary) must make various representations
regarding compliance with securities laws, anti-money laundering
laws, and Know-Your-Client standards. However, CFOs may not have
the status to make certain of these representations until the CFO
has issued funded liabilities or has acquired the LP interests, so
the timing of these representations by the CFO Issuer or its
subsidiary should be considered to confirm that they are accurate
when made. - Are subscription credit facilities involved?
If the underlying funds do not have subscription lines in place to
cover capital calls, the GP should consider requiring LPs
transferring their interests to agree that they will cover any
defaults of the new LPs to meet capital call obligations. On the
other hand, if there is a subscription line in place and the
original LP was part of the fund’s borrowing base, the GP
should provide the subscription credit lender with sufficient
advance notice of the transfer to assess any impact on the
borrowing base. - Has tax counsel been consulted? Each
underlying fund’s tax counsel should assess the implications of
any change of location of the LP holder that may be effected by a
transfer of the LP interest to the CFO Issuer or its subsidiary, if
the LP interest is currently held by a different investor.
What Are Considerations for Fund LPs?
- Has the transferring LP obtained the GP’s
consent? The GP must consent to transfer an LP’s
interest in the fund. Due to confidentiality provisions in the
underlying fund, the GP will likely require the LP to sign a
non-disclosure agreement before consenting. The LP should allow
ample time to work through any issues with the GP and obtain the
GP’s consent for the LP to transfer their interest to the CFO
Issuer. - Does the CFO transaction’s timing align with the
underlying fund’s timing requirements? Fund agreements
often provide that LP interest transfers can only take effect at
specified times during the year, whether quarterly, bi-annually, or
annually. The LP should ensure that the timing of the CFO closing
or portfolio accumulation aligns with these parameters on the
timing of transfers. - Has the LP complied with the provisions of the fund
documentation? To transfer the LP interest to the CFO
Issuer, the LP must comply with the terms of the fund’s
governing documents, including tax, securities, anti-money
laundering, and Know-Your-Client requirements. Accordingly, LPs
should confirm access to and compliance with these fund
documents. - Has the LP considered the costs involved? Each
transfer of an LP interest will result in legal expenses in
addition to the cost of the CFO transaction itself. In addition,
transaction counsel for the various CFO parties will generate legal
expenses.
Next Steps: What Do We Expect for CFOs?
Investors will continue to be motivated by the higher interest
rates offered by CFO notes over traditional securitizations and the
optimistic returns on equity investments. Investors, funds, and
portfolio companies are all drawn to the enhanced flexibility and
customized options that CFOs offer.
We anticipate that as investors become increasingly comfortable
with these vehicles, CFOs will gain popularity as a source of
liquidity in the fund finance market. For additional information on
CFOs, you can read the following legal updates:
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Mayer Brown article provides information and comments on legal
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