Anxious to unload some of the burden of their private equity investments, banking companies are looking into packaging them in collateralized debt obligations as an alternative to selling stakes of their portfolios directly to secondary buyers.
Interest in CDOs, a type of credit derivative that has grown popular with fixed-income buyers, has been gaining as scores of high-risk private equity investments go sour, dragging down the profitability of private equity units. Also, the Federal Reserve raised its capital requirements for banks that make investments in nonfinancial companies, making some banks eager to reduce their exposure.
Within the past two and a half years a handful of private equity CDO deals have entered the nascent market. They include a $700 million CDO called Princess Private Equity Holding Ltd. and $576 million Pearl Holding Ltd.; $132 million Prime Edge Capital Private Equity; and most recently Aon Corp.s Private Equity Partnership Structures I LLC deal, which was reportedly $450 million and closed at the end of last year.
Banks, insurance companies, and pension funds sell private equity interests to free up capital to make new investments. The secondary market for these is small dominated by a handful of active investment firms and illiquid at times.
In contrast, CDOs attract a wider array of institutional buyers, including pension funds, insurance companies, high-net-worth individuals, and hedge funds. Another benefit is that collateralization allows the seller to retain some ownership interest.
Some players have stumbled with CDOs. J.P. Morgan Chase & Co. attempted to shed some of its private equity holdings at the beginning of last year through a CDO called Porter Global Private Equity Ltd., but the deal fell apart after about four months on the market. Morgan Chase declined to discuss Porter, but according to market participants, investors gave the deal expected to total between $600 million and $800 million a cool reception, considering it too complicated.
Almost all of the private equity CDOs that have been arranged so far have been placed in Europe, but industry experts said they are sensing more interest among U.S. banks, particularly those forced to pony up more capital to meet the Feds new requirements.
There will be transactions done to ease regulatory capital before the end of the year, said Jeffrey DSouza, a managing director of global credit derivatives at Deutsche Banks London office who helps put together CDO deals.
Several investment banks are believed to be in serious conversations with clients about collateralizing private equity portfolios, according to market participants. A number of our clients are talking about doing private equity CDOs, said J. Paul Forrester, a partner in Chicago with the Mayer, Brown, Rowe & Maw law firm. A lot of people are interested in it. A lot of people are talking about it.
Eric Green, a partner at J.P. Morgan Partners who would not talk about the Porter deal specifically, compares the private equity CDO market to the loan and bond securitization markets of the early 1990s. I would say we are sort of in the science-experiment phase of private equity securitization, he said; bankers are playing with a variety of structures to see what will work.
The experimental nature of the new market was evident last year, when Morgan Chase failed to drum up interest. Investors have said they were skeptical of the deal because the company did not clearly align its interests with theirs by committing itself up front to retaining some equity.
Morgan Chase trotted the opportunity past potential buyers during last years first quarter and part of the second, but market factors spooked investors: Halfway through the marketing process reports surfaced that the private equity market would face negative returns.
Last July Morgan Chase announced a 77% decline in second-quarter profits, largely due to unexpectedly large writedowns in its private equity portfolio. By that time the company had already pulled the Porter deal from the market.
Building up the private equity CDO market could be tricky. Mark Adelson, a director and head of structured finance research at Nomura Securities International Inc., said that it may be harder to securitize private equity holdings than credit card or commercial paper receivables, because venture and buyout investments have speculative cash flows. The more predictable the cash flow, the better securitization works, Mr. Adelson said.
Consistency would get the market more traction, Mr. Green said. Securitization of private equity will be an important part of the landscape of how private equity funds get financed, just like its been in the loan market and high-yield market, he said.
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